<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-----------------
FORM 8-KA
(AMENDMENT NO. 2)
Current Report
Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
Date of Report: April 30, 1997
HIGHLANDS INSURANCE GROUP, INC.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware
- --------------------------------------------------------------------------------
(State or Other Jurisdiction of Incorporation)
1-14028 75-2370945
- --------------------------------------------------------------------------------
(Commission File Number) (IRS Employee Identification No.)
10370 Richmond Avenue, Houston, Texas 77042-4123
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(713)952-9555
- --------------------------------------------------------------------------------
Registrant's telephone number, including area code
<PAGE>
ITEM 2. Acquisition or Disposition of Assets.
On May 15, 1997, Highlands Insurance Group, Inc., a Delaware Corporation
("Highlands") filed with the Securities and Exchange Commission a Report of Form
8-K (the "Initial 8-K Report") with respect to Highlands' acquisition of Vik
Brothers Insurance, Inc. and its subsidiaries. On June 10, 1997, Highlands
filed with the Securities and Exchange Commission a Report of Form 8-KA ("8-KA
Report, Amendment No. 1") for the purpose of including additional exhibits.
This amendment is being filed for the purpose of including financial statements
and proforma financial information and should be read in conjunction with the
Initial 8-K Report and 8-KA Report, Amendment No. 1.
<PAGE>
ITEM 7. Financial Statement, Pro Forma Financial Information and Exhibits.
(a) Financial Statements of Business Acquired:
Audited Financial Statements
Reports of Independent Public Accountants
Consolidated Balance Sheets as of December 31, 1996 and 1995
Consolidated Statements of Operations for the years ended
December 31, 1996, 1995 and 1994
Consolidated Statements of Shareholders' Equity for the years
ended December 31, 1996, 1995 and 1994
Consolidated Statements of Cash Flows for the years ended
December 31, 1996, 1995 and 1994
Notes to Consolidated Financial Statements
Interim Financial Statements
Consolidated Balance Sheets as of March 31, 1997 (Unaudited)
and December 31, 1996
Unaudited Consolidated Statements of Income for the three
months ended March 31, 1997 and 1996
Consolidated Statements of Stockholders' Equity for
the three months ended March 31, 1997 (Unaudited) and year ended
December 31, 1996
Unaudited Consolidated Statements of Cash Flow for the three
months ended March 31, 1997 and 1996
Condensed Notes to Unaudited Consolidated Financial Statements
(b) Pro Forma Financial Information
Unaudited Pro Forma Condensed Combined Balance Sheet as of
March 31, 1997
Notes to Unaudited Pro Forma Condensed Combined Balance Sheet
Unaudited Pro Forma Condensed Combined Statement of Operations
as of December 31, 1996
Unaudited Pro Forma Condensed Combined Statement of Operations
as of March 31, 1997
Notes to Unaudited Pro Forma Condensed Combined Statement of
Operations
<PAGE>
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 hereunto duly authorized.
HIGHLANDS INSURANCE GROUP, INC.
June 30, 1997 By: /s/ Charles J. Bachand
------------------------------
Charles J. Bachand
Vice President and Treasurer
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors
Vik Brothers Insurance, Inc.:
We have audited the accompanying consolidated balance sheet of Vik Brothers
Insurance, Inc. and subsidiaries (the Company) as of December 31, 1996, and the
related consolidated statements of operations, shareholders' equity (deficit)
and cash flows for the year then ended. These consolidated financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
As discussed in note 14 to the consolidated financial statements, the Company
was acquired on April 30, 1997.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Vik Brothers
Insurance, Inc. and subsidiaries as of December 31, 1996, and the results of
their operations and their cash flows for the year then ended, in conformity
with generally accepted accounting principles.
As discussed in note 13 to the consolidated financial statements, the Company
changed its method of accounting for reserve guarantees in a business
combination accounted for as a purchase in 1996.
KPMG PEAT MARWICK LLP
Raleigh, North Carolina
May 22, 1997
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Vik Brothers Insurance, Inc.
We have audited the accompanying consolidated balance sheets of Vik Brothers
Insurance, Inc. and subsidiaries as of December 31, 1995 and 1994, and the
related consolidated statements of operations, shareholders' equity and cash
flows for each of the three years in the period ended December 31, 1995. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Vik Brothers
Insurance, Inc. and subsidiaries at December 31, 1995 and 1994, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1995 and 1994, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1995, in conformity with generally accepted
accounting principles.
In 1994, as discussed in Notes 1 and 2 to the consolidated financial statements,
the Company changed its method of accounting for certain investment securities.
ERNST & YOUNG LLP
March 15, 1996,
except of Note 14, as to which
the date is March 22, 1996
<PAGE>
Vik Brothers Insurance, Inc. and Subsidiaries
Consolidated Balance Sheets
(dollars in thousands)
<TABLE>
<CAPTION>
DECEMBER 31
1996 1995
-------- ----------
<S> <C> <C>
Assets
Cash and invested assets:
Fixed maturities available for sale, at fair value $483,240 $ 534,750
Equity securities, at fair value 162 116
Other invested assets - 188
Real estate, net of accumulated depreciation 1,009 1,054
Cash and cash equivalents 36,026 93,662
-------- ----------
Total cash and invested assets 520,437 629,770
Premiums receivable 90,664 100,193
Reinsurance recoverables:
Paid losses and loss adjustment expenses 31,624 18,481
Unpaid losses and loss adjustment expenses 106,163 114,296
Prepaid reinsurance premiums 27,108 28,433
Deferred policy acquisition costs 29,124 37,646
Accrued investment income 6,324 7,556
Funds on deposit with reinsurers 56,481 52,269
Deferred tax asset - 5,716
Values of businesses acquired (net of accumulated
amortization: 1996-$5,758; 1995-$4,300 ) 10,344 12,314
Other assets 24,420 16,614
-------- ----------
Total assets $902,689 $1,023,288
======== ==========
</TABLE>
See accompanying notes to consolidated financial statements.
3
<PAGE>
Vik Brothers Insurance, Inc. and Subsidiaries
Consolidated Balance Sheets
(dollars in thousands)
<TABLE>
<CAPTION>
DECEMBER 31
1996 1995
-------- ----------
<S> <C> <C>
LIABILITIES AND SHAREHOLDERS' EQUITY
Reserves for losses and loss adjustment expenses $539,027 $ 577,789
Unearned premiums 188,153 204,903
Amounts payable to reinsurers 16,032 12,867
Notes payable 40,000 38,000
Fair value of acquired assets in excess of purchase price
(net of accumulated amortization: 1996-$840;
1995-$649) 1,060 1,250
Drafts outstanding 6,420 6,462
Current income taxes 343 5,454
Accounts payable and accrued expenses 22,147 21,095
Obligation under acquisition agreement 33,738 22,500
Other liabilities 21,610 14,844
-------- ----------
868,530 905,164
Redeemable preferred stock and
common stock warrants 44,297 41,020
Commitments and contingencies (Notes 1,7,9,11,12 and 13)
Shareholders' equity:
Common stock - -
Preferred stock 3 2
Additional paid-in capital 40,373 38,934
Unrealized gains on investments, net 1,313 10,166
Retained earnings (deficit) (51,827) 28,002
-------- ----------
Total shareholders' equity (deficit) (10,138) 77,104
-------- ----------
Total liabilities and shareholders' equity $902,689 $1,023,288
======== ==========
</TABLE>
See accompanying notes to consolidated financial statements.
4
<PAGE>
Vik Brothers Insurance, Inc. and Subsidiaries
Consolidated Statements of Operations
(dollars in thousands)
YEAR ENDED DECEMBER 31
1996 1995 1994
-------- -------- --------
Revenue:
Net premiums earned $327,873 $296,766 $201,498
Investment income 37,413 32,275 10,760
Net realized gains (losses) on investments 2,324 9,003 (1,580)
Other income 4,318 4,865 10,083
-------- -------- --------
371,928 342,909 220,761
Losses and expenses:
Losses and loss adjustment expenses incurred 278,813 211,783 143,910
Underwriting expenses 132,227 88,303 78,654
Other expenses 15,810 4,814 5,620
-------- -------- --------
426,850 304,900 228,184
-------- -------- --------
Net income (loss) before income taxes and
cumulative effect of a change
in accounting principle (54,922) 38,009 (7,423)
Income tax expense (benefit):
Current (5,162) 5,700 (1,358)
Deferred 11,698 (10,920) 106
-------- -------- --------
6,536 (5,220) (1,252)
-------- -------- --------
Cumulative effect of a change
in accounting principle (net
of federal income taxes of $1,537) (2,854) - -
-------- -------- --------
Net income (loss) $(64,312) $ 43,229 $ (6,171)
======== ======== ========
See accompanying notes to consolidated financial statements.
5
<PAGE>
Vik Brothers Insurance, Inc. and Subsidiaries
Consolidated Statements of Shareholders' Equity (Deficit)
(dollars in thousands)
<TABLE>
<CAPTION>
UNREALIZED
ADDITIONAL GAIN/(LOSSES) RETAINED TOTAL
COMMON PREFERRED PAID-IN ON EARNINGS/ SHAREHOLDERS
STOCK STOCK CAPITAL INVESTMENTS (DEFICIT) EQUITY (DEFICIT)
--------- ---------- ----------- ------------- ----------- ----------------
<S> <C> <C> <C> <C> <C> <C>
Balances at January 1, 1994 $- $- $20,228 $ 190 $ (3,611) $ 16,807
Net loss - - - - (6,171) (6,171)
Cumulative effect of accounting change - - - 1,605 - 1,605
Unrealized losses on investments - - - (10,388) - (10,388)
Preferred stock dividends - - 180 - (180) -
Redeemable preferred stock dividends - - - - (1,097) (1,097)
------- --------- ------- -------- -------- --------
Balances at December 31, 1994 $- $- $20,408 $ (8,593) $(11,059) $ 756
======= ========= ======= ======== ======== ========
Net income $- $- $ - $ - $ 43,229 $ 43,229
Unrealized gains on investments - - - 18,759 - 18,759
Issuance of preferred stock, Series 4 - 1 9,999 - - 10,000
Issuance of preferred stock, Series 7 - 1 7,499 - - 7,500
Preferred stock dividends - - 1,028 - (1,028) -
Redeemable preferred stock dividends - - - - (3,140) (3,140)
------- --------- ------- -------- -------- --------
Balances at December 31, 1995 - $2 $38,934 $ 10,166 $ 28,002 $ 77,104
======= ========= ======= ======== ======== ========
Net loss $- $- $ - $ - $(64,312) $(64,312)
Unrealized losses on investments - - - (8,853) - (8,853)
Unearned inducement fee charged to equity - - - - (10,000) (10,000)
Preferred stock dividends - 1 1,439 - (1,440) -
Redeemable preferred stock dividends - - - (4,077) (4,077)
------- --------- ------- -------- -------- --------
Balances at December 31, 1996 $- $3 $40,373 $ 1,313 $(51,827) $(10,138)
======= ========= ======= ======== ======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
6
<PAGE>
Vik Brothers Insurance, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(dollars in thousands)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1996 1995 1994
--------- --------- --------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $ (64,312) $ 43,229 $ (6,171)
Adjustments to reconcile net income (loss)to net cash provided
by (used in) operating activities:
Depreciation and amortization 2,931 763 1,387
Provision for deferred taxes 10,161 (10,920) 106
Net realized (gains) losses on investments (2,324) (9,003) 1,580
Change in operating assets and liabilities net of effects from
acquisitions:
Premiums receivable 9,529 18,102 4,202
Amortization of policy acquisition costs 79,061 48,314 42,988
Deferral of policy acquisition costs (70,539) (71,586) (33,398)
Losses and loss adjustment expense reserves (38,762) (11,962) 19,474
Unearned premiums (16,751) (19,492) (8,864)
Net reinsurance and funds held balances (4,734) 16,785 (7,398)
Accrued investment income 1,812 2,441 53
Other assets (14,980) (3,758) (284)
Obligation under acquisition agreements 11,238 - 5,688
Accounts payable and other liabilities (7,433) 6,753 (12,461)
Drafts outstanding (41) (1,560) 392
--------- --------- --------
Net cash provided by (used in ) operating activities (105,144) 8,106 7,294
INVESTING ACTIVITIES
Fixed maturity securities available-for-sale:
Purchases (187,874) (184,288) (16,586)
Sales 194,872 188,407 7,818
Maturities 33,083 12,247 5,565
Fixed maturity securities held-to-maturity (held for investment in 1994):
Purchases - - (55)
Sales - - -
Maturities - 6,521 49
Equity securities:
Sales - 1,346 -
Acquisition of Northwestern National Holding Company, Inc. - (26,220) -
(net of cash and cash equivalents acquired of $36,907)
Sales of property and equipment 6,227 - -
--------- --------- --------
Net cash provided by (used in) investing activities 46,308 (1,987) (3,209)
--------- --------- --------
Financing activities
Issuance of notes payable 40,000 38,000 -
Repayment of notes payable (38,000) (3,500) (23,750)
Issuance of preferred stock - 10,000 -
Issuance of redeemable preferred stock and
common stock warrants - 12,000 -
Cash dividends paid (800) (588) -
--------- --------- --------
Net cash provided by (used in) financing activities 1,200 55,912 (23,750)
Increase (decrease) in cash and cash equivalents (57,636) 62,031 (19,665)
Cash and cash equivalents at beginning of year 93,662 31,631 51,296
--------- --------- --------
Cash and cash equivalents at end of year $ 36,026 $ 93,662 $ 31,631
========= ========= ========
</TABLE>
See accompanying notes to consolidated financial statements.
7
<PAGE>
Vik Brothers Insurance, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 1996
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Vik Brothers Insurance, Inc. (the "Company") is a privately-owned insurance
holding company which owns State Capital Insurance Company ("SCI") and LMI
Insurance Company ("LMI"). SCI and LMI own 51% and 49%, respectively, of
American Professionals Insurance Company ("API"). In addition, in 1995, the
Company purchased Northwestern National Holding Company, Inc. ("NNHC")(See Note
13). The Company and LMI each own 50% of NNHC. NNHC owns Northwestern National
Casualty Company ("NNCC") and its wholly-owned subsidiaries NN Insurance Company
and SICO, Inc. and its wholly-owned subsidiaries, Statesman Insurance Company
("SIC") and Timeco, Inc., Pacific National Insurance Company ("PNIC") and its
wholly-owned subsidiary Pacific Automobile Insurance Company ("PAIC"). NNCC is
affiliated with Northwestern National County Mutual Insurance Company ("NNCM"),
an unconsolidated mutual insurance company which is controlled by NNCC. All
insurance company subsidiaries are property and casualty insurers and all
subsidiaries are wholly-owned. On April 30, 1997, the Company was acquired by
Highlands Insurance Group, Inc. (see Note 14).
The Company, through its insurance subsidiaries, primarily writes commercial
insurance policies for small to medium-sized businesses where the Company has
developed underwriting and pricing expertise and an understanding of customer
and agent needs. The Company's commercial policyholders, primarily located in
suburban and rural areas, consist of customers in the habitational sector (such
as apartments, condominiums, motels and hotels), retailers, wholesalers, service
businesses, funeral homes, lumber yards, woodworking operations, office
buildings and religious institutions. The Company also writes a smaller amount
of personal lines insurance focusing on homeowners multiple peril and dwelling
fire insurance. The Company's products are marketed through independent agents
located throughout the United States, with the highest concentration of business
written in New Jersey, California, Texas and Pennsylvania.
As a result of its writings of personal and commercial property coverages, the
Company is exposed to losses from catastrophes. As discussed in Note 7, the
1996, 1995 and 1994 Statements of Operations have been affected by catastrophe
losses.
The preparation of financial statements of insurance companies requires
management to make estimates and assumptions that affect amounts reported in the
financial statements and accompanying notes. Such estimates and assumptions
could change in the future as more information becomes known which could impact
the amounts reported and disclosed herein.
Significant estimates are utilized in the calculation of loss and loss
adjustment expense reserves,
8
<PAGE>
reinsurance recoverables on unpaid losses and loss adjustment expenses and
deferred policy acquisition costs. It is reasonably possible that these
estimates may change in the near term, thereby possibly having a material effect
on the financial statements.
BASIS OF PRESENTATION
The accompanying financial statements have been prepared in accordance with
generally accepted accounting principles ("GAAP") which, for the subsidiary
insurance companies, differ from statutory accounting practices prescribed or
permitted by regulatory authorities (See Note 5). The consolidated financial
statements include the accounts and operations of the Company and its
subsidiaries.
Significant intercompany balances have been eliminated in consolidation. The
significant accounting policies followed by the Company and subsidiaries that
materially affect financial reporting are summarized in this note.
INVESTMENTS
Prior to January 1, 1994, fixed maturity securities were stated at amortized
cost, less reductions for other than temporary market declines in accordance
with the then existing accounting standards. In May 1993, the Financial
Accounting Standard Board ("FASB") issued Statement of Financial Accounting
Standards ("SFAS") No. 115, Accounting for Certain Investments in Debt and
Equity Securities. SFAS No. 115 superseded SFAS No. 12, Accounting for Certain
Marketable Securities and generally replaced the historical cost method of
accounting for debt securities with the fair value method. SFAS No. 115 requires
debt securities to be segregated into three categories: held-to-maturity,
available-for-sale, or trading. The classification of a particular security
affects its carrying value as well as the timing of the recognition of gains and
losses in the income statement. The Company adopted SFAS No. 115, as of January
1, 1994, with no effect on net income and $1,605,000 increase in shareholders'
equity as the cumulative effect of adopting SFAS No. 115.
Management determines the appropriate classification of debt securities at the
time of purchase. Debt securities are classified as held-to-maturity when the
Company has the positive intent and ability to hold the securities to maturity.
Held-to-maturity securities are stated at amortized cost. Securities not
classified as held-to-maturity are classified as available-for-sale. Available-
for-sale securities are stated at fair value, with the unrealized gains and
losses reported as a separate component of shareholders' equity. The amortized
cost of securities classified as held-to-maturity or available-for-sale is
adjusted for amortization of premiums and accretion of discounts to estimated
maturity. Such amortization is included in investment income. Realized gains and
losses include any declines in value judged to be other-than-temporary. The cost
of securities sold is based on the specific identification method.
For structured securities, anticipated prepayments are used to determine the
effective yield of an issue at purchase. Prepayment assumptions are obtained
from internal estimates and are based on
9
<PAGE>
the current interest rate and economic environment. The retrospective adjustment
method is used to value all such securities.
On December 31, 1995, the Company transferred its entire $76,000,000 fixed
maturity portfolio from the "held-to-maturity" category to the "available-for-
sale" category with a related $3,800,000 unrealized gain. This transfer provides
management greater flexibility in managing the Company's investment portfolio on
a total return basis.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on deposit in financial institutions,
deposits in money market instruments, which are recorded at cost which
approximates fair value, and deposits in a cash alternative investment fund
which are recorded at fair value. The Company considers all highly liquid
investments with a maturity of three months or less to be cash equivalents.
PREMIUMS
Premiums written are earned pro rata over the terms of the policies and are
reported net of reinsurance. Unearned premiums are calculated using the monthly
pro rata basis.
POLICY ACQUISITION COSTS
Policy acquisition costs consisting of commissions, premium taxes and certain
other expenses incurred in the acquisition of business, net of reinsurance
commission allowances, are deferred and amortized as the related net premiums
are earned.
Amounts deferred are limited to the estimated amounts recoverable after
providing for losses and expenses that are expected to be incurred, based upon
historical and current experience. Anticipated investment income is considered
in determining whether a premium deficiency exists.
VALUES OF BUSINESSES ACQUIRED AND FAIR VALUE OF ACQUIRED ASSETS IN EXCESS OF
PURCHASE PRICE
Values of businesses acquired represent the excess of the amounts paid over the
fair value of assets acquired. The businesses acquired include: SCI on November
30, 1989; certain business of American Reliance Insurance Company, American
Reliance Casualty Company and the American Reliance Group, Inc. (collectively
"ARI") on June 30, 1993; and NNHC on April 7, 1995 (see Note 13). Fair value of
acquired assets in excess of purchase price resulted from the acquisition of LMI
on December 18, 1992. The values of businesses acquired and the fair value of
acquired assets in excess of purchase price are being amortized over ten years.
RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
The reserves for losses and loss adjustment expenses represent the estimated
ultimate liabilities for all reported and unreported losses incurred but unpaid
through December 31 and the estimated loss adjustment expenses relative to these
claims. Reserves for losses and loss adjustment
10
<PAGE>
expenses are estimated using individual case-basis valuations and statistical
analyses and represent estimates of the ultimate cost of all losses incurred
through December 31 of each year. These estimates are subject to the effects of
trends in loss severity and frequency. Although considerable variability is
inherent in such estimates and the estimates are material in relation to the
Company's equity, management believes that reserves for losses and loss
adjustment expenses are adequate. The estimates are continually reviewed and
adjusted as necessary as experience develops or new information becomes known;
such adjustments are included in current operations.
REINSURANCE
The Company assumes and cedes reinsurance and participates in various
involuntary pools and associations. The reinsurance arrangements allow
management to control exposure to potential losses arising from large risks, and
provide additional capacity for growth. The reinsurance is effected under quota-
share contracts and excess-of-loss contracts. Amounts recoverable from
reinsurers for unpaid losses and loss adjustment expenses are estimated in a
manner consistent with the related liabilities associated with reinsured
policies.
Reinsurance contracts which do not subject the reinsurers to the reasonable
possibility of significant loss are accounted for utilizing deposit accounting.
Deposit accounting requires that the amounts paid under the contract less the
amounts to be retained by reinsurers are recorded on the balance sheet as a net
asset or liability. These amounts are excluded from the statement of operations.
EMPLOYEE PROFIT SHARING PLAN
The Company has an employee profit sharing (401(k)) plan which covers all
employees who meet certain requirements as to age and length of service.
Contributions by the Company are matched based on one-half of employee
contributions to the plan, up to a maximum of 3% of compensation. In addition,
discretionary Company contributions are determined as a percentage of employee
annual cash compensation. The Company's contributions, net of forfeitures, to
the Plan in 1996, 1995 and 1994 were $1,600,000, $527,000 and $1,223,000,
respectively.
During 1995, NNCC and PNIC withdrew from participation in the Northwestern
National Insurance Group Retirement Plan in connection with the acquisition by
the Company (see Note 13) and, thus, the employees became eligible to
participate in the Company's profit sharing plan.
LEASES
The Company leases office space and equipment under operating lease agreements.
The expense charged to operations was $3,038,000, $3,867,000 and $2,005,000 in
1996, 1995, and 1994, respectively. Future minimum lease commitments require
payments of $3,916,000, $2,722,000 $1,871,000, $1,188,000 and $356,000 in 1997,
1998, 1999, 2000 and 2001, respectively.
11
<PAGE>
INCOME TAXES
The Company accounts for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes. Deferred tax assets, net of a valuation allowance,
and liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts and tax basis of
existing assets and liabilities.
RECLASSIFICATIONS
Certain accounts in the prior year financial statements have been reclassified
to conform to the 1996 presentation. Such reclassifications had no effect on
previously reported shareholders' equity or net income.
2. INVESTMENTS
The amortized cost and estimated fair value of investments in fixed maturities
and equity securities were as follows:
AVAILABLE-FOR-SALE SECURITIES: (dollars in thousands)
DECEMBER 31, 1996
-------------------------------------------
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- --------
Fixed Maturities:
U. S. Treasury securities
and obligations of U.S.
government corporations
and agencies $169,109 $1,090 $1,509 $168,690
Obligations of states and
political subdivisions 45 6 0 51
Corporate securities 111,567 3,264 1,128 113,703
Mortgage-backed securities 200,608 1,421 1,233 200,796
-------- ------ ------ --------
Total 481,329 5,781 3,870 483,240
Equity securities - 162 - 162
-------- ------ ------ --------
Total $481,329 $5,943 $3,870 $483,402
======== ====== ====== ========
12
<PAGE>
AVAILABLE-FOR-SALE SECURITIES:
(dollars in thousands)
DECEMBER 31, 1995
-------------------------------------------
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- --------
Fixed Maturities:
U. S. Treasury securities
and obligations of U.S.
government corporations
and agencies $189,478 $ 3,420 $1 $192,897
Obligations of states and
political subdivisions 44 7 0 51
Corporate securities 146,063 8,606 0 154,669
Mortgage-backed
securities 183,911 3,223 1 187,133
-------- ------- -- --------
Total 519,496 15,256 2 534,750
Equity securities - 116 - 116
-------- ------- -- --------
Total $519,496 $15,372 $2 $534,866
======== ======= == ========
The amortized cost and fair value of investments in bonds at December 31, 1996,
by contractual maturity, are shown below. Actual maturities may differ from
contractual maturities as certain issuers of the securities may have the right
to call or prepay obligations with or without penalty.
FIXED MATURITY SECURITIES (dollars in thousands)
AVAILABLE-FOR-SALE:
ESTIMATED
AMORTIZED FAIR
COST VALUE
-------- --------
Due in one year or less $ 18,287 $ 18,353
Due after one year through five years 123,135 123,544
Due after five years through ten years 80,149 80,011
Due after ten years 59,150 60,536
Mortgage-backed securities 200,608 200,796
-------- --------
$481,329 $483,240
======== ========
13
<PAGE>
The Company's realized gains and losses on investments for the years ended
December 31 are summarized as follows:
(dollars in thousands)
1996 1995 1994
------- ------- -------
Fixed maturity securities available-for-sale:
Gross realized gains $ 3,237 $ 9,594 $ -
Gross realized losses (900) (91) (173)
Equity securities - net realized gain 22 690 -
Other investments - net realized losses (35) (1,190) (1,407)
------- ------- -------
Total net realized gains (losses) $ 2,324 $ 9,003 $(1,580)
======= ======= =======
Major categories of investment income for the year ended December 31 are
summarized as follows:
(dollars in thousands)
1996 1995 1994
------- ------- -------
Bonds $37,320 $29,948 $10,104
Real estate 110 101 45
Other invested assets 3 5 12
Cash and cash equivalents 1,596 3,637 1,505
------- ------- -------
Total investment income 39,029 33,691 11,666
Expenses (1,616) (1,416) (906)
------- ------- -------
Net investment income $37,413 $32,275 $10,760
======= ======= =======
At December 31, 1996 and 1995, the Company had investments in bonds with a
carrying amount of $128,270,654 and $104,238,000 respectively, on deposit with
state insurance departments to satisfy regulatory requirements.
3. PREMIUMS RECEIVABLE
Major categories of the Company's premiums receivables at December 31 are
summarized as follows:
(dollars in thousands)
1996 1995
-------- --------
Receivables from agents and insureds $ 93,572 $ 97,701
Premium finance receivables 2,841 4,532
-------- --------
96,413 102,233
Less allowance for doubtful accounts (5,749) (2,040)
-------- --------
Net premiums receivables $ 90,664 $100,193
======== ========
14
<PAGE>
4. DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs at December 31, were as follows:
(dollars in the thousands)
DECEMBER 31
1996 1995 1994
-------- -------- --------
Deferred policy acquisition costs
at beginning of year $ 37,646 $ 14,374 $ 23,964
Policy acquisition costs deferred 70,539 71,586 33,398
Policy acquisition costs amortized (79,061) (48,314) (42,988)
-------- -------- --------
Deferred policy acquisition costs at
end of year $ 29,124 $ 37,646 $ 14,374
======== ======== ========
In connection with the acquisition of NNHC on April 7, 1995 (see Note 13),
deferred policy acquisition costs of $19,337,000 were not assigned a value in
the Company's allocation of the purchase price. As a result of this purchase
price allocation, deferred policy acquisition costs amortized in 1995 were lower
by approximately $18,390,000, since deferred policy acquisition costs are
amortized over one year or less.
5. REGULATORY MATTERS
Insurance laws and regulations of the domiciliary states of the Company's
insurance subsidiaries require such subsidiaries to maintain certain minimum
capital and surplus. The net assets of the insurance subsidiaries available for
transfer to a parent company are limited on an annual basis to amounts by which
the insurance subsidiaries are able to pay dividends determined in accordance
with insurance laws and regulations which are generally based upon statutory
surplus levels or net income.
The following table sets forth for each subsidiary the unaudited statutory net
income (loss) for the year ended December 31, 1996, the unaudited statutory
capital and surplus at December 31, 1996, the statutory minimum capital and
surplus (for each subsidiary's state of domicile) and risk-based capital ("RBC")
company action level capital and surplus (defined below) at December 31, 1996:
15
<PAGE>
<TABLE>
<CAPTION>
(dollars in thousands)
STATUTORY CAPITAL & SURPLUS
---------------------------------- ---------------------------------
STATE OF NET INCOME CAPITAL & STATUTORY RBCCOMPANY
SUBSIDIARY DOMICILE (LOSS) SURPLUS MINIMUM ACTION LEVEL
- ----------- ------------------ ----------------- --------------- -------------- -----------------
<S> <C> <C> <C> <C> <C>
LMI Ohio ($28,549) $23,023 $10,000 $62,891
NNCC Wisconsin 3,120 74,583 4,000 37,083
SCI North Carolina (3,769) 11,488 2,250 10,373
PNIC California (3,350) 15,357 5,400 12,067
PAIC California (1,553) 3,933 5,400 2,137
SIC Indiana 670 10,026 1,000 120
NNI Wisconsin 255 8,158 4,000 24
API Indiana 79 11,475 1,000 1,541
</TABLE>
The insurance subsidiaries prepare their statutory-basis financial statements in
accordance with accounting practices prescribed or permitted by their respective
domiciliary insurance departments. "Prescribed" statutory accounting practices
include state laws, regulations, and general administrative rules, as well as a
variety of publications of the National Association of Insurance Commissioners
("NAIC"). "Permitted" statutory accounting practices may differ from state to
state, may differ from company to company within a state, and may change in the
future. The NAIC currently is in the process of codifying statutory accounting
practices, the result of which ultimately may constitute the only source of
"prescribed" statutory accounting practices. Accordingly, that project, which is
expected to be completed in 1998, will likely change, to some extent, prescribed
statutory accounting practices, and may result in changes to the accounting that
insurance enterprises use to prepare their statutory financial statements.
For 1996 and 1995, LMI received approval from the Ohio Department of Insurance
for its statutory accounting with respect to certain reinsurance agreements and
affiliated company investments. LMI requested permission for these accounting
practices because they differ from prescribed statutory accounting practices. If
the Ohio Department of Insurance were to rescind its permission for these
accounting practices, LMI's statutory surplus would have been reduced by
$64,442,000 and $68,869,000 at December 31, 1996 and 1995, respectively. On
April 30, 1997 in connection with the Highlands acquisition and a plan submitted
by LMI to the Ohio Insurance Department, these reinsurance agreements and
affiliated investments were eliminated.
The Company allocates certain reinsurance costs and data processing costs to its
insurance subsidiaries. The insurance subsidiaries have requested approval of
the intercompany allocation methods from their respective domiciliary insurance
departments. Also, certain insurance subsidiaries have requested permitted
accounting practices related to the Company's aging method for premiums
receivable and the Company's accounting for an intercompany reinsurance
agreement.
16
<PAGE>
The Company has not yet received responses from the insurance regulators. If
unfavorable responses are received from insurance regulators, it could adversely
impact statutory surplus levels of certain subsidiaries, but the Company would
have the opportunity to correct any statutory surplus deficiency. Management
believes that the resolution of these matters will not have a material adverse
impact on the consolidated financial position of the Company after consideration
of the capital contributions and other events described in Note 14.
Several of the insurance subsidiaries are subject to regulatory restrictions.
Prior to the acquisition, PNIC, PAIC and LMI were permitted to pay dividends
only upon the prior approval of their domiciliary departments of insurance.
These restrictions were removed on April 30, 1997 in connection with the
acquisition by Highlands. Subsequent to the acquisition, the amount of dividends
available for payment to the Company in 1997 without prior regulatory approval
based on unaudited statutory net income and unaudited capital and surplus is
$1,955,000 from NNCC and $1,345,000 from PNIC. SCI and LMI are required to limit
the amount of their net written premium to 275% of their surplus. LMI and API
are restricted from writing new and renewal business in several states where
they are licensed.
The NAIC has developed minimum risk-based capital requirements for insurance
enterprises that have been adopted under the insurance laws of the states in
which the insurance subsidiaries are domiciled. The formulas for determining the
amount of RBC specify various weighting factors that are applied to financial
balances or various levels of activity based on the perceived degree of risk.
Regulatory compliance is determined by a ratio of the enterprise's regulatory
total adjusted capital, as defined by the NAIC, to its authorized control level
RBC, as defined by the NAIC. Enterprises below specified ratios are classified
within certain levels, each of which requires corrective action.
At December 31, 1996, LMI's surplus fell below the required RBC level and was at
the "authorized control" level. Accordingly, it was required to file a plan with
the Ohio Insurance Department setting forth its plan to attain the required
level of regulatory capital. The plan, which contemplated the acquisition of the
Company by Highlands, included commuting reinsurance agreements and implementing
numerous affiliated transactions, including LMI transferring assets to
affiliates for securities or cash, the distribution of the shares of NNHC owned
by LMI to the Company, the contribution of capital to LMI, entering into
reinsurance agreements so that LMI ceased to retain net insurance liability and,
ultimately, causing LMI to cease writing premium. The plan was approved by the
Ohio Insurance Department and transactions which required approval of other
insurance departments received the required approval. On April 30, 1997, in
compliance with the plan, Highlands made a direct capital contribution of
$5,000,000 and an indirect capital contribution through the Company of
$22,500,000 to LMI (see Note 14). Highlands is not committed to make additional
contributions.
17
<PAGE>
Statutory surplus for PAIC as of December 31, 1996 was $3,933,000, which was
below the minimum capital and surplus of $5,400,000 required in California. PAIC
received a capital contribution of $1,500,000 on April 30, 1997 to correct the
deficiency (see Note 14).
All of the Company's other insurance subsidiaries' RBC levels exceeded the
minimum threshold requiring company action.
Currently, the domiciliary insurance departments of SCI, LMI, NNCC, NNI, API and
SIC are conducting triennial examinations of these companies. The final reports
on these examinations have not yet been issued. Management believes that the
completion of these examinations will not have a material adverse impact on the
consolidated financial position of the Company after consideration of the
capital contributions and other events described in Note 14.
6. INCOME TAXES
The Company and its subsidiaries file a consolidated federal income tax return.
Taxable income varies from financial statement income primarily due to: purchase
accounting adjustments, deferred policy acquisition costs, unearned premium
adjustments, discounting of loss and loss adjustment expense reserves and loss
portfolio transfer adjustments.
18
<PAGE>
Significant components of the provision for income taxes attributable to
operations (excluding federal income taxes associated with the cumulative effect
of a change in accounting principle) for the years ended December 31 were as
follows:
(dollars in thousands)
1996 1995 1994
-------- --------- --------
Current:
Federal $(5,267) $ 5,573 $(1,705)
State 105 127 347
------- -------- -------
Total current expense (benefit) (5,162) 5,700 (1,358)
Deferred:
Federal 11,698 (10,920) 106
------- -------- -------
Total tax expense (benefit) $ 6,536 $ (5,220) $(1,252)
======= ======== =======
The reconciliation of income tax attributable to operations computed at the U.S.
federal statutory tax rate to income tax expense (benefit) for the years ended
December 31 is shown below.
(dollars in thousands)
1996 1995 1994
--------- --------- --------
Tax at federal statutory rates $(19,223) $ 12,923 $(2,524)
Change in the valuation allowance 29,035 (23,987) 105
Net operating loss carryback (5,267) - -
Prior year amendment - 5,573 -
Goodwill 107 331 105
Alternative minimum tax - - 634
Other 1,884 (60) 428
-------- -------- -------
Tax as reported $ 6,536 $ (5,220) $(1,252)
======== ======== =======
19
<PAGE>
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities as of December 31 were as
follows:
(dollars in thousands)
1996 1995
------- --------
Deferred tax assets:
Amounts due from reinsurers $ 1,178 $ 3,580
Fixed assets 330 531
Policyholder dividends 1,391 1,329
Reserves for losses and loss adjustment expenses 25,562 27,679
Bad debt reserves 1,802 685
Tax loss carryforward 21,086 9,830
Unearned discounts on processing fees 4,744 1,573
Unearned premiums 9,959 10,226
Investment basis differences 1,719 -
Reserve guarantee related to acquisition 3,933 -
Other 1,563 356
------- --------
73,267 55,789
Valuation allowance for deferred tax assets 56,004 (26,969)
------- --------
Total deferred tax assets 17,263 28,820
Deferred tax liabilities:
Capitalized software 1,934 571
Deferred policy acquisition costs 10,193 12,800
Unrealized capital gains 774 5,909
Values of businesses acquired 2,824 3,164
Other 1,538 660
------- --------
Total deferred tax liabilities 17,263 23,104
------- --------
Deferred tax asset net of deferred tax liabilities $ - $ 5,716
======= ========
Management has determined that a valuation allowance against its deferred tax
assets is required. There is uncertainty regarding whether the Company will be
able to realize benefits from its deferred tax assets due to operating losses
for financial reporting purposes in the last three years. Components of the
valuation allowance are as follows:
20
<PAGE>
(dollars in thousands)
1996 1995
------- --------
Opening valuation allowance $26,969 $ 15,853
Acquired upon purchase of NNHC - 38,025
Decrease for prior year unrealized capital loss - (2,922)
Increase (decrease) in allowance 29,035 (23,987)
------- --------
Ending valuation allowance $56,004 $ 26,969
======= ========
At December 31, 1996, the Company had separate return loss limitations, which
could only be used to offset the earnings of the NNHC group of $14,105,000, and
API of $5,167,000. The NNHC group losses will expire between 2000 and 2008 and
the API losses in 1999 and 2000. For financial reporting purposes, the valuation
allowance includes a provision to offset the deferred tax assets related to
these carryforwards. Taxes paid in 1996, 1995 and 1994 were $213,000, $561,000
and $-0- respectively.
7. REINSURANCE AND LOSS PORTFOLIO AGREEMENTS
Certain premiums and losses are ceded to other insurance companies under various
reinsurance agreements. These agreements principally provide the Company with
increased capacity to write larger risks. The insurance subsidiaries provide
policy coverages up to $20,000,000 which are reinsured under various quota share
and excess of loss agreements. These contracts, which expire June 30, 1997,
maintain retention levels of $500,000 for property and casualty lines. Under the
catastrophe treaty program, the Company retains $4,000,000 of each loss
occurrence and has protection for 50% of all losses in excess thereof up to
$8,500,000, 100% of all losses in excess of $8,500,000 up to $55,000,000 and 48%
for all losses in excess of $55,000,000 up to $80,000,000.
The Company is subject to credit risk with respect to reinsurers since
reinsurance ceded contracts do not relieve the Company from its obligations to
policyholders. The Company remains liable to its policyholders to the extent
reinsuring companies are unable to meet their obligations under the reinsurance
agreements. Failure of reinsurers to honor their obligations could result in
losses to the Company; consequently, allowances are established for amounts
deemed or estimated to be uncollectable. To minimize its exposure to significant
losses from reinsurance insolvencies, management evaluates the financial
condition of its reinsurers and monitors concentrations of credit risk arising
from similar geographic regions, activities, or economic characteristics of the
reinsurers.
The Company generally holds collateral under related reinsurance agreements in
the form of letters of credit for reinsurers not licensed to do business in the
insurance subsidiaries' states of domicile.
21
<PAGE>
The Company's largest unsecured reinsurance recoverables with individual
reinsurers at December 31, 1996 were as follows:
(dollars in thousands)
American Re-Insurance Company $ 38,732
Employers Reinsurance Company 30,273
Prudential Property and Casualty Insurance Company 10,108
General Reinsurance Corporation 4,942
Sorema North America Reinsurance Company 4,704
Munich American Reinsurance Company 2,882
St. Paul Fire & Marine Insurance Company 2,811
SCOR Reinsurance Company 2,796
Continental Casualty Company 2,519
Everest Reinsurance 2,289
First Excess and Reinsurance Corporation 2,272
Constitution Reinsurance Company 1,799
P.G.L. America Re. Incorporated 1,644
NAC Reinsurance Corporation 1,219
Western Atlantic Reinsurance Company 1,081
Great Lakes American Reinsurance Company 1,057
New England Reinsurance Company 1,033
Winterthur Reinsurance Corporation of America 992
Signet Star Reinsurance Company 969
Continental Reinsurance Corporation 626
Northwestern National Life Insurance Company 619
Details of premiums written and earned in 1996, 1995 and 1994 are summarized as
follows:
<TABLE>
<CAPTION>
(dollars in thousands)
1996 1995 1994
--------------------- --------------------- ---------------------
WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED
--------- --------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Direct $ 384,646 $ 395,577 $ 369,775 $ 392,036 $ 277,845 $ 284,808
Assumed-NNCM 21,144 24,481 20,087 18,183 - -
Assumed-other 9,174 11,656 22,121 22,608 16,626 18,527
Ceded (102,517) (103,841) (107,982) (136,061) (118,623) (101,837)
--------- --------- --------- --------- --------- ---------
Net $ 312,447 $ 327,873 $ 304,001 $ 296,766 $ 175,848 $ 201,498
========= ========= ========= ========= ========= =========
</TABLE>
Losses and loss adjustment expenses incurred have been reduced by ceded loss
recoveries of $73,050,000, $101,192,000 and $92,295,000 in 1996, 1995 and 1994,
respectively. The Company incurred direct losses and loss adjustment expenses
from catastrophes of $52,227,000, $22,078,000 and $71,590,000, reduced by
reinsurance recoveries of $37,428,000, $18,312,000 and $55,043,000, resulting in
net catastrophe losses and loss adjustment expenses incurred of $14,799,000,
$3,766,000 and $16,547,000 for the years ended December 31, 1996, 1995 and 1994,
respectively.
22
<PAGE>
LMI has entered into certain reinsurance facilities whereby LMI has agreed to
assume a share of property catastrophe reinsurance and property excess of loss
reinsurance written by ceding reinsurers. The facilities cover risks in the
United States and Canada, with territorial exclusions covering known
concentrations of exposure, marine risks worldwide and risks outside the United
States and Canada. The facilities are written either on a surplus basis under
which LMI assumes liability under an excess of loss catastrophe reinsurance
program on a varying percentage basis in excess of the ceding company's retained
liability, or on a quota share basis where LMI participates on a fixed
percentage basis with the ceding company on excess of loss reinsurance coverage.
LMI has entered into an aggregate excess of loss agreement with Prudential
Property and Casualty Insurance Company ("Prupac"), its former parent, as a
result of the sale of LMI from Prupac to the Company. The agreement indemnifies
LMI for the effects of Hurricane Andrew.
On June 30, 1993, LMI entered into a loss portfolio transfer ("LPT") agreement
with Inter-Ocean Reinsurance Company, Ltd. ("Inter-Ocean") covering certain
policies written or renewed on January 1, 1989 or subsequent on accidents or
occurrences arising through December 31, 1992 (see Note 14). The parent, Vik
Brothers Insurance, Inc., has ultimately guaranteed any losses experienced by
the reinsurers. As a result, this agreement does not qualify for reinsurance
accounting and is reflected as a financing transaction utilizing deposit
accounting in the accompanying financial statements. The assets collateralizing
this agreement are held in a trust and include 21,366 shares of redeemable, 6%
cumulative Preferred Stock Series 3 ($1,000 par) of the Company (see Note 12).
On December 31, 1994, the Company entered into a quota share reinsurance
agreement with Inter-Ocean ("Inter-Ocean quota share"). The Company entered into
a related agreement with Inter-Ocean on December 31, 1995 that effectively
amended the LPT agreement referred to above to include the cash flow and
investment income of the Inter-Ocean quota share agreement. As a result, at
December 31, 1995, the Inter-Ocean quota share no longer qualifies for
reinsurance accounting in the consolidated financial statements. The related
ceded loss and unearned premium reserves and a deferred gain of $827,000 at
December 31, 1995 were reported as a financing arrangement utilizing deposit
accounting. For 1995, premiums of $56,822,000, losses of $27,105,000,
commissions of $18,807,000 and contingent profit commissions of $6,041,000 have
been reported as ceded reinsurance under this arrangement. In 1996, premiums and
losses under this arrangement have been recorded utilizing deposit accounting
and, accordingly, have not been included in the accompanying 1996 statement of
operations. The LPT agreement and the Inter-Ocean quota share were terminated
effective April 30, 1997. (see Note 14).
8. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
The following table is a reconciliation for the Company of beginning and ending
reserves for unpaid losses and loss adjustment expenses ("LAE"), net of
reinsurance recoverables, for the years ended December 31 and a reconciliation
to reserves at the end of the periods indicated:
23
<PAGE>
(dollars in thousands)
1996 1995 1994
-------- -------- ---------
Reserves for losses and LAE, net of
reinsurance recoverable, at beginning of year $463,493 $213,244 $218,264
Add:
Reserves for losses and LAE, net of
reinsurance recoverables, of companies
acquired during the year - 302,276 -
Losses and LAE incurred claims
occurring in the current year, net of
reinsurance recoverables 253,362 203,423 150,458
Increase (decrease) in estimated losses and
LAE for claims occurring in prior years,
net of reinsurance 25,451 8,360 (6,548)
-------- -------- --------
Losses and LAE incurred during the current
year, net of reinsurance 278,813 211,783 143,910
-------- -------- --------
Deduct losses and LAE payments for claims,
net of reinsurance occurring during:
Current year 128,935 83,460 63,999
Prior years 180,507 180,350 84,931
-------- -------- --------
309,442 263,810 148,930
-------- -------- --------
Reserve for losses and LAE, net of
reinsurance recoverables, at end of year 432,864 463,493 213,244
Reinsurance recoverables on unpaid losses
and LAE at end of year 106,163 114,296 47,094
-------- -------- --------
$539,027 $577,789 260,338
======== ======== ========
The 1996 increase in the prior year reserves of $25,451,000 included adverse
development experienced in LMI of $35,090,000 which included a strengthening
action of $25,000,000 in the fourth quarter of 1996, primarily in the commercial
multi-peril line of business, in recognition both of adverse development on case
loss reserves and greater than anticipated paid allocated loss adjustment
expense. NNCC experienced favorable development of $11,631,000, chiefly in the
other liability line of business, where actual emergence was less than expected.
The 1995 year increase in the December 31, 1994 reserves of $8,360,000 was a
result of favorable development of $8,800,000 on the NNHC reserves offset by
adverse development primarily related to catastrophic events occurring in 1994
including the Northeastern winter storms and the Northridge earthquake and
additional reported losses on involuntary pools. The $6,548,000 favorable
reserve development recognized in 1994 was primarily attributable to a
conservative estimate of the impact of unprocessed workers' compensation claims
at December 31, 1993.
9. NOTES PAYABLE
24
<PAGE>
On March 22, 1996, the Company repaid its $38,000,000 debt and replaced it with
a new debt structure that includes a $40,000,000 senior secured amortizing term
loan with maturity date of March 31, 2002 and a $5,000,000 senior secured stand-
by loan which is convertible to a term loan with maturity date of March 31,
2003. The interest rate is set at the beginning of each quarter at the option of
the Company as either LIBOR plus 3% or Prime plus 1.5%.
The new debt structure also included the issuance of two detachable common stock
warrants (see Note 12).
Principal repayments under the new debt structure are $6,000,000 in 1997,
$9,000,000 in 1999, $10,000,000 in both 2000 and 2001 and the remaining
$5,000,000 in 2002.
Security under the debt agreement includes 100% of the outstanding common stock
of LMI Insurance Company and State Capital Insurance Company, 50% of the
outstanding common stock of Northwestern National Holding Company and $5,496,000
held in an interest bearing trust account.
The ability of the Company to generate cash flow sufficient to meet its debt
obligations is contingent upon its ability to obtain funds from its insurance
subsidiaries (see Notes 5 and 14).
Interest paid in 1996, 1995 and 1994 was $3,506,000, $3,477,000 and $1,331,000
respectively.
As of December 31, 1996, the Company failed to meet certain financial covenants
in the credit agreement, resulting in an event of default under the credit
agreement. On March 31, 1997 the Company and the Agent Bank agreed that the
Agent would not accelerate the maturity of the loan until effectively April 30,
1997, the date of the planned merger with Highlands Insurance Group Inc. On
April 30, 1997, the note was repaid in full in connection with the merger (see
Note 14).
10. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts and fair values of the Company's financial instruments at
December 31 were as follows:
(dollars in thousands)
1996 1995
------------------- ------------------
CARRYING FAIR Carrying Fair
AMOUNT VALUE Amount Value
---------- -------- -------- --------
Cash and cash equivalents $ 36,026 $ 36,026 $ 93,662 $ 93,662
Fixed maturities 483,240 483,240 534,750 534,750
Equity securities 162 162 116 116
Funds on deposit with reinsurers 56,481 56,481 52,269 52,269
Notes payable 40,000 40,000 38,000 38,000
25
<PAGE>
The fair value of cash and cash equivalents, accrued investment income and
accounts payable and accrued expenses approximate their carrying amounts due to
their nearness to maturity. Fair values of fixed maturity securities generally
represent quoted market prices, as reported by a nationally recognized pricing
service, for securities traded in the public market place. For securities not
readily traded in the public market place, fair values are determined by
recognized bond dealers using bid side market valuations. Fair values of common
stocks are based on closing market price. The fair value of funds on deposit
with reinsurers is determined based upon cash deposits valued at their carrying
amounts plus the value of the Company's Series Three Preferred Shares (see Note
12) valued at its original stated value plus accumulated paid-in-kind ("PIK")
dividends since the date of issue. The fair value of notes payable approximates
its carrying value because the debt carries a variable market interest rate.
11. COMMITMENTS AND CONTINGENCIES
The insurance subsidiaries are named as defendants in various legal actions
primarily arising from claims made under insurance policies and contracts. These
actions are considered by the insurance subsidiaries in estimating reserves for
losses and loss adjustment expenses. Management believes that the resolution of
these actions will not have a material adverse affect on the Company's financial
position or results of operations.
The insurance subsidiaries are required to be members of various state insurance
guaranty associations in order to conduct business in those states. These
associations have the authority to assess member companies in the event that an
insurance company conducting business in that state is unable to meet its
policyholder obligations. The Company recognizes the expense for these
assessments in the year they are assessed.
The Company and LMI have brought an action against Prupac as a result of
Prupac's nonpayment of monies owed to LMI under two reinsurance agreements and
received a judgement in favor of the Company for balances due as of September
30, 1995, which totaled $1,917,000. Additionally, Prupac lost its appeal of this
judgement which was again found to be in favor of the Company. The amount due
the Company for paid losses and loss adjustment expenses totaled $5,880,000 at
December 31, 1996. In addition, at December 31, 1996, the Company ceded reserves
for losses and loss adjustment expenses to Prupac of $1,599,000. The judgement
includes accrual of interest at the rate of 10% per annum. The Company has not
accrued interest on this recoverable.
In 1995, the Company entered into a five year agreement with American Re-
Insurance Company ("Am Re"), a preferred shareholder (see Note 12) and also
reinsurer, whereby the Company pays Am Re a minimum of $500,000 annually for
reinsurance brokerage and consulting services. This agreement was terminated by
mutual consent of the Company and American Re-Insurance Company in 1997 (see
Note 14).
26
<PAGE>
The Company entered a ten-year agreement with Policy Management Systems
Corporation ("PMSC"), a preferred shareholder (see Note 12), effective January
1995, to obtain data processing services, including significant enhancements to
existing systems and the development of a new integrated system for the entire
organization. Processing fees under this agreement include minimum annual
charges plus variable amounts based on time and annual written premium volume.
As of December 31, 1996, the minimum annual fees for the Company under the PMSC
agreement are $7,719,000 for 1997 through 2001. Effective on May 1, 1997, the
PMSC agreement was amended. The minimum annual fees for the Company under the
PMSC agreement, as amended, are $7,014,000 for 1997 and $6,662,000 for 1998
through 2001. The fees under this agreement were $10,324,000 and $7,623,000 for
the years ended December 31, 1996 and 1995, respectively. In February 1997, PMSC
served a written demand on the company for immediate payment of certain 1996 and
1997 charges totaling $4,799,000, and accelerated the outstanding balance of the
total minimum base processing charges in the amount of $15,358,000, based on a
claim that the Company had breached the terms of the agreement by, among other
things, failing to pay when due certain amounts under the agreement. On February
4, 1997, PMSC filed suit against the Company and its insurance subsidiaries
alleging breach of contract and seeking judgment in the amount of $19,842,422,
plus interest, costs and late charges. On February 18, 1997, PMSC and the
Company entered into a letter agreement pursuant to which the parties entered
into a Joint Motion under which the time by which the Company and subsidiaries
are required to respond to the PMSC suit was extended until May 12, 1997. As
discussed in Note 14, on May 1, 1997, PMSC dismissed its action against the
Company without prejudice.
Effective December 1992, the Company entered into a ten year data processing
services agreement with Electronic Data Systems Corporation ("EDS"). Processing
fees under this agreement include minimum annual charges plus variable amounts
based on annual written premium volume. On March 3, 1997, the Company signed a
Separation Agreement with EDS to terminate the use of their services. According
to the agreement, any new and renewal business with effective dates after 1996
will no longer be processed through EDS. The Company will utilize EDS to service
the run-off of policies issued before 1997 until no later than March 31, 1998,
during which time the Company will pay to EDS a fixed base fee of $65,000 per
month. Additionally, the Company paid a termination fee to EDS of $2,000,000 in
the first quarter of 1997 as stipulated in the Separation Agreement. This amount
was accrued as a liability during 1996 and was recorded in underwriting expenses
in the accompanying 1996 statement of operations.
12. COMMON STOCK, PREFERRED STOCK, REDEEMABLE PREFERRED STOCK AND REDEEMABLE
COMMON STOCK WARRANTS
As discussed in Note 14, all of the Company's common and preferred stock and
common stock warrants were canceled as a result of the acquisition of the
Company by Highlands Insurance Group, Inc. on April 30, 1997.
A description of capitalization for the Company at December 31, 1996 is shown
below (see Note 14 for subsequent event related to capitalization):
27
<PAGE>
<TABLE>
<CAPTION>
(dollars in thousands)
--------------------------------------------
REDEEMABLE
NUMBER OF SHARES PAR VALUE ADDITIONAL PREFERRED STOCK
AUTHORIZED ISSUED OUTSTANDING PER SHARE CAPITAL PAID IN AND WARRANTS
---------- ----------- ----------- --------- ---------- --------------- ---------------
<S> <C> <C> <C> <C> <C> <C> <C>
Common Stock 2,000,000 271,800 271,800 $0.001 $ - $14,138 $ -
------- ------- -------
Preferred Stock
Series 1 1,500 1,500 1,500 0.10 1 3,000 -
Series 2 2,500 1,232 1,232 0.10 - 3,695 -
Series 3 50,000 21,366 21, 366 0.10 - - 21,366
Series 4 10,000 10,000 10,000 0.10 1 9,999 -
Series 5 20,000 1,389 1,389 0.10 - - 1,389
Series 6 10,000 10,000 10,000 0.10 - - 10,000
Series 7 40,000 19,084 19,084 0.10 1 9,541 9,542
------- ------- -------
Total Preferred 3 26,235 42,297
Common stock warrants - - 2,000
------- ------- -------
Totals $ 3 $40,373 $44,297
======= ======= =======
A description of capitalization for the Company at December 31, 1995 is shown
below:
(dollars in thousands)
--------------------------------------------
REDEEMABLE
NUMBER OF SHARES PAR VALUE ADDITIONAL PREFERRED STOCK
AUTHORIZED ISSUED OUTSTANDING PER SHARE CAPITAL PAID IN AND WARRANTS
---------- ----------- ----------- --------- ---------- --------------- ---------------
Common Stock 2,000,000 271,800 271,800 0.001 $ - $14,138 $ -
------- ------- -------
Preferred Stock
Series 1 1,500 1,500 1,500 0.10 - 3,000 -
Series 2 2,500 1,161 1,161 0.10 - 3,482 -
Series 3 50,000 20,131 20,131 0.10 - - 20,131
Series 4 10,000 10,000 10,000 0.10 1 9,999 -
Series 5 20,000 573 573 0.10 - - 573
Series 6 10,000 10,000 10,000 0.10 - - 10,000
Series 7 40,000 16,631 16,631 0.10 1 8,315 8,316
------- ------- -------
Total Preferred 2 24,796 39,020
Common stock warrants - - 2,000
------- ------- -------
Totals $ 2 $38,934 $41,020
======= ======= =======
</TABLE>
The Company is authorized to issue up to 2,000,000 shares of preferred stock
through any number of preferred stock series. During 1995 and in connection with
the financing arranged to acquire NNHC, the Company issued four new classes of
preferred stock and common stock warrants. In April 1996, pursuant to an
amendment to the inducement provision in the Company's data processing agreement
with PMSC, the data processing services provider transferred its interest in the
Series 4 and Series 5 Preferred Stock (described below) to the holder of the
Series 1 Preferred Stock who is a relative of the common shareholders. While the
transaction had no cash impact, the Company established an unearned inducement
fee liability
28
<PAGE>
through a charge to retained earnings in the amount of $10 million to reflect
the distribution to the related party. This unearned inducement fee will be
earned over the remaining life of the service agreement. A description of all of
the Company's classes of preferred stock, as well as the common stock warrants,
is summarized below:
SERIES ONE PREFERRED SHARES: 1,500 authorized, non-voting shares issued and
outstanding; non-cumulative dividend at the prime rate at an Indiana National
Bank with no dividends declared to date. The shares were issued in November 1989
for $3,000,000 or $2,000 per share. The liquidation preference is $2,000 per
share plus dividends. The shares are subordinate to the Series Six shares
described below.
SERIES TWO PREFERRED SHARES: 2,500 authorized, non-voting shares with varying
amounts issued and outstanding as a result of the paid-in-kind ("PIK") dividend.
At December 31, 1996, there were 1,232 shares issued and outstanding of which 71
shares were issued as PIK dividends in 1996. Cumulative dividends are payable
quarterly at 6% and can be in the form of cash or PIK with PIK dividends being
elected to date. The shares were issued in July 1993 for $3,000,000 or $3,000
per share. The liquidation preference is $3,000 per share plus cumulative
dividends. The Series Two shares are subordinate to the Series Six shares
described below.
SERIES THREE PREFERRED SHARES: 50,000 authorized, non-voting shares with varying
amounts issued and outstanding as a result of the PIK dividend. At December 31,
1996, there were 21,366 shares issued and outstanding of which 1,235 shares were
issued as PIK dividends in 1996. Cumulative dividends are payable quarterly at
6% and can be in the form of cash or PIK with PIK dividends being elected to
date. The shares were issued in 1993 for $17,000,000 or $1,000 per share as part
of the reinsurance transaction with Inter-Ocean Reinsurance Company, Ltd. (see
Note 7), the current owner of the Series Three shares. The Series Three shares
are mandatorily redeemable at January 1, 2004, and are subordinate to the rights
of the Series Six shares described below. The liquidation preference amount is
$1,000 per share plus cumulative, unpaid dividends.
SERIES FOUR PREFERRED SHARES: 10,000 authorized issued and outstanding, non-
voting shares sold to PMSC for $10,000,000 or $1,000 per share on April 7, 1995.
The Series Four shares have cumulative dividends payable at an annual rate of
7.5%. The dividends are payable on a quarterly basis in the form of cash or PIK
Series 5 Preferred Shares at the discretion of the Company. Dividends to date
have been PIK. The Series 4 and 5 shares have a $1,000 liquidation preference.
Each of the Series 4 shares is convertible into 4.11 shares of voting common
stock subject to adjustment to maintain an antidilutive position. The Series
Four shares are subordinate to the Series Six shares described below.
SERIES FIVE PREFERRED SHARES: 20,000 shares authorized, non-voting shares to be
used as the dividend vehicle for the Series Four shares described above. The
number of shares issued and outstanding varies with the PIK dividend declared on
the Series Four shares. At December 31, 1996, there are 1,389 shares issued and
outstanding to the Series Four holders. During 1996, 816 shares were issued as
PIK dividends. The Series Five shares are subject to mandatory
29
<PAGE>
redemption when the Series Six shares described below are redeemed and are
subordinate to the Series Six shares.
SERIES SIX PREFERRED SHARES: 10,000 shares authorized, issued and outstanding
sold to Am Re for $10,000,000 or $1,000 per share. Cumulative cash dividends are
payable in equal quarterly installments at the annual rate of 8% through March
31, 1998, 10% through March 31, 2001 and 12% thereafter. The cash dividends have
been paid to Am Re through December 31, 1996. The Series Six shares are
generally non-voting unless the Company fails to pay dividends for two or more
consecutive quarters, at which time Am Re may elect one member to the Board of
Directors. The Series Six shares are subject to redemption upon the occurrence
of certain items including a change in control of the Company and the continued
employment of certain Company employees.
The Series Six shares are redeemable at the liquidation preference of $1,000 per
share, in whole or in part, at the option of the Company on or after April 1,
1998 and are mandatorily redeemable on April 1, 2003. The Series Six shares have
seniority over the other preferred shares issued. Under a common stock warrant
described below, the Series Six shares are guaranteed a minimum rate of return
of 20% and maximum common stock ownership of up to 25%.
SERIES SEVEN PREFERRED SHARES: 40,000 shares authorized, non-voting, with 15,000
shares initially issued on April 7, 1995 for $15,000,000 or $1,000 per share.
The number of shares issued and outstanding varies in relation to the PIK
dividend and, at December 31, 1996, 19,084 shares were outstanding. During 1996,
2,453 shares were issued as PIK dividends. Dividends are cumulative and payable
in quarterly installments at an annual rate of 14%. The Series Seven shares are
50% mandatorily redeemable on the earlier of July 1, 2004, or the occurrence of
a change in control, at $1,000 per share liquidation preference. Under a common
stock warrant described below, the Series Seven shares are guaranteed a minimum
rate of return of 30% and a maximum common stock ownership of up to 30%. The
Series Seven shares are subordinate to the Series Six shares.
The terms of the Series Seven shares require that only 50% of the Series Seven
shares are mandatorily redeemable and, accordingly, 50% of the Series Seven
shares have been recorded as redeemable preferred stock at the liquidation
preference.
In exchange for the issuance of the Series Seven Preferred Shares, the
shareholders transferred $4,651,000 to Armco as consideration for the purchase
of NNHC; $10,306,000 to other parties to satisfy obligations of the Company
which were included in other liabilities and accrued expenses at December 31,
1994; and $43,000 of cash to the Company.
TRIUMPH-CONNECTICUT REDEEMABLE COMMON STOCK WARRANTS: Triumph-Connecticut
Limited Partnership ("Triumph") acquired, for $2,000,000, a warrant to purchase
up to 12% of the outstanding common shares of the Company on a fully diluted
basis at an exercise price of $.01 per share. The applicable percentage of
common shares available for purchase by Triumph under this warrant are subject
to adjustment for certain events including outstanding balances
30
<PAGE>
under the Credit Facility (see Note 9), declining A.M. Best ratings and
corporate headquarters location. The exercise price of the Triumph warrants can
be adjusted from time-to-time to maintain the antidilutive position of the
warrants. The Triumph warrants have mandatory put rights at the later of March
31, 2000 or the date of payment in full under the Credit Facility if the Company
has not registered the warrant shares or completed an initial public offering;
if the Company has sold any of its insurance subsidiaries; or if the Company has
a change in certain employees. Triumph also was a party to the Credit Facility
issued to finance the acquisition of NNHC.
ING COMMON STOCK WARRANTS: ING received a warrant to purchase up to 2% of the
outstanding common shares of the Company at an exercise price of $.01 per share
in connection with the issuance of a $25,000,000 Credit Facility (see Note 9).
The warrant was repurchased by the Company in April 1995 for $501,000.
As discussed in Note 9, in 1996, the Company entered into a new debt structure.
As a part of the new debt structure, the Company issued two detachable common
stock warrants which allow for the purchase of up to 4% of the Company's
outstanding common stock and expires on December 31, 2006. The first warrant
allows for the purchase of up to 1.5% of the Company's common stock. The second
warrant allows for the purchase of up to 2.5% of the Company common stock and is
callable under certain circumstances.
AMERICAN RE-INSURANCE (AM-RE) COMMON STOCK WARRANTS: Am Re received a warrant to
purchase common stock in connection with the purchase of the Series 6 Preferred
Stock for no additional consideration beyond the $10,000,000 preferred stock
investment. The warrant provides Am-Re with the ability to purchase up to 47,410
shares of common stock at an exercise price of $210.92, subject to antidilutive
adjustment, with an expiration date of April 7, 2007. Upon exercise of this
warrant, Am-Re is guaranteed a minimum rate of return of 20% on its investment
with the Company from dividends received and from the issuance of additional
common stock limited to 25% of the fully diluted outstanding common stock.
ALEXANDER M. AND GUSTAV M. VIK ("VIK") COMMON STOCK WARRANTS: Vik received a
warrant to purchase common stock in connection with the purchase of the Series 7
Preferred Stock for no additional consideration beyond the $15,000,000 preferred
stock investment. The warrant provides Vik with the ability to purchase up to
47,410 shares of common stock at an exercise price of $210.92, subject to
antidilutive adjustment, with an expiration date of April 7, 2007. Upon exercise
of this warrant, Vik is guaranteed a minimum rate of return of 30% on its
investment with the Company from dividends received and from the issuance of
additional common stock limited to 30% of the fully diluted outstanding common
stock.
31
<PAGE>
13. ACQUISITIONS
On April 7, 1995, the Company purchased all of the issued and outstanding shares
of NNHC. NNHC is an insurance holding company with six property and casualty
insurance operating subsidiaries. The acquisition was accounted for utilizing
the purchase method of accounting, resulting in the recording of assets and
liabilities acquired at fair market value, and goodwill of $1,655,000 which is
being amortized over 10 years. Accordingly, the results of operations have been
included with those of the Company beginning on April 7, 1995.
The Company paid $64,151,000 for NNHC at closing, excluding acquisition costs of
$3,627,000, and has agreed to pay a renewal commission of $15,000,000 in April
1998, subject to final adjustment. The renewal commission is reduced by the
amount by which the Final Loss amount exceeds the Closing Reserves. The Final
Loss amount is defined as the cumulative loss and loss adjustment expenses paid
during 1995, 1996 and 1997 on 1994 and prior accident years, plus the loss and
loss adjustment expense reserves on 1994 and prior accident years as of December
31, 1997. Closing Reserves are defined as $15,000,000 plus the recorded loss and
loss adjustment expense reserves as of December 31, 1994. The renewal commission
may also increase by one-half of the amount by which Closing Reserves exceed the
Final Loss amount. The Company recorded a liability of $22,500,000 in its
financial statements for the renewal commission on the acquisition date. This
amount has been included in the total purchase price and in the determination of
goodwill. During 1996, the Emerging Issues Task Force of the Financial
Accounting Standards Board ("FASB") issued additional guidance on the proper
accounting for reserve guarantees in a business combination accounted for as a
purchase. The new accounting announcement requires that changes in the estimated
liabilities for reserve guarantees be recognized in income in the period the
estimates are changed. Accordingly, the Company adopted this accounting
principle and recorded an additional provision of $11,238,000 during 1996. Of
this amount, $4,391,000 relates to calendar year 1995 losses and loss adjustment
expense reserve reductions and is accounted for as a change in accounting
principle and $6,847,000 relates to calendar year 1996 reserve reductions and is
reported in other expenses in the Consolidated Statements of Operations.
14. SUBSEQUENT EVENTS
On February 13, 1997, the Company executed an amended and restated merger
agreement with Highlands Insurance Group, Inc. ("Highlands") and Highlands
Acquisition Corp. (a wholly-owned subsidiary of Highlands), which was
subsequently amended on March 10, 1997 (as amended, the "Merger Agreement") for
Highlands to acquire the Company and its subsidiaries. Highlands is a publicly
traded insurance holding company that, through Highlands Insurance Company
("HIC") and its other insurance subsidiaries, is primarily engaged in the
commercial property and casualty insurance business. The acquisition was
completed on April 30, 1997, and the Company was renamed American Reliance, Inc.
Pursuant to the Merger Agreement, Highlands paid $50,631,778 and issued
1,656,780 shares of its common stock to holders of common stock, warrants,
preferred stock, and creditors of the
32
<PAGE>
Company. The common stock of the Company was canceled, and the common stock of
Highlands Acquisition Corp. became the common stock of the Company. The common
stock warrants were purchased by the payment of cash or the issuance of
Highlands common stock. The shares of preferred stock of the Company, except for
the series 3 preferred stock, were exchanged for 1,383,933 shares of common
stock of Highlands. The 21,366 shares of Series 3 preferred stock of the Company
were exchanged for 21,366 shares of Series 1 preferred stock of Highlands with
identical terms. In connection with the merger, the note payable, which equaled
$35,559,278 including interest at April 30, 1997, was paid, and a liability of
the Company related to the acquisition of NNHC totaling $33,738,000 was settled
for $11,000,000 in cash and 214,707 shares of common stock of Highlands.
Simultaneously with the closing, a number of related transactions occurred.
Highlands caused (i) the contribution of $5 million to PNIC (which in turn
contributed $1.5 million to its wholly-owned subsidiary, PAIC); (ii) the
contribution of $27.5 million to LMI; and (iii) the contribution of $7 million
to SCI. Highlands and NNCC entered into reinsurance agreements with LMI to
assume all of LMI's business effective January 1, 1997. LMI will cease writing
new and renewal business.
Pursuant to a letter agreement, PMSC has withdrawn its suit, as discussed in
Note 11, without prejudice. Additionally, on April 30, 1997, the Company entered
into a Commutation and Release Agreement, ("the Commutation Agreement") with
Inter-Ocean. Pursuant to the Commutation Agreement, the Company settled all
obligations and liabilities related to the Inter-Ocean LPT and the Inter-Ocean
quota share treaty (see Note 7). In settlement of these obligations, Inter-Ocean
transferred $35,669,000 to the Company and redeemed the Company's Series Three
Preferred Stock. The Company will record an immaterial loss on the commutation
in 1997. Also, on April 30, 1997, the Company terminated its five-year brokerage
and consulting services agreement with American Re-Insurance Company (see Note
11).
33
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
ASSETS 1997 1996
------------ ------------
(Unaudited)
<S> <C> <C>
Investments:
Fixed maturity securities:
Available for sale, at fair value (amortized cost of $471,053 at
3/31/97 and $481,329 at 12/31/96) $ 464,804 483,240
Equity securities, at fair value (cost of $0 at 3/31/97 and 12/31/96) 162 162
Other investments 1,007 1,009
------------ ------------
Total investments 465,973 484,411
Cash and cash equivalents 19,198 36,026
Premiums in course of collection, net 83,444 90,664
Receivable from reinsurers 133,560 137,787
Prepaid reinsurance premiums 27,462 27,108
Funds on deposit with reinsurers 57,428 56,481
Deferred taxes 2,081 -
Accrued investment income 5,497 6,324
Deferred policy acquisition costs 26,729 29,124
Values of businesses acquired, net 9,929 10,344
Other assets 26,205 24,420
------------ ------------
Total assets $ 857,506 902,689
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Loss and loss adjustment expense reserves $ 528,351 539,027
Unearned premiums 180,298 188,153
Notes payable 35,303 40,000
Obligation under acquisition agreement 33,738 33,738
Accounts payable and accrued liabilities 52,599 67,612
------------ ------------
Total liabilities 830,289 868,530
Redeemable preferred stock and common stock warrants 44,297 44,297
Commitments and contingent liabilities
Stockholders' equity:
Common stock - -
Preferred stock 3 3
Additional paid-in capital 40,373 40,373
Net unrealized gain (loss) on investments, net of taxes (3,991) 1,313
Retained earnings (deficit) (53,465) (51,827)
------------ ------------
Total stockholders' equity (deficit) (17,080) (10,138)
------------ ------------
Total liabilities and stockholders' equity $ 857,506 902,689
=========== ===========
</TABLE>
The accompanying notes to consolidated financial statements are an integral part
of these statements.
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS)
THREE MONTHS THREE MONTHS
ENDED ENDED
MARCH 31, 1997 MARCH 31, 1996
-------------- --------------
Revenues:
Net premiums earned $ 78,188 87,439
Net investment income 8,589 9,792
Net realized gains (losses) (946) 484
-------------- --------------
Total revenues 85,831 97,715
-------------- --------------
Expenses:
Losses and loss adjustment expenses
incurred 55,312 71,117
Underwriting expenses 30,818 31,174
Interest expense and debt amortization 938 1,357
Other expenses (income), net (374) (455)
-------------- --------------
Total expenses 86,694 103,193
-------------- --------------
Loss before income tax expense (863) (5,478)
Income tax expense 775 1,314
-------------- --------------
Net loss $ (1,638) (6,792)
============== ==============
The accompanying notes to consolidated financial statements are an integral part
of these statements.
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
Net
Unrealized Total
Additional Retained Gain Stockholders'
Common Preferred Paid-in Earnings (Loss) on Equity
Stock Stock Capital (Deficit) Investments (Deficit)
--------- --------- ---------- ---------- ----------- ------------
<S> <C> <C> <C> <C> <C> <C>
For the year ended December 31, 1996:
Balances at December 31, 1995 $ - 2 38,934 28,002 10,166 77,104
Net loss - - - (64,312) - (64,312)
Unrealized losses on investments - - - - (8,853) (8,853)
Unearned inducement fee charged to equity - - - (10,000) - (10,000)
Preferred stock dividends - 1 1,439 (1,440) - -
Redeemable preferred stock dividends - - - (4,077) - (4,077)
------- ------ -------- ---------- -------- --------
Balances at December 31, 1996 $ - 3 40,373 (51,827) 1,313 (10,138)
======= ====== ======== ========== ======== ========
For the three months ended March 31, 1997 (Unaudited):
Balances at December 31, 1996 $ - 3 40,373 (51,827) 1,313 (10,138)
Net loss - - - (1,638) - (1,638)
Unrealized loss on investments - - - - (5,304) (5,304)
------- ------ -------- ---------- -------- --------
Balances at March 31, 1997 $ - 3 40,373 (53,465) (3,991) (17,080)
======= ====== ======== ========== ======== ========
</TABLE>
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS THREE MONTHS
ENDED ENDED
MARCH 31, 1997 MARCH 31, 1996
-------------- --------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (1,638) (6,792)
-------------- --------------
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 7,462 16,732
Change in deferred policy acquisition costs (4,724) (18,877)
Net realized investment losses (gains) 946 (484)
Decrease in premiums in course of collection 7,220 2,700
Decrease in funds on deposit with reinsurers (6,260) (28,209)
Increase in deferred taxes 775 -
(Decrease) increase in loss and loss adjustment expense reserves (10,675) 2,347
Decrease in unearned premiums (7,855) (6,558)
Change in other operating assets and liabilities (3,550) (5,122)
-------------- --------------
Total adjustments (16,661) (37,471)
-------------- --------------
Net cash used in operating activities (18,299) (44,263)
Cash flows from investing activities:
Proceeds from sales-
Fixed maturity securities available for sale 64,730 31,552
Proceeds from maturities or calls-
Fixed maturity securities available for sale 4,500 14,605
Investments purchases-
Fixed maturity securities available for sale (60,023) (64,031)
Sales (purchases) of property and equipment (3,039) 677
-------------- --------------
Net cash (used in) provided by investing activities 6,168 (17,197)
-------------- --------------
Cash flows from financing activities:
Repayment of notes payable (4,697) (38,200)
Issuance of notes payable - 40,000
-------------- --------------
Net cash (used in) provided by financing activities (4,697) 1,800
-------------- --------------
Net decrease in cash and cash equivalents (16,828) (59,660)
Cash and cash equivalents at beginning of year 36,026 93,662
-------------- --------------
Cash and cash equivalents at end of year $ 19,198 34,002
============== ==============
Supplemental disclosure of cash flow information:
Interest paid $ 869 1,312
============== ==============
</TABLE>
The accompanying notes to consolidated financial statements are an integral
part of these statements.
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1997
1. BASIS OF PRESENTATION
The accompanying consolidated financial statements as of March 31, 1997 and
for the three month period ended March 31, 1997 and 1996 are unaudited and
include the accounts of American Reliance, Inc. (ARI) (formerly Vik Brothers
Insurance, Inc.- See Note 6), and its subsidiaries (the Company). The Company
is an insurance holding company for State Capital Insurance Company (SCI),
American Professionals Insurance Company, LMI Insurance Company (LMI) and
Northwestern National Holding Company (NNHC) and its subsidiaries, including
Northwestern National Casualty Company (NNCC) and its subsidiaries, and Pacific
National Insurance Company (PNIC) and its subsidiary,. In the opinion of
management, the financial information reflects all adjustments which are
necessary for a fair presentation of financial position and results of
operations for the periods. The results for the period are not necessarily
indicative of the results to be expected for the entire year. The accompanying
consolidated financial statements should be read in conjunction with the
consolidated financial statements and related notes included in the Company's
financial statements for the year ended December 31, 1996.
Certain financial information that is normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
but is not required for interim reporting purposes has been condensed or
omitted.
Certain reclassifications have been made to the prior year's financial
statements to conform to the current year's presentation.
2. INCOME TAXES
The Company's effective tax rate differs from the statutory rate primarily
due to the valuation allowance. The income tax expense for the three months
ended March 31, 1997 reflects an increase in the valuation allowance against its
deferred tax asset. The charge was attributable to the decline in the value of
its investment portfolio.
Page 1
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1997
3. NOTES PAYABLE
On March 22, 1996, the Company repaid its debt under the Credit Facility
and replaced it with a new debt structure that includes a $40,000,000 senior
secured amortizing term loan with a final maturity date of March 31, 2002 and a
$5,000,000 senior secured stand-by loan which is convertible to a term loan with
a maturity date of March 31, 2003. The interest rate is set at the beginning of
each quarter at the option of the Company as either LIBOR plus 3% or Prime plus
1.5%.
The new debt structure also included the issuance of two detachable common
stock warrants which allow for the purchase of up to 4% of the Company's
outstanding common stock and expires on December 31, 2006.
As of December 31, 1996 and March 31, 1997, the Company failed to meet
certain financial covenants in the credit agreement, resulting in an event of
default under the credit agreement. On March 31, 1997 the Company and Agent
Bank agreed that the Agent would not accelerate the maturity of the loan until
effectively April 30, 1997, the date of the planned merger with Highlands
Insurance Group, Inc. (Highlands). On April 30, 1997, the note was repaid in
full in connection with the merger (see Note 6).
4. COMMITMENTS AND CONTINGENCIES
The Company and LMI have brought an action against Prupac as a result of
Prupac's nonpayment of monies owed to LMI under two reinsurance agreements and
received a judgment in favor of the Company for balances due as of September 30,
1995, which totaled $1,917,000. Additionally, Prupac lost its appeal of this
judgment which was again found to be in favor of the Company. The amount due the
Company for paid losses and loss adjustment expenses totaled $5,880,000 at
December 31, 1996. In addition, at December 31, 1996, the Company ceded reserves
for losses and loss adjustment expenses to Prupac of $1,599,000. The judgment
includes accrual of interest at the rate of 10% per annum. The Company has not
accrued interest on this recoverable.
The Company entered a ten-year agreement with Policy Management Systems
Corporation ("PMSC"), a preferred shareholder, effective January 1995, to obtain
data processing services, including significant enhancements to existing systems
and the development of a new integrated system for the entire organization.
Processing fees under this agreement include minimum annual charges plus
variable amounts based on time and annual written premium volume. As of
December 31, 1996, the minimum annual fees for the Company under the PMSC
agreement are $7,719,000 for 1997 through 2001. Effective on May 1, 1997, the
PMSC agreement was amended. The minimum annual fees for
Page 2
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1997
the Company under the PMSC agreement, as amended, are $7,014,000 for 1997 and
$6,662,000 for 1998 through 2001. The fees under this agreement were $10,324,000
and $7,623,000 for the years ended December 31, 1996 and 1995, respectively. In
February 1997, PMSC served a written demand on the company for immediate payment
of certain 1996 and 1997 charges totaling $4,799,000, and accelerated the
outstanding balance of the total minimum base processing charges in the amount
of $15,358,000, based on a claim that the Company had breached the terms of the
agreement by, among other things, failing to pay when due certain amounts under
the agreement. On February 4, 1997, PMSC filed suit against the Company and its
insurance subsidiaries alleging breach of contract and seeking judgment in the
amount of $19,842,422, plus interest, costs and late charges. On February 18,
1997, PMSC and the Company entered into a letter agreement pursuant to which the
parties entered into a Joint Motion under which the time by which the Company
and subsidiaries are required to respond to the PMSC suit was extended until May
12, 1997. On May 1, 1997, PMSC dismissed its action against the Company without
prejudice.
Effective December 1992, the Company entered into a ten year data
processing services agreement with Electronic Data Systems Corporation ("EDS").
Processing fees under this agreement include minimum annual charges plus
variable amounts based on annual written premium volume. On March 3, 1997, the
Company signed a Separation Agreement with EDS to terminate the use of their
services. According to the agreement, any new and renewal business with
effective dates after 1996 will no longer be processed through EDS. The Company
will utilize EDS to service the run-off of policies issued before 1997 until no
later than March 31, 1998, during which time the Company will pay to EDS a fixed
base fee of $65,000 per month. Additionally, the Company paid a termination fee
to EDS of $2,000,000 in the first quarter of 1997 as stipulated in the
Separation Agreement. This amount was accrued as a liability during 1996 and
was recorded in underwriting expenses in the accompanying 1996 statement of
operations.
5. REGULATORY MATTERS
The National Association of Insurance Commissioners (NAIC) has developed
minimum risk-based capital (RBC) requirements for insurance enterprises that
have been adopted under the insurance laws of the states in which the insurance
subsidiaries are domiciled. The formulas for determining the amount of RBC
specify various weighting factors that are applied to financial balances or
various levels of activity based on the perceived degree of risk. Regulatory
compliance is determined by a ratio of the enterprise's regulatory
Page 3
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1997
total adjusted capital, as defined by the NAIC, to its authorized control level
RBC, as defined by the NAIC. Enterprises below specified ratios are classified
within certain levels, each of which requires corrective action.
At December 31, 1996, LMI's surplus fell below the required RBC level and
was at the "authorized control" level. Accordingly, it was required to file a
plan with the Ohio Insurance Department setting forth its plan to attain the
required level of regulatory capital. The plan, which contemplated the
acquisition of the Company by Highlands, included commuting reinsurance
agreements and implementing numerous affiliated transactions including LMI
transferring assets to affiliates for securities or cash, the distribution of
the shares of NNHC owned by LMI to the Company, the contribution of capital to
LMI, entering into reinsurance agreements so that LMI ceased to retain net
insurance liability and, ultimately, causing LMI to cease writing premiums. The
plan was approved by the Ohio Insurance Department and transactions which
required approval of other insurance departments received the required approval.
On April 30, 1997, in compliance with the plan, Highlands made a direct capital
contribution of $5,000,000 and an indirect capital contribution through the
Company of $22,500,000 to LMI (see Note 6). All of the Company's other
insurance subsidiaries' RBC levels exceeded the minimum threshold requiring
company action as of December 31, 1996.
6. SUBSEQUENT EVENTS
On February 13, 1997, the Company executed an amended and restated merger
agreement with Highlands and Highlands Acquisition Corp. (a wholly-owned
subsidiary of Highlands), which was subsequently amended on March 10, 1997 (as
amended, the "Merger Agreement") for Highlands to acquire the Company and its
subsidiaries. Highlands is a publicly traded insurance holding company that,
through Highlands Insurance Company (HIC) and its other insurance subsidiaries,
is primarily engaged in the commercial property and casualty insurance business.
The acquisition was completed on April 30, 1997, and the Company was renamed
American Reliance, Inc.
Simultaneously with the closing, a number of related transactions occurred.
Highlands caused (i) the contribution of $5 million to PNIC (which in turn
contributed $1.5 million to its wholly-owned subsidiary, Pacific Automobile
Insurance Company); (ii) the contribution of $27.5 million to LMI; and (iii) the
contribution of $7 million to SCI. Highlands and NNCC entered into reinsurance
agreements with LMI to assume all of LMI's business effective January 1, 1997.
LMI will cease writing new and renewal business.
Page 4
<PAGE>
AMERICAN RELIANCE, INC. AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1997
On April 30, 1997, the Company entered into a Commutation and Release
Agreement, ("the Commutation Agreement") with Inter-Ocean. Pursuant to the
Commutation Agreement, the Company settled all obligations and liabilities
related to the Inter-Ocean LPT and the Inter-Ocean quota share treaty. In
settlement of these obligations, Inter-Ocean transferred $35,669,000 to the
Company and redeemed the Company's Series Three Preferred Stock. The Company
will record an immaterial loss on the commutation in April 1997.
Page 5
<PAGE>
UNAUDITED PRO FORMA FINANCIAL INFORMATION
The following unaudited pro forma condensed combined statements of operations
of Highlands Insurance Group, Inc. and its subsidiaries (Company) for the year
ended December 31, 1996 and the three months ended March 31, 1997 present the
results for the Company as if Company's issuance of its convertible subordinated
debentures (Debentures) had occurred as of January 1, 1996 and the acquisition
of American Reliance, Inc. (ARI) (then named Vik Brothers Insurance, Inc.) had
occurred as of January 1, 1996 and January 1, 1997, respectively. The
accompanying unaudited pro forma condensed combined balance sheet as of March
31, 1997 gives effect to the acquisition of ARI as if it had occurred March 31,
1997. The unaudited pro forma information does not purport to represent what the
Company's financial position or results of operations would have been had the
acquisition in fact occurred on the dates indicated, or to project the Company's
financial position or results of operations for any future date or period. The
pro forma adjustments are based on available information and certain assumptions
that the Company currently believes are reasonable in the circumstances.
The pro forma adjustments and pro forma combined amounts are provided for
informational purposes only. The Company's financial statements will reflect
the effects of the ARI acquisition and the Company's issuance of Debentures,
only from the dates such events occur. The pro forma adjustments are applied to
the historical financial statements to, among other things, account for the
acquisition as a purchase. Under purchase accounting, the total purchase costs
of the acquisition will be allocated to the ARI assets and liabilities based on
their fair values. Allocations are subject to valuations as of the date of the
acquisition based on appraisals and other studies, which are not yet completed.
Accordingly, the final allocations will be different from the amounts reflected
herein. Although the final allocations will differ, the unaudited pro forma
financial information reflects management's best estimate based on currently
available information as of the date of this Form 8-K.
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET
AS OF MARCH 31, 1997
<TABLE>
<CAPTION>
COMPANY ARI PRO FORMA PRO FORMA
HISTORICAL HISTORICAL ADJUSTMENTS COMBINED
---------- ---------- ----------- ---------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
ASSETS
Fixed maturities:
Available for sale, at market $314,175 464,804 355,547 E 1,134,526
Held to maturity, at amortized cost 349,663 - (349,663)E 0
Equity securities 24,853 162 25,015
Other investments 3,423 - 3,423
Real estate, net of accumulated depreciation - 1,007 1,007
---------- -------- ------- ----------
Total investments 692,114 465,973 5,884 1,163,971
Cash and cash equivalents 59,051 19,198 9,852 A 88,101
Premiums in course of collection, net 18,917 83,444 102,361
Retrospective premiums receivable 119,097 - 119,097
Receivable from reinsurers 571,834 133,560 705,394
Prepaid reinsurance premiums - 27,462 27,462
Deferred taxes 38,751 2,081 7,725 B 46,498
(2,059)E
Accrued investment income 10,787 5,497 16,284
Funds on deposit with reinsurers 16,562 57,428 (21,366)D 52,624
Receivable from former affiliate 250 - 250
Deferred policy acquisition costs 5,842 26,729 32,571
Cost of acquired business in excess of net
assets - 9,929 8,549 B 8,549
(9,929)B
Other assets 29,701 26,205 3,138 B 60,935
1,891 B
---------- -------- ------- ----------
Total assets $1,562,906 857,506 3,685 2,424,097
========== ======== ======= ==========
LIABILITIES
Loss and loss adjustment expense reserves $1,162,360 528,351 1,690,711
Unearned premiums 29,257 180,298 209,555
Funds held 19,712 6,417 26,129
Notes payable - 35,303 (35,303)B -
Senior bank debt - - 65,000 A 65,000
Obligation under acquisition agreement - 33,738 (33,738)B -
Convertible subordinated debentures 55,646 - 55,646
Accounts payable and accrued liabilities 32,991 46,182 (1,013)B 81,090
- 2,930 B
---------- -------- ------- ----------
Total liabilities 1,299,966 830,289 (2,124) 2,128,131
---------- -------- ------- ----------
Redeemable preferred stock and common - 44,297 21,366 A -
stock warrants (44,297)B
(21,366)D
STOCKHOLDERS' EQUITY
Common stock 114 - 17 A 131
Preferred stock - 3 (3)C -
Additional paid-in capital:
Common stock 192,339 26,235 29,184 A 221,523
(26,235)C
Preferred stock - 14,138 (14,138)C -
Unrealized investment gains, net of taxes (522) (3,991) 3,991 C 3,303
3,825 E
Retained earnings (deficit) 71,009 (53,465) 53,465 C 71,009
---------- -------- ------- ----------
Total stockholders' equity (deficit) 262,940 (17,080) 50,106 295,966
---------- -------- ------- ----------
Total liabilities and stockholders
equity $1,562,906 857,506 3,685 2,424,097
========== ======== ======= ==========
Book value per share:
Reported $ 23.30 (1) 22.58
========== ==========
Fully diluted $18.87 (1) 18.78
========== ==========
</TABLE>
(1) Per share amounts were increased due to the effect of reclassifying the
Company's fixed maturities from held to maturity to available for sale
which amounted to $3,825,000.
See Notes to Unaudited Pro Forma Condensed Combined Balance Sheet
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET
(DOLLARS IN THOUSANDS)
A. The following proforma adjustments reflect the funding of the ARI acquisition
and concurrent settlement of certain ARI obligations as follows:
<TABLE>
<CAPTION>
Increase
--------
<S> <C>
Incurrence of Senior Credit Facility............................................... $ 65,000
Issuance of Company common stock:
Par value......................................................................... 17
Paid-in capital................................................................... 29,184
Issuance of Company Series 1 redeemable preferred stock............................ 21,366
--------
115,567
Less excess cash proceeds.......................................................... 9,852
--------
Total funding..................................................................... $105,715
========
</TABLE>
B. The following pro forma adjustments result from the allocation of purchase
price to ARI based upon the fair value of the underlying net assets acquired
and settlement of certain ARI obligations. The amounts and assumptions
related to the primary adjustments follow:
<TABLE>
<CAPTION>
ASSETS INCREASE (DECREASE)
-------------------
<S> <C>
Elimination of ARI's purchase price over fair value of net assets acquired......... $ (9,929)
Excess of purchase price for ARI over fair value of net assets acquired............ 8,549
Recognitation of deferred tax asset due to projected future taxable income......... 7,725
Fair market value adjustment to real estate occupied by ARI........................ 1,891
Adjustments to other assets - capitalization of transaction costs and
elimination of ARI's existing notes payable issuance costs........................ 3,138
========
LIABILITIES
Repayment of existing ARI notes payable............................................ $(35,303)
Redemption of ARI preferred stock and common stock warrants........................ (44,297)
Elimination of obligation under acquisition agreement.............................. (33,738)
Recognition of liabilities for restructuring and relocation costs.................. 2,930
Adjustments to other liabilities - elimination of other intangibles................ (1,013)
========
</TABLE>
The allocation of the purchase price to the assets and liabilities of ARI is
subject to valuations as of the date of the acquisition based upon appraisals
and other studies, which are not yet complete. Accordingly, the final
allocations will differ from the amounts reflected herein. Although the final
allocations will differ, the unaudited pro forma financial information reflects
management's best estimate based on currently available information as of the
date of this Form 8-K.
C. Adjustment to eliminate ARI's stockholders' equity.
<TABLE>
<CAPTION>
INCREASE (DECREASE)
-------------------
<S> <C>
Preferred stock.................................................................... $ (3)
Additional paid-in capital:
Common............................................................................ (26,235)
Preferred......................................................................... (14,138)
Unrealized investment loss......................................................... 3,991
Retained deficit................................................................... 53,465
========
</TABLE>
<PAGE>
D. Adjustment to eliminate intercompany balances resulting from cancellation,
concurrent with the acquisition of ARI, of certain non risk transferring
reinsurance agreements.
INCREASE (DECREASE)
-------------------
Funds on deposit with reinsurers.................. $ (21,366)
Company Series 1 redeemable preferred stock....... (21,366)
=========
E. Reclassification of the Company's historical fixed maturities from held to
maturity to available for sale to align investment accounting principles.
INCREASE (DECREASE)
-------------------
Available for sale, at market..................... $ 355,547
Held to maturity, at amortized cost............... (349,663)
Deferred taxes.................................... (2,059)
Unrealized investment gains, net of taxes......... 3,825
=========
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 1996
<TABLE>
<CAPTION>
Company ARI Pro Forma Pro Forma
Historical Historical Adjustments Combined
---------- ---------- ----------- ---------
(Dollars in Thousands, Except Per Share Amounts)
<S> <C> <C> <C> <C>
Revenues:
Net premiums earned $152,048 327,873 479,921
Net investment income 50,988 37,413 88,401
Net realized investment gains 1,199 2,324 3,523
-------- -------- ------- --------
Total revenues 204,235 367,610 - 571,845
-------- -------- ------- --------
Expenses:
Losses and loss adjustment expense incurred 156,589 278,813 435,402
Underwriting expenses 56,487 132,227 188,714
Interest expense and debt amortization 6,903 4,189 507 a 11,599
Other expenses (income) net 1,697 7,303 (1,365)b 7,635
-------- -------- ------- --------
Total expenses 221,676 422,532 (858) 643,350
-------- -------- ------- --------
Income (loss) before income tax (expense)
benefit (17,441) (54,922) 858 (71,505)
Federal and foreign income tax (expense)
benefit 12,098 (6,536) 223 c 5,785
Cumulative effect of a change in accounting
principle - (2,854) (2,854)
-------- -------- ------- --------
Net income (loss) $ (5,343) (64,312) 1,081 (68,574)
======== ======== ======= ========
Pro forma
Net loss per share $ (0.47) (5.23)
======== ========
Weighted average number of common shares
and common stock equivalents
outstanding 11,448 13,105
======== ========
GAAP Ratios:
Loss 103.0% 85.0% 90.7%
Expense 37.1% 40.3% 39.3%
-------- -------- --------
Combined 140.1% 125.3% 130.0%
======== ======== ========
</TABLE>
See Notes to Unaudited Pro Forma Condensed Combined Statements of Operations
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
FOR THE PERIOD ENDED MARCH 31, 1997
<TABLE>
<CAPTION>
COMPANY ARI PRO FORMA PRO FORMA
HISTORICAL HISTORICAL ADJUSTMENTS COMBINED
---------- ---------- ----------- ---------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Revenues:
Net premiums earned $29,715 78,188 107,903
Net investment income 12,857 8,589 21,446
Net realized investment gains (losses) 484 (946) (462)
------- ------- ----- --------
Total revenues 43,056 85,831 - 128,887
------- ------- ----- --------
Expenses:
Losses and loss adjustment expense incurred 27,831 55,312 83,143
Underwriting expenses 9,524 30,818 40,342
Interest expense and debt amortization 1,798 938 148 a 2,884
Other expenses (income) net 354 (374) (251)b (271)
------- ------- ----- --------
Total expenses 39,507 86,694 (103) 126,098
------- ------- ----- --------
Income (loss) before income tax (expense)
benefit 3,549 (863) 103 2,789
Federal and foreign income tax (expense)
benefit (592) (775) 63 c (1,304)
------- ------- ----- --------
Net income (loss) $ 2,957 (1,638) 166 1,485
======= ======= ===== ========
Pro forma
Net income per share:
Primary $ 0.21 0.10
======= ========
Weighted average number of common shares
and common stock equivalents
outstanding:
Primary 14,620 15,945
======= ========
GAAP Ratios:
Loss 93.7% 70.7% 77.1%
Expense 32.1% 39.4% 37.4%
------- ------- --------
Combined 125.8% 110.1% 114.5%
======= ======= ========
</TABLE>
See Notes to Unaudited Pro Forma Condensed Combined Statements of Operations
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
(DOLLARS IN THOUSANDS)
The following pro forma adjustments reflect the effects of the Company's sale of
Debentures and the acquisition of ARI as if each occurred as of January 1 for
each period presented. The amounts and assumptions related to the adjustments
follow:
<TABLE>
<CAPTION>
INCREASE (DECREASE)
--------------------------------------------
THREE MONTHS
YEAR ENDED ENDED
DECEMBER 31, MARCH 31,
1996 1997
------------------- -------------------
<S> <C> <C>
a. Interest expense and debt amortization
Interest expense at 6.44% and 6.45% (LIBOR + 1.00%),
respectively, on the Senior Credit Facility, including
amortization of issuance costs................................... $ 4,396 1,086
Debenture interest expense and amortization of issuance
costs (1)........................................................ 300 -
ARI's notes payable interest and
amortization of issuance costs................................... (4,189) (938)
------- -----
$ 507 148
======= =====
b. Other expense (income), net
Elimination of amortization of goodwill
and acquisition costs for prior ARI transactions................. $(1,780) (355)
Amortization of transaction costs and the excess of the
ARI purchase price over the fair value of net assets
acquired over 30 years........................................... 415 104
------- ----
$(1,365) (251)
======= ====
</TABLE>
(1) For the period January 1, 1996 through January 23, 1996.
c. Adjustment to reflect the federal income tax effects of a above.
d. Pro forma net income (loss) per share has been calculated based upon the
11,451,541 and 11,448,430 shares of Company Common Stock as of March 31,
1997 and December 31, 1996, respectively plus 1,656,780 shares of Company
Common Stock issued in connection with the purchase of ARI and concurrent
settlement of certain ARI obligations. Primary net income per share amounts
as of March 31, 1997 are based upon the weighted average number of common
stock shares and common stock equivalents, common stock warrants and options
outstanding during the period. Common stock warrants and stock options
(common stock equivalents) are antidilutive for primary net income per share
for the period ended December 31, 1996. Fully diluted net income per share
is not presented for all periods as the effects of the convertible
subordinated debentures are antidilutive for all periods presented.
