UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF --- THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1999 ------------- or TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) --- OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ----------- --------- Commission File Number 0-3021 ------ THE ST. PAUL COMPANIES, INC. ------------------------------------------ (Exact name of Registrant as specified in its charter) Minnesota 41-0518860 ------------------------- ------------------------- (State or other jurisdiction of (I.R.S. Employer Identification incorporation or organization) No.) 385 Washington St., Saint Paul, MN 55102 ---------------------------------- ---------- (Address of principal executive (Zip Code) offices) Registrant's telephone number, including area code: (651) 310-7911 -------------- Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- The number of shares of the Registrant's Common Stock, without par value, outstanding at August 9, 1999, was 226,638,192.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES TABLE OF CONTENTS Page No. PART I. FINANCIAL INFORMATION ---------- Consolidated Statements of Operations (Unaudited), Three Months and Six Months Ended June 30, 1999 and 1998 3 Consolidated Balance Sheets, June 30, 1999 (Unaudited) and December 31, 1998 4 Consolidated Statements of Shareholders' Equity, Six Months Ended June 30, 1999 (Unaudited) and Twelve Months Ended 6 December 31, 1998 Consolidated Statements of Comprehensive Income (Unaudited), Six Months Ended June 30, 1999 and 1998 7 Consolidated Statements of Cash Flows (Unaudited), Six Months Ended June 30, 1999 and 1998 8 Notes to Consolidated Financial Statements (Unaudited) 9 Management's Discussion and Analysis of Financial Condition and Results of Operations 22 PART II. OTHER INFORMATION Item 1 through Item 6 38 Signatures 38 EXHIBIT INDEX 39
PART I FINANCIAL INFORMATION THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Consolidated Statements of Operations (Unaudited) Three Months Ended Six Months Ended June 30 June 30 (In millions, except per share ------------------- ------------------- data) 1999 1998 1999 1998 ----- ----- ----- ----- Revenues: Premiums earned $1,412 1,468 2,815 2,966 Net investment income 402 398 797 795 Asset management 85 75 166 146 Realized investment gains 68 136 133 185 Other 31 23 61 52 ----- ----- ----- ----- Total revenues 1,998 2,100 3,972 4,144 ----- ----- ----- ----- Expenses: Insurance losses and loss adjustment expenses 1,013 1,345 2,048 2,408 Life policy benefits 85 62 152 122 Policy acquisition expenses 359 385 699 761 Operating and administrative 251 596 517 876 ----- ----- ----- ----- Total expenses 1,708 2,388 3,416 4,167 ----- ----- ----- ----- Income (loss) from continuing operations before income taxes and cumulative effect of accounting change 290 (288) 556 (23) Income tax expense (benefit) 69 (95) 135 (34) ----- ----- ----- ----- Income (loss) from continuing operations before cumulative effect of accounting change 221 (193) 421 11 Cumulative effect of accounting change, net of taxes - - (30) - ----- ----- ----- ----- Income (loss) from continuing operations 221 (193) 391 11 Loss from discontinued operations, net of taxes (17) (81) (22) (90) ----- ----- ----- ----- Net income (loss) $204 (274) 369 (79) ===== ===== ===== ===== Basic earnings (loss) per common share: Income (loss) from continuing operations before cumulative effect of accounting change $0.97 (0.84) 1.81 0.02 Cumulative effect of accounting change, net of taxes - - (0.13) - ----- ----- ----- ----- Income (loss) from continuing operations $0.97 (0.84) 1.68 0.02 Loss from discontinued operations, net of taxes (0.08) (0.34) (0.09) (0.38) ----- ----- ----- ----- Net income (loss) $0.89 (1.18) 1.59 (0.36) ===== ===== ===== ===== Diluted earnings (loss) per common share: Income (loss) from continuing operations before cumulative effect of accounting change $0.91 (0.84) 1.71 0.02 Cumulative effect of accounting change, net of taxes - - (0.12) - ----- ----- ----- ----- Income (loss) from continuing operations 0.91 (0.84) 1.59 0.02 Loss from discontinued operations, net of taxes (0.07) (0.34) (0.09) (0.38) ----- ----- ----- ----- Net income (loss) $0.84 (1.18) 1.50 (0.36) ===== ===== ===== ===== Dividends declared on common stock $0.26 0.25 0.52 0.50 ===== ===== ===== ===== See notes to consolidated financial statements.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Consolidated Balance Sheets (In millions) June 30, December 31, ASSETS 1999 1998 - ------ ------------ ------------- (Unaudited) Investments: Fixed maturities, at estimated fair value $20,849 $21,056 Equities, at estimated fair value 1,393 1,259 Real estate and mortgage loans 1,531 1,507 Venture capital, at estimated fair value 640 571 Securities lending collateral 1,822 1,368 Other investments 315 373 Short-term investments, at cost 771 982 -------- -------- Total investments 27,321 27,116 Cash 126 120 Investment banking inventory securities 67 107 Reinsurance recoverables: Unpaid losses 4,113 3,978 Paid losses 190 157 Ceded unearned premiums 285 288 Receivables: Underwriting premiums 2,435 2,152 Interest and dividends 368 361 Other 204 117 Deferred policy acquisition expenses 1,007 878 Deferred income taxes 1,339 1,193 Office properties and equipment, at cost less accumulated depreciation of $478 (1998; $405) 531 518 Goodwill 574 592 Other assets 769 746 -------- -------- Total assets $39,329 $38,323 ======== ======== See notes to consolidated financial statements.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Consolidated Balance Sheets (continued) (In millions) June 30, December 31, LIABILITIES AND SHAREHOLDERS' EQUITY 1999 1998 - ------------------------------------ ---------- ----------- (Unaudited) Liabilities: Insurance reserves: Losses and loss adjustment expenses $18,486 $18,458 Future policy benefits 4,604 4,142 Unearned premiums 3,342 3,266 -------- -------- Total insurance reserves 26,432 25,866 Debt 1,506 1,260 Payables: Reinsurance premiums 346 291 Income taxes 258 221 Accrued expenses and other 1,089 1,238 Securities lending 1,822 1,368 Other liabilities 1,085 940 -------- -------- Total liabilities 32,538 31,184 -------- -------- Company-obligated mandatorily redeemable preferred capital securities of subsidiaries or trusts holding solely convertible subordinated debentures of the Company 503 503 -------- -------- Shareholders' equity: Preferred: Series B convertible preferred stock; 1.45 shares authorized; 0.9 shares outstanding in 1999 and 1998 132 134 Guaranteed obligation - PSOP (114) (119) -------- -------- Total preferred shareholders' equity 18 15 -------- -------- Common: Common stock, 480 shares authorized; 227 shares outstanding (234 shares in 1998) 2,078 2,128 Retained earnings 3,541 3,480 Accumulated other comprehensive income: Unrealized appreciation 670 1,027 Unrealized loss on foreign currency translation (19) (14) -------- -------- Total accumulated other comprehensive income 651 1,013 -------- -------- Total common shareholders' equity 6,270 6,621 -------- -------- Total shareholders' equity 6,288 6,636 -------- -------- Total liabilities, redeemable preferred securities and shareholders' equity $39,329 $38,323 ======== ======== See notes to consolidated financial statements.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Consolidated Statements of Shareholders' Equity (In millions) Six Twelve Months Ended Months Ended June 30 December 31 ------------ ------------ 1999 1998 ------ ------ (Unaudited) Preferred shareholders' equity: Series B PSOP convertible preferred stock: Beginning of period $134 $138 Redemptions during period (2) (4) ------- ------- End of period 132 134 ------- ------- Guaranteed obligation - PSOP: Beginning of period (119) (121) Principal payments 5 2 ------- ------- End of period (114) (119) ------- ------- Total preferred shareholders' equity 18 15 ------- ------- Common shareholders' equity: Common stock: Beginning of period 2,128 2,057 Stock issued under stock incentive plans 22 70 Stock issued for preferred shares redeemed 3 8 Reacquired common shares (75) (35) Other - 28 ------- ------- End of period 2,078 2,128 ------- ------- Retained earnings: Beginning of period 3,480 3,720 Net income 369 89 Dividends declared on common stock (114) (223) Dividends declared on preferred stock, net of taxes (4) (9) Reacquired common shares (190) (100) Tax benefit on employee options and awards 2 7 Premium on preferred shares redeemed (2) (4) ------- ------- End of period 3,541 3,480 ------- ------- Unrealized appreciation, net of taxes: Beginning of period 1,027 846 Change during the period (357) 181 ------- ------- End of period 670 1,027 ------- ------- Unrealized gain (loss)loss on foreign currency translation, net of taxes: Beginning of period (14) (23) Change during the period (5) 9 ------- ------- End of period (19) (14) ------- ------- Guaranteed obligation - ESOP: Beginning of period - (8) Principal payments - 8 ------- ------- End of period - - ------- ------- Total common shareholders' equity 6,270 6,621 ------- ------- Total shareholders' equity $6,288 $6,636 ======= ======= See notes to consolidated financial statements.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income Unaudited (In millions) Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- 1999 1998 1999 1998 ------ ------ ------ ------ (In thousands) Net income (loss) $204 $(274) $369 $(79) ----- ----- ----- ----- Other comprehensive income, net of taxes: Change in unrealized appreciation (249) (28) (357) 21 Change in unrealized loss on foreign currency translation (3) (4) (5) - ----- ----- ----- ----- Other comprehensive income (loss) (252) (32) (362) 21 ----- ----- ----- ----- Comprehensive income (loss) $(48) $(306) $7 ($58) ===== ===== ===== ===== See notes to consolidated financial statements.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Unaudited (In millions) Six Months Ended June 30 ----------------------- 1999 1998 -------- ------- OPERATING ACTIVITIES Net income (loss) $369 $(79) Adjustments: Change in property-liability insurance reserves 181 351 Change in reinsurance balances (117) (112) Change in premiums receivable (341) (58) Change in asset management balances 16 (3) Depreciation and amortization 69 64 Realized investment gains (133) (185) Other (79) 3 ----- ----- Net Cash Used by Operating Activities (35) (19) ----- ----- INVESTING ACTIVITIES Purchase of investments (3,440) (2,288) Proceeds from sales and maturities of investments 2,923 2,433 Change in short-term investments 170 16 Change in open security transactions 54 101 Net purchases of office properties and equipment (73) (52) Acquisitions - (98) Other (20) 107 ----- ----- Net Cash Provided (Used) by Investing Activities (386) 219 ----- ----- FINANCING ACTIVITIES Deposits on universal life and investment contracts 602 181 Withdrawals on universal life and investment contracts (56) (131) Dividends paid on common and preferred stock (123) (103) Proceeds from issuance of debt 286 36 Repayment of debt (41) (194) Repurchase of common shares (265) - Stock options exercised and other 22 27 ----- ----- Net Cash Provided (Used) by Financing Activities 425 (184) ----- ----- Effect of exchange rate changes on cash 2 - ----- ----- Increase in cash 6 16 Cash at beginning of period 120 113 ----- ----- Cash at end of period $126 $129 ===== ===== See notes to consolidated financial statements.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Unaudited June 30, 1999 Note 1 - Basis of Presentation - ------------------------------ The financial statements include The St. Paul Companies, Inc. and subsidiaries (The St. Paul), and have been prepared in conformity with generally accepted accounting principles. The St. Paul completed its merger with USF&G Corporation (USF&G) in April 1998. The financial statements for all current and prior periods in this report reflect the combined accounts and results of operations of The St. Paul and USF&G. In July 1999, The St. Paul announced an agreement to sell its standard personal insurance business to MetLife Auto and Home. The results of the operations sold have been accounted for as discontinued operations for all current and prior year periods presented in this report. See Note 9 on page 17 for further information regarding this sale. These consolidated financial statements rely, in part, on estimates. In the opinion of management, all necessary adjustments, consisting of normal recurring adjustments, have been reflected for a fair presentation of the results of operations, financial position and cash flows in the accompanying unaudited consolidated financial statements. The results for the period are not necessarily indicative of the results to be expected for the entire year. Reference should be made to the "Notes to Consolidated Financial Statements" in The St. Paul's annual report to shareholders for the year ended December 31, 1998. The amounts in those notes have not changed materially except as a result of transactions in the ordinary course of business or as otherwise disclosed in these notes. Some amounts in the 1998 consolidated financial statements have been reclassified to conform with the 1999 presentation. These reclassifications had no effect on net income or shareholders' equity, as previously reported.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 2 - Earnings Per Share - --------------------------- Earnings per common share (EPS) amounts were calculated by dividing net income, as adjusted, by the average common shares outstanding. Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- 1999 1998 1999 1998 ----- ----- ----- ----- (In millions, except per share data) EARNINGS Basic: Net income (loss), as reported $204 $(274) $369 $(79) Dividends on preferred stock, net of taxes (2) (2) (4) (4) Premium on preferred shares redeemed (1) (1) (2) (2) ----- ----- ----- ----- Net income (loss) available to common shareholders $201 $(277) $363 $(85) ===== ===== ===== ===== Diluted: Net income (loss) available to common shareholders $201 $(277) $363 $(85) Effect of dilutive securities: Convertible preferred stock 2 - 3 - Convertible monthly income preferred securities 2 - 4 - Zero coupon convertible notes 1 - 2 - ----- ----- ----- ----- Net income (loss) available to common shareholders $206 $(277) $372 $(85) ===== ===== ===== ===== COMMON SHARES Basic: Weighted average common shares outstanding 226 235 228 235 ===== ===== ===== ===== Diluted: Weighted average common shares outstanding 226 235 228 235 Effect of dilutive securities: Stock options 2 - 2 - Convertible preferred stock 7 - 7 - Convertible monthly income preferred securities 7 - 7 - Zero coupon convertible notes 3 - 3 - ----- ----- ----- ----- Total 245 235 247 235 ===== ===== ===== ===== EARNINGS (LOSS) PER SHARE Basic $0.89 $(1.18) $1.59 $(0.36) ===== ===== ===== ===== Diluted $0.84 $(1.18) $1.50 $(0.36) ===== ===== ===== =====
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 3 - Investments - -------------------- Investment Activity. A summary of investment transactions is presented below. Six Months Ended June 30 ------------------------ 1999 1998 -------- -------- (In millions) Purchases: Fixed maturities $2,519 $1,146 Equities 654 820 Real estate and mortgage loans 110 149 Venture capital 107 86 Other investments 50 87 ----- ----- Total purchases 3,440 2,288 ----- ----- Proceeds from sales and maturities: Fixed maturities 2,039 1,230 Equities 675 915 Real estate and mortgage loans 78 173 Venture capital 110 43 Other investments 21 72 ----- ----- Total sales and maturities 2,923 2,433 ----- ----- Net purchases (sales) $517 $(145) ===== ===== Change in Unrealized Appreciation. The increase (decrease) in unrealized appreciation of investments recorded in common shareholders' equity was as follows: Six Months Ended Twelve Months Ended June 30, 1999 December 31, 1998 ---------------- ------------------- (In millions) Fixed maturities $(787) $203 Equities 85 69 Venture capital 27 45 Life deferred policy acquisition costs and policy benefits 59 (1) Single premium immediate annuity reserves 43 (17) Other - (16) ----- ----- Total change in pretax unrealized appreciation (573) 283 Change in deferred taxes 216 (102) ----- ----- Total change in unrealized appreciation, net of taxes $(357) $181 ===== =====
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 4 - Income Taxes - --------------------- The components of income tax expense on income from continuing operations before the cumulative effect of accounting change is as follows : Three Months Ended Six Months Ended June 30 June 30 ---------------- ---------------- 1999 1998 1999 1998 ------ ------ ------ ------ (In millions) Federal current tax expense (benefit) $ 2 $ (7) $ 14 $ 44 Federal deferred tax expense (benefit) 59 (93) 105 (93) ----- ----- ----- ----- Total federal income tax expense (benefit) 61 (100) 119 (49) Foreign income taxes 6 3 13 10 State income taxes 2 2 3 5 ----- ----- ----- ----- Total income tax expense (benefit) on continuing operations $69 $(95) $135 $(34) ===== ===== ===== ===== Note 5 - Contingent Liabilities - ------------------------------- In the ordinary course of conducting business, The St. Paul and some of its subsidiaries have been named as defendants in various lawsuits. Some of these lawsuits attempt to establish liability under insurance contracts issued by those companies. Plaintiffs in these lawsuits are asking for money damages or to have the court direct the activities of the company's operations in certain ways. Although it is possible that the settlement of a contingency may be material to The St. Paul's results of operations and liquidity in the period in which the settlement occurs, The St. Paul believes that the total amounts that it or its subsidiaries will ultimately have to pay in all of these lawsuits will have no material effect on its overall financial position. In some cases, plaintiffs seek to establish coverage for their liability under environmental protection laws. See "Environmental and Asbestos Claims" in Management's Discussion and Analysis for information on these claims.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 6 - Debt - ------------- Debt consists of the following: June 30, December 31, 1999 1998 --------------- --------------- Book Fair Book Fair Value Value Value Value ----- ------ ----- ------ (In millions) Medium-term notes $617 $618 $637 $675 Commercial paper 434 434 257 257 8 3/8% senior notes 150 156 150 160 Zero coupon convertible notes 92 97 111 118 7 1/8% senior notes 80 81 80 86 Variable rate borrowings 64 64 - - Floating rate notes 46 46 - - Real estate mortgages 15 16 15 16 Nuveen short-term borrowings 8 8 10 10 ----- ----- ----- ----- Total debt $1,506 $1,520 $1,260 $1,322 ===== ===== ===== ===== A number of The St. Paul's real estate entities are parties to variable rate loan agreements aggregating $63.8 million. The borrowings mature in the year 2030, with principal paydowns starting in the year 2006. The interest rate is set weekly by a third party, and was 3.8% at June 30, 1999. Note 7 - Segment Information - ---------------------------- The St. Paul has seven reportable business segments in its property-liability insurance operation, consisting of the Commercial Lines Group, Specialty Commercial, Surety, Specialty Auto, International, Reinsurance and Investment Operations. (In July 1999, The St. Paul announced an agreement to sell its standard personal insurance business to Metropolitan Property and Casualty Insurance Company in a transaction expected to close near the end of the third quarter of 1999, subject to regulatory approval. The results of the operations to be sold have been accounted for as discontinued operations for all current and prior year periods presented in this report and are not included in The St. Paul's segment data). The St. Paul also has a life insurance segment (Fidelity and Guaranty Life) and an asset management segment (The John Nuveen Company). The St. Paul evaluates the performance of its property-liability underwriting segments based on GAAP underwriting results. The property- liability investment operation is disclosed as a separate reportable segment because that operation is managed at the corporate level and the invested assets, net investment income and realized gains are not allocated to individual underwriting segments. The life insurance and asset management segments are evaluated based on their respective pretax operating results, which include investment income. The St. Paul does not aggregate its segments for purposes of reporting segment information. The reportable underwriting business segments in The St. Paul's property-liability operation are each managed separately because each offers insurance products to unique customer classes and utilizes different underwriting criteria and marketing strategies. For example, the Commercial Lines Group provides "commodity-type" insurance products to the extensive, small and medium-sized commercial markets. It also targets certain large industry groups, such as the construction industry. By contrast, the Specialty Commercial segment markets specialized insurance products and services tailored to meet the individual needs of specific commercial customer groups, such as doctors, lawyers, officers and directors, as well as technology firms and government entities. Customers in the Specialty Commercial segment generally require specialized underwriting expertise and claim settlement services. The tabular information on the following pages provides revenue and income data for each of The St. Paul's business segments for the three months and six months ended June 30, 1999 and 1998. In 1999, The St. Paul revised its segment reporting structure to separately disclose its Surety underwriting operation as a business
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) - --------------------------------------- segment, which differs from its prior classification as a component of the Commercial Lines Group. This revision reflects the distinct nature of this operation, which provides surety bond coverages (primarily for construction contractors). The Surety operation is managed and evaluated separately from other components of the Commercial Lines Group, and is also the largest underwriter of surety bonds in North America, based on 1997 written premium volume. Segment information for 1998 has been restated to be consistent with the 1999 presentation. Three Months Ended Six Months Ended June 30 June 30 ------------------ ------------------ 1999 1998 1999 1998 ----- ----- ----- ------ (In millions) Revenues from Continuing Operations Property-liability insurance: U.S. Underwriting: Commercial Lines Group $526 $564 $1,029 $1,155 Specialty Commercial 318 334 679 672 Surety 94 91 184 164 Specialty Auto 56 63 114 120 ----- ----- ----- ----- Total U.S. Underwriting 994 1,052 2,006 2,111 International 139 127 260 241 ----- ----- ----- ----- Total primary insurance operations 1,133 1,179 2,266 2,352 Reinsurance 242 263 484 564 ----- ----- ----- ----- Total property-liability premiums earned 1,375 1,442 2,750 2,916 ----- ----- ----- ----- Investment operations: Net investment income 321 331 643 663 Realized investment gains 71 132 132 180 ----- ----- ----- ----- Total investment operations 392 463 775 843 Other 27 20 53 42 ----- ----- ----- ----- Total property- liability insurance 1,794 1,925 3,578 3,801 ----- ----- ----- ----- Life insurance 110 94 209 184 ----- ----- ----- ----- Asset management 86 76 169 149 ----- ----- ----- ----- Total reportable segments 1,990 2,095 3,956 4,134 Parent company, other operations and consolidating eliminations 8 5 16 10 ----- ----- ----- ----- Total revenues from continuing operations $1,998 $2,100 $3,972 $4,144 ===== ===== ===== =====
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) - --------------------------------------- Three Months Ended Six Months Ended June 30 June 30 ----------------- ---------------- 1999 1998 1999 1998 ----- ----- ----- ----- (In millions) Income (Loss) from Continuing Operations Before Income Taxes and Cumulative Effect of Accounting Change Property-liability insurance: U.S. Underwriting: Commercial Lines Group $(77) $(349) $(172) $(427) Specialty Commercial (26) (42) (43) (47) Surety 13 19 28 33 Specialty Auto - 1 - (1) ----- ----- ----- ----- Total U.S. Underwriting (90) (371) (187) (442) International (17) (15) (53) (40) ----- ----- ----- ----- Total primary insurance (107) (386) (240) (482) Reinsurance 6 2 29 16 ----- ----- ----- ----- Total GAAP underwriting result (101) (384) (211) (466) ----- ----- ----- ----- Investment operations: Net investment income 321 331 643 663 Realized investment gains 71 132 132 180 ----- ----- ----- ----- Total investment operations 392 463 775 843 Other (1) (190) (21) (217) ----- ----- ----- ----- Total property- liability insurance 290 (111) 543 160 ----- ----- ----- ----- Life insurance 9 (33) 28 (14) ----- ----- ----- ----- Asset management: Pretax income before minority interest 40 33 77 64 Minority interest (10) (8) (18) (15) ----- ----- ----- ----- Total asset management 30 25 59 49 ----- ----- ----- ----- Total reportable segments 329 (119) 630 195 Parent company, other operations and consolidating eliminations (39) (169) (74) (218) ----- ----- ----- ----- Total income from continuing operations before income taxes and cumulative effect of accounting change $290 $(288) $556 $(23) ===== ===== ===== =====
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 8 - Reinsurance - -------------------- The St. Paul's consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to The St. Paul's acceptance of certain insurance risks that other insurance companies have underwritten. Ceded reinsurance involves transferring certain insurance risks The St. Paul has underwritten to other insurance companies who agree to share these risks. The primary purpose of ceded reinsurance is to protect The St. Paul from potential losses in excess of the amount it is prepared to accept. The St. Paul expects those with whom it has ceded reinsurance to honor their obligations. In the event these companies are unable to honor their obligations, The St. Paul will pay these amounts. The St. Paul has established allowances for possible nonpayment of amounts due to it. The effect of assumed and ceded reinsurance on premiums written, premiums earned and insurance losses and loss adjustment expenses is as follows: Three Months Six Months Ended June 30 Ended June 30 ---------------- --------------- ($ in millions) 1999 1998 1999 1998 ----- ----- ----- ----- Written premiums: Direct $1,201 $1,185 $2,375 $2,465 Assumed 580 426 900 764 Ceded (250) (163) (423) (387) ----- ----- ----- ----- Net premiums written 1,531 1,448 2,852 2,842 ===== ===== ===== ===== Earned premiums: Direct 1,256 1,292 2,506 2,680 Assumed 376 344 710 711 Ceded (220) (168) (401) (425) ----- ----- ----- ----- Net premiums earned 1,412 1,468 2,815 2,966 ===== ===== ===== ===== Insurance losses and loss adjustment expenses: Direct 1,051 1,262 2,009 2,248 Assumed 222 264 496 502 Ceded (260) (181) (457) (342) ----- ----- ----- ----- Net insurance losses and loss adjustment expenses $1,013 $1,345 $2,048 $2,408 ===== ===== ===== =====
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 9 - Discontinued Operations - -------------------------------- In June 1999, The St. Paul made a strategic decision to sell its standard personal insurance business. On July 12, 1999 an agreement was reached to sell this business to Metropolitan Property and Casualty Insurance Company (Metropolitan) for approximately $600 million. As a result, the standard personal insurance operations were accounted for as a discontinued operation for the second quarter and first six months of 1999, and prior period results were restated to be consistent with the 1999 presentation. The Specialty Auto line of business, which was previously aggregated with standard personal insurance to form The St. Paul's Personal Insurance segment for reporting purposes, was not included in this sale. The St. Paul anticipates that this transaction will close near the end of the third quarter of 1999, subject to regulatory approval. The St. Paul estimates that it will recognize a modest gain on this transaction, net of the costs associated with the sale as well as the estimated loss from operations expected during the third quarter 1999, which will be recorded on closing. Proceeds from the sale, to be received on closing, will be used for general corporate purposes, which may include strategic acquisitions to augment The St. Paul's existing specialty insurance and general commercial lines, expansion of specialty product offerings, and continuation of The St. Paul's common share repurchase program. Under the terms of the agreement, Metropolitan will purchase the Economy Fire & Casualty Company and its wholly-owned subsidiaries (Economy). Economy's net book value at June 30, 1999 approximates $370 million, including investments and other assets, loss reserves, unearned premium and other liabilities. As of June 30, 1999, these balance sheet amounts are included in the applicable line items of The St. Paul's consolidated balance sheet. Economy represents a portion of the personal lines business to be sold. Additionally, The St. Paul will sell its rights and interests in those policies constituting the remaining portion of its standard personal insurance operations and certain related assets. This business will be transferred to Metropolitan by way of a reinsurance and facility agreement pursuant to which The St. Paul will transfer assets, representing the unearned premium on the inforce policies, of approximately $330 million to Metropolitan. As a result of the sale, all 1,700 standard personal insurance employees of The St. Paul will transfer to Metropolitan, effective on closing. An additional 500 to 600 positions will be eliminated, commensurate with the expected revenue decline from the sale. The severance and other costs related to these terminations will be included in The St. Paul's calculation of its gain on the sale and recognized at closing. Note 10 - Cumulative Effect of Accounting Change - ------------------------------------------------ Effective Jan. 1, 1999, The St. Paul adopted the provisions of the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) No. 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments." The SOP provides guidance for recognizing and measuring liabilities for guaranty fund and other insurance-related assessments. The St. Paul recorded a pretax expense of $46 million ($30 million after-tax) in the first quarter of 1999 representing the cumulative effect of adopting the provisions of the SOP. The majority of the cumulative effect related to assessments for workers' compensation second-injury funds, with a lesser amount related to insurance guaranty funds. Second-injury funds provide reimbursement to insurance carriers or employers for workers' compensation claims when the cost of a workers' second injury combined with a prior accident or disability is greater than what the second injury alone would have produced. Second-injury funds are established to help ensure that employers are not made to suffer a greater monetary loss or increased insurance costs because of hiring previously injured or handicapped employees. The St. Paul's total accrued pre-tax expense related to insurance assessments was $74 million at March 31, 1999, which consisted of the $46 million first quarter cumulative effect of adopting SOP 97-3 and $28 million of previously recorded liabilities. The accrual was recorded as follows: $53 million in other liabilities, $16 million in insurance reserves, and $5 million in other assets as an offset to deferred premium tax recoverable. The accrued amounts are expected to be disbursed as assessed during a period of up to 30 years.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 11 - Merger with USF&G Corporation - --------------------------------------- On April 24, 1998, The St. Paul issued 66.5 million of its common shares in exchange for all of the outstanding common stock of USF&G Corporation, a holding company for property- liability and life insurance operations. The St. Paul recorded a pretax charge to earnings of $292 million in the second quarter of 1998 related to the merger, primarily consisting of severance and other employee-related costs, facilities exit costs, asset impairments and transaction costs. The St. Paul estimated that approximately 2,000 positions would be eliminated due to the combination of the two organizations, resulting from efficiencies to be realized by the larger organization and the elimination of redundant functions. All levels of employees, from technical staff to senior management, were affected by the reductions. The number of positions expected to be reduced by function included approximately 950 in The St. Paul's property-liability underwriting operation, 350 in claims and 700 in finance and other administrative positions. The reductions are occurring throughout the United States. Through June 30, 1999, approximately 2,100 positions had been eliminated, and the cost of termination benefits paid was $124 million. The St. Paul expects to realize annualized pretax expense savings of approximately $210 million as a result of the merger (as measured against the combined 1997 pre-merger expenses of The St. Paul and USF&G), primarily due to the reduction in employee salaries and benefits. The merger-related charge was determined in accordance with Emerging Issues Task Force (EITF) Issue No 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity," Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the Impairment of Long- Lived Assets and for Long-Lived Assets to Be Disposed Of," SFAS No. 5, "Accounting for Contingencies," and Accounting Principles Board Opinion No. 16, "Business Combinations." The following table provides information about the components of the 1998 charge, payments made and the balance of accrued amounts remaining at June 30, 1999.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 11 - Merger with USF&G Corporation (continued) - -------------------------------------------------- Pre-tax Charges to earnings: Charge - ------------------- ------ (in millions) USF&G corporate headquarters $36 Long-lived assets 23 Software depreciation acceleration 10 Computer leases and equipment 9 Other equipment and furniture 8 ----- Subtotal 86 ----- Accrued charges subject to rollforward: ----------------------- Reserve at Pre-tax Pay- Adjust- June 30, Charge ments ments 1999 ------- ------ ------ -------- Executive severance 89 $(84) $(2) $3 Other severance 53 (40) 0 13 Branch lease exit costs 34 (5) 0 29 Transaction costs 30 (30) 0 - ----- ----- ----- ----- Accruals subject to rollforward 206 $(159) $(2) $45 ----- ===== ===== ===== Total $292 ===== The following discussion provides more information regarding the rationale for and calculation of certain components of the merger- related charge: USF&G Corporate Headquarters - ---------------------------- After consummating the merger in April 1998, The St. Paul vacated a significant portion of a building in Baltimore, MD that had been the site of USF&G's corporate headquarters. Having developed a plan to lease the space to outside parties, The St. Paul categorized the building as an "asset to be held or used" as defined by SFAS No. 121 for purposes of evaluating the potential impairment of its $64 million carrying value. Based on an independent appraisal, The St. Paul recorded a $36 million writedown in its carrying value. Computer leases and equipment - ----------------------------- The St. Paul conducted an extensive technology study upon consummation of the merger which identified redundant computer hardware. As a result, The St. Paul recorded a $9 million expense for lease buy-out transactions and disposals of computer equipment. The expense represented the lease termination fee obligation (lease buy-outs), calculated as the discounted value of the remaining computer lease obligations; and the net book value of redundant computer equipment. Executive severance - ------------------- Represents the obligations The St. Paul is required to pay in accordance with the USF&G Senior Executive Severance Plan in place at the time of the merger. The merger with USF&G qualified as a change in control under the Severance Plan, which obligated The St. Paul to make payments to covered employees on the occurrence of certain triggering events within two years of the closing of the merger. Such triggering events, which have occurred, included the employee's involuntary termination without cause by the company or the employee's termination for "good reason" which included such factors as diminution of responsibilities, change in job title, or being required to relocate beyond a certain distance. In addition, The St. Paul had an obligation to certain employees who, although not terminated, had "good reason" to take action which would trigger payment under the Severance Plan.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 11 - Merger with USF&G Corporation (continued) - -------------------------------------------------- Other severance - --------------- Represents severance and related benefits such as out-placement counseling, vacation buy-out and medical coverage to be paid to terminated employees not covered under the USF&G Senior Executive Severance Plan. Branch lease exit costs - ----------------------- As a result of the merger, excess space was created in several locations due to staff reductions in the combined organization. The charge for branch lease exit costs was calculated by determining the percentage of anticipated excess space at each site and the current lease costs over the remaining lease period. In certain locations, the lease is expected to be terminated. For leases not expected to be terminated, the amount of expense included in the charge was calculated as the percentage of excess space (20% to 100%) times the net of: remaining rental payments plus capitalized leasehold improvements less actual sub-lease income. No amounts were discounted to present value in the calculation. Transaction costs - ----------------- This amount consists of registration fees, costs of furnishing information to stockholders, consultant fees, investment banker fees, and legal and accounting fees. Long-lived assets - ----------------- Upon consummation of the merger, The St. Paul determined that several of USF&G's real estate investments were not consistent with The St. Paul's real estate investment strategy. A plan was developed to sell a number of apartment buildings and various other miscellaneous holdings, with an expected disposal date by year-end 1999. In applying the provisions of SFAS No. 121, it was determined that four of these miscellaneous investments should be written down to fair value, based on The St. Paul's plan to sell them. Fair value was determined based on a discounted cash flow analysis, or based on market prices for similar assets. The four investments were as follows: 1) Description of Percentage rents retained after sale investment: of a portfolio of stores to a third party Carrying $21.6 million prior to writedown of amount: $16.6 million, for current amount of $5.0 million, with $4.3 million held in the property-liability segment and $0.7 million held in the life segment 2) Description of 138-acre land parcel in New Jersey, investment: with farm buildings being rented out Carrying $4.9 million prior to writedown of amount: $2.1 million, for current amount of $2.8 million, held in the property- liability segment 3) Description of Receivable representing cash flow investment: guarantee payments related to real estate partnerships. Carrying $4.8 million prior to writedown of amount: $1.7 million, sold with no further gain or loss. 4) Description of Limited partnership interests in investment: three citrus groves Carrying $4.5 million prior to writedown of amount: $2.4 million. Two of the partnership interests have been exchanged for an investment in a new partnership, with one of the original citrus grove partnership interests remaining. This partnership is carried at a current balance of $.6 million, held in "parent company and other" operations
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 12 - Fourth Quarter 1998 Restructuring Charge - -------------------------------------------------- In the fourth quarter of 1998, The St. Paul recorded a pretax restructuring charge of $34 million. The majority of the charge, $26 million, related to the anticipated termination of approximately 520 employees in the following operations: Claims, Commercial Lines Group, Information Systems, Medical Services and Professional Markets. The remaining charge of $8 million related to costs to be incurred to exit lease contracts. As of June 30, 1999, approximately 300 employees had been terminated under the restructuring plan, and the cost of termination benefits paid was $18 million. The remaining reserve related to severance was written down by $3 million, for a balance at June 30, 1999 of $5 million. Less than $1 million had been paid related to branch leases as of June 30, 1999. Actions to take place under this restructuring plan are expected to be completed by the end of 1999. The St. Paul anticipates realizing annualized pretax expense savings of approximately $50 million in 1999 (compared with 1997 levels), primarily as the result of the reduction in employee salaries and benefits. Note 13 - Subsequent Event - Cost Reduction Program - --------------------------------------------------- In August 1999, The St. Paul announced a cost reduction program designed to enhance its efficiency and effectiveness in a highly competitive industry environment. The program includes the elimination of approximately 1,000 additional employee positions, primarily staff functions, by year-end 1999. These reductions are separate from positions to be eliminated as a result of the sale of The St. Paul's standard personal insurance business to Metropolitan. The St. Paul expects to record a charge to earnings in the third quarter of 1999, primarily for severance and other expenses related to the cost reduction program.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations June 30, 1999 In July 1999, The St. Paul announced an agreement to sell its standard personal insurance business to Metropolitan Property and Casualty Insurance Company. The results of the operations to be sold have been accounted for as discontinued operations for all current and prior year periods, and are thus excluded from any table or discussion of continuing operations. Consolidated Results -------------------- The following table summarizes The St. Paul's results for the second quarter and first six months of 1999 and 1998. Three Months Six Months Ended June 30 Ended June 30 -------------- -------------- (in millions, except per share data) 1999 1998 1999 1998 ----- ----- ----- ----- Pretax income (loss): Property-liability insurance: GAAP underwriting result $(101) $(384) $(211) $(466) Net investment income 321 331 643 663 Realized investment gains 71 132 132 180 Other (1) (190) (21) (217) ----- ----- ----- ----- Total property- liability insurance 290 (111) 543 160 Life insurance 9 (33) 28 (14) Asset management 30 25 59 49 Parent and other (39) (169) (74) (218) ----- ----- ----- ----- Income (loss) from continuing operations before income taxes and cumulative effect of accounting change 290 (288) 556 (23) Income tax expense (benefit) 69 (95) 135 (34) ----- ----- ----- ----- Income (loss) from continuing operations before cumulative effect of accounting change 221 (193) 421 11 Cumulative effect of accounting change, net of taxes - - (30) - ----- ----- ----- ----- Income (loss) from continuing operations 221 (193) 391 11 Loss from discontinued operations, net of taxes (17) (81) (22) (90) ----- ----- ----- ----- Net income (loss) $204 $(274) $369 $(79) ===== ===== ===== ===== Diluted net income (loss) per common share $0.84 $(1.18) $1.50 $(0.36) ===== ===== ===== ===== The St. Paul's pretax income from continuing operations of $290 million in the second quarter of 1999 represented a significant improvement over the pretax loss of $288 million in the same 1998 period. The 1998 loss included a pretax charge of $292 million related to The St. Paul's merger with USF&G, primarily for severance and other employee-related costs and facilities exit costs. The 1998 pretax loss from continuing operations also included a $215 million provision to reflect the application of The St. Paul's loss reserving policies to USF&G's loss and loss adjustment expense reserves subsequent to the April 1998 merger, and a $41 million writedown in the carrying value of deferred acquisition costs in The St. Paul's life insurance segment. Excluding these charges, which totaled $548 million, pretax income from continuing operations totaled $260 million in 1998's second quarter, $30 million less than the equivalent total of $290 million in this year's second quarter. Earnings growth in 1999 resulted from an improvement in property-liability underwriting results and a reduction in expenses due to merger- related efficiencies, which were partially offset by declines in the property-liability operations' investment income and realized investment gains. Through the first six months of 1999, pretax income from continuing operations of $556 million was 6% higher than comparable 1998 income of $525 million (excluding the charges referred to above).
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Results (continued) ------------------------------- The merger-related efficiencies realized in the first half of 1999 primarily resulted from the elimination of duplicate functions throughout the combined organization, including the consolidation of corporate headquarters' functions, and the elimination of approximately 2,100 employees since the consummation of the merger. By the end of 1999, The St. Paul expects to realize pretax annualized expense savings of approximately $260 million (as measured against the combined 1997 pre-merger expenses of The St. Paul and USF&G) as a result of the merger and the restructuring of its Commercial Lines Group and Specialty Commercial underwriting business segments in late 1998. The St. Paul's net income for the first half of 1999 totaled $369 million, compared with a net loss of $79 million in the same period of 1998, which reflected the impact of earnings charges recorded in last year's second quarter. Net income in 1999 included a pretax expense of $46 million ($30 million after-tax), representing the cumulative effect of adopting the AICPA's Statement of Position (SOP) 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments." The SOP provides guidance for recognizing and measuring liabilities for guaranty and other insurance-related assessments. In June 1999, The St. Paul made a strategic decision to exit the standard personal property-liability insurance market, and in July 1999, announced an agreement to sell those operations to Metropolitan Property and Casualty Insurance Company (Metropolitan) in a transaction expected to close near the end of the third quarter of 1999, subject to regulatory approval. Accordingly, the results of these operations have been segregated and presented as discontinued operations for all periods presented in this report. The loss from discontinued operations reported for the second quarter and first six months of 1998, respectively, include a $35 million pretax provision to reflect the application of The St. Paul's loss reserving policies to USF&G's loss and loss adjustment expense reserves subsequent to the April 1998 merger, and also reflect the impact of severe catastrophe losses resulting from several spring storms in the second quarter of the year. Under terms of the sale agreement, Metropolitan will purchase the Economy Fire & Casualty Company (a wholly-owned subsidiary of The St. Paul) and its wholly-owned subsidiaries, as well as the rights and interests in those policies constituting the remaining standard personal insurance operations of The St. Paul. These rights and interests will be transferred to Metropolitan by way of a reinsurance and facility agreement pursuant to which The St. Paul will transfer assets, representing the unearned premium on the inforce policies, of approximately $330 million to Metropolitan. The sale is a strategic move to focus The St. Paul's property- liability insurance operations on its business and professional insurance lines. Proceeds from the sale are expected to total approximately $600 million, and The St. Paul expects to realize a modest gain upon completion of the sale. The approximately 1,700 employees of The St. Paul directly involved in the personal insurance business will be transferred to Metropolitan upon the closing of the transaction. As a result of the sale, The St. Paul plans to terminate an additional 500 to 600 employees by the end of 1999 to maintain expenses at a level commensurate with a smaller revenue base going forward. The severance and other related costs associated with the elimination of these positions will be included in The St. Paul's calculation of its anticipated gain on the sale to be recorded on the closing. In August 1999, The St. Paul announced a cost reduction program designed to enhance its efficiency and effectiveness in a highly competitive industry environment. The program includes the elimination of approximately 1,000 additional employee positions, primarily staff functions, by year-end 1999. This new initiative is separate from the actions associated with The St. Paul's pending sale of its standard personal insurance operations to Metropolitan. The St. Paul expects to record a charge to earnings in the third quarter of 1999, primarily for severance and other expenses related to the cost reduction program.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance ---------------------------- The following summarizes key financial results by property- liability underwriting business segment (Underwriting results are presented on a GAAP basis; combined ratios are presented on a statutory accounting basis): % of Three Months Six Months 1999 Ended June 30 Ended June 30 ($ in millions) Written ------------- ------------- Premiums 1999 1998 1999 1998 -------- ----- ----- ----- ----- Commercial Lines Group: Written Premiums 35% $507 543 1,007 1,094 Underwriting Result $(77) (349) (172) (427) Combined Ratio 114.9 165.6 116.3 139.4 Specialty Commercial: Written Premiums 20% $264 259 578 540 Underwriting Result $(26) (42) (43) (47) Combined Ratio 111.1 116.1 109.7 111.3 Surety: Written Premiums 8% $111 109 214 200 Underwriting Result $13 19 28 33 Combined Ratio 80.5 79.4 79.8 79.1 Specialty Auto: Written Premiums 4% $58 61 124 134 Underwriting Result $- 1 - (1) Combined Ratio 99.6 99.1 98.9 98.2 ----- ----- ----- ----- ----- Total U.S. Underwriting: Written Premiums 67% $940 972 1,923 1,968 Underwriting Result $(90) (371) (187) (442) Combined Ratio 110.1 139.2 110.1 124.0 International: Written Premiums 12% $236 158 345 279 Underwriting Result $(17) (15) (53) (40) Combined Ratio 109.9 110.5 118.1 115.1 ----- ----- ----- ----- ----- Total Primary Insurance: Written Premiums 79% $1,176 1,130 2,268 2,247 Underwriting Result $(107) (386) (240) (482) Combined Ratio 109.3 135.8 110.9 122.9 Reinsurance: Written Premiums 21% $355 318 584 595 Underwriting Result $6 2 29 16 Combined Ratio 90.1 95.4 91.4 95.9 ----- ----- ----- ----- ----- Total Property-Liability Insurance: Written Premiums 100% $1,531 1,448 2,852 2,842 GAAP Underwriting Result $(101) (384) (211) (466) Statutory Combined Ratio: Loss and Loss Expense Ratio 73.7 93.3 74.5 82.6 Underwriting Expense Ratio 32.0 35.0 32.9 35.1 ----- ----- ----- ----- Combined Ratio 105.7 128.3 107.4 117.7 ===== ===== ===== =====
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Overview - -------- Consolidated written premiums from continuing operations of $1.53 billion in the second quarter of 1999 were 6% higher than comparable 1998 premiums of $1.45 billion. Premium volume in The St. Paul's U.S. Underwriting operations declined 3% from 1998's second quarter, reflecting the impact of competitive domestic market conditions, and corrective underwriting and pricing actions implemented in the Commercial Lines Group aimed at improving the quality of that book of business. That decline, however, was more than offset by a significant increase in International volume and growth in Reinsurance premiums. Year-to-date written premiums of $2.85 billion were virtually level with the same period of 1998, with an 8% decline in Commercial Lines Group volume substantially offset by new business growth in the Surety and International segments. The consolidated loss ratio, measuring insurance losses and loss adjustment expenses as a percentage of earned premiums, was 73.7 for the second quarter of 1999, compared with an adjusted loss ratio of 78.4 in the same period of 1998, which excludes a 14.9 point impact of the $215 million provision to reflect the application of The St. Paul's loss reserving policies to USF&G's loss and loss adjustment expense reserves subsequent to the April 1998 merger. Of the 4.7 point improvement over last year's adjusted second quarter loss ratio, 1.3 points was attributable to a decline in catastrophe losses, from $79 million in 1998 to $58 million in 1999's second quarter. The balance of the improvement over 1998 reflects the effect of profit improvement initiatives implemented in the Commercial Lines Group. Through the first half of 1999, the loss ratio of 74.5 was less than one point better than the adjusted 1998 six-month ratio of 75.2. The consolidated expense ratio, measuring underwriting expenses as a percentage of written premiums, was 32.0 for the 1999 second quarter, an improvement of three points compared with the 1998 second quarter ratio of 35.0. The expense ratio reduction reflects cost savings realized as a result of the merger with USF&G, and efficiencies resulting from the restructuring of the Commercial Lines Group and Specialty Commercial segments in late 1998. That restructuring resulted in the elimination of approximately 300 positions from these segments during the first six months of 1999. These positions are separate from those positions eliminated as a result of the merger with USF&G. The year-to-date expense ratio of 32.9, over two points better than last year's comparable ratio of 35.1, also reflects the merger-related and restructuring cost savings initiated in 1998. Underwriting Results by Segment - ------------------------------- Commercial Lines Group - ---------------------- The Commercial Lines Group segment includes The St. Paul's Middle Market and Small Commercial business centers, and several other business centers providing specialized products and services for targeted industry groups. Second quarter 1999 written premiums of $507 million declined 7% from comparable 1998 premiums of $543 million. The reduction was centered in the Middle Market business center, where a 16% decline in premium volume reflects the impact of management's initiatives to improve profitability by refusing to underwrite inadequately-priced business. Small Commercial premium volume for the quarter of $116 million increased 4% over the comparable 1998 total of $112 million. Written premiums in the Construction business center grew 10% over the second quarter of 1998, primarily due to price increases and the effect of retroactive premium adjustments on prior year business. Year-to- date premiums for the total Commercial Lines Group segment were 8% below comparable 1998 levels, with the Middle Markets business center accounting for the majority of the decrease. This segment's underwriting loss of $77 million in the second quarter of 1999 was a significant improvement over last year's second quarter loss of $349 million, which included $197 million of the provision to reflect the application of
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- The St. Paul's loss reserving policies to USF&G's loss and loss adjustment expense reserves subsequent to the April 1998 merger. Excluding that provision, the 1999 result was still $75 million better than last year's loss of $152 million, reflecting progress achieved through corrective underwriting and pricing initiatives, a decline in catastrophe losses and ongoing expense reductions. The expense ratio in this segment improved by over three points over the second quarter of 1998. The year-to-date underwriting loss of $172 million was $58 million less than the adjusted 1998 loss of $230 million. Specialty Commercial - -------------------- The Specialty Commercial segment includes the Medical Services, Custom Markets and Professional Markets business centers, all of which provide specialized insurance products and services tailored to meet the needs of specific commercial customer groups. Second- quarter 1999 premium volume totaled $264 million, 2% ahead of comparable 1998 premiums of $259 million. Medical Services' volume grew 10% over the second quarter of 1998, largely due to premiums on a three-year policy recorded during the quarter. Custom Markets' written premiums of $81 million were virtually level with the second quarter of 1998, as an increase in Technology volume was offset by a decline in Surplus Lines production. Professional Markets posted a 4% decline in premiums compared with last year's second quarter, primarily due to a reduction in Public Sector volume. Year-to-date premiums of $578 million in the Specialty Commercial segment grew 7% over the same period of 1998, but that rate was inflated by a first-quarter reporting endorsement on an existing Medical Services account which generated a premium of $37 million. Excluding that amount, six-month 1999 written premiums were level with the same period of 1998. Excluding the $18 million provision (to reflect the application of The St. Paul's loss reserving policies to USF&G's loss and loss adjustment expense reserves subsequent to the April 1998 merger) from the 1998 second quarter underwriting loss, Specialty Commercial's second quarter 1999 underwriting loss of $26 million was virtually level with 1998. Medical Services' underwriting result improved $9 million over last year's second quarter, but the Technology and Financial and Professional Services business operation experienced a decline in underwriting profitability. The 1999 year-to-date underwriting loss of $43 million in the Specialty Commercial segment was driven by Medical Services; Custom Markets and Professional Markets posted breakeven results through the first half of 1999. Specialty Auto - -------------- The Specialty Auto segment provides personal property-liability insurance products and services to individuals who are unable to obtain standard coverage due to their inability to meet certain underwriting criteria. These operations were not included in the sale of The St. Paul's standard personal insurance business to Metropolitan. In an increasingly competitive marketplace for these coverages, written premium volume of $58 million in the second quarter was slightly below last year's second-quarter total of $61 million. Year-to-date premiums of $124 million fell 7% short of the comparable 1998 total. This segment posted virtually break- even underwriting results for the second quarter and first six months of both 1999 and 1998. Surety - ------ The St. Paul is the largest underwriter of surety bonds in North America, based on 1998 written premiums. Written premiums in 1999's second quarter of $111 million were virtually level with second-quarter 1998 volume of $109 million. In the first six months of 1999, written premiums of $214 million grew 7% over the comparable 1998 total of $200 million. An increase in contract surety business, driven by the strong economy in the United States and Mexico which has fueled new construction activity, was the chief factor in 1999 premium growth. This segment continues to produce strong results, posting underwriting profits of $13 million and $28 million in the second quarter and first half of 1999, respectively.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- International - ------------- The St. Paul's International segment provides commercial and personal property-liability insurance products and services in selected international markets. Premium volume of $236 million in the second quarter grew almost 50% over the comparable 1998 total of $158 million. Growth was centered in the Lloyd's of London operation, where The St. Paul has significantly increased its underwriting capacity on the syndicates that are managed by the managing agencies that it owns. New commercial business opportunities in Europe and a large account recorded in Canada were also contributing factors to the 1999 growth rate. The strong second quarter premium total pushed year-to-date premiums to $345 million, 23% higher than those for the same period in 1998. The second quarter underwriting loss of $17 million was slightly worse than last year's second quarter loss of $15 million but was significantly better than the first quarter 1999 loss of $36 million. The six-month 1999 loss of $53 million was $13 million worse than the year-to-date 1998 result, primarily due to significant losses in Canada and reserve strengthening in the Global Marine business center in the first quarter. Reinsurance - ----------- The St. Paul's Reinsurance segment underwrites treaty and facultative reinsurance for property, liability, ocean marine, surety and certain specialty classes of business, and provides products and services to the alternative risk transfer market. Premium volume in the second quarter of $355 million increased 12% over the same period of 1998, primarily the result of new opportunities in non-traditional business as well as changes made to The St. Paul's estimates of premiums that have been earned, but not yet reported, by ceding insurers. Excluding that change in estimate, which added approximately $20 million to the second quarter total, premium volume increased 5% over the second quarter of 1998. Worldwide reinsurance markets remain highly competitive, driven by excess capacity in primary insurance markets which has put downward pressure on the demand for and price of reinsurance coverages. Excluding the impact of the change in estimated premiums, year-to-date volume fell 10% below the comparable 1998 total. The Reinsurance segment posted a $6 million underwriting profit in the second quarter of 1999, pushing the year-to-date profit to $29 million. Underwriting profits in the equivalent periods of 1998 were $2 million and $16 million, respectively. During the second quarter of 1999, the Reinsurance segment ceded, under an aggregate excess of loss reinsurance contract, $56 million in losses, less related ceded premiums of $25 million, for a net recovery of $31 million. Investment Operations - --------------------- The St. Paul's property-liability insurance operations produced pretax investment income of $321 million in the second quarter of 1999, 3% below the comparable 1998 total of $331 million. Year-to- date pretax investment income of $643 million was also 3% below the 1998 six-month total. Negative underwriting cash flows over the last several quarters (an excess of loss and expense payments over premium revenues) have resulted in a net reduction in the underwriting operations' invested assets compared with the same time in 1998. In addition, merger-related and restructuring payments of $176 million over the last fourteen months have further reduced opportunities for growth in the investment portfolio. Recent investment maturities have also generally been reinvested at current market yields which are lower than the average yield on the portfolio. These factors have resulted in a trend of declining investment income over recent quarters. The St. Paul does not anticipate substantial improvement in its underwriting cash flow situation during the remainder of 1999. The pending sale of The St. Paul's standard personal insurance business, expected to close near the end of the third quarter of 1999, subject to regulatory approval, will result in the transfer of approximately $370 million of net invested assets to Metropolitan, further reducing investment income in the future.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Investment Operations (continued) - -------------------------------- Pretax realized investment gains in The St. Paul's property- liability insurance operations of $71 million in the second quarter of 1999 declined from gains of $132 million in the same period of 1998. Sales of equity and venture capital investments accounted for the majority of the 1999 total. In last year's second quarter, The St. Paul took advantage of favorable market conditions to restructure its equity portfolio, which resulted in an unusually high level of realized gains. Pretax gains for the first half of 1999 totaled $132 million, compared with $180 million through the first six months of 1998. The $17.2 billion carrying value of the property-liability fixed maturities portfolio on June 30, 1999 included $405 million of pretax unrealized appreciation in market value. An upward movement in market interest rates during the first half of 1999 resulted in a $611 million pretax decline in the unrealized appreciation of the bond portfolio since the end of 1998. Approximately 96% of that portfolio is rated at investment grade (BBB or above). The weighted average pretax yield on those investments was 6.8% at June 30, 1999. Environmental and Asbestos Claims --------------------------------- The St. Paul continues to receive claims alleging injuries from environmental pollution or alleging covered property damages for the cost to clean up polluted sites. The company also receives asbestos injury and property damage claims arising out of product liability coverages under general liability policies. The vast majority of these claims arise from policies written many years ago. The St. Paul's alleged liability for both environmental and asbestos claims is complicated by significant legal issues, primarily pertaining to the scope of coverage. In the company's opinion, court decisions in certain jurisdictions have tended to broaden insurance coverage beyond the intent of original insurance policies. The St. Paul's ultimate liability for environmental claims is difficult to estimate because of these legal issues. Insured parties have submitted claims for losses not covered in their respective insurance policies, and the ultimate resolution of these claims may be subject to lengthy litigation, making it difficult to estimate The St. Paul's potential liability. In addition, variables, such as the length of time necessary to clean up a polluted site and controversies surrounding the identity of the responsible party and the degree of remediation deemed necessary, make it difficult to estimate the total cost of an environmental claim. Estimating the ultimate liability for asbestos claims is equally difficult. The primary factors influencing the estimate of the total cost of these claims are case law and a history of prior claim development. The following table represents a reconciliation of total gross and net environmental reserve development for the six months ended June 30, 1999, and the years ended Dec. 31, 1998 and 1997. Amounts in the "net" column are reduced by reinsurance recoverables. 1999 Environmental (six months) 1998 1997 - ------------ ----------- ------ ------ (in millions) Gross Net Gross Net Gross Net ----- ---- ----- ---- ----- ---- Beginning reserves $783 $645 $867 $677 $889 $676 Incurred losses 8 9 (16) 26 44 58 Paid losses (21) (19) (68) (58) (66) (57) ---- ---- ---- ---- ---- ---- Ending reserves $770 $635 $783 $645 $867 $677 ==== ==== ==== ==== ==== ====
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Environmental and Asbestos Claims (continued) -------------------------------------------- The following table represents a reconciliation of total gross and net reserve development for asbestos claims for the six months ended June 30, 1999, and the years ended Dec. 31, 1998 and 1997. 1999 Asbestos (six months) 1998 1997 - -------- ----------- ------ ------ (in millions) Gross Net Gross Net Gross Net ----- ---- ----- ---- ----- ---- Beginning reserves $402 $277 $397 $279 $413 $304 Incurred losses 3 9 44 13 22 (5) Paid losses (15) (11) (39) (15) (38) (20) ---- ---- ---- ---- ---- ---- Ending reserves $390 $275 $402 $277 $397 $279 ==== ==== ==== ==== ==== ==== The St. Paul's reserves for environmental and asbestos losses at June 30, 1999 represent its best estimate of its ultimate liability for such losses, based on all information currently available. Because of the inherent difficulty in estimating such losses, however, The St. Paul cannot give assurances that its ultimate liability for environmental and asbestos losses will, in fact, match current reserves. The St. Paul continues to evaluate new information and developing loss patterns, but it believes any future additional loss provisions for environmental and asbestos claims will not materially impact The St. Paul's results of operations, liquidity or financial position. Total gross environmental and asbestos reserves at June 30, 1999 of $1.16 billion represented approximately 6% of gross consolidated reserves of $18.49 billion.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Life Insurance -------------- The St. Paul's life insurance segment consists of Fidelity and Guaranty Life Insurance Company and subsidiaries ("F&G Life"). F&G Life's primary products are deferred annuities (including tax- sheltered annuities and equity indexed annuities), structured settlement annuities and immediate annuities. F&G Life also underwrites traditional life insurance products. Highlights of F&G Life's financial performance for the second quarter and first six months of 1999 and 1998 were as follows: Three Months Six Months Ended June 30 Ended June 30 -------------- -------------- (in millions) 1999 1998 1999 1998 ----- ----- ----- ----- Pretax earnings (loss) $9 ($33) $28 ($14) Sales (annualized premiums) $312 $71 $616 $151 Premiums and policy charges $38 $26 $65 $50 Policy surrenders $52 $62 $100 $114 Net investment income $82 $67 $153 $132 Life insurance in force $11,044 $10,744 F&G Life's pretax earnings in the second quarter and first six months of 1999 benefited from growing spread from increased assets under management and strong product sales, offset by realized investment losses of $9 million and increased product development and channel expansion expenses. The pretax loss of $33 million in the second quarter of 1998 was driven by a $41 million writedown in the carrying value of deferred acquisition costs, and $9 million of charges (primarily for severance and writedowns in the carrying value of investments) related to The St. Paul's merger with USF&G. Excluding realized investment gains and losses in both years and earnings charges in 1998, pretax earnings of $37 million for the first half of 1999 were level with the same period of 1998. After- tax earnings, however, increased slightly over 1998 levels, reflecting the impact of F&G Life's adoption of an investment strategy to allocate 1% of its investment portfolio to tax-favored investments. These investments generate tax credits that have lowered F&G Life's effective tax rate. The significant increase in sales volume in the second quarter and first six months of 1999 compared with the same periods of 1998 resulted from sales of an equity-indexed annuity product introduced in June 1998. F&G Life has been the leading equity-indexed annuity producer in the United States for the past nine months. Sales of that product accounted for $235 million, or 75%, of total sales in the second quarter, and $485 million, or 79%, of total year-to-date sales. Credited interest rates on this product are tied to the performance of the S&P 500 equity index. Sales of fixed interest rate annuities in 1999 declined due to the negative impact of continued low levels of market interest rates on F&G Life's fixed rate products. The demand for annuity products is affected by fluctuating interest rates and the relative attractiveness of alternative investments, particularly equity-based products. In July 1999, F&G Life announced that it will begin to provide its products to banks and broker-dealers that specialize in offering annuities and life insurance directly to consumers. The entry into the institutional marketplace, which will complement existing distribution channels, is expected to enable F&G Life to distribute its products in markets to which it has previously had limited access.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Life Insurance (continued) ------------------------- The increase in premiums and policy charges over the second quarter and first six months of 1998 resulted from an increase in sales of structured settlement annuities and life-contingent single premium immediate annuities ("SPIA"). Structured settlement annuities are sold primarily to property-liability insurers to settle insurance claims. Sales of structured settlement annuities, annuities with life contingencies and term life insurance are recognized as premiums earned under GAAP. However, sales of investment-type contracts, such as equity-indexed, deferred and tax sheltered annuities and universal life-type contracts are recorded directly on the balance sheet and are not recognized as premium revenue under GAAP. The expansion of the structured settlement program into The St. Paul's property-liability claim organization led to the increase in structured settlement sales. The growth in SPIA sales resulted from an increased emphasis on this product in 1999. Deferred annuities and universal life products are subject to surrender by policyholders. Nearly all of F&G Life's surrenderable annuity policies allow a refund of the cash value balance less a surrender charge. Surrender activity in 1999 has declined from 1998 levels. Policy surrenders in 1998 reflected surrenders on a block of single premium deferred annuities ("SPDA") policies sold through a distributor that ceased doing business with F&G Life in 1997. The decrease in SPDA surrenders in 1999 was partially offset by an increase in tax-sheltered annuity surrenders. Net investment income in the second quarter and first half of 1999 grew 22% and 16%, respectively, over the same periods of 1998 as a result of an increasing asset base generated by positive cash flow. Asset Management ---------------- The St. Paul's portion of pretax earnings from The John Nuveen Company (Nuveen) was $30 million in the second quarter of 1999, compared with $25 million in 1998's second quarter. For the first half of 1999, The St. Paul's $59 million portion of Nuveen's pretax earnings was 21% higher than comparable earnings of $49 million in 1998. The company holds a 78% interest in Nuveen. Nuveen's asset management revenues continue to grow at a strong rate, accounting for Nuveen's increase in earnings over 1998. Those revenues totaled $76 million and $149 million for the second quarter and first six months of 1999, respectively, compared with $67 million and $132 million in the corresponding periods of 1998. Total managed assets grew to $59.5 billion at June 30, 1999, a $4.3 billion increase over year-end 1998 and $7.4 billion higher than at the same time a year ago. The increase was due to new product sales, particularly managed accounts sold through Rittenhouse Financial Services, Inc., a Nuveen subsidiary. At the end of June 1999, Nuveen announced the sale of its investment banking division to U.S. Bancorp Piper Jaffray. The transaction will enable Nuveen to focus on its asset management business. The transaction is not expected to have a material impact on the results of Nuveen's operations. Capital Resources ----------------- Common shareholders' equity totaled $6.27 billion at June 30, 1999, down $350 million from the year-end 1998 total of $6.62 billion, primarily due to a $506 million decline in the after-tax unrealized appreciation of the consolidated fixed maturity investment portfolio and significant common share repurchases, which more than offset The St. Paul's six-month net income of $369 million. The St. Paul repurchased 8.3 million of its common shares for a total cost of $265 million during the first half of 1999, for an average cost of $32.03 per share. An increase in market interest rates during the first six months of 1999 led to the decline in the unrealized appreciation of The St. Paul's bond holdings compared with year-end 1998.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Capital Resources (continued) ---------------------------- Total debt outstanding at June 30, 1999 of $1.51 billion increased by $246 million over the year-end 1998 total of $1.26 billion, primarily due to the issuance of commercial paper to finance the company's common share repurchases. Consolidated debt also reflects the $64 million of variable rate borrowings entered into by a number of The St. Paul's real estate entities, and the February 1999 issuance of $46 million of floating rate notes by a special purpose offshore entity that is providing reinsurance to a property-liability subsidiary of The St. Paul. In March 1999, The St. Paul purchased $33.5 million face amount of its $1,000 principal amount zero coupon convertible notes from note holders for a total cash consideration of $21 million, which represented the original issue price plus the original issue discount accrued to the date of purchase. The St. Paul purchased the notes at the option of the note holders. Approximately 41% of The St. Paul's consolidated debt outstanding at June 30, 1999 consisted of medium-term notes bearing a weighted- average interest rate of 6.9%. The ratio of total debt to total capitalization of 18% increased from the year-end 1998 ratio of 15%. The company anticipates that any major capital expenditures during the remainder of 1999 would involve further repurchases of its common shares or acquisitions of existing businesses. At June 30, 1999, The St. Paul had approximately $100 million of capacity to repurchase additional common shares under the $500 million repurchase program authorized by the company's board of directors in November 1998. The St. Paul anticipates that net proceeds from the sale of its standard personal insurance business will be used for general corporate purposes, which may include strategic acquisitions to augment The St. Paul's existing specialty insurance and general commercial lines, expansion of our specialty product offerings, and continuation of The St. Paul's common share repurchase program. There are no major capital improvements planned for the remainder of the year. For the first six months of 1999, The St. Paul's ratio of earnings to fixed charges was 8.06, and the ratio of earnings to combined fixed charges and preferred stock dividend requirements was 7.29. For the first six months of 1998, The St. Paul's loss from continuing operations before income taxes was inadequate to cover fixed charges by $23 million and combined fixed charges and preferred stock dividend requirements by $32 million. Fixed charges consist of interest expense, distributions on capital securities and that portion of rental expense deemed to be representative of an interest factor. Liquidity --------- Liquidity is a measure of The St. Paul's ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations. Net cash outflows from operating activities totaled $35 million in the first six months of 1999, compared with a net outflow of $19 million in the same period of 1998. Operational cash flows in both 1999 and 1998 were negatively impacted by the decline in premium volume and investment receipts in The St. Paul's property-liability insurance operations, as well as cash disbursements associated with The St. Paul's merger with USF&G and the restructuring of the company's commercial insurance operations. The St. Paul does not anticipate significant improvement in operational cash flows during the remainder of 1999 due to the expected continuation of the decline in premium volume, severance payments associated with the elimination of approximately 1,600 employees by the end of the year, and a further reduction in investment income. On a long-term basis, The St. Paul believes its operational cash flows will benefit from the corrective pricing and underwriting actions under way in its property-liability operations as well as expense control initiatives. The St. Paul's financial strength and conservative level of debt provide it with the flexibility and capacity to obtain funds externally through debt or equity financings on both a short-term and long-term basis should the need arise.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Market Risk ----------- Upward movement in market interest rates during the first half of 1999 resulted in a significant decline in the unrealized appreciation of the bond portfolio since the end of 1998, as discussed in Property-Liability Insurance - Investment Operations. However, The St. Paul's portfolio mix, and therefore its exposure to market risk, has not changed materially from its position at December 31, 1998. Year 2000 Readiness Disclosure ------------------------------ Many computer systems in the world have the potential of being disrupted at the turn of the century due to programming limitations that may cause the two-digit year code of "00" to be recognized as the year 1900, instead of 2000. The St. Paul is heavily dependent on its many computer systems, and those of its independent agents and brokers (The St. Paul "distribution network") and its vendors, for virtually every aspect of its operations, including underwriting, claims, investments and financial reporting. Thus, the "Year 2000" issue involves potentially serious operational risks for the Company. For several years, The St. Paul has been evaluating its computer systems to determine the impact of the Year 2000 issue on its operations. As compliance evaluation of systems has progressed to an advanced stage, a shift of emphasis from evaluation to correction and compliance testing has taken place. The St. Paul has also been working with vendors and members of its distribution network in an effort to address Year 2000 issues that such relationships involve. Finally, The St. Paul has been reviewing and taking action to address non-systems related issues that may arise as a result of the Year 2000 problem, including insurance and reinsurance coverage issues, and it has also been seeking to reduce the Company's Year 2000-related exposures through the development of contingency plans. The following discussion describes The St. Paul's efforts to date and future plans to deal with the Year 2000 issue. These plans have been and continue to be updated and revised as additional information becomes available. State of Readiness - ------------------ The St. Paul established a Review Board in the third quarter of 1997 to review the remediation and testing methodology applied to the hundreds of internally developed and externally sourced systems used in the Company's corporate headquarters in St. Paul, MN. To coordinate the Year 2000 remediation efforts, The St. Paul created the Year 2000 Project Office, which is responsible for the oversight, coordination and monitoring of Year 2000 efforts including, among other things, reviewing the compliance status of information systems in all operating units and subsidiaries, both foreign and domestic, directing the Year 2000 coordinators assigned to operating units, and formulating company-wide contingency plans. Prior to The St. Paul's merger with USF&G in April 1998, a separate "Y2K Action Committee" was maintained by USF&G, and a comprehensive program to address each of three identified aspects to the Year 2000 issue (readying USF&G's systems, coordinating with agents and other third parties with whom USF&G interacts, and managing the risk of claims from insured parties) had been established. The Year 2000 program developed by USF&G's Y2K Action Committee has now been integrated into The St. Paul's overall Year 2000 response. Information Technology Systems - ------------------------------ All of The St. Paul's systems, whether internally developed or externally sourced, are subject to the company-wide comprehensive testing and compliance standards promulgated by the Company's Information Services Division (ISD), the oversight and monitoring of which is the responsibility of the Year 2000 Project Office. Insofar as internal systems maintained in St. Paul, MN. are concerned, with few exceptions, Year 2000 compliance was achieved by December 31, 1998. With few exceptions, initial compliance validation of all such systems was completed by March 31, 1999. All subsidiaries not headquartered in Saint Paul, MN or Baltimore, MD completed initial validation testing of their application systems on or before June 30, 1999.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Year 2000 Readiness Disclosure (continued) ----------------------------------------- The Year 2000 Project Office's plan for remediation and validation of externally sourced systems provides for the Company to work with the vendors of those systems to ensure that those systems become Year 2000 compliant at the earliest practicable date. Compliance testing in accordance with ISD standards takes place as and when compliant versions and/or affirmations of compliance from vendors are received. The St. Paul has identified what it believes to be all of its third-party supplied mission critical systems, and, with few exceptions, expects to receive Year 2000 compliant versions and/or affirmations of compliance for each of them, and to complete the validation process, before September 30, 1999. Third-Party Service Providers and Distribution Network - ------------------------------------------------------ The St. Paul relies indirectly on the information technology systems of its service providers and those of its distribution network. The Year 2000 Project Office is communicating with the Company's service providers, including financial institutions providing custody accounts and other services, its independent agents and brokers, and other entities with which it does business, to identify and resolve Year 2000 issues and to determine the potential impact, where relevant, of the possible failure of certain of such persons to achieve Year 2000 compliance on a timely basis. Results of this process are expected to be used in The St. Paul's contingency planning efforts discussed below. Nuveen Systems - -------------- Having started the development and implementation of internal four- digit date code software and system standards in the early 1980s, Nuveen's Year 2000 program consists primarily of Year 2000 compliance examination and testing of the software packages and hardware provided by third parties and of the systems and software of its service providers. Certification of Year 2000 compliance and testing of critical third-party hardware and software systems used in trade processing at Nuveen was completed by the end of the first quarter of 1999. The remaining certification and testing was completed in the second quarter of 1999. Nuveen is in the process of developing contingency plans based upon its examination of the Year 2000 readiness of its third-party supplied systems and its service providers. Nuveen believes that the costs associated with its Year 2000 efforts will not be material to its operations and financial position. Embedded Chip Issues - -------------------- Given the nature of its business, and that of its vendors and the members of its distribution network, The St. Paul believes that its exposure to embedded chip Year 2000 issues is minimal (other than its exposure to possible disruptions in electricity, telecommunications and other essential services provided by public utilities that are subject to embedded chip-related disruption). The St. Paul is, where deemed appropriate, coordinating with vendors to obtain certificates of Year 2000 compliance for the embedded computer technology equipment that it uses. Year 2000 Compliance Program Costs - ---------------------------------- The St. Paul has developed and implemented plans to address the system modifications required to prepare for the Year 2000, and does not expect the planning and implementation costs associated with Year 2000 efforts to be material to its results of operations, cash flows or consolidated financial position. Through December 31, 1997, the costs of Year 2000 remediation measures incurred, including costs incurred by USF&G prior to the merger, totaled approximately $8.7 million. The St. Paul incurred costs of approximately $11.3 million in 1998, and it anticipates additional costs of approximately $6.6 million in 1999.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Year 2000 Readiness Disclosure (continued) ----------------------------------------- Contingency Planning - -------------------- During the first half of 1999, contingency plans were developed by business and staff units, field offices and subsidiary location teams in accordance with a model that focuses first on restoring and maintaining infrastructure, and secondly on business resumption. Individual teams identified their critical processes and then identified pre-emptive actions to mitigate the potential impact of a Year 2000 disruption. Teams also developed plans for reacting to potential threat and duration scenarios. Plans have been received and assessed across the organization. Each team has been advised of any required plan modifications and asked to incorporate the modifications by the end of July. Test plans are under development and will encompass integrated testing with a simulated "command center" providing oversight and coordination. The St. Paul believes that its most significant Year 2000 exposure is the potential business disruptions that would be caused by widespread failure of public utility systems, particularly in the power generation/distribution and the telecommunication industries. While the contingency plans The St. Paul is developing will provide alternative procedures to lessen the impact of short duration disruptions, prolonged failure of power and telecommunications systems could have a material adverse effect on the Company's results of operations, cash flows and consolidated financial position. As noted above, The St. Paul indirectly relies on the information systems of the many components of its distribution network, which includes thousands of independent agents and brokers. The St. Paul is aware that some of its independent agents and brokers are currently Year 2000 non-compliant and expects that a much lesser number, unknown at this time and expected to consist primarily of smaller agents, will be non-compliant on January 1, 2000. The St. Paul believes that Year 2000-related difficulties experienced by members of its distribution network have the potential to materially disrupt its business and that such potential disruptions constitute its second greatest area of potential exposure to the Year 2000 problem. As part of its contingency planning effort, The St. Paul has been providing information to members of its distribution network intended to sensitize them to the Year 2000 issue and to encourage them to take appropriate steps to become Year 2000 compliant. Although the Company's distribution network consists of thousands of agents and brokers, the number of different systems used by the constituent members is far less. For example, the Company believes that fewer than 20 different types of agency management systems are used by its property-liability insurance agents in the United States. Contingency arrangements are being discussed with distribution network members pursuant to which the Company may, among other provisional steps, provide data in alternative formats and institute temporary direct billing services in the event of a disruption in their individual systems. The Company notes that the Year 2000 issue by its nature carries the risk of unforeseen and potentially very serious problems of internal or external origin. Some commentators believe that the Year 2000 issue has the potential of destabilizing the global economy or causing a global recession, either of which could adversely affect the Company. While The St. Paul believes it is taking appropriate action with respect to third parties on whose systems and services it relies to a significant extent, there can be no assurance that the systems of such third parties will be Year 2000 compliant or that any third party's failure to have Year 2000 compliant systems would not have a material adverse effect on The St. Paul's earnings, cash flows or financial condition.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Year 2000 Readiness Disclosure (continued) ----------------------------------------- Insurance Coverage - ------------------ The St. Paul also faces potential Year 2000 claims under coverages provided by insurance and reinsurance policies sold to insured parties who may incur losses as a result of the failure of such parties, or the customers or vendors of such parties, to be Year 2000 compliant. Because coverage determinations depend on unique factual situations, specific policy language and other variables, it is not possible to determine in advance whether and to what extent insured parties will incur losses, the amount of the losses or whether any such losses would be covered under The St. Paul's insurance policies. In some instances, coverage is not provided under the insurance policies or reinsurance contracts, while in other instances, coverage may be provided under certain circumstances. The St. Paul's standard property and inland marine policies require, among other things, direct physical loss or damage from a covered cause of loss as a condition of coverage. In addition, it is a fundamental principle of all insurance that a loss must be fortuitous to be considered potentially covered. Given the fact that Year 2000-related losses are not unforeseen, and that The St. Paul expects that such losses will not, in most if not all cases, cause direct physical loss or damage, The St. Paul has concluded that its property and inland marine policies do not generally provide coverage for losses relating to Year 2000 issues. To reinforce its view on coverage afforded by such policies, The St. Paul has developed and is implementing a specific Year 2000 exclusion endorsement. The Company may also face claims from the beneficiaries of its surety bonds resulting from Year 2000-related performance failures by the purchasers of the bonds. As with insurance policies in general, because surety claims depend on particular factual situations, specific bond language and other variables, it is not possible to determine in advance whether and to what extent Year 2000-related claims will arise under surety bonds issued by The St. Paul, the amount of any such claims or whether any such claims will by payable under surety bonds issued by The St. Paul. The St. Paul is taking a number of actions to address its exposure to insurance claims arising from its liability coverages, including individual risk evaluation, communications with insured parties, the use of exclusions in certain types of policies, and classification of high hazard exposures that in the Company's view present unacceptable risk. The St. Paul does not believe that Year 2000-related insurance or reinsurance coverage claims will have a material adverse effect on its earnings, cash flows or financial position. However, the uncertainties of litigation are such that unexpected policy interpretations could compel claim payments substantially beyond the Company's coverage intentions, possibly resulting in a material adverse effect on its results of operations and/or cash flows and a material adverse effect on its consolidated financial position. Impact of Accounting Pronouncements to be Adopted in the Future - --------------------------------------------------------------- In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet, and measure those instruments at fair value. In June 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133," which amended SFAS No. 133 to make it effective for all quarters of fiscal years beginning after June 15, 2000, and prohibits retroactive application to financial statements of prior periods. The St. Paul intends to implement the provisions of SFAS No. 133 in the first quarter of 2001. The St. Paul currently has limited involvement with derivative instruments, primarily for purposes of hedging against fluctuations in market indices, foreign currency exchange rates and interest rates. The company cannot at this time reasonably estimate the potential impact of this adoption on its financial position or results of operations for future periods.
THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Impact of Accounting Pronouncements to be Adopted in the Future (continued) - --------------------------------------------------------------- In October 1998, the AICPA issued SOP No. 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk," which provides guidance for accounting for such contracts. The SOP specifies that insurance and reinsurance contracts for which the deposit method of accounting is appropriate should be classified in one of four categories, and further specifies the accounting treatment for each of these categories. The SOP is effective for fiscal years beginning after June 15, 1999. The St. Paul currently intends to implement the provisions of the SOP in the first quarter of the year 2000. The company cannot at this time reasonably estimate the potential impact of this adoption on its financial position or results of operations for future periods. Forward-looking Statement Disclosure ------------------------------------ This report contains certain forward-looking statements within the meaning of the Private Litigation Reform Act of 1995. Forward- looking statements are statements other than historical information or statements of current condition. Words such as expects, anticipates, intends, plans, believes, seeks or estimates, or variations of such words, and similar expressions are also intended to identify forward-looking statements. Examples of these forward- looking statements include statements about The St. Paul's expectations concerning: market conditions and their effect on future premiums, revenues, cash flow and investment income; expense savings resulting from the USF&G merger and the restructuring actions announced in 1998 and 1999; the timing of the closing of the sale of the standard personal insurance business and its impact on The St. Paul's earnings; and Year 2000 issues and the company's efforts to address them. In light of the risks and uncertainties inherent in future projections, many of which are beyond The St. Paul's control, actual results could differ materially from those in forward- looking statements. These statements should not be regarded as a representation that anticipated events will occur or that expected objectives will be achieved. Risks and uncertainties include, but are not limited to, the following: general economic conditions including changes in interest rates and the performance of financial markets; changes in domestic and foreign laws, regulations and taxes; changes in the demand for, pricing of, or supply of insurance or reinsurance; catastrophic events of unanticipated frequency or severity; loss of significant customers; judicial decisions and rulings; receipt of required approvals and the satisfaction of the conditions to closing for the sale of the standard personal insurance business; the pace and effectiveness of the transfer of that personal insurance business from The St. Paul to Metropolitan; and various other matters, including the effects of the merger with USF&G. Actual results and experience relating to Year 2000 issues could differ materially from anticipated results or other expectations as a result of a variety of risks and uncertainties, including the impact of system faults, the failure to successfully remediate material systems, the time it may take to remediate system failures once they occur, the failure of third parties (including public utilities, agents and brokers) to properly remediate material Year 2000 problems, and unanticipated judicial interpretations of the scope of the insurance or reinsurance coverage provided by The St. Paul's policies. The St. Paul undertakes no obligation to release publicly the results of any future revisions we may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
PART II OTHER INFORMATION Item 1. Legal Proceedings. The information set forth in Note 5 to the consolidated financial statements is incorporated herein by reference. Item 2. Changes in Securities. Not applicable. Item 3. Defaults Upon Senior Securities. Not applicable. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. Item 5. Other Information. Not applicable. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. An Exhibit Index is set forth as the last page in this document. (b) Reports on Form 8-K. 1) The St. Paul filed a Form 8-K Current Report dated April 30, 1999, relating to the announcement of its financial results for the quarter ended March 31, 1999. 2) The St. Paul filed a Form 8-K Current Report dated July 12, 1999 relating to the announcement of The St. Paul's sale of its standard personal insurance underwriting operations to Metropolitan Property and Casualty Insurance Company. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE ST. PAUL COMPANIES, INC. (Registrant) Date: August 12, 1999 By /s/ Bruce A. Backberg --------------------- Bruce A. Backberg Senior Vice President-Legal Services (Authorized Signatory) Date: August 12, 1999 By /s/ Thomas A. Bradley --------------------- Thomas A. Bradley Senior Vice President and Corporate Controller (Principal Accounting Officer)
EXHIBIT INDEX ---------------- Exhibit - --------- (2) Plan of acquisition, reorganization, arrangement, liquidation or succession**................................... (i) Stock and Asset Purchase Agreement Dated as of July 12, 1999 Between St. Paul Fire and Marine Insurance Company and Metropolitan Property and Casualty Insurance Company......... (1) (3) (i) Articles of incorporation*.................................... (ii) By-laws*..................................................... (4) Instruments defining the rights of security holders, including indentures*......................................... (10) Material contracts............................................... (11) Statement re computation of per share earnings**................. (1) (12) Statement re computation of ratios**............................. (1) (15) Letter re unaudited interim financial information*............... (18) Letter re change in accounting principles*....................... (19) Report furnished to security holders*............................ (22) Published report regarding matters submitted to vote of security holders*..................................... (23) Consents of experts and counsel*................................. (24) Power of attorney*............................................... (27) Financial data schedule**........................................ (1) (99) Additional exhibits*............................................. * These items are not applicable. ** This exhibit is included only with the copies of this report that are filed with the Securities and Exchange Commission. However, a copy of the exhibit may be obtained from the Registrant for a reasonable fee by writing to The St. Paul Companies, Inc., 385 Washington Street, Saint Paul, MN 55102, Attention: Corporate Secretary. (1) Filed herewith.