-----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, GlONRrAJWMbspEFZgqr/h5whFQqC4TWlVk0efNWVF7fY+lwOiVhHCwfUlRZYn4Fx B2HakvuhQT7Y3U42YaRcDg== 0000891836-98-000239.txt : 19980427 0000891836-98-000239.hdr.sgml : 19980427 ACCESSION NUMBER: 0000891836-98-000239 CONFORMED SUBMISSION TYPE: 8-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19980423 ITEM INFORMATION: ITEM INFORMATION: FILED AS OF DATE: 19980424 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: ST PAUL COMPANIES INC /MN/ CENTRAL INDEX KEY: 0000086312 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 410518860 STATE OF INCORPORATION: MN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 8-K SEC ACT: SEC FILE NUMBER: 001-10898 FILM NUMBER: 98600554 BUSINESS ADDRESS: STREET 1: 385 WASHINGTON ST CITY: SAINT PAUL STATE: MN ZIP: 55102 BUSINESS PHONE: 6122217911 FORMER COMPANY: FORMER CONFORMED NAME: SAINT PAUL COMPANIES INC DATE OF NAME CHANGE: 19900730 8-K 1 FORM 8-K SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 8-K CURRENT REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Date of Report (Date of earliest event reported): April 24, 1998 THE ST. PAUL COMPANIES, INC. (Exact name of registrant as specified in its charter) MINNESOTA 0-3021 41-0518860 (State or other jurisdiction (Commission (IRS Employer of incorporation) File Number) Identification No.) 385 Washington Street St. Paul, Minnesota 55102 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (612) 310-7911 N/A (Former name or former address, if changed since last report) ITEM 1. NOT APPLICABLE. ITEM 2. ACQUISITION OR DISPOSITION OF ASSETS. On April 24, 1998, USF&G Corporation, a Maryland corporation ("USF&G") became a wholly owned subsidiary of The St. Paul Companies, Inc., a Minnesota corporation ("St. Paul"), upon the consummation of the merger (the "Merger") of SP Merger Corporation, a Maryland corporation and a wholly owned subsidiary of St. Paul ("Merger Sub"), with and into USF&G in accordance with the terms of the Agreement and Plan of Merger, dated as of January 19, 1998, as amended (the "Merger Agreement"), among USF&G, St. Paul and Merger Sub. At the effective time of the Merger, each share of common stock, par value $2.50 per share ("Shares"), of USF&G issued and outstanding immediately prior to the effective time of the Merger (other than Shares owned by St. Paul, USF&G or any of their respective direct or indirect subsidiaries (and in each case not held on behalf of third parties)) was converted into the right to receive 0.2821 shares of common stock, no par value ("St. Paul Common Stock"), of St. Paul (the "Exchange Ratio"). The Exchange Ratio was determined pursuant to a formula set forth in the Merger Agreement and was a result of arms' length negotiations between the parties. No fractional shares of St. Paul Common Stock are being issued as a result of the Merger. Instead, each holder of Shares who would otherwise be entitled to receive a fractional share of St. Paul Common Stock will receive such holder's proportionate interest in the net proceeds from the sale by First Chicago Trust Company, as Exchange Agent, on behalf of such holders of the fractional shares of St. Paul Common Stock that such holders would otherwise be entitled to receive. Based on 117,846,687, the number of outstanding Shares as of April 22, 1998 as reflected on the stock transfer books of USF&G, St. Paul estimates that it will issue approximately 33,244,550 shares of St. Paul Common Stock pursuant to the Merger. St. Paul currently intends to continue to use USF&G's plant, equipment and other physical property to conduct insurance operations as it further develops and implements its integration strategy. Pursuant to the Merger Agreement, the Company intends to expand its board of directors to 16, and to elect Norman P. Blake, Jr. and two other members of the pre-merger board of directors of USF&G, to the board of directors of the Company. Such expansion of the board and election of directors is expected to take place shortly after the Company's Annual Meeting of Shareholders, which is scheduled to be held on May 5, 1998. ITEMS 3-6. NOT APPLICABLE. -2- ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITS. (a) Financial Statements of Businesses Acquired. Copies of the USF&G Corporation historical financial statements as of December 31, 1997 and 1996 and for the years ended December 31, 1997, 1996 and 1995 are attached hereto as Exhibit 99.2 and incorporated herein by reference. (b) Pro Forma Financial Information. Copies of The St. Paul Companies, Inc. and USF&G Corporation unaudited pro forma condensed combined balance sheet as of December 31, 1997, and unaudited pro forma condensed combined statements of income for the years ended December 31, 1997, 1996 and 1995 are attached hereto as Exhibit 99.3 and incorporated herein by reference. (c) Exhibits. 23. Consent of Ernst & Young LLP 99.1 Press Release of The St. Paul Companies, Inc., dated April 24, 1998. 99.2 USF&G Corporation historical financial statements as of December 31, 1997 and 1996 and for the years ended December 31, 1997, 1996 and 1995. 99.3 The St. Paul Companies, Inc. and USF&G Corporation unaudited pro forma condensed combined balance sheet as of December 31, 1997, and unaudited pro forma condensed combined statements of income for the years ended December 31, 1997, 1996 and 1995. ITEM 8. NOT APPLICABLE. -3- SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. THE ST. PAUL COMPANIES, INC. Date: April 24, 1998 By: /s/ Bruce A. Backberg ------------------------------------- Name: Bruce A. Backberg Title: Senior Vice President and Chief Legal Counsel -4- EXHIBIT INDEX EXHIBIT NO. DESCRIPTION - ----------- ----------- 23. Consent of Ernst & Young LLP 99.1 Press Release of The St. Paul Companies, Inc., dated April 24, 1998. 99.2 USF&G Corporation historical financial statements as of December 31, 1997 and 1996 and for the years ended December 31, 1997, 1996 and 1995. 99.3 The St. Paul Companies, Inc. and USF&G Corporation unaudited pro forma condensed combined balance sheet as of December 31, 1997, and unaudited pro forma condensed combined statements of income for the years ended December 31, 1997, 1996 and 1995. EX-23 2 CONSENT OF ERNST & YOUNG LLP Exhibit 23 - Consent of Independent Auditors We consent to the incorporation by reference in this Current Report on Form 8-K of The St. Paul Companies, Inc. of our report dated February 20, 1998, included in USF&G Corporation's Current Report on Form 8-K dated February 26, 1998. We consent to the incorporation by reference in the Registration Statements on Form S-8 (SEC File No. 2-69894, No. 33-15392, No. 33- 20516, No. 33- 23446, No. 33-23948, No. 33-24220, No. 33-24575, No. 33-26923, No. 33-49273, No. 33-56987, No. 333-01065, No. 333-22329, No. 333-25203, No. 333-28915 and No. 333- 48121), Form S-3 (SEC File No. 33-33931, No. 33-50115, No. 33-58491 and No. 333- 06465) and Form S-4 (SEC File No. 333-47007) of The St. Paul Companies, Inc., of our report dated February 20, 1998 with respect to the consolidated financial statements of USF&G Corporation included or incorporated by reference in this Current Report on Form 8-K. /s/ ERNST & YOUNG LLP Baltimore, Maryland April 24, 1998 EX-99.1 3 ST. PAUL COMPANIES PRESS RELEASE, DATED 4/24/98 NEWS RELEASE From: Corporate Communications Department The St. Paul Companies, Inc. 385 Washington Street St. Paul, MN 55102 Contact: Mark Hamel Telephone: (612) 310-3588 April 24, 1998 -- THE ST. PAUL COMPANIES COMPLETES MERGER WITH USF&G CORPORATION SAINT PAUL, Minn -- The St. Paul Companies (NYSE:SPC) today announced the completion of its merger with USF&G Corporation. The merger, which creates the United States' eighth-largest property-liability insurance company, was announced January 19, 1998 pending shareholder and regulatory approvals. The approval process was completed Thursday. "I am extremely pleased with the rapid approval this transaction has received from all constituencies," said Douglas W. Leatherdale, chairman and chief executive officer of The St. Paul. "The overwhelming approval by shareholders earlier this month, and the rapid review by regulators demonstrates that this is a positive development for all of our stakeholders. The St. Paul will now be even better-positioned to succeed in a highly competitive industry." On a combined basis, The St. Paul and USF&G had 1997 revenues of $9.6 billion, total assets of more than $37 billion, and written premiums of more than $7 billion. The record date for USF&G's first-quarter dividend preceded today's closing. Accordingly, the USF&G dividend of $.07 per share payable to USF&G shareholders of record on April 6, 1998, will be paid as scheduled on April 30, 1998. The St. Paul Companies, headquartered in Saint Paul, Minn., provides property-liability insurance underwriting and reinsurance products and services worldwide. -2- EX-99.2 4 USF&G HISTORICAL FINANCIAL STATEMENTS I. FINANCIAL STATEMENTS
USF&G CORPORATION Consolidated Statement of Operations Years Ended December 31 (dollars in millions except per share data) 1997 1996 1995 -------------------------------------------- Revenues Premiums earned $2,682 $2,731 $2,666 Net investment income 691 705 733 Other 16 18 53 -------------------------------------------- Revenues before net realized gains 3,389 3,454 3,452 Net realized gains on investments 15 44 7 -------------------------------------------- Total revenues 3,404 3,498 3,459 -------------------------------------------- Expenses Losses, loss expenses and policy benefits 2,071 2,181 2,178 Underwriting, acquisition and operating expenses 1,002 1,044 1,048 Interest expense 34 39 44 Reorganization severance 5 17 -- Facilities exit costs/(sublease income) -- (42) (6) -------------------------------------------- Total expenses 3,112 3,239 3,264 -------------------------------------------- Income from operations before income taxes 292 259 195 Provision for income taxes 84 (2) (14) Distributions on USF&G-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely junior subordinated deferrable interest debentures of USF&G, net of tax 14 -- -- -------------------------------------------- Net income $ 194 $ 261 $ 209 -------------------------------------------- Preferred stock dividend requirements 2 20 28 -------------------------------------------- Net income available to common stock $ 192 $ 241 $ 181 -------------------------------------------- Basic earnings per share $ 1.72 $ 2.05 $ 1.63 -------------------------------------------- Diluted earnings per share 1.63 1.95 1.53 -------------------------------------------- Weighted-average common shares outstanding (in 000s): Basic 111,688 117,674 111,474 Diluted 120,109 127,734 130,064 -------------------------------------------- See Notes to Consolidated Financial Statements.
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USF&G CORPORATION Consolidated Statement of Financial Position At December 31 (dollars in millions except per share data) 1997 1996 --------------------------- Assets Investments: Fixed maturities available for sale, at market (cost, 1997, $8,183; 1996, $8,066) $ 8,495 $ 8,164 Common and preferred stocks, at market (cost, 1997, $51; 1996, $16) 49 16 Short-term investments 571 535 Mortgage loans 641 406 Real estate 336 554 Other invested assets 852 401 --------------------------- Total investments 10,944 10,076 --------------------------- Cash 90 73 Accounts, notes and other receivables 878 763 Reinsurance receivables 1,646 1,576 Servicing carrier receivables 710 661 Deferred policy acquisition costs 468 456 Other assets 1,083 802 --------------------------- Total assets $15,819 $14,407 --------------------------- Liabilities Unpaid losses, loss expenses and policy benefits $10,017 $ 9,584 Unearned premiums 1,148 1,113 Corporate debt 516 477 Real estate and other debt 5 5 Other liabilities 1,760 1,159 --------------------------- Total liabilities 13,446 12,338 --------------------------- USF&G-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely junior subordinated deferrable interest debentures of USF&G 296 100 --------------------------- Shareholders' Equity Preferred stock, par value $50.00 (12,000,000 shares authorized; shares issued, 1996, 3,999,910) __ 200 Common stock, par value $2.50 (240,000,000 shares authorized; shares issued, 1997, 116,402,199; 1996, 114,240,489) 291 286 Paid-in capital 1,126 1,091 Net unrealized gains on investments and foreign currency 167 62 Retained earnings 493 330 --------------------------- Total shareholders' equity 2,077 1,969 --------------------------- Total liabilities, capital securities and shareholders' equity $15,819 $14,407 --------------------------- See Notes to Consolidated Financial Statements.
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USF&G CORPORATION Consolidated Statement of Cash Flows Years Ended December 31 (in millions) 1997 1996 1995 --------------------------------------------- Operating Activities Direct premiums collected $ 2,166 $ 2,183 $ 2,078 Net investment income collected 699 707 743 Direct losses, loss expenses and policy benefits paid (1,681) (1,751) (1,725) Net reinsurance activity (159) (13) 69 Underwriting and operating expenses paid (844) (769) (760) Interest paid (30) (37) (37) Income taxes paid (7) (5) (5) Other items, net 1 15 36 --------------------------------------------- Net cash provided from operating activities 145 330 399 --------------------------------------------- Investing Activities Net (purchases), sales and maturities of short-term investments (30) (249) 148 Sales of fixed maturities held to maturity -- -- 21 Maturities/repayments of fixed maturities held to maturity -- -- 110 Purchases of fixed maturities available for sale (2,022) (1,189) (1,123) Sales of fixed maturities available for sale 1,293 588 489 Maturities/repayments of fixed maturities available for sale 743 702 443 Purchases of other investments (414) (228) (302) Sales, maturities and repayments of other investments 430 412 332 Purchase of subsidiaries (67) (57) -- Purchases of property and equipment (86) (59) (32) Sales of property and equipment 3 14 2 --------------------------------------------- Net cash (used in) provided from investing activities (150) (66) 88 --------------------------------------------- Financing Activities Deposits for universal life and investment contracts 460 438 310 Withdrawals of universal life and investment contracts (209) (535) (659) Purchase of structured settlement annuity coinsurance contract (104) -- -- Net repayments of short-term borrowings 2 -- (227) Long-term borrowings -- -- 228 Repayments of long-term borrowings -- (125) (42) Issuances of capital securities 198 98 -- Issuances of common stock 21 11 6 Repurchases of common stock (101) (150) -- Redemptions of preferred stock (200) (2) -- Cash dividends paid to shareholders (33) (45) (53) Cash distributions paid to holders of capital securities (12) -- -- --------------------------------------------- Net cash provided from (used in) financing activities 22 (310) (437) --------------------------------------------- Increase (decrease) in cash 17 (46) 50 Cash at beginning of year 73 119 69 --------------------------------------------- Cash at end of year $ 90 $ 73 $ 119 --------------------------------------------- Noncash Transactions Coinsurance transactions: Transfer of investments and other assets in exchange for reinsurance receivables $ 40 $ 964 $ -- --------------------------------------------- See supplemental cash flow information at Note 1.15. See Notes to Consolidated Financial Statements.
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USF&G CORPORATION Consolidated Statement of Shareholders' Equity Years Ended December 31 (in millions except per share data) 1997 1996 1995 -------------------------------------------- Preferred Stock Balance at beginning of year $ 200 $ 213 $ 331 Par value of Series B shares converted to common shares -- (12) (51) Par value of Series C shares converted to common shares -- -- (66) Par value of shares redeemed (200) (1) (1) -------------------------------------------- Balance at end of year -- 200 213 -------------------------------------------- Common Stock Balance at beginning of year 286 299 262 Par value of shares issued for conversion of Series B shares -- 5 21 Par value of shares issued for conversion of Series C shares -- -- 14 Par value of shares issued in Titan acquisition 13 -- -- Par value of other shares issued 4 3 2 Par value of shares repurchased (12) (21) -- -------------------------------------------- Balance at end of year 291 286 299 -------------------------------------------- Paid-In Capital Balance at beginning of year 1,091 1,188 1,104 Excess of proceeds over par value of Series B shares converted -- 7 29 Excess of proceeds over par value of Series C shares converted -- -- 50 Excess of proceeds over par value of shares issued in Titan acquisition 99 -- -- Excess of proceeds over par value of other shares issued 17 8 5 Excess of cost over par value of shares repurchased (90) (129) -- Accrued stock-based compensation 4 15 -- Tax benefit from exercise of stock options 5 2 -- -------------------------------------------- Balance at end of year 1,126 1,091 1,188 -------------------------------------------- Net Unrealized Gains (Losses) on Investments and Foreign Currency Balance at beginning of year 62 271 (147) Change in unrealized gains (losses) 105 (209) 418 -------------------------------------------- Balance at end of year 167 62 271 -------------------------------------------- Minimum Pension Liability Balance at beginning of year -- (100) (63) Change in unfunded accumulated benefits -- 100 (37) -------------------------------------------- Balance at end of year -- -- (100) -------------------------------------------- Retained Earnings (Deficit) Balance at beginning of year 330 113 (46) Net income 194 261 209 Common stock dividends declared (per share, 1997, $.26; 1996 and 1995, $.20) (29) (24) (22) Preferred stock dividend declared (per share, 1997, Series A, $1.03; 1996, Series A, $4.10, Series B $7.69; 1995, Series A $4.10, Series B, $10.25) (2) (20) (28) -------------------------------------------- Balance at end of year 493 330 113 -------------------------------------------- Total shareholders' equity $2,077 $1,969 $1,984 -------------------------------------------- See Notes to Consolidated Financial Statements.
-4- II. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS USF&G CORPORATION Notes to Consolidated Financial Statements Note 1 Summary of Significant Accounting Policies 1.1. Basis of presentation The consolidated financial statements are prepared in accordance with generally accepted accounting principles ("GAAP"). These statements include the accounts of USF&G Corporation and its subsidiaries (collectively, "USF&G" or "the Corporation"). Certain of the subsidiaries are consolidated on a one-month lag, the effect of which is not material. Certain prior year amounts have been reclassified to conform to the 1997 presentation. The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from these estimates. USF&G is primarily engaged in the business of insurance. Property/casualty insurance, which accounted for 88 percent of revenues before net realized gains in 1997, is written primarily by United States Fidelity and Guaranty Company ("USF&G Company") and is sold primarily through independent agents and brokers supported by USF&G Company's underwriting, marketing, administrative and claim services offices located throughout the United States. Life insurance and annuities, which accounted for 12 percent of revenues before net realized gains in 1997, are written by Fidelity and Guaranty Life Insurance Company and its subsidiary (collectively, "F&G Life"), and are sold throughout the United States through independent agents, managing general agents and specialty insurance brokerage firms. Noninsurance operations are composed primarily of the parent company and asset management services. Additional information on the Corporation's business segments is included in Note 16, "Information on Business Segments". 1.2. Subsequent event On January 19, 1998, The St. Paul Companies, Inc. ("St. Paul"), a Minnesota corporation, and USF&G announced the signing of a definitive merger agreement pursuant to which a wholly-owned subsidiary of St. Paul will be merged into USF&G. The combined company will operate under the St. Paul name and be based in St. Paul, Minnesota. The transaction is expected to be accounted for as a pooling of interests and is intended to qualify as a tax-free reorganization. If the merger is completed, the combined company would become the eighth-largest property/casualty company in the United States, based on 1996 net written premiums. Completion of the transaction is subject to, among other things, approvals by the shareholders of USF&G and St. Paul, in addition to certain regulatory approvals, and is expected to occur in mid-1998. Under the terms of the merger agreement, each issued and outstanding share of USF&G common stock will be converted into a number of shares of St. Paul common stock determined according to a specified exchange ratio. That exchange ratio will be based on the average of the average of the high and low market prices of St. Paul's common stock during a 20-day trading period ending on the third trading day prior to the date USF&G's shareholders vote on the approval of the merger (the "St. Paul Average Price"). If the St. Paul Average Price is greater than $78, USF&G shareholders will receive 0.2821 of a share of St. Paul common stock for each USF&G share; if the St. Paul Average Price is less than $74 per share, USF&G shareholders will receive 0.2973 of a share of St. Paul common stock for each USF&G share; and if the St. Paul Average Price is between $74 and $78 per share, USF&G shareholders will receive a fraction of a St. Paul share equal to $22 divided by the St. Paul Average Price. In connection with the merger, St. Paul and USF&G entered into a Stock Option Agreement dated as of January 19, 1998. Pursuant to this agreement, USF&G granted St. Paul an option, exercisable only in certain circumstances, to purchase shares of USF&G common stock in an amount equal to 19.9 percent of the shares of USF&G common stock outstanding at the time of exercise. 1.3. New accounting pronouncements In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share" ("EPS"), which simplifies the standards for computing EPS. SFAS No. 128 replaces primary EPS with basic EPS, which excludes common stock equivalents, and requires disclosure of EPS on the face of the income statement for all entities, such as USF&G, with complex capital structures. USF&G adopted SFAS No. 128 effective December 31, 1997. In accordance with SFAS No. 128, all prior periods presented have been restated to conform to the 1997 presentation. -5- In June 1996, the FASB issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities", which provides new accounting and reporting standards for transfers and servicing of receivables and other financial assets and extinguishments of liabilities. As issued, the standard was effective for transactions occurring after December 31, 1996, and was to be applied prospectively. SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125", was issued in December 1996, and deferred for one year both the criteria for determination of a sale versus a secured borrowing for certain transactions, and new accounting standards for assets transferred as collateral. Once adopted for transactions occurring after December 31, 1997, SFAS No. 125 will impact USF&G's accounting for participation in securities lending programs as well as for assets pledged as collateral; however, this impact will primarily be limited to reclassifications on the Consolidated Statement of Financial Position. In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income", which establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997 and requires that an enterprise: (a) classify items of other comprehensive income by their nature in a financial statement, and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. Once adopted, USF&G anticipates that the major impact of SFAS No. 130 will be the required reporting of unrealized gains or losses on available for sale securities in comprehensive income. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". The Statement establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that selected information about operating segments be included in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The definition of operating segments in this standard is based on the way that management organizes and manages the segments within an enterprise. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997, and will require USF&G to revise and expand its business segment disclosures. In December 1997, the American Institute of Certified Public Accountants issued Statement of Position ("SOP") No. 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments". The SOP provides guidance for determining when an entity should recognize a liability for guaranty fund and other insurance-related assessments and on the measurement of the liability. Additionally, it provides guidance on when an asset should be recognized for a portion or all of the liability or paid assessment that can be recovered through premium tax offsets of policy surcharges. The SOP is effective for fiscal years beginning after December 15, 1998. The cumulative effect of adopting SOP No. 97-3 may be material; however, no reasonable estimation can be made at this time. 1.4. Permitted statutory accounting practices USF&G has both domestic and foreign subsidiaries. Reporting practices for insurance subsidiaries prescribed or permitted by domestic or foreign regulatory authorities (statutory accounting practices) differ from GAAP. Statutory amounts for USF&G's insurance operations follow. (in millions) 1997 1996 1995 ------------------------ Statutory Net Income for the Years Ended December 31: Property/casualty insurance* $ 210 $ 167 $-- Subsidiaries and affiliates** 24 8 -- Life insurance 21 27 15 ---------------------- Statutory Surplus at December 31: Property/casualty insurance* $1,455 $1,374 Subsidiaries and affiliates** 236 243 Life insurance 195 213 ---------------- - ------------------- * Includes USF&G Company and all subsidiaries required to be included in its combined statutory statements. ** Includes those property/casualty subsidiaries and affiliates not included in USF&G Company's combined statutory statements. -6- USF&G's primary insurance subsidiaries, USF&G Company and F&G Life, are domiciled in the State of Maryland and prepare their statutory financial statements in accordance with statutory accounting practices prescribed or permitted by the Maryland Insurance Administration. Prescribed statutory accounting practices include state laws, regulations and general administrative rules issued by the State of Maryland as well as a variety of publications and manuals of the National Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting practices encompass all accounting practices not so prescribed, but allowed by the state of domicile. The NAIC is currently in the process of developing a codification of statutory accounting principles. The project, if finalized and implemented, could cause changes to the calculation of statutory net income and statutory surplus. The impact of any changes cannot be reasonably estimated at this time. Property/Casualty Insurance: USF&G Company has received written approval from the Maryland Insurance Administration to extend the required disposal period for certain real property acquired as security for loans or other obligations. Under the current Maryland Insurance Code, these assets are required to be disposed of within five years from the date of acquisition. The Maryland Insurance Administration extended this time period for certain properties. At December 31, 1997 and 1996, permitted transactions increased statutory surplus by $20 million over what it would have been had prescribed accounting practices been followed without the variances permitted by the regulatory authorities. Life Insurance: In 1997, F&G Life received permission from the Maryland Insurance Administration to release $39 million of capital gains related to a coinsurance contract from the Interest Maintenance Reserve ("IMR"). In conjunction with this release from the IMR, F&G Life established a $10 million voluntary investment reserve funded from policyholders' surplus. The voluntary investment reserve cannot be reduced until 1999 and requires Maryland Insurance Administration permission to do so. As of December 31, 1997 and 1996, this permitted practice had the effect of increasing statutory surplus by $23 million and $38 million, respectively, over what it would have been had prescribed accounting practices been followed without the variances permitted by the regulatory authorities. Since Maryland does not specifically prescribe by law or regulation reserves for universal life ("UL") policies or group annuities, F&G Life follows reserving practices which are permitted by the State of Maryland. For older generation universal life policies, F&G Life holds the full account value as a reserve. For newer generation UL policies, reserves are held based on a calculation according to the NAIC UL Model Regulation, which has been adopted by many states. Many of the group annuities sold by F&G Life are used to fund qualified pension and/or profit sharing plans. For these annuities, the funds are not allocated to individual participants, and the full account value is held as the reserve. For group annuities where the funds and/or benefits are allocated to the individual certificate holder, reserves are calculated according to laws prescribed for individual annuities. 1.5. Investments Fixed Maturities: USF&G classifies all of its fixed maturities as "available for sale". These securities are held for an indefinite period of time and may be sold in response to changes in interest rates and the yield curve, prepayment risk, liquidity needs, or other factors. Fixed maturities classified as "available for sale" are carried at market value, with unrealized gains and losses recorded as a separate component of shareholders' equity. Unrealized gains or losses on fixed maturities available for sale are offset by an adjustment to life insurance deferred policy acquisition costs ("DPAC") which is made on a pro forma basis as if the unrealized gains or losses on those assets which match certain life insurance liabilities were realized. Specific write-downs in the carrying value of fixed maturities are recognized in income when an impairment is deemed other than temporary. Common and Preferred Stocks: Investments in common and preferred stocks where USF&G has significant influence over the investees' operating and financial policies are accounted for using the equity method and included in other invested assets. Other investments in common and preferred stocks are carried at market value with the resulting unrealized gains or losses reported directly in shareholders' equity. Securities Lending: USF&G participates in a securities lending program whereby certain securities from its portfolio are loaned to other institutions for short periods of time. A fee is paid to USF&G by the borrower. Collateral that exceeds the market value of the loaned securities is maintained by the lending agent and reported in USF&G's other invested assets with an offsetting liability reported in other liabilities. Invested assets and other liabilities include $515 million and $128 million at December 31, 1997 and 1996, respectively, related to securities lending collateral. -7- USF&G's policy is to require collateral equal to 102 percent of the market value of the loaned securities. The securities are marked to market on a daily basis to maintain the value of the collateral. The cash collateral is held by lending agents and reinvested in certain approved types of securities. USF&G has an indemnification agreement with the lending agents in the event a borrower becomes insolvent or fails to return securities. Mortgage Loans and Real Estate: Mortgage loans are carried at unpaid principal balances. Real estate investments are reported at cost adjusted for equity participation. Real estate acquired through foreclosure or deed-in-lieu of foreclosure is initially recorded at estimated market value. Valuation allowances are recognized for mortgage loans with deteriorations in collateral performance which are deemed other than temporary, based on quarterly evaluations. Impairments in the value of real estate investments are recorded as direct reductions in the carrying value of those investments and are recognized in income when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. Interest and Dividend Income: Interest on fixed maturity investments is recorded as income when earned and is adjusted for any amortization of purchase premium or discount. Dividends on equity securities are recorded as income on ex-dividend dates. Realized Gains and Losses: Realized gains and losses on the sale of investments are determined based on specific cost. Realized losses are also recorded when an investment's net realizable value is below cost and the decline is deemed other than temporary. 1.6. Recognition of premium revenues Property/Casualty Insurance: Property/casualty insurance premiums are earned principally on a pro rata basis over the lives of the policies and include accruals for ultimate premium revenue anticipated under auditable and retrospectively rated policies. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of policies in force. Unearned premiums also include estimated and unbilled premium adjustments. Life Insurance: Premiums on life insurance policies with fixed and guaranteed premiums and benefits, and premiums on annuities with significant life contingencies are recognized when due. Premiums received on UL policies and annuity contracts are not recorded as revenues; instead, they are recognized as deposits. Policy charges and surrender penalties are recorded as revenues. 1.7. Unpaid losses, loss expenses and policy benefits Property/Casualty Insurance: The liability for unpaid property/casualty insurance losses and loss expenses is based on an evaluation of reported losses and on estimates of incurred but unreported losses. The reserve liabilities are determined using adjusters' individual case estimates and statistical projections. The liability was reported net of estimated salvage and subrogation recoverables of $78 million and $99 million at December 31, 1997 and 1996, respectively. Adjustments to the liability based on subsequent developments or other changes in the estimate are reflected in results of operations in the period in which such adjustments become known. Certain liabilities for unpaid losses and loss expenses related to workers' compensation and assumed reinsurance coverage are discounted to present value. The carrying amount of such liabilities, net of reinsurance and net of discounts of $401 million was $1.3 billion and $1.4 billion at December 31, 1997 and 1996, respectively. Interest rates of up to four percent are used to discount these liabilities. Life Insurance: Ordinary life insurance reserves are computed under the net level premium method using assumptions for future investment yields, mortality and withdrawal rates. These assumptions reflect F&G Life's experience, modified to reflect anticipated trends, and provide for possible adverse deviation. Reserve interest rate assumptions are graded and range from 2.5 percent to 6.0 percent. Universal life and deferred annuity reserves are computed on the retrospective deposit method, which produces reserves equal to the cash value of the contracts. Such reserves are not reduced for charges that would be deducted from the cash value of policies surrendered. Reserves on immediate annuities with guaranteed payments are computed on the prospective deposit method, which produces reserves equal to the present value of future benefit payments. -8- 1.8. Deferred policy acquisition costs Acquisition costs, consisting of commissions, brokerage and other expenses incurred at policy issuance, are generally deferred. Amortization of DPAC totaled $687 million, $707 million and $714 million for the years ended December 31, 1997, 1996 and 1995, respectively, and was included in underwriting, acquisition and operating expenses in the Consolidated Statement of Operations. Property/Casualty Insurance: Anticipated losses, loss expenses, remaining costs of servicing the policies and anticipated investment income are considered in determining the recoverability of deferred property/ casualty insurance acquisition costs. Such deferrals are amortized over the period that related premiums are earned. Life Insurance: Anticipated policy benefits, remaining costs of servicing the policies and anticipated investment income are considered in determining the recoverability of DPAC for interest-sensitive life and annuity products. Life insurance acquisition costs are amortized based on assumptions consistent with those used for computing policy benefit reserves. DPAC on ordinary life business are amortized over their assumed premium paying periods. Universal life and investment annuity acquisition costs are amortized in proportion to the present value of their estimated gross profits over the products' assumed durations, which are regularly evaluated and adjusted as appropriate. 1.9. Foreign currency translation The functional currency for USF&G's foreign operations is typically the applicable local currency. For those subsidiaries in highly inflationary economies, however, the functional currency is the reporting currency (the U.S. dollar). Local currency balance sheet accounts are translated to U.S. dollars using exchange rates in effect at the balance sheet date, and revenue and expense accounts maintained in the local currency are translated using the average exchange rates prevailing during the year. The unrealized gains or losses, net of applicable deferred income taxes, resulting from translation are included in shareholders' equity. In highly inflationary economies (e.g., Mexico), monetary assets and liabilities are remeasured into U.S. dollars using exchange rates in effect at the balance sheet date, whereas nonmonetary balances are remeasured using historical exchange rates. Revenue and expense accounts are remeasured using the average exchange rates prevailing during the year for monetary transactions and historical exchange rates for nonmonetary transactions. Realized gains or losses resulting from remeasurement are included in net income. USF&G's exposure to fluctuating currency exchange rates may be reduced or effectively eliminated by certain financial instruments. 1.10. Goodwill Goodwill, which represents the excess of cost over the fair value of net assets acquired, is amortized on a straight-line basis over periods not exceeding 40 years. USF&G regularly evaluates the recoverability of goodwill to determine if there has been any permanent impairment. The assessment is performed based on the estimated future cash flows compared with the carrying value of the asset. If impairment were indicated, a writedown to fair value (normally measured by discounting estimated cash flows) would be taken. 1.11. Earnings per share Basic earnings per share are computed by dividing income available to common shareholders by the weighted-average common shares outstanding during the period. Common stock equivalents are excluded from the calculation. Diluted earnings per share assume the conversion of all securities whose contingent issuance would have a dilutive effect on earnings. -9- The following table sets forth the computations of basic and diluted earnings per share. (dollars in millions except per share data, shares in thousands) 1997 1996 1995 --------------------------- Numerator: Net income $194 $261 $209 Preferred Stock Dividends: Series A (2) (16) (16) Series B -- (4) (12) --------------------------- Total preferred stock dividends (2) (20) (28) --------------------------- Numerator for basic EPS (income available to common shareholders) 192 241 181 --------------------------- Effect of Dilutive Securities: Series B preferred stock dividends -- 4 12 Zero coupon convertible notes 3 5 6 --------------------------- 3 9 18 --------------------------- Numerator for diluted EPS (income available to common shareholders after assumed conversions) $195 $250 $199 --------------------------- Denominator: Denominator of basic EPS (weighted-average shares) 111,688 117,674 111,474 Effect of dilutive securities: Stock options 2,954 1,846 1,432 Contingent stock (variable award plan) 285 279 -- Convertible preferred stock -- 2,151 9,931 Zero coupon convertible notes 5,182 5,784 7,227 --------------------------- Dilutive potential common shares 8,421 10,060 18,590 --------------------------- Denominator for diluted EPS (adjusted weighted-average shares and assumed conversions) 120,109 127,734 130,064 --------------------------- Basic earnings per share $1.72 $2.05 $1.63 Diluted earnings per share 1.63 1.95 1.53 --------------------------- Stock options to purchase a total of 10 million shares of USF&G's common stock were outstanding at December 31, 1997. Of this total, 2.3 million options with exercise prices ranging from $22.19 to $30.82 per share were not included in the computation of diluted earnings per share in 1997 because the exercise prices of these options exceeded the average market price of the common shares and, therefore, would be antidilutive. The weighted-average exercise price for these outstanding options was $22.92 per share. Additionally, based upon certain cumulative multi-year income targets, a maximum of 1.3 million shares of common stock could be issued under USF&G's Long-Term Incentive Program ("LTIP"). In 1997, approximately 740,000 of these potentially issuable shares of common stock were not included in the calculation of diluted earnings per share because the applicable multi-year income targets were not currently being achieved. -10- 1.12. Reorganization severance Severance costs covering approximately 280 and 700 employees in 1997 and 1996, respectively, totaled $5 million and $17 million, respectively. During 1997, USF&G's field structure was reorganized to accommodate the transfer of certain policy and claim processing activities from the branch offices to three new Centers for Agency Services and the Claim Reception Center. In 1998, the field will be further consolidated and support functions will be centralized in response to worsening market conditions. 1.13. Facilities exit costs/sublease income During 1994, USF&G committed to a plan to consolidate its home office operations in Baltimore, Maryland at its Mount Washington facility. The facilities exit costs recorded in 1994 represented the present value of the rent and other operating expenses to be incurred under the lease on the Corporation's principal office building (the "Tower") from the time USF&G vacated the Tower through the expiration of the lease in September 2009, but did not consider any potential future sublease income, as such income was neither probable nor reasonably estimable at that time. To the extent that additional or extended subleases are subsequently negotiated, the present value of income to be received over the term of those subleases is recognizable in the period such income becomes probable and reasonably estimable. Sublease income of $54 million and $6 million was recognized under the facilities exit plan in 1996 and 1995, respectively, as a result of USF&G's negotiation of subleases with new and existing tenants. A credit of $12 million was also recognized in 1996 related to reduced property tax assessments on the Tower. During 1997, 1996 and 1995, the reserve for facilities exit costs was increased by $12 million, $13 million and $16 million, respectively, due to the amortization of the present value discount, and was reduced by $20 million, $12 million and $10 million, respectively, of rent and other operating expenses which were paid in 1997, 1996 and 1995 but were recognized in the 1994 charge. Additionally, USF&G recognized approximately $24 million of facilities exit costs in 1996, representing the present value of the rent and other operating expenses estimated to be incurred over the life of certain leases as a result of the downsizing or closure of numerous branch offices. The reserve was reduced in 1997 by $6 million of rent and other operating expenses which were paid in 1997 but were recognized in the 1996 charge. 1.14. Business combinations On December 22, 1997, USF&G acquired TITAN Holdings, Inc. ("Titan"), a property/casualty insurance company located in San Antonio, Texas, for $259 million including assumed debt. Titan specializes in the non-standard automobile and government entities insurance markets. The transaction was accounted for as a purchase and resulted in goodwill of approximately $151 million. The consideration paid included 5.1 million shares of the Corporation's common stock, valued at approximately $112 million. As of December 31, 1997, $47 million in cash payments were made to reduce debt and cover certain other acquisition-related expenses. The remaining consideration of $97 million, consisting of cash payments to Titan's shareholders, was subsequently paid in February 1998. The results of Titan's operations for the period from December 22 through December 31, 1997 have not been included in USF&G's Consolidated Statement of Operations for 1997 as they were not material. On December 17, 1996, USF&G acquired Afianzadora Insurgentes, S.A. de C.V. ("Afianzadora"), a surety bond company in Mexico, for $65 million in cash. This acquisition, which was accounted for as a purchase, resulted in goodwill of $18 million. The results of Afianzadora's operations for the period from December 17 through December 31, 1996 were not included in USF&G's Consolidated Statement of Operations for 1996 as they were not material. -11- 1.15. Supplemental cash flow information The Consolidated Statement of Cash Flows is presented using the "direct method", which reports major classes of cash receipts and cash payments. A reconciliation of net income to net cash provided from operating activities is as follows: (in millions) 1997 1996 1995 ----------------------- Net income $ 194 $ 261 $209 Adjustments to reconcile net income to net cash provided from operating activities: Net realized gains on investments (15) (44) (7) Reorganization severance 5 17 -- Facilities exit costs/(sublease income) -- (42) (6) Change in accrued income taxes 77 (7) (20) Distributions on capital securities 14 -- -- Depreciation expense 38 29 25 Change in insurance liabilities 58 66 294 Change in DPAC (18) 38 (36) Change in receivables (145) (167) (99) Change in other liabilities 76 61 79 Change in other assets (123) 122 (31) Change in other items, net (16) (4) (9) ----------------------- Net cash provided from operating activities $ 145 $ 330 $399 ----------------------- Cash provided from operating activities does not include a $104 million portion of a coinsurance contract purchased to cede certain structured settlement annuity obligations (refer to Note 12, "Reinsurance"). This transaction is considered financing in nature as it transfers a fixed payment obligation to the coinsurer. Note 2 Investments 2.1. Components of net investment income (in millions) 1997 1996 1995 ------------------------ Fixed maturities $593 $630 $664 Common and preferred stocks 1 3 4 Short-term investments 32 20 23 Mortgage loans and real estate 69 48 46 Other investment income, net of interest expense on funds held 11 19 13 ------------------------ Total investment income 706 720 750 Investment expenses (15) (15) (17) ------------------------ Net investment income $691 $705 $733 ------------------------ 2.2. Net realized gains on investments (in millions) 1997 1996 1995 ------------------------ Net Gains (Losses) on Sales: Fixed maturities $ 3 $(12) $ 6 Common and preferred stocks -- 79 4 Mortgage loans and real estate 34 17 2 Other 14 18 18 ------------------------ Net gains on sales 51 102 30 Impairments (36) (58) (23) ------------------------ Net realized gains on investments $ 15 $ 44 $ 7 ------------------------ -12- 2.3. Unrealized gains (losses) At December 31 (in millions) 1997 1996 ---------------- Unrealized Gains: Fixed maturities available for sale $319 $161 Common and preferred stocks 3 2 Foreign currency and other 20 20 ---------------- Gross unrealized gains 342 183 ---------------- Unrealized Losses: Fixed maturities available for sale (7) (63) Common and preferred stocks (5) (2) Foreign currency and other (6) (4) ---------------- Gross unrealized losses (18) (69) DPAC and policy benefits adjustment (67) (19) Deferred taxes on net unrealized gains (90) (33) ---------------- Net unrealized gains $167 $ 62 ---------------- 2.4. Change in net unrealized gains (losses) (in millions) 1997 1996 1995 ------------------------ Fixed maturities available for sale $214 $(242) $ 524 DPAC and policy benefits adjustment (48) 54 (106) Common and preferred stocks (2) 2 4 Foreign currency and other (2) 10 (4) ------------------------ Total change in unrealized gains (losses) before taxes 162 (176) 418 Deferred taxes on net unrealized gains (57) (33) -- ------------------------ Net change in unrealized gains (losses) $105 $(209) $ 418 ------------------------ -13- 2.5. Estimated market values of fixed maturity investments There were no fixed maturities classified as "held to maturity" at December 31, 1997 and 1996. The cost and market value of fixed maturities available for sale were as follows: At December 31, 1997 Gross Unrealized Market (in millions) Cost Gains Losses Value --------------------------------- U.S. Government bonds $ 497 $ 12 $(1) $ 508 Mortgage-backed securities 1,392 29 -- 1,421 Asset-backed securities 664 14 -- 678 Corporate bonds 4,249 199 (3) 4,445 State and political subdivision bonds 1,209 53 (1) 1,261 Foreign government bonds 172 12 (2) 182 --------------------------------- Total $8,183 $319 $(7) $8,495 --------------------------------- At December 31, 1996 Gross Unrealized Market (in millions) Cost Gains Losses Value --------------------------------- U.S. Government bonds $ 334 $ 7 $ (3) $ 338 Mortgage-backed securities 1,464 22 (3) 1,483 Asset-backed securities 731 11 (1) 741 Corporate bonds 4,882 107 (51) 4,938 State and political subdivision bonds 425 6 (1) 430 Foreign government bonds 230 8 (4) 234 --------------------------------- Total $8,066 $161 $(63) $8,164 --------------------------------- 2.6. Stated due dates of fixed maturities The following table shows the stated due dates of fixed maturities available for sale at December 31, 1997. Market (in millions) Cost Value ------------------ In 1998 $ 239 $ 240 1999 through 2002 2,090 2,141 2003 through 2007 1,613 1,683 After 2007 2,185 2,332 ------------------ Subtotal 6,127 6,396 Mortgage/asset-backed securities 2,056 2,099 securities ------------------ Fixed maturities available for sale $8,183 $8,495 ------------------ Actual maturities may differ from stated due dates as borrowers may have the right to call or prepay obligations. Information regarding sales, repayments and maturities of fixed maturities available for sale during 1997 is set forth in the following table. Gross Gross (in millions) Cost Proceeds Gains Losses ------------------------------- Proceeds from sales $1,295 $1,293 $28 $(30) Proceeds from 738 743 5 -- maturities/repayments ------------------------------- Total proceeds $2,033 $2,036 $33 $(30) ------------------------------- -14- Proceeds from sales of fixed maturities classified as available for sale in 1996 totaled $588 million with gross gains of $14 million and gross losses of $28 million. In 1995, such sales totaled $489 million with gross gains of $16 million and gross losses of $13 million. Proceeds from sales of fixed maturities held to maturity were $21 million (with no gross gains and gross losses of $3 million) in 1995. These sales involved five different issuers and were based on evidence of significant deterioration of the issuers' creditworthiness, as determined from developments related specifically to the issuers. USF&G performed a detailed analysis of the issuers' operating trends, cash flows and ability to meet debt service. From January 1, 1995 through December 3, 1995, reclassifications from held to maturity to available for sale totaled $31 million of amortized cost. These reclassifications were based on evidence of significant deterioration of the issuers' creditworthiness. Gross unrealized losses on these securities totaled $9 million at the time of the reclassifications. On December 4, 1995, all remaining securities classified as held to maturity were reclassified to available for sale as permitted by supplemental guidance to SFAS No. 115 issued by the FASB in November 1995. This reclassification was made to allow maximum flexibility in the management of the investment portfolio without being restricted by accounting interpretations. The securities had a total amortized cost of $4.5 billion, with gross unrealized gains of $117 million, at the time of the reclassification. 2.7. Nonincome-producing investments Fixed maturities at December 31, 1997 and 1996, for which no income was recorded during those years, totaled $1 million. In addition, nonincome-producing real estate totaled $20 million and $28 million at December 31, 1997 and 1996, respectively. Note 3 Insurance Liabilities 3.1. Property/casualty insurance reserves - unpaid losses and loss expenses Activity in unpaid losses and loss expenses for the property/casualty segment is summarized as follows: (in millions) 1997 1996 1995 ------------------------ Total reserve at beginning of year, gross $6,032 $6,097 $6,158 Less reinsurance recoverables 987 984 1,016 ------------------------ Net balance at January 1 5,045 5,113 5,142 ------------------------ Incurred Related To: Current year 1,933 2,030 1,856 Prior years (139) (162) (54) ------------------------ Total incurred 1,794 1,868 1,802 ------------------------ Paid Related To: Current year 726 764 635 Prior years 1,225 1,190 1,196 ------------------------ Total paid 1,951 1,954 1,831 ------------------------ Net balance at December 31 4,888 5,027 5,113 Plus reserves acquired* 140 18 -- Plus reinsurance recoverables 1,172 987 984 ------------------------ Total reserve at end of year, gross $6,200 $6,032 $6,097 ------------------------ *Reserves acquired relate to the purchases of Titan in 1997 and Afianzadora in 1996. Losses and loss expenses recorded in the current period financial statements are affected by changes in estimates of insured events occurring in prior periods. Loss and loss expense reserves are established based on actuarial evaluation of required reserves by accident year. Each accident year is independently evaluated. Typically, the reserve requirements are greatest in the most recent accident year, where there is the higher degree of uncertainty. -15- Losses incurred in 1997, 1996 and 1995 included $116 million, $110 million and $77 million, respectively, of favorable development related to prior years' experience in the assumed reinsurance business. Given the inherent uncertainty in reserving for assumed reinsurance losses, current accident year reserves are established on a conservative basis. Based on actuarial analysis in 1997 and 1996, the favorable development in assumed reinsurance from prior accident years was substantially offset by the establishment of current accident year reserves. The workers' compensation line was the key contributor of the remaining favorable development of $23 million in 1997 and $52 million in 1996. These favorable trends in older accident years are attributable to reform efforts by various states in the early 1990s to contain workers' compensation loss costs, the results of which are emerging in recent calendar years. In addition, favorable development in 1996 included recognition of the effect on reserve estimation models of the increased use of structured settlement annuities to close workers' compensation claims. Prior years' loss reserve decreases in workers' compensation were substantially offset by reserve increases in liability lines for the current accident years. Reserves for asbestos-related illnesses and environmental claims cannot be estimated with traditional loss reserving techniques. Liabilities are established for known claims (including the cost of litigation) when sufficient information has been developed to indicate the involvement of a specific insurance policy and management can reasonably estimate its liability. In addition, liabilities have been established to cover additional exposures on both known and unasserted claims. Estimates of the liabilities are reviewed and updated continually. Developed case law and adequate claim history do not exist for such claims, especially because significant uncertainty exists about the outcome of coverage litigation and whether past claim experience will be representative of future loss experience. 3.2. Life benefit reserves The table below shows F&G Life's benefit reserves by policy type. At December 31 (in millions) 1997 1996 ----------------- Single Premium Annuities: Deferred $1,374 $1,314 Immediate 1,048 1,001 Other annuities 367 610 Universal/term/group life 1,027 627 ----------------- Gross balance 3,816 3,552 Reinsurance receivable 786 782 ----------------- Total reserves, net $3,030 $2,770 ----------------- Note 4 Debt 4.1. Debt outstanding At December 31 (in millions) 1997 1996 ---------------- Corporate: Short-term and Current Maturities of Long-term: Credit facility $ 35 $-- 7% Senior Notes due 1998 145 -- Long-term: Zero Coupon Convertible Notes due 2009 107 102 8 3/8% Senior Notes due 2001 149 150 7% Senior Notes due 1998 -- 145 7 1/2% Senior Notes due 2005 80 80 ---------------- Total corporate debt 516 477 Real estate and other debt 5 5 ---------------- Total debt outstanding $521 $482 ---------------- -16- 4.2. Short-term debt For general corporate purposes, USF&G maintained two committed, standby credit facilities with a group of foreign and domestic banks totaling $450 million at December 31, 1997. The facility in place for $200 million will expire in December 1998 and the remaining facility will expire in 2002. These facilities replaced the $250 million committed, standby credit facility and the $150 million multi-currency credit facility in place at December 31, 1996, and permit either borrowing of funds or letter of credit issuances. USF&G pays facility fees on the total amount of the commitments based on its long-term debt credit ratings. Borrowings at December 31, 1997 totaled $35 million. There were no borrowings against the committed, standby credit facility or the multi-currency credit facility at December 31, 1996. Interest rates on borrowed funds are based on current market rates. At December 31, 1997 and 1996, the annual weighted-average interest rate under the facilities was 5.96% and 5.76%, respectively. USF&G was in compliance with the covenants contained in these agreements at December 31, 1997 and 1996. The most restrictive covenants require USF&G to maintain a tangible net worth of at least $1.3 billion plus 50 percent of the net income earned during the commitment period and an indebtedness-to-capital ratio below 55 percent. 4.3. Debt extinguishments From April through August 1996, USF&G repurchased approximately $39 million of outstanding Zero Coupon Convertible Notes through the use of excess corporate cash and borrowings from the credit facility. The balance of the credit facility was repaid in December 1996 with excess corporate cash and proceeds from the issuance of capital securities (refer to Note 6). In 1996, real estate and other debt was reduced by $11 million as a result of a deed-in-lieu of foreclosure whereby property with an outstanding $7 million note was conveyed back to the lender and a $4 million loan was repaid. 4.4. Shelf registration USF&G Corporation has available $142 million of unissued debt, preferred stock, common stock and warrants under a 1994 shelf registration. 4.5. Redeemable debt The Zero Coupon Convertible Notes are redeemable beginning in 1999 for an amount equal to the original issue price plus amortized original issue discount. -17- 4.6. Maturities of long-term debt Real Estate (in millions) Corporate and Other ------------------------- 1998 $145 $-- 1999 -- -- 2000 -- -- 2001 149 -- 2002 -- -- ------------------------- Note 5 Leases USF&G occupies office facilities under lease agreements that expire at various dates through 2009. In addition, data processing, office and transportation equipment is leased under agreements that expire at various dates through 2002. Most leases contain renewal options that may provide for rent increases based on prevailing market conditions. Some leases also may contain purchase options based on fair market value or contractual values, if greater. Capital leases are immaterial in amount. Rent expense for the years ended December 31, 1997, 1996 and 1995 was $25 million, $40 million and $44 million, respectively. The following table shows the future minimum payments to be made under noncancelable leases at December 31, 1997. Home Other Office Office Equip- (in millions) Building Space ment Total ----------------------------------- 1998 $ 16 $22 $15 $ 53 1999 19 19 7 45 2000 25 15 5 45 2001 26 9 14 49 2002 25 5 -- 30 After 2002 174 1 -- 175 ----------------------------------- Total $285 $71 $41 $397 ----------------------------------- USF&G is also the lessor under various subleases on its office facilities. The minimum rentals to be received in the future under noncancelable subleases is $96 million at December 31, 1997. USF&G's principal office lease involves the Tower which the Corporation sold in 1984 and subsequently leased back. As of January 1997, USF&G has vacated the Tower (refer to Note 1.13); however, USF&G is obligated to continue to make rental payments under the lease, which provides for rent increases every five years through its expiration in September 2009. Note 6 Capital Securities of Subsidiary Trusts Series A: On December 24, 1996, USF&G Capital I ("Capital I"), a business trust wholly owned by USF&G, issued $100 million (100,000 shares) of 8.5% Capital Securities, Series A ("Series A Securities"). Payments on the Series A Securities are guaranteed by USF&G on a subordinated basis, but only to the extent Capital I has funds available to make such payments. This guarantee, considered together with the terms of debentures issued by USF&G (described below) and an agreement for USF&G to pay other expenses and liabilities of Capital I, constitutes a full and unconditional subordinated guarantee by USF&G of Capital I's obligations under the Series A Securities. Capital I used the proceeds from the Series A Securities issuance to purchase $100 million principal amount of 8.5% Junior Subordinated Debentures issued by USF&G ("Series A Debentures"). The Series A Debentures rank junior and subordinate in right of payment to certain other indebtedness of USF&G, and mature on December 15, 2045. Interest payments on the Series A Debentures are deferrable, at USF&G's option, at any time for up to five years at a time, and provided there has not been an event of default. In the event USF&G elects to defer interest payments on the Series A Debentures, payments of distributions on the Series A Securities will likewise be deferred. Interest and distributions continue to accrue during any payment deferral period. -18- The Series A Debentures are redeemable under certain circumstances related to tax events at a price of $1,000 per debenture plus any accrued and unpaid interest and a "make whole" payment. Proceeds from any redemptions of the Series A Debentures will be used to redeem a like amount of the Series A Securities. Additionally, USF&G has the right, under certain circumstances related to tax events, to shorten the maturity of the Series A Debentures to a date no earlier than June 24, 2016, in which case the stated maturity of the Series A Securities will likewise be affected. Series B: On January 10, 1997, USF&G Capital II ("Capital II"), a second business trust wholly owned by USF&G, issued $100 million (100,000 shares) of 8.47% Capital Securities, Series B ("Series B Securities"). Payments on the Series B Securities are guaranteed on the same basis as the guarantee of the Series A Securities. Capital II used the proceeds from the Series B Securities issuance to purchase $100 million principal amount of 8.47% Deferrable Interest Junior Subordinated Debentures, Series B ("Series B Debentures") issued by USF&G, which mature on January 10, 2027. The Series B Debentures also rank junior and subordinate to certain other indebtedness of USF&G, but rank equal with the Series A Debentures. The Series B Debentures and Series B Securities have interest/ distribution deferral terms similar to those of the Series A Debentures and Series A Securities, described above. The Series B Debentures are redeemable at USF&G's option at any time beginning in January 2007 at scheduled redemption prices ranging from $1,042 to $1,000 per debenture, plus any accrued and unpaid interest. The Series B Debentures are also redeemable prior to January 2007 under certain circumstances related to tax and other special events. Proceeds from any redemptions of the Series B Debentures will be used to redeem a like amount of the Series B Securities. Additionally, USF&G has the right, under certain circumstances related to tax events, to shorten the maturity of the Series B Debentures to a date no earlier than July 10, 2016, in which case the stated maturity of the Series B Securities will likewise be affected. Series C: On July 8, 1997, USF&G Capital III ("Capital III"), a third business trust wholly owned by USF&G, issued $100 million (100,000 shares) of 8.312% Capital Securities, Series C ("Series C Securities"). Payments on the Series C Securities are guaranteed on the same basis as the guarantee of the Series A and Series B Securities. Capital III used the proceeds from the Series C Securities issuance to purchase $100 million principal amount of 8.312% Junior Subordinated Debentures issued by USF&G ("Series C Debentures"). The Series C Debentures rank junior and subordinate in right of payment to certain other indebtedness of USF&G, but rank equal with the Series A and Series B Securities. The Series C Debentures and Series C Securities have interest/distribution deferral terms similar to those of the Series A and Series B Debentures and Series A and Series B Securities, described above. The Series C Debentures mature on July 1, 2046, and are redeemable under certain circumstances related to tax events at a price of $1,000 per debenture plus any accrued and unpaid interest and a "make whole" payment. Proceeds from any redemptions of the Series C Debentures will be used to redeem a like amount of the Series C Securities. Additionally, USF&G has the right, under certain circumstances related to tax events, to shorten the maturity of the Series C Debentures to a date no earlier than April 8, 2012, in which case the stated maturity of the Series C Securities will likewise be affected. The Series A , Series B and Series C Debentures and related interest expense and income, as well as USF&G's interest in Capital I, Capital II and Capital III, are eliminated in consolidation. The Series A, Series B and Series C Securities are shown in the Consolidated Statement of Financial Position under the caption, "USF&G-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely junior subordinated deferrable interest debentures of USF&G". Distributions on the Series A, Series B and Series C Securities are shown, net of tax, in the Consolidated Statement of Operations under the caption "Distributions on USF&G-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely junior subordinated deferrable interest debentures of USF&G, net of tax". The sole assets of Capital I, Capital II and Capital III are the Series A, Series B and Series C Debentures, respectively. Neither Capital I, Capital II nor Capital III have operations independent of the aforementioned relationships with USF&G and the holders of their respective capital securities. In the event USF&G exercises its right to defer interest payments on the Series A, Series B or Series C Debentures, it will be prohibited from making payments with respect to any capital debt or securities which rank equal or junior in right of payment to the Series A, Series B and Series C Debentures, including cash dividends on its common or preferred stock. In no case may the deferral of payments described above extend beyond the stated maturity dates of the respective securities. -19- Note 7 Shareholders' Equity 7.1. Classes of stock USF&G is authorized to issue 12 million shares of $50 par value preferred stock and 240 million shares of $2.50 par value common stock. 7.2. Preferred stock USF&G had no preferred stock outstanding at December 31, 1997. At December 31, 1996 and 1995, there were 4 million shares of $4.10 Series A Convertible Exchangeable Preferred Stock ("Series A Preferred Stock") issued and outstanding. During the first half of 1997, USF&G called for redemption all of the remaining outstanding shares of its Series A Preferred Stock. Holders of 10,227 shares of the Series A Preferred Stock converted their shares into 12,308 shares of common stock. USF&G redeemed all of the remaining outstanding shares of its Series A Preferred Stock for $200 million cash. USF&G had 277,550 shares and 1.3 million shares of $10.25 Series B Cumulative Convertible Preferred Stock ("Series B Preferred Stock") issued and outstanding at December 31, 1996 and 1995, respectively. During 1996 and 1995, USF&G called for redemption 233,550 shares and 832,650 shares, respectively, of its Series B Preferred Stock. These shares were converted into 1.9 million shares and 6.9 million shares, respectively, of common stock in accordance with the terms of the Series B Preferred Stock. Holders of an additional 20,000 shares and 189,800 shares of Series B Preferred Stock voluntarily converted their shares into 166,320 shares and 1.6 million shares, respectively, of common stock during 1996 and 1995. The holder of another 24,000 shares of Series B Preferred Stock voluntarily redeemed those shares for cash during 1996. 7.3. Changes in common stock shares 1997 1996 1995 -------------------------------------- Outstanding, January 1 114,240,489 119,606,095 104,810,794 Shares repurchased (4,706,430) (8,400,700) -- Shares issued 6,868,140 3,035,094 14,795,301 -------------------------------------- Outstanding, December 31 116,402,199 114,240,489 119,606,095 -------------------------------------- In December 1997, USF&G issued approximately 5.1 million shares of common stock in consideration for its acquisition of Titan. In conjunction with a stock repurchase program instituted in 1996, USF&G repurchased 4.7 million and 8.4 million shares of its common stock during 1997 and 1996, respectively. USF&G also issued 2.1 million shares of common stock during 1996 for the conversion of the Series B Preferred Stock. During 1995, USF&G issued 8.5 million shares of common stock for the conversion of the Series B Preferred Stock, and 5.5 million shares of common stock for the conversion of the $5.00 Series C Cumulative Convertible Preferred Stock. 7.4. Shareholder rights plan USF&G has a shareholder rights plan ("the plan") to deter coercive or unfair takeover tactics and to prevent a potential purchaser from gaining control of USF&G without offering a fair price to all of the Corporation's shareholders. The plan, which otherwise would have expired in 1997, was extended until 2007 and amended in several respects in February 1997. Under the plan, as amended, each outstanding share of USF&G's common stock has one preferred share purchase right (a "right") expiring in 2007. Each right entitles the registered holder to purchase 1/100 of a share of a new class of junior preferred stock for $105. The rights cannot be exercised unless certain events occur that might lead to a concentration in ownership of common shares or unless certain other events relating to a change in control take place. At that time, each right may be converted into rights to acquire common stock having a value of twice the $105 exercise price. In certain circumstances, the plan also provides that the rights can be exchanged for USF&G's common stock without payment of the purchase price. Rights held by holders of 15 percent or more of USF&G's common stock, or their associates, may be null and void. Under certain conditions, the rights also become convertible into the rights to acquire shares of common stock of an acquiror having a value of twice the exercise price. USF&G will generally be entitled to redeem the rights, at $.01 per right, any time before the tenth day (subject to further deferral) after a 15 percent position is acquired. In January 1998, the plan was amended to provide that the rights would not become exercisable as a result of the transactions contemplated with St. Paul under the merger agreement or the related stock option agreement. -20- 7.5. Dividend restrictions There are certain restrictions on payments of dividends by insurance subsidiaries that may limit USF&G Corporation's ability to receive funds from its subsidiaries. Under the Maryland Insurance Code, Maryland insurance subsidiaries, such as USF&G Company and F&G Life, must provide the Maryland Insurance Commissioner (the "Commissioner") with not less than thirty days' prior written notice before payment of an "extraordinary dividend" to its holding company. (Refer to Section 4.3, "Dividend Restrictions", of Management's Discussion and Analysis of Financial Condition and Results of Operations.) In addition, ten days' prior notice of any other dividend must be given to the Maryland Insurance Commissioner prior to payment, and the Commissioner has the right to prevent payment of such dividend if it is determined that such payment could impair the insurer's surplus or financial condition. Cash dividends of $136 million, $134 million and $83 million were paid during 1997, 1996 and 1995, respectively, to USF&G Corporation by USF&G Company. Such dividends were not subject to the requirements for extraordinary dividends. In addition, effective June 1, 1995, and with the Commissioner's consent, USF&G Company declared an extraordinary dividend payable to USF&G Corporation valued at $323 million, which consisted of all of the issued and outstanding capital stock of F&G Life. Prior to payment of such dividend, F&G Life was a wholly-owned subsidiary of USF&G Company. As a result of such dividend payment, F&G Life is now a direct, wholly-owned subsidiary of USF&G Corporation. Dividends of up to $146 million will be available for payment from USF&G Company to USF&G Corporation during 1998 without being deemed extraordinary. Cash dividends of $40 million, $139 million and $31 million were paid during 1997, 1996 and 1995, respectively, to USF&G Corporation by F&G Life. In addition, effective December 17, 1997 and December 29, 1995 and with the Commissioner's consent, F&G Life declared extraordinary dividends payable to USF&G Corporation consisting of investments in various real estate properties, totaling $25 million and $28 million, respectively. Consequently, all of the 1997 and 1996 dividends were deemed extraordinary, and were paid with the Commissioner's consent. Further, any dividends which F&G Life would propose to pay in 1998 would be deemed extraordinary dividends and subject to the thirty-day notice period. Note 8 Financial Instruments and Derivatives Fair value information is based on quoted market prices where available. In cases where quoted market prices are not available, fair values are based on internal estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, such as applicable discount rate and estimated future cash flows. Therefore, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Fair value disclosure requirements exclude certain financial instruments and all nonfinancial instruments. The fair value of many insurance-related liabilities do not require disclosure. However, in its strategy of asset/liability matching, USF&G takes into consideration the future cash requirements of its insurance-related liabilities. Had a presentation of these liabilities been made, due to their long-term nature, the fair value of insurance-related liabilities would have been significantly less than their carrying value. 8.1. Financial instruments Cash and Short-Term Investments: The carrying amounts reported in the Consolidated Statement of Financial Position for these instruments approximate their fair values. Fixed Maturity Investments: Fair values for publicly-traded fixed maturity investments are based on quoted market prices. For privately-placed fixed maturities, estimated fair values are derived by discounting expected future cash flows using a current market rate applicable to the yield, credit quality and maturity of the investment. At December 31, 1997, the amortized costs and market values of fixed maturity investments were as follows: Amortized Market (in millions) Cost Value ------------------------ Publicly traded $7,696 $8,015 Private placements 487 480 ------------------------ Total fixed maturity investments $8,183 $8,495 ------------------------ All fixed maturities are classified as available for sale and are reported in the Consolidated Statement of Financial Position at market value. -21- Common and Preferred Stocks: The carrying values of common and preferred stocks as reported in the Consolidated Statement of Financial Position are based on quoted market prices and reflect their fair values. Mortgage Loans and Policy Loans: The fair values for mortgage loans and policy loans are estimated based on discounted cash flow analyses, using interest rates currently being offered for loans with similar credit risk. Loans with similar characteristics are aggregated for purposes of the calculations. At December 31, 1997, the carrying amounts and fair values of investments in mortgage loans and policy loans were as follows: Carrying Fair (in millions) Amount Value ------------------------ Mortgage loans $641 $658 Policy loans 82 86 ------------------------ Other Assets and Other Liabilities: Other invested assets considered financial instruments include equity interests in minority ownership investments, interests in limited partnerships and related notes receivable. It is not practicable to estimate their fair value due to the closely-held nature of these investments. Other assets and liabilities considered financial instruments include agents' balances receivable, prepaid and accrued expenses and other receivables generally of a short-term nature. It is assumed the carrying value of these financial instruments approximates their fair value. Short- and Long-Term Debt: The carrying amount of USF&G's short-term borrowings approximates its fair value. The fair value of long-term debt is based on market quotes or estimated discounted cash flow analyses, based on USF&G's current incremental borrowing rates for similar types of borrowing arrangements. The carrying amounts and estimated fair value of debt instruments at December 31, 1997 were as follows: Carrying Fair (in millions) Amount Value ------------------------ Corporate $516 $545 Real estate and other 5 5 ------------------------ Total debt $521 $550 ------------------------ Investment Contracts: Fair values for F&G Life's single premium deferred annuities, other deferred annuities, single premium immediate annuities and supplementary contracts are primarily derived by estimating the cost to extinguish its liabilities under an assumption reinsurance transaction. The estimated statutory profits the assuming company would realize from the transaction are discounted at a typical internal rate of return objective. If such a transaction were to occur, GAAP would require the unamortized balance of deferred policy acquisition costs associated with these liabilities to be immediately expensed. The amount of the related unamortized DPAC was approximately $136 million at December 31, 1997. The fair values of the remaining liabilities under investment contracts are estimated using discounted cash flow calculations, based on interest rates currently being offered for like contracts with similar maturities. The carrying amounts and estimated fair values of F&G Life's liabilities for investment contracts at December 31, 1997 were as follows: Carrying Fair (in millions) Amount Value ------------------------ Single premium deferred annuities $ 699 $ 654 Other deferred annuities 709 637 Single premium immediate annuities and supplementary contracts 85 81 Group annuities 65 63 ------------------------ Total $1,558 $1,435 ------------------------ -22- Off-Balance Sheet Financial Instruments: The fair values of USF&G's financial guarantees written totaled $2 million at December 31, 1997, and were estimated using discounted cash flow analyses based on USF&G's current incremental borrowing rate for similar types of borrowing arrangements. The fair value of foreign exchange options, which are derived from quoted market prices, were less than $1 million at December 31, 1997. The estimates of the fair value of USF&G's interest rate swaps were obtained from the counterparties to the agreement or were derived by discounting the expected future cash flows, and totaled $4 million at December 31, 1997. 8.2. Derivatives USF&G uses derivative instruments, including options and swaps, to manage foreign exchange and interest rate risk, reduce borrowing costs and minimize the impact of rate fluctuations on the settlement of debt and other financial instruments. USF&G limits its use of derivative instruments. Foreign exchange options are used to manage exposure to the effects of foreign currency exchange rate fluctuations on foreign-denominated transactions. Cash-settled equity swaps on USF&G common stock are used to manage exposure to stock price fluctuations on stock-based incentive compensation expense. Interest rate swaps are used to manage the exposure to fluctuating rates and the relationship of fixed/floating interest rates on corporate debt. Individually, and in the aggregate, the impact of these transactions on the financial position and results of operations is not material. At December 31, 1997, the Corporation's mark-to-market position on these derivative instruments was a gross gain of $4 million and a gross loss of less than $1 million. In addition, exchange-traded and over-the-counter catastrophe options and swaps, linked to an index of losses related to natural disasters, are an additional insurance-related source of income. USF&G limits and monitors its maximum exposure to loss. Individually, and in the aggregate, the impact of these transactions on the financial position and results of operations is not material. At December 31, 1997, the maximum exposure to loss was less than $3 million and gross unrealized gains and gross unrealized losses were approximately $1 million. USF&G is subject to the risk that the counterparties will fail to perform. However, these risks are mitigated by the credit quality of the counterparties and the gains and losses of the underlying instruments. USF&G seeks to manage the credit risk by establishing minimum credit ratings for counterparties to the transactions. Note 9 Stock-Based Compensation Stock options have been granted to full-time officers and key employees under four incentive plans: Stock Option Plan of 1987, Stock Option Plan of 1990, Stock Incentive Plan of 1991, and Stock Incentive Plan of 1997 (collectively, the "Management Plans"). In addition, the 1994 Stock Plan for Employees of USF&G (the "Broad-Based Plan") grants eligible employees, other than officers and key employees participating in other stock incentive plans, options to purchase shares. The Corporation applies Accounting Principles Board Opinion ("APB") No. 25 and related interpretations in accounting for its employee stock options. Under APB No. 25, no compensation expense is recognized since the exercise price of the options is equal to the market price of the underlying stock on the date of the grant. In addition, under the Corporation's Long-Term Incentive Program, USF&G awards shares of common stock to full-time officers based on three-year performance goals established by the Board of Directors. Compensation expense, determined under APB No. 25 as the number of shares to be issued at a given performance level times the current market price of the stock, is accrued over the three-year performance cycle. Net income for 1997 and 1996 included $6 million and $13 million, respectively, of compensation expense for LTIP awards. Under the Management Plans and Broad-Based Plan, the Corporation may grant options to participating employees to purchase up to 16 million and 5 million shares of common stock, respectively. At December 31, 1997, 7 million and 1 million options were available for future grant under the Management Plans and Broad-Based Plan, respectively. Under all plans, the exercise price of each option equals the market price of USF&G's stock on the date of grant, and an option's maximum term is ten years. Options vest ratably over three years under the Management Plans, and vest after two years under the Broad-Based Plan. -23- Had compensation expense for these plans been determined based on the fair value of awards at the grant date, as prescribed by SFAS No. 123, net income and earnings per share would have been as follows: 1997 1996 1995 -------------------- Pro forma net income (in millions) $ 182 $ 254 $ 205 Pro forma basic earnings per share 1.61 1.99 1.59 Pro forma diluted earnings per share 1.52 1.89 1.49 -------------------- Note: The effects of applying SFAS No. 123 shown here are not likely to be representative of the effects in future years due to the exclusion of awards granted in prior years but vesting (and therefore expensed) in 1995, 1996 and 1997. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted-average assumptions used for grants in each year were as follows: 1997 1996 1995 ------------------------------- Expected volatility 21.1% 25.0% 25.4% Dividend yield 1.13% 1.24% 1.53% Management Plans: Risk-free interest rates 6.52% 6.36% 7.25% interest rates Expected lives 5 years 7 years 7 years Broad-Based Plan: Risk-free interest rates 6.35% 5.98% 7.07% Expected lives 3 years 4 years 4 years ------------------------------- The Black-Scholes method is one of many models used to calculate the fair value of an option. Because the models are sensitive to changes in the different assumptions used, the effect on fair value estimates can be significant. Accordingly, the derived fair value of options cannot be substantiated by comparison to independent markets. The fair value also cannot be realized in immediate settlement. A summary of the status of USF&G's stock option plans as of December 31, 1997, 1996 and 1995, and changes during the years ended on those dates are presented in the table below. The 1997 activity includes options granted pursuant to the merger agreement with Titan, in which the Corporation assumed 899,731 exercisable outstanding options, based on the exchange ratio applicable to the acquisition. Weighted-Average Exercise Shares Price ----------------------------- Outstanding at January 1, 1997 9,101,408 $13.95 Granted 2,404,142 22.52 Granted in conjunction with acquistion 899,731 12.14 Exercised (1,533,314) 13.20 Surrendered or canceled (873,341) 18.23 ----------------------------- Outstanding at December 31, 1997 9,998,626 $15.58 ----------------------------- Options exercisable at December 31, 1997 5,146,295 $13.24 ----------------------------- Weighted-average fair value of options granted during 1997 $ 5.66 ----------------------------- -24- Weighted-Average Exercise Shares Price ----------------------------- Outstanding at January 1, 1996 7,290,207 $12.97 Granted 3,363,988 14.63 Exercised (910,396) 11.45 Surrendered or canceled (642,391) 15.30 ----------------------------- Outstanding at December 31, 1996 9,101,408 $13.95 ----------------------------- Options exercisable at December 31, 1996 3,714,777 $13.39 ----------------------------- Weighted-average fair value of options granted during 1996 $ 4.55 ----------------------------- Weighted-Average Exercise Shares Price ----------------------------- Outstanding at January 1, 1995 5,908,451 $12.86 Granted 2,714,806 13.72 Exercised (733,603) 7.33 Surrendered or canceled (599,447) 16.86 ----------------------------- Outstanding at December 31, 1995 7,290,207 $12.97 ----------------------------- Options exercisable at December 31, 1995 2,707,398 $12.82 ----------------------------- Weighted-average fair value of options granted during 1995 $ 4.63 ----------------------------- The following table summarizes information about stock options outstanding at December 31, 1997: Range of Options Outstanding Options Exercisable Exercise Remaining Average Average Price Number Life* Price** Number Price** -------------------------------------------------------- $6.25-10 1,129,256 3.6 $ 9.19 1,129,256 $ 9.19 11-15 6,236,325 7.2 13.97 3,708,650 13.74 16-20 378,312 6.4 16.78 176,940 16.94 21-28 2,129,005 9.2 22.53 5,721 22.50 29-30.82 125,728 1.7 29.48 125,728 29.48 -------------------------------------------------------- $6.25-30.82 9,998,626 7.1 $15.30 5,146,295 $13.24 -------------------------------------------------------- *Represents the weighted-average remaining contractual life of options in years. **Represents the weighted-average exercise price of options. Under the terms of the merger agreement with St. Paul, all options outstanding as of the effective date of the merger and that were granted prior to January 19, 1998, will become fully vested and exercisable upon consummation of the merger. -25- Note 10 Retirement Benefits 10.1. Retirement plans USF&G has noncontributory retirement plans covering most regular full-time employees of the Corporation and its affiliates. An employee's pension benefit is based on salary, years of service and Social Security benefits. USF&G makes contributions to the retirement plans based on amounts required to be funded under provisions of the Employee Retirement Income Security Act of 1974, as amended. The plans' funded status and amounts recognized in the consolidated financial statements were as follows: At December 31 (dollars in millions) 1997 1996 ------------------- Actuarial Present Value of: Accumulated benefit obligation $410 $370 Vested benefits 392 355 ------------------- Plan assets at fair value $439 $379 Projected benefit obligation 427 385 ------------------- Funded status 12 (6) Unrecognized net loss 91 105 Unrecognized prior service cost (benefit) (12) (15) Adjustment for minimum pension liability -- -- ------------------- Net prepaid pension cost $ 91 $ 84 ------------------- Actuarial Assumptions: Weighted-average discount rate 7.00% 7.50% Average rate of increase in future compensation levels 5.00 5.00 ------------------- As a result of the lower interest rate environment, USF&G decreased the discount rate assumption as of December 31, 1997, which increased the accumulated benefit obligation. The expected long-term rate of return on assets was 8.5% for 1997, 1996 and 1995. The assets held by the plan consist primarily of fixed-income and equity securities. USF&G classifies prepaid pension cost with other assets in the Consolidated Statement of Financial Position. The components of net pension expense were as follows: (in millions) 1997 1996 1995 ------------------------ Service cost $ 7 $ 8 $ 5 Interest cost 29 28 27 Actual return on plan assets (71) (20) (63) Net amortization (deferral) 43 (4) 43 ------------------------ Net periodic pension expense $ 8 $ 12 $ 12 ------------------------ -26- 10.2. Postretirement benefits USF&G sponsors a defined-dollar postretirement health care (medical and dental) plan and noncontributory life insurance plan covering most regular full-time employees of the Corporation and its affiliates. USF&G's contributions and costs are determined based on the annual salary and the type of coverage elected by covered employees. USF&G's contributions to the plan are a percentage of plan costs based on age and service of employees at retirement. Additionally, the plan costs are capped at projected 1998 cost levels, and retiree contributions are increased for the total medical costs over the projected levels. USF&G accrues the cost of health care, life insurance and other retiree benefits when the employees' services are rendered, and funds the health care and life insurance benefit costs principally on a pay-as-you-go basis.The plans' combined funded status and amounts recognized in the consolidated financial statements were as follows: At December 31 (in millions) 1997 1996 ---------------- Accumulated Postretirement Benefit Obligation: Retirees $43 $43 Fully-eligible active plan participants 1 1 Other active plan participants 8 7 ---------------- 52 51 Plan assets at fair value -- -- ---------------- Unfunded obligation 52 51 Unrecognized net (loss) gain (1) 2 ---------------- Accrued postretirement benefit costs $51 $53 ---------------- USF&G classifies accrued postretirement benefit costs with other liabilities in the Consolidated Statement of Financial Position. Net periodic postretirement benefit costs consisted of $1 million of service cost and $4 million of interest cost for each of the years ended December 31, 1997, 1996 and 1995. The weighted-average annual assumed rate of increase in per capita cost of covered benefits (i.e., medical trend rate) for the plans is 7.25 percent for 1998 and 1997, and is assumed to decrease to 5.25 percent in 2003 for participants age 65 or younger, and 7.00 percent for 1998 and 1997, decreasing to 5.25 percent for participants over age 65, and remain at that level thereafter. Increasing the assumed medical trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation by approximately $4 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year by less than $1 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.00 percent and 7.50 percent at December 31, 1997 and 1996, respectively. Note 11 Income Taxes USF&G Corporation and its subsidiaries file a consolidated federal income tax return. Deferred tax liabilities or assets are recognized for the estimated future tax effects attributable to net operating loss carryforwards ("NOLs") and to temporary differences between the tax basis and GAAP basis of an asset or a liability. A valuation allowance is required if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax asset will not be realized. At December 31, 1997, the net deferred tax asset of $317 million recorded by USF&G was supported by a combination of forecasted taxable income and a tax strategy that USF&G would implement to prevent NOLs from expiring. Based on the weight of positive and negative evidence, USF&G believes that it is more likely than not that it will be able to realize all of its deferred tax assets. Accordingly, no valuation allowance was provided at December 31, 1997. -27- 11.1. Significant components of deferred tax assets and liabilities At December 31 (in millions) 1997 1996 ---------------- Deferred Tax Liabilities: DPAC $145 $146 Net unrealized gains 90 33 Prepaid pension cost 32 29 Real estate 24 15 Other invested assets 5 4 Other 38 37 ---------------- Total deferred tax liabilities 334 264 ---------------- Deferred Tax Assets: Facilities exit costs 48 51 Unpaid losses and loss expenses 220 228 Future policy benefits 66 59 Unearned premiums 52 54 Foreign reinsurance 48 47 Postretirement benefits 18 19 Other 15 40 NOLs 184 202 ---------------- Total deferred tax assets 651 700 Valuation allowance for deferred tax assets -- -- ---------------- Deferred tax assets, net of valuation allowance 651 700 ---------------- Net deferred tax assets $317 $436 ---------------- The components of the changes in the valuation allowance were recorded through shareholders' equity and operations, as follows: (in millions) 1997 1996 1995 --------------------- Changes Recognized in Shareholders'Equity: Changes related to net unrealized (gains) losses $-- $ 95 $(147) Change related to minimum pension liability -- (35) 13 --------------------- Total changes recognized in shareholders' equity -- 60 (134) --------------------- Changes Recognized in Statement of Operations: Reduction for increased likelihood of realization -- (96) (81) Other adjustments -- -- 2 --------------------- Total changes recognized in statement of operations -- (96) (79) --------------------- Total change in valuation allowance $-- $(36) $(213) --------------------- -28- 11.2. Income tax expense (benefit) The components of the total income tax expense (benefit) were recorded through shareholders' equity and operations, as follows: (in millions) 1997 1996 1995 ---------------------- Recorded in Shareholders' Equity: Benefit from deduction of employee stock options exercised $ (5) $(2) $ -- Deferred expense for change in unrealized gain on investments 57 33 -- --------------------- Net expense recorded in shareholders' equity 52 31 -- --------------------- Recorded in Statement of Operations: Expense on net income 84 (2) (14) Benefit from distributions on capital securities (7) -- -- --------------------- Total expense (benefit) recorded in statement of operations 77 (2) (14) --------------------- Total income tax expense (benefit) recorded $129 $29 $(14) --------------------- 11.3. Components of provision for income taxes (benefit) (in millions) 1997 1996 1995 ---------------------- Current tax $ 28 $ 8 $ 61 NOL utilization (18) (5) (56) ---------------------- Current tax, net of NOL utilization 10 3 5 Deferred tax (benefit) 67 91 62 Tax benefit of capital securities 7 -- -- Adjustment of the beginning of the year valuation allowance -- (96) (81) ---------------------- Provision for income taxes (benefit) $ 84 $ (2) $(14) ---------------------- Income taxes paid $ 7 $ 5 $ 5 ---------------------- 11.4. Reconciliation of taxes at federal rates to provision for income taxes (benefit) (in millions) 1997 1996 1995 ---------------------- Tax at federal rates $102 $ 91 $ 68 Tax Effect (Benefit): Adjustment of the beginning of the year valuation allowance -- (96) (81) Tax-exempt interest income (14) (2) (2) Other (4) 5 1 ---------------------- Provision for income taxes (benefit) $ 84 $ (2) $(14) ---------------------- -29- 11.5. Net operating loss carryforwards At December 31, 1997, USF&G had NOLs remaining for tax return purposes expiring in 2006. The amount and timing of recognizing the benefit of these NOLs depends on future taxable income and limitations imposed by tax laws. The approximate amounts of USF&G's NOLs on a regular tax basis and an alternative minimum tax ("AMT") basis at December 31, 1997 were as follows: (in millions) Tax Return NOLs ----------------- Regular tax basis $525 AMT basis 393 ----------------- Note 12 Reinsurance USF&G reinsures portions of its policy risks with other insurance companies or underwriters, and assumes policy risks from other insurance companies and through participation in pools and associations. Reinsurance gives USF&G the ability to write larger risks and control its exposure to losses from catastrophes or other events that cause unfavorable underwriting results. USF&G's ceding reinsurance agreements are generally structured on a treaty basis whereby all risks meeting certain criteria are automatically reinsured. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve USF&G from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to USF&G. USF&G evaluates the financial condition of its reinsurers and monitors concentrations of credit risks arising from similar economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. At December 31, 1997 and 1996, property/casualty reinsurance receivables totaled $860 million and $794 million, respectively. Of these amounts, approximately $89 million and $95 million, respectively, were associated with the Workers' Compensation Reinsurance Bureau ("WCRB"), a single voluntary reinsurance association of primary workers' compensation insurers formed for the purpose of providing excess of loss reinsurance to its members. USF&G is a member of this pool. Each member is required to hold collateral, for the benefit of all member companies, in the form of investment-grade securities equaling 115 percent of the member's share of outstanding receivables of the WCRB. This collateral requirement mitigates the risk of the WCRB becoming insolvent. Risk of loss is minimal for the remainder of receivables due to similar pool arrangements with collateral requirements, other contracts where funds are withheld, or letters of credit maintained. Credit risk is also diversified among numerous reinsurers. Additionally, USF&G has been active in the involuntary market as a servicing carrier whereby USF&G processes business for a pool but takes no direct underwriting risk because it is directly reimbursed for the cost of processing policies and settling any related claims. Servicing carrier receivables of $710 million and $661 million associated with this business are separately disclosed in the Consolidated Statement of Financial Position at December 31, 1997 and 1996, respectively. In August 1996, F&G Life entered into a coinsurance contract with an unaffiliated life insurance company to cede a significant portion of F&G Life's block of single premium deferred annuities (the "broker SPDA block"). As part of the transaction, F&G Life transferred $932 million of investments and other assets to the coinsurer, and recorded a reinsurance receivable of $964 million. In December 1997, F&G Life entered into another coinsurance agreement with an unaffiliated life reinsurance company whereby F&G Life transferred approximately $144 million of investments and other assets to the reinsurer and recorded a reinsurance receivable of $131 million. These transactions had no material effect on USF&G's 1997 or 1996 net income. As of December 31, 1997, the addition of receivables under the 1997 contract, offset by surrender activity under the 1996 contract, reduced the reserves for the transferred annuity blocks and the related reinsurance receivable balances to $765 million. At December 31, 1997 and 1996, F&G Life's reinsurance receivables totaled $786 million and $782 million, respectively. -30- The effect of reinsurance on USF&G's premiums and losses was as follows: 1997 Premiums Losses Unpaid Unearned (in millions) Written Earned Incurred Losses Premiums -------------------------------------------- Property/Casualty: Direct $2,391 $2,386 $1,699 $4,703 $1,057 Assumed 539 573 355 1,451 91 -------------------------------------------- Gross 2,930 2,959 2,054 6,154 1,148 Ceded (478) (414) (260) (1,125) (184) -------------------------------------------- Net 2,452 2,545 1,794 5,029 964 Life N/A 137 277 3,816 N/A -------------------------------------------- Total $2,452 $2,682 $2,071 $8,845 $ 964 -------------------------------------------- 1996 Premiums Losses Unpaid Unearned (in millions) Written Earned Incurred Losses Premiums -------------------------------------------- Property/Casualty: Direct $2,401 $2,346 $1,721 $4,614 $ 991 Assumed 621 609 372 1,418 122 -------------------------------------------- Gross 3,022 2,955 2,093 6,032 1,113 Ceded (383) (369) (225) (987) (120) -------------------------------------------- Net 2,639 2,586 1,868 5,045 993 Life N/A 145 313 3,552 N/A -------------------------------------------- Total $2,639 $2,731 $2,181 $8,597 $ 993 -------------------------------------------- 1995 Premiums Losses Unpaid Unearned (in millions) Written Earned Incurred Losses Premiums -------------------------------------------- Property/Casualty: Direct $2,318 $2,253 $1,607 $4,675 $ 945 Assumed 634 637 436 1,422 110 -------------------------------------------- Gross 2,952 2,890 2,043 6,097 1,055 Ceded (389) (398) (241) (984) (136) -------------------------------------------- Net 2,563 2,492 1,802 5,113 919 Life N/A 174 376 3,719 N/A -------------------------------------------- Total $2,563 $2,666 $2,178 $8,832 $ 919 -------------------------------------------- Included in assumed unpaid losses in the preceding tables are $18 million and $34 million related to loss portfolio transfer agreements at December 31, 1997 and 1996, respectively. USF&G has not entered into any such agreements to cede its unpaid losses. Note 13 Financial Guarantees As of December 31, 1997, USF&G was contingently liable for par value amounts totaling approximately $89 million on financial guarantee exposures ceded through reinsurance agreements with a monoline insurance company in which USF&G formerly had a minority ownership interest. In addition, USF&G has other financial guarantee obligations where the par value guaranteed totaled $3 million at December 31, 1997, maturing at various dates through 2005. USF&G has also committed, in connection with the sale of certain real estate mortgages, to assumption of the first $15 million in losses, if any, that would arise as a result of default on multi-family mortgages securitized as mortgage-backed securities. -31- Note 14 Legal Contingencies USF&G's insurance subsidiaries are routinely engaged in litigation in the normal course of their businesses, including defending claims for punitive damages. As insurers, they defend third-party claims brought against their insureds, as well as defend themselves against first-party and coverage claims. Additionally, contingencies may arise from insurance regulatory matters and regulatory litigation matters (refer to Note 14.3). In the opinion of management, such contingencies and the contingencies described below are not expected to have a material adverse effect on USF&G's consolidated financial position, although it is possible that the results of operations in a particular quarter or annual period would be materially affected by an unfavorable outcome. 14.1. Workers' compensation litigation A series of class actions have been filed against the National Council on Compensation Insurance ("NCCI"), the insurance companies which served as servicing carriers in various states, and the National Workers' Compensation Reinsurance Pool ("NWCRP"). The complaints generally allege that the defendants conspired to fix servicing carrier fees at unreasonably high and noncompetitive levels thereby allegedly causing inflated deficits in the voluntary market, excessive expansion of the residual market and excessive contraction of the voluntary market. The plaintiffs generally seek unspecified compensatory and punitive damages and, in some cases, civil penalties, treble damages under state antitrust laws, and temporary and permanent injunctive relief. Plaintiffs' counsel in these cases have, from time to time, indicated that similar cases may be filed in other states. USF&G believes that it has meritorious defenses to each of the class actions and has determined to defend the actions vigorously. A determination of the outcome of these cases cannot be made at this time. Each of the currently pending cases is described below. North Carolina: On November 24, 1993, N.C. Steel, Inc., and six other North Carolina employers filed a class action captioned N.C. Steel, Inc., et al., v. National Council on Compensation Insurance, et al., in the General Court of Justice, Superior Court Division, Wake County, North Carolina against the NCCI, North Carolina Rate Bureau, USF&G and eleven other insurance companies that served as servicing carriers for the North Carolina involuntary workers' compensation market. On January 20, 1994, the plaintiffs filed an amended complaint seeking to certify a class of all employers who purchased workers' compensation insurance in the State of North Carolina after November 24, 1989. On February 14, 1995, the trial court granted the defendants' motion to dismiss the complaint. The plaintiffs appealed, and on July 16, 1996, the North Carolina Court of Appeals affirmed the dismissal of the plaintiffs' first claim for relief, which is premised on alleged excessive rates, but reversed the trial court's decision to dismiss the plaintiffs' second claim for relief, which is premised on employers allegedly being improperly shifted from the voluntary market to the assigned risk market as a result of stricter underwriting caused by high residual market burdens. The parties are awaiting the decision of the North Carolina Supreme Court following a hearing of both issues on March 18, 1997. -32- South Carolina: On August 22, 1994, the Attorney General of the State of South Carolina filed a suit captioned State of South Carolina, County of Greenville, et al., v. National Council on Compensation Insurance, et al., in the County of Greenville, South Carolina against the NCCI, the NWCRP, USF&G and seven other insurance companies that served as servicing carriers for the South Carolina involuntary workers' compensation market. The Attorney General alleges that the conspiracy occurred for an unspecified period of time prior to January 1994. Discovery is underway in the case and a trial is scheduled for November 1998. Kansas: On October 3, 1996, a Kansas employer filed a class action captioned Amundson & Associates Art Studies, Ltd., et al., v. National Council on Compensation Insurance, et al., in the District Court of Wyandotte County, Kansas against the NCCI and the insurance companies that acted as servicing carriers for the Kansas involuntary workers' compensation market. The defendants removed the case to the United States District Court for the District of Kansas, but on September 17, 1997, the federal District Court granted the plaintiff's motion to remand the case to the state court. The defendants have filed a motion to dismiss the case, and a hearing on that motion is scheduled for March 2, 1998. No trial date has yet been set. Tennessee: On December 31, 1996, four Tennessee employers filed a class action captioned Jo Ann Forman, Inc., et al., v. National Council on Compensation Insurance, et al., in the Chancery Court of Marion County, Tennessee against the NCCI, NWCRP and the insurance companies that acted as servicing carriers for the Tennessee involuntary workers' compensation market. The defendants have filed a motion to dismiss the case and are awaiting the decision of the trial court following a hearing on July 14, 1997. No discovery has yet occurred. Missouri: On February 20, 1997, six Missouri employers filed a class action captioned Atlas Reserve Temporaries, Inc., et al., v. Vanliner Insurance Co., et al., in the Circuit Court of Cole County, Missouri against the NCCI, USF&G and other insurance companies that acted as servicing carriers for the Missouri involuntary workers' compensation market. On August 26, 1997, the trial court denied the defendants' motion to dismiss the case, and the defendants appealed that decision. On September 26, 1997, the Missouri Court of Appeals denied the defendants' appeal. The defendants have moved for a change in venue. No discovery has yet occurred. -33- 14.2. Shareholder lawsuits On January 23 and February 2, 1998, two shareholders of USF&G filed separate suits against the Corporation captioned Sam Dickstein v. USF&G Corporation, et al., and Ethel Theodore v. USF&G Corporation, et al., in the Circuit Court for Baltimore City, Maryland. In these actions, the Corporation and some or all of its directors were named as defendants, along with St. Paul. The suits generally allege that the proposed merger agreement between USF&G and St. Paul is wrongful, unfair and harmful to USF&G's public shareholders and that USF&G's directors failed to: (1) undertake an adequate evaluation of USF&G's worth; (2) take adequate steps to enhance USF&G's value; (3) effectively expose USF&G to the marketplace; and (4) act independently to protect the interests of USF&G's shareholders. St. Paul is accused of aiding and abetting the alleged breaches of duty. The suits seek to have a plaintiff class certified of all shareholders of USF&G (excluding the individual defendants) and seek to enjoin the proposed merger and/or obtain monetary damages for the alleged conduct. USF&G believes the allegations in the suits are without merit, and is determined to defend the actions vigorously. A determination of the outcome of these cases cannot be made at this time. 14.3. Regulation USF&G's insurance subsidiaries are subject to extensive regulatory oversight in the jurisdictions where they do business. From time to time, the insurance regulatory framework has been the subject of increased scrutiny. At any one time there may be numerous initiatives within state legislatures or state insurance departments to alter and, in many cases, increase state authority to regulate insurance companies and their businesses. It is not possible to predict the future impact of increasing regulation on USF&G's operations. (Additional information regarding regulatory matters may be found in Section 9, "Regulation", of Management's Discussion and Analysis of Financial Condition and Results of Operations.) -34- Note 15 Interim Financial Data (Unaudited) (in millions except Quarter per share data) First Second Third Fourth* ------------------------------------ Revenues 1997 $845 $872 $828 $859 1996 867 858 871 902 1995 818 856 885 900 ------------------------------------ Net income 1997 $45 $47 $48 $54 1996 57 67 35 102 1995 49 46 49 65 ------------------------------------ Basic EPS** 1997 $.38 $.43 $.43 $.48 1996 $.43 $.52 $.26 $.84 1995 .39 .35 .37 .52 ------------------------------------ Diluted EPS** 1997 $.36 $.40 $.40 $.46 1996 .42 .50 .25 .79 1995 .36 .33 .36 .48 ------------------------------------ *The fourth quarter 1996 and 1995 results reflect tax benefits of $3 million and $15 million, respectively (refer to Note 11). The fourth quarter 1996 results also reflect $(30) million in facilities exit costs/(sublease income) as discussed in Note 1.13. **The sum of quarterly income per share amounts may not equal the full year's amount due to stock issuances, repurchases and redemptions during presented periods. Note 16 Information on Business Segments USF&G's principal business segments are property/casualty insurance and life insurance. 16.1. Assets The assets of the insurance operations are primarily investments. Foreign assets, consisting primarily of the assets of Afianzadora (refer to Note 1.14), are not material. Assets of the business segments were as follows: At December 31 (in millions) 1997 1996 ------------------- Property/casualty insurance $11,204 $10,099 Life insurance 4,478 4,204 Noninsurance operations and eliminations 137 104 ------------------- Consolidated total $15,819 $14,407 ------------------- -35- 16.2 Operations USF&G's insurance business is geographically diversified throughout North America. Reinsurance and noninsurance operations are located in the United States, Europe and various foreign countries. Foreign operations, in total, are not material. Summarized financial information for the business segments is as follows: Income (Loss) from Operations Revenues Before Income Taxes** (in millions) 1997 1996 1995 1997 1996 1995 ---------------------------------------------------------------------- Property/Casualty Insurance Underwriting Results: Commercial Insurance Group $ 936 $ 954 $ 876 $ (89) $ (82) $ (97) Family and Business Insurance Group 932 989 982 (71) (147) (119) Discover Re 29 22 25 4 2 1 F&G Re 459 480 490 30 52 43 Surety Group 189 141 119 27 8 16 ----------------------------------------------------------------------- Property/casualty underwriting results 2,545 2,586 2,492 (99) (167) (156) Net investment income* 443 441 438 443 441 438 Net realized gains on investments* 12 63 14 12 63 14 Other 9 10 12 (27) (106) (42) ----------------------------------------------------------------------- Total property/casualty insurance 3,009 3,100 2,956 329 231 254 ----------------------------------------------------------------------- Life Insurance: Premium income 137 145 174 Net investment income 253 269 306 Net realized gains (losses) on investments 14 (57) 1 Other -- -- 1 ----------------------------------------------------------------------- Total life insurance 404 357 482 78 (8) 28 ----------------------------------------------------------------------- Noninsurance operations and eliminations (9) 41 21 (115) 36 (87) ----------------------------------------------------------------------- Consolidated total $3,404 $3,498 $3,459 $ 292 $ 259 $ 195 ----------------------------------------------------------------------- * Net investment income and net realized gains (losses) on investments are not allocated to property/casualty business units. ** Income (loss) from operations before income taxes for 1996 included facilities exit (costs)/income by segment as follows: Property/casualty, $(28) million; and Noninsurance operations, $70 million.
-36- USF&G CORPORATION Report of Independent Auditors Board of Directors USF&G Corporation We have audited the accompanying consolidated statement of financial position of USF&G Corporation as of December 31, 1997 and 1996, and the related consolidated statements of operations, cash flows and shareholders' equity for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of USF&G Corporation at December 31, 1997 and 1996, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. /s/ ERNST & YOUNG LLP Baltimore, Maryland February 20, 1998 EX-99.3 5 COMBINED FINANCIAL STATEMENTS UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS OF ST. PAUL AND USF&G The following unaudited pro forma financial information combines the historical consolidated balance sheets and statements of income of St. Paul and USF&G, including their respective subsidiaries, after giving effect to the Merger. The unaudited pro forma condensed combined balance sheet at December 31, 1997, set forth below, gives effect to the Merger as if it had occurred at December 31, 1997. The unaudited pro forma condensed combined statements of income for each of the three years ended December 31, 1997, 1996 and 1995 give effect to the Merger as if it had occurred on January 1, 1995. These statements are prepared on the basis of accounting for the Merger as a "pooling of interests" and are based on the assumptions set forth in the notes thereto. The following pro forma financial information has been prepared from, and should be read in conjunction with, the audited historical consolidated financial statements and related notes thereto of St. Paul and USF&G, incorporated by reference herein. The following information is not necessarily indicative of the financial position or operating results that would have occurred had the Merger been consummated on the date, or at the beginning of the period for which the Merger is being given effect, nor is it necessarily indicative of future financial position or operating results. See "Where You Can Find More Information." -1- ST. PAUL AND USF&G UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET AS OF DECEMBER 31, 1997
HISTORICAL PRO FORMA ----------------------- ------------------------ ST. PAUL USF&G ADJUSTMENTS COMBINED ---------- ----------- ----------- ----------- (DOLLARS IN MILLIONS, EXCEPT SHARE DATA) ASSETS Investments............................................ $ 15,036 $ 10,944 $ 0 $ 25,980 Reinsurance recoverables............................... 1,963 2,355 (12)(6) 4,306 Receivables............................................ 1,798 878 0 2,676 Deferred income taxes.................................. 845 317 66(9) 1,228 Other assets........................................... 1,859 1,325 (41)(7) 3,143 ---------- ----------- ----------- ----------- TOTAL ASSETS....................................... $ 21,501 $ 15,819 $ 13 $ 37,333 ---------- ----------- ----------- ----------- ---------- ----------- ----------- ----------- LIABILITIES Insurance reserves: Losses, loss adjustment expenses and policy benefits........................................... $ 11,817 $ 10,017 $ 135(6)$ 21,969 Unearned premiums.................................... 2,380 1,148 0 3,528 ---------- ----------- ----------- ----------- Total insurance reserves........................... 14,197 11,165 135 25,497 Debt................................................... 783 521 0 1,304 Other liabilities...................................... 1,687 1,760 28(8) 3,475 ---------- ----------- ----------- ----------- TOTAL LIABILITIES.................................. 16,667 13,446 163 30,276 ---------- ----------- ----------- ----------- Company-obligated mandatorily redeemable preferred securities of subsidiary............................. 207 296 0 503 ---------- ----------- ----------- ----------- SHAREHOLDERS' EQUITY PREFERRED SHAREHOLDERS' EQUITY......................... 17 0 0 17 ---------- ----------- ----------- ----------- COMMON: Common stock........................................... 512 1,417 0 1,929 Retained earnings...................................... 3,451 493 (150)(9) 3,794 Other.................................................. 647 167 0 814 ---------- ----------- ----------- ----------- TOTAL COMMON SHAREHOLDERS' EQUITY.................. 4,610 2,077 (150) 6,537 ---------- ----------- ----------- ----------- TOTAL SHAREHOLDERS' EQUITY......................... 4,627 2,077 (150) 6,554 ---------- ----------- ----------- ----------- TOTAL LIABILITIES, REDEEMABLE PREFERRED SECURITIES AND SHAREHOLDERS' EQUITY........................... $ 21,501 $ 15,819 $ 13 $ 37,333 ---------- ----------- ----------- ----------- ---------- ----------- ----------- ----------- Book value per common share............................ $ 55.06 $ 17.84 $ 56.08 Common shares outstanding.............................. 83,727,800 116,402,199 32,837,060(3) 116,564,860
------------------------ The accompanying notes are an integral part of these pro forma condensed combined financial statements. -2- ST. PAUL AND USF&G UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF INCOME FOR THE YEAR ENDED DECEMBER 31, 1997
HISTORICAL PRO FORMA --------------------- ----------------------- ST. PAUL USF&G ADJUSTMENTS COMBINED --------- ---------- ----------- ---------- (DOLLARS IN MILLIONS, EXCEPT SHARE DATA) REVENUES: Premiums earned......................................... $ 4,616 $ 2,682 $ 0 $ 7,298 Net investment income................................... 886 691 0 1,577 Realized gains.......................................... 408 15 0 423 Asset management-investment banking..................... 262 0 0 262 Other................................................... 47 16 0 63 --------- ---------- ----------- ---------- Total revenues from continuing operations........... 6,219 3,404 0 9,623 --------- ---------- ----------- ---------- EXPENSES: Insurance losses, loss adjustment expenses and policy benefits.............................................. 3,345 2,071 (37)(7) 5,379 Policy acquisition expenses............................. 1,021 687 0 1,708 Operating and administrative............................ 834 375 5(7) 1,214 --------- ---------- ----------- ---------- Total expenses...................................... 5,200 3,133 (32) 8,301 --------- ---------- ----------- ---------- INCOME BEFORE INCOME TAXES.......................... 1,019 271 32 1,322 Income tax expense...................................... 246 77 11(9) 334 --------- ---------- ----------- ---------- INCOME FROM CONTINUING OPERATIONS................... $ 773 $ 194 $ 21 $ 988 --------- ---------- ----------- ---------- --------- ---------- ----------- ---------- INCOME FROM CONTINUING OPERATIONS PER COMMON SHARE: Basic................................................... $ 9.10 $ 1.72 $ 8.46 Diluted................................................. $ 8.39 $ 1.63 $ 7.85 ADJUSTED AVERAGE COMMON SHARES OUTSTANDING: Basic................................................... 83,572,000 111,688,000 31,507,000 115,079,000 Diluted................................................. 92,261,000 120,109,000 33,883,000 126,144,000
------------------------ The accompanying notes are an integral part of these pro forma condensed combined financial statements. -3- ST. PAUL AND USF&G UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF INCOME FOR THE YEAR ENDED DECEMBER 31, 1996
HISTORICAL PRO FORMA --------------------- ----------------------- ST. PAUL USF&G ADJUSTMENTS COMBINED --------- ---------- ----------- ---------- (DOLLARS IN MILLIONS, EXCEPT SHARE DATA) REVENUES: Premiums earned...................................... $ 4,448 $ 2,731 $ 0 $ 7,179 Net investment income................................ 807 705 0 1,512 Realized gains....................................... 219 44 4(7) 267 Asset management-investment banking.................. 220 0 0 220 Other................................................ 40 18 0 58 --------- ---------- ----------- ---------- Total revenues from continuing operations........ 5,734 3,498 4 9,236 --------- ---------- ----------- ---------- EXPENSES: Insurance losses, loss adjustment expenses and policy benefits........................................... 3,318 2,181 (28)(7) 5,471 Policy acquisition expenses.......................... 975 707 0 1,682 Operating and administrative......................... 742 351 12(7) 1,105 --------- ---------- ----------- ---------- Total expenses................................... 5,035 3,239 (16) 8,258 --------- ---------- ----------- ---------- INCOME BEFORE INCOME TAXES....................... 699 259 20 978 Income tax expense (benefit)......................... 141 (2) 7(9) 146 --------- ---------- ----------- ---------- INCOME FROM CONTINUING OPERATIONS..................................... $ 558 $ 261 $ 13 $ 832 --------- ---------- ----------- ---------- --------- ---------- ----------- ---------- INCOME FROM CONTINUING OPERATIONS PER COMMON SHARE: Basic................................................ $ 6.57 $ 2.05 $ 6.87 Diluted.............................................. $ 6.11 $ 1.95 $ 6.45 ADJUSTED AVERAGE COMMON SHARES OUTSTANDING: Basic................................................ 83,474,000 117,674,000 33,196,000(3) 116,670,000 Diluted.............................................. 91,897,000 127,734,000 36,034,000(3) 127,931,000
------------------------ The accompanying notes are an integral part of these pro forma condensed combined financial statements. -4- ST. PAUL AND USF&G UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF INCOME FOR THE YEAR ENDED DECEMBER 31, 1995
HISTORICAL PRO FORMA --------------------- ----------------------- ST. PAUL USF&G ADJUSTMENTS COMBINED --------- ---------- ----------- ---------- (DOLLARS IN MILLIONS, EXCEPT SHARE DATA) REVENUES: Premiums earned......................................... $ 3,971 $ 2,666 $ 0 $ 6,637 Net investment income................................... 741 733 0 1,474 Realized gains.......................................... 85 7 0 92 Asset management-investment banking..................... 221 0 0 221 Other................................................... 38 53 0 91 --------- ---------- ----------- ---------- Total revenues from continuing operations........... 5,056 3,459 0 8,515 --------- ---------- ----------- ---------- EXPENSES: Insurance losses, loss adjustment expenses and policy benefits.............................................. 2,864 2,178 (32)(6) 5,010 Policy acquisition expenses............................. 857 714 0 1,571 Operating and administrative............................ 666 372 1(7) 1,039 --------- ---------- ----------- ---------- Total expenses...................................... 4,387 3,264 (31) 7,620 --------- ---------- ----------- ---------- INCOME BEFORE INCOME TAXES.......................... 669 195 31 895 Income tax expense (benefit)............................ 131 (14) 11(9) 128 --------- ---------- ----------- ---------- INCOME FROM CONTINUING OPERATIONS........................................ $ 538 $ 209 $ 20 $ 767 --------- ---------- ----------- ---------- --------- ---------- ----------- ---------- INCOME FROM CONTINUING OPERATIONS PER COMMON SHARE: Basic................................................... $ 6.26 $ 1.63 $ 6.29 Diluted................................................. $ 5.88 $ 1.53 $ 5.91 ADJUSTED AVERAGE COMMON SHARES OUTSTANDING: Basic................................................... 84,385,000 111,474,000 31,447,000(3) 115,832,000 Diluted................................................. 91,637,000 130,064,000 36,691,000(3) 128,328,000
------------------------ The accompanying notes are an integral part of these pro forma condensed combined financial statements. -5- ST. PAUL AND USF&G NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS 1. DESCRIPTION OF TRANSACTIONS The Merger Agreement provides that each share of USF&G Common Stock will be converted into and become the right to receive a number of shares of St. Paul Common Stock based upon the Exchange Ratio. For purposes of the unaudited pro forma condensed combined financial statements, an Exchange Ratio of 0.2821 has been assumed. If the maximum Exchange Ratio of 0.2973 were assumed, pro forma combined diluted earnings per share for the years ended December 31, 1997, 1996 and 1995 would be $7.74, $6.35 and $5.82, respectively. 2. RECLASSIFICATIONS AND RESTATEMENTS Certain items in USF&G's historical financial statements have been reclassified to conform to St. Paul's presentation. St. Paul sold its insurance brokerage operation, Minet, in May 1997. St. Paul's historical financial data for all periods presented reflect Minet as a discontinued operation. 3. PER COMMON SHARE DATA The pro forma combined per common share data has been computed based on the combined historical income from continuing operations as adjusted for retroactive changes in certain accounting methods of both companies in order to achieve conformity on the combined historical weighted average common shares outstanding. For purposes of this calculation, USF&G's weighted average common shares outstanding was multiplied by the assumed Exchange Ratio of 0.2821. 4. INTERCOMPANY TRANSACTIONS Transactions between St. Paul and USF&G are not material in relation to the pro forma condensed combined financial statements and therefore intercompany balances have not been eliminated from the pro forma combined amounts. 5. RESTRUCTURING CHARGE The pro forma condensed combined financial statements do not reflect a planned Merger-related restructuring charge that is currently expected to be between $300 million and $500 million, primarily for costs related to the combination of headquarters, the integration of the information technology systems of St. Paul and USF&G, headcount reduction and legal expenses, because such restructuring charges are non-recurring. Although there can be no assurance that the restructuring charge will fall within the range provided, this range represents management's best estimate based upon the information currently available. 6. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES Liabilities for unpaid losses and loss adjustment expenses related to workers' compensation coverages were discounted to present value in the historical financial statements of USF&G. St. Paul did not discount workers' compensation reserves. On a combined basis, St. Paul and USF&G will discount certain workers' compensation reserves using an interest rate of up to four percent. Accordingly, the pro forma income -6- ST. PAUL AND USF&G NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS (CONTINUED) 6. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES (CONTINUED) statement adjustments for all periods presented include a reduction in insurance losses and loss adjustment expenses to conform the accounting policies of both companies. Those pro forma adjustments to the condensed combined statements of income for the years ended December 31, 1997, 1996 and 1995 are $46 million, $33 million and $32 million, respectively. 7. SOFTWARE CAPITALIZATION Included in USF&G's historical financial statements are capitalized costs for internal use software. These costs were amortized over their useful lives. St. Paul does not capitalize such expenditures. On a combined basis, St. Paul and USF&G do not expect to capitalize development costs for internal use software. Accordingly, the pro forma adjustments for all periods presented conform the historical financial statements of USF&G to the combined presentation. Those pro forma adjustments to the condensed combined statements of income are as follows:
YEARS ENDED DECEMBER 31, ----- ----- ----- (IN MILLIONS) Insurance losses and loss adjustment expenses..................... $ 9 $ 5 $ 0 Operating and administrative expenses............................. 5 12 1 Realized loss..................................................... 0 (4) 0 ------- -------- ------ Total............................................................. $ 14 $ 13 $ 1 ======= ======== ======
8. ADJUSTMENTS TO RECORD ANTICIPATED TRANSACTION COSTS Transaction costs of the Merger, representing investment banker and other professional fees, are expected to be approximately $28 million. The unaudited pro forma condensed combined statements of income do not reflect these charges. The unaudited pro forma condensed combined balance sheet reflects these charges. It is anticipated that these charges will be incurred by St. Paul and USF&G and expensed at the Effective Time, which is currently expected to be in mid-1998. 9. INCOME TAXES The income tax effect of adjustments made to the unaudited pro forma condensed combined financial statements was calculated using St. Paul's statutory income tax rate of 35%. 10. STOCK SPLIT Historical per share data for St. Paul has been adjusted to reflect a two-for-one split of the St. Paul Common Stock which took place in 1994. All per share amounts contained in the unaudited pro forma condensed combined financial statements and the notes thereto reflect such stock split. This data does not reflect the St. Paul Stock Split. -7- -----END PRIVACY-ENHANCED MESSAGE-----