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SCHEDULE 14A
(RULE 14A-101)
INFORMATION REQUIRED IN PROXY STATEMENT
SCHEDULE 14A INFORMATION
PROXY STATEMENT PURSUANT TO SECTION 14(A) OF THE SECURITIES
EXCHANGE ACT OF 1934
Filed by the Registrant [X]
Filed by a Party other than the Registrant [_]
Check the appropriate box:
[_]CONFIDENTIAL, FOR USE OF THE
[_] Preliminary Proxy Statement COMMISSION ONLY (AS PERMITTED BY
RULE 14A-6(E)(2))
[X] Definitive Proxy Statement
[_] Definitive Additional Materials
[_] Soliciting Material Pursuant to (S)240.14a-11(c) or (S)240.14a-12
HIGHLANDS INSURANCE GROUP, INC.
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(Name of Registrant as Specified In Its Charter)
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(Name of Person(s) Filing Proxy Statement, if other than the Registrant)
Payment of Filing Fee (Check the appropriate box):
[X] No fee required.
[_] Fee computed on table below per Exchange Act Rules 14a-6(i)(4) and 0-11.
(1) Title of each class of securities to which transaction applies:
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(3) Per unit price or other underlying value of transaction computed
pursuant to Exchange ActRule 0-11 (Set forth the amount on which the
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[_] Fee paid previously with preliminary materials.
[_] Check box if any part of the fee is offset as provided by Exchange Act
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paid previously. Identify the previous filing by registration statement
number, or the Form or Schedule and the date of its filing.
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(4) Date Filed:
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------------------------------------------
PROXY STATEMENT
AND
1996 ANNUAL REPORT
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Highlands Insurance Group, Inc.
<PAGE>
TABLE OF CONTENTS
<TABLE>
<S> <C>
CHAIRMAN'S LETTER......................................................... 1
NOTICE OF ANNUAL MEETING.................................................. 5
PROXY STATEMENT........................................................... 6
The Meeting............................................................. 6
Certain Relationships and Related Transactions.......................... 9
Stock Ownership of Certain Beneficial Owners and Management............. 11
Board of Directors...................................................... 13
Executive Officers...................................................... 17
Other Meeting Items..................................................... 23
Stockholders' Proposals................................................. 31
1996 ANNUAL REPORT
The Company............................................................. A-1
Selected Financial Data................................................. A-3
Management's Discussion and Analysis of Financial Condition and Results
of Operations.......................................................... A-5
Market for Company's Common Stock and Related Stockholder Matters....... A-19
Index to Financial Statements and Schedules............................. A-20
1995 STOCK OPTION PLAN.................................................... B-1
ANNUAL INCENTIVE PLAN..................................................... C-1
</TABLE>
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
10370 Richmond Avenue
Houston, Texas 77042
March 21, 1997
To Our Stockholders:
You are cordially invited to attend the 1997 Annual Meeting of Stockholders
of Highlands Insurance Group, Inc. to be held at the Adam's Mark Hotel located
at 2900 Briarpark Drive, Houston, Texas on Friday, May 9, 1997, at 10:00 a.m.,
local time. It is my pleasure to welcome you and provide information to assist
you in understanding your investment. I encourage you to read carefully in
their entireties the enclosed Proxy Statement and 1996 Annual Report. In
particular, the Proxy Statement will provide you with detailed information
regarding the first Annual Meeting of Stockholders and the items that you will
be asked to act upon at such Meeting. We look forward to your participation in
the Annual Meeting.
On January 23, 1996 Highlands Insurance Group, Inc. was spun-off by
Halliburton Company, becoming an independent publicly traded company. In
conjunction with the spin-off of Highlands, Insurance Partners and Highlands'
management invested $62.85 million in the Company in the form of convertible
debt with warrants. At the same time I became chief executive officer.
Our first actions were geared toward aligning management's and shareholders'
interests. Top management was given an opportunity to invest on the same terms
as Insurance Partners with special incentives if the stock price performed
well. Additionally stock options were granted to more than 40 employees. The
Company's annual bonus plan was changed dramatically -- both to increase the
potential award sizes and more importantly to base the awards on accident year
underwriting results. Company contributions to the employee retirement and
savings plan were changed to be based on accident year underwriting results.
In the past contributions were made regardless of results.
We reorganized the Company into profit centers and appointed presidents or
general managers of each of our five profit centers. Critical operating
functions including marketing, underwriting, claims, and processing are now
managed within each division.
At the same time, we provided written objectives to each employee and
established a meaningful performance evaluation process. The market value of
every position in the Company was determined with the assistance of an outside
consultant. We found that our salaries were generally below market. Salary
increases were granted to over 100 employees to bring employees to market
levels. We have just completed our first series of annual performance
evaluations, and we believe that we have made progress tying pay to
performance.
Major changes were initiated for Highlands' insurance operations immediately
following the agreement between Insurance Partners and Halliburton. We stopped
writing assumed reinsurance, probate bonds, and personal lines including
Florida homeowners insurance. These were business lines where the Company's
historical results were consistently poor and where the prospects for
achieving meaningful returns on equity were slim.
Upon exiting non-performing lines and reorganizing our business into profit
centers we began to focus on reducing costs. We re-negotiated computer and
telecommunication contracts which will save more than $1.5 million in 1997.
Most significantly we reduced our workforce by 46% from 657 at September 30,
1995 to 354 at March 1, 1997. Productivity and quality measures improved
throughout the year despite these expense reductions. We continue to look for
expense improvements in all areas.
In June we announced a definitive agreement to purchase VIK Brothers
Insurance, Inc. (VBII) for $164 million plus additional performance incentive
payments which could have added $32 million to the price. This acquisition was
consistent with our stated plan to build Highlands by acquisition. VBII
produced over $400 million in direct premiums written in 1996, more than twice
Highlands' level.
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After the initial agreement was reached, VBII sustained significant losses
related to Hurricanes Fran and Bertha. As a result of this and other issues,
the VBII purchase has been re-negotiated. The revised price of approximately
$97 million in consideration includes no performance incentives. The
acquisition will be financed through the assumption of bank debt, the issuance
of preferred stock, the issuance of approximately 1.4 million shares of
Highlands common stock and $4 million in cash. We continue to work towards
completion of this transaction, and expect the purchase to close in the second
quarter of 1997.
Our financial results were totally unacceptable -- but largely reflected the
"sins of the past", namely inadequate loss reserves and previously improperly
accounted for premiums and expenses. In total, financial adjustments made for
events occurring prior to 1996 reduced pre-tax income by $34.6 million. In
1996 restructuring costs reduced pre-tax income by $1.3 million.
For the year revenues decreased 19.1% to $204.2 million, despite investment
income increasing by $2.5 million or 5.1%. Our net loss was $5.3 million, down
from a loss of $120.7 million in 1995. The 1995 loss reflected a reserve
increase of $125 million taken by Highlands prior to the spin-off.
A brief review of our business segments follows:
COMMERCIAL INSURANCE DIVISION (CID)
CID provides guaranteed cost commercial coverages including workers'
compensation and property coverage to Texas and Louisiana accounts. For the
year CID's underwriting loss was $32.3 million, 150.9% of earned premium. Of
this loss approximately $11.7 million was attributable to prior year loss
reserve increases and accounting adjustments and the 1996 restructuring
charge. Net premiums written and earned decreased from 1995 by 32.8% and
14.7%, respectively.
Ken Javor, who was hired in January 1996, has led a major restructuring
replacing most staff underwriting positions. Ken has begun the process of
hiring to fill critical claim processing needs: managed care, house counsel,
and fraud detection and investigation. These were formerly provided by third
party vendors. Prices have been increased, underwriting standards tightened
and underperforming agencies terminated. Employee positions have been reduced
by more than 50% and branch offices consolidated from six to two.
We expect premiums to decrease for most of 1997. We expect three new product
offerings introduced in late 1996 and early 1997 to generate additional 1997
premiums, partially offsetting reductions in business written without a
product focus. Our combined ratio target of 100 by 1999 remains intact.
SPECIAL ACCOUNTS DIVISION (SAD)
SAD writes large, complex accounts headquartered in Texas and Louisiana.
Target accounts for the Division have standard premiums in excess of $1.0
million and/or purchase coverage on a loss sensitive basis. Most accounts are
written on either a retrospectively rated basis (where we retrospectively
adjust the premium to reflect the losses of the account) or on a deductible
basis (where the account agrees to pay for all individual losses up to an
agreed upon amount). Because of the risk sharing mechanisms built into SAD
business, margins are expected to be smaller but less volatile than margins in
our other divisions.
In 1996 net premiums written and earned decreased 7.0% and 7.9%,
respectively. SAD sustained an underwriting loss of $9.5 million, 130.4% of
earned premiums, $9.1 million of which was attributable to prior year loss
development and accounting adjustments. During the year, seven of our 27 large
accounts were lost to either acquisition or competition. No new accounts were
written, largely reflecting our unwillingness to match or undercut what we
believed were historically inadequate pricing levels in this segment of the
industry.
Dale Montgomery, President of this division, continues to restructure.
Within the last three months he has added two key executives.
Large account business is extraordinarily price competitive. In many
instances we have been able to renew business because of the proven quality of
services we provided and our strong long-term relationships.
We expect continued reduced premium levels and improved underwriting
results.
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INSURANCE SERVICES DIVISION (ISD)
ISD exists to provide service to Halliburton, our former parent. As part of
the spin-off agreement we signed a four year contract to provide insurance to
Halliburton on terms which provide Highlands with both a reasonable
opportunity to make a fair return and a significant incentive to reduce
Halliburton's total insurance costs.
During 1996 ISD's net premiums written and earned were $30.4 million and
$30.7 million, respectively down 43.8% and 43.3%, respectively, from 1995. We
achieved planned accident year underwriting profitability because of superior
plan execution and $1.2 million of expense reductions. Premiums tend to
fluctuate widely based on Halliburton's employment levels and insurance
claims.
Kent Peden, President of ISD, made remarkable progress in 1996 improving our
service levels. 1997 initiatives include improved data access and reporting
for Halliburton and continued focus on reducing costs, while increasing
quality.
No major changes are expected in 1997 results.
MARINE
Our Marine Division provides insurance to small commercial fishing
operations, boats that service drilling platforms and a number of
miscellaneous marine classifications.
A solid underwriting profit was generated in 1996 on $16.5 million of
premiums earned. This was the 4th consecutive year of underwriting profit.
Bill Fehlis, President of the Marine Division, and his staff have continued
to underwrite to high standards, while at the same time reducing expenses.
With the recent addition of inland marine specialists to this division,
modest growth and underwriting profit are planned for 1997.
SURETY
Net premiums written and earned in 1996 were $.6 million and $3.0 million,
respectively, substantial decreases from 1995 levels. The entire decline was
caused by our decision to exit the probate bond business. Probate bond
underwriting losses of $3.7 million were sustained. Surety and miscellaneous
bond operations, under the leadership of Richard Westbrook, remains
profitable.
DISCONTINUED LINES
Jose Ferrer, ably assisted by Jerry Reed, has the difficult task of settling
losses from most discontinued businesses. In addition, they are responsible
for collecting reinsurance on any claims for which we are reinsured.
Losses from discontinued lines were $14.0 million on earned premiums of $7.1
million. Losses largely reflect prior year reserve strengthening, although we
did have the misfortune to reinsure both the TWA and ValuJet losses in 1996.
Premiums are expected to drop to less than $.5 million in 1997 as our last
reinsurance contract expires. Losses are expected to decrease substantially.
OTHER AREAS
In addition to business units, progress was made in a number of staff areas.
Notable achievements include the development of improved financial reporting
capabilities, the settlement of three large legal disputes and increased
computer access and reliability.
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SUMMARY
1996 was a year of tremendous change for Highlands and its employees. During
the year our balance sheet was strengthened. We dealt aggressively with most
expense issues. We have begun to hire -- and are upgrading our personnel at
every opportunity. The stabilization of Highlands is largely complete. We
expect that increased capability in data collection and management will lead
to more sophisticated pricing and the early identification of problems and
opportunities.
We have goals that we understand. We have an increasingly committed and
talented workforce and we have the will to win. We will stay on course.
We believe commercial insurance results for the industry will continue to be
poor. While we do not anticipate less competition in 1997, there is mounting
evidence that industry results are worse than reported. Even reported industry
results demonstrate inadequate returns on capital. We believe that companies
earning inadequate returns will disappear through consolidation or liquidation
and, consequently, that substantial consolidation will continue. Size has not
been, and will not be, a criterion for success. Focus, intelligence and
discipline will prevail.
I would like to especially thank my associates who have had to deal with
constant changes and so many new initiatives. Thanks also to our agents. Their
loyalty is greatly appreciated and will be rewarded.
Thanks also to our Directors whose counsel and encouragement has been
especially important to me.
ANNUAL MEETING
At the Meeting, you will be asked to elect four directors, two to serve
until the 1999 Annual Meeting and two to serve until the 2000 Annual Meeting,
to ratify the Company's 1995 Stock Option Plan, to approve an amendment of the
Company's 1995 Stock Option Plan to increase the number of shares of the
Company's Common Stock for which options may be granted thereunder from
350,000 to 800,000, to approve the Company's Annual Incentive Plan and to
ratify the appointment of the Company's independent public accountants.
To ensure that your shares of Common Stock are represented at the Meeting,
you are urged to promptly complete, date, sign and return the accompanying
Proxy in the enclosed envelope, whether or not you plan to attend the Meeting
in person. You may, if you wish, vote personally on all matters brought before
the Meeting, even if you have previously returned your signed Proxy.
Sincerely yours,
/s/ Richard M. Haverland
Richard M. Haverland
Chairman, President and Chief
Executive Officer
Enclosure
YOUR VOTE IS IMPORTANT
PLEASE SIGN, DATE AND RETURN YOUR PROXY
4
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTICE OF ANNUAL MEETING OF STOCKHOLDERS
TO BE HELD ON MAY 9, 1997
To the Stockholders of Highlands Insurance Group, Inc.:
NOTICE IS HEREBY GIVEN THAT the 1997 Annual Meeting of Stockholders (the
"Meeting") of Highlands Insurance Group, Inc., a Delaware corporation (the
"Company"), will be held at the Adam's Mark Hotel located at 2900 Briarpark
Drive, Houston, Texas on Friday, May 9, 1997, at 10:00 a.m., local time, for
the following purposes:
(1) to elect two Class I directors, each to serve until the 1999 Annual
Meeting of Stockholders and until their successors are elected and
qualified;
(2) to elect two Class II directors, each to serve until the 2000 Annual
Meeting of Stockholders and until their successors are elected and
qualified;
(3) to ratify the Highlands Insurance Group, Inc. 1995 Stock Option Plan
(the "1995 Stock Option Plan");
(4) to consider and vote upon a proposal to amend the 1995 Stock Option
Plan to increase the number of shares of Common Stock with respect to which
options may be granted thereunder from 350,000 to 800,000;
(5) to consider and vote upon a proposal to approve the Highlands
Insurance Group, Inc. Annual Incentive Plan;
(6) to ratify the appointment of independent public accountants for the
Company and its subsidiaries for fiscal year 1997; and
(7) to transact such other business as may properly come before the
Meeting or any adjournment(s) or postponement(s) thereof.
The Board of Directors of the Company has fixed the close of business on
March 25, 1997 as the record date for determining the stockholders entitled to
notice of, and to vote at, the Meeting and any adjournment(s) or
postponement(s) thereof. Stockholders who execute proxies solicited by the
Board of Directors of the Company retain the right to revoke them at any time;
unless so revoked, the shares of Common Stock represented by such proxies will
be voted at the Meeting in accordance with the directions given therein. If a
stockholder does not specify a choice on such stockholder's proxy, the proxy
will be voted in favor of proposals 3, 4, 5 and 6 described above and in favor
of the Board of Directors' nominees for directors.
Further information regarding the Meeting and the matters to be considered
thereat is set forth in the accompanying Proxy Statement.
YOU ARE CORDIALLY INVITED TO ATTEND THE MEETING. HOWEVER, WHETHER OR NOT YOU
PLAN TO ATTEND THE MEETING IN PERSON, PLEASE PROMPTLY COMPLETE, DATE, SIGN AND
MAIL THE ENCLOSED PROXY, WHICH IS BEING REQUESTED BY THE BOARD OF DIRECTORS.
AN ADDRESSED RETURN ENVELOPE WHICH REQUIRES NO POSTAGE IF MAILED IN THE UNITED
STATES IS ENCLOSED FOR THAT PURPOSE. THE PROXY IS REVOCABLE AND WILL NOT BE
USED IF YOU ARE PRESENT AT THE MEETING AND PREFER TO VOTE IN PERSON.
By Order of the Board of Directors
Sincerely,
/s/ Dwayne D. Hallman
Dwayne D. Hallman
Vice President and Secretary
March 21, 1997
10370 Richmond Avenue
Houston, Texas 77042
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----------------
PROXY STATEMENT
----------------
THE MEETING
TIME, DATE AND PLACE OF THE MEETING
This Proxy Statement is furnished to the stockholders of Highlands Insurance
Group, Inc., a Delaware corporation (the "Company"), in connection with the
solicitation of proxies by the Board of Directors of the Company for use at
the 1997 Annual Meeting of Stockholders of the Company (the "Meeting"), and at
any adjournment(s) or postponement(s) thereof, to be held on Friday, May 9,
1997, at 10:00 a.m. local time at the Adam's Mark Hotel located at 2900
Briarpark Drive, Houston, Texas.
The Company's principal executive office is located at 10370 Richmond
Avenue, Houston, Texas 77042. The approximate date on which this Proxy
Statement and the form of proxy are first being sent or given to stockholders
of the Company is March 25, 1997.
BACKGROUND
The Meeting will be the first annual meeting of stockholders since the
Company became an independent publicly traded company on January 23, 1996.
Prior to such date, the Company was a wholly-owned subsidiary of Halliburton
Company ("Halliburton"). On January 23, 1996, each holder of record of common
stock of Halliburton on January 4, 1996 received, in the form a dividend, one
share of common stock, par value $.01 per share, of the Company (the "Common
Stock") for every ten shares of Halliburton common stock owned by such holder
(the "Distribution"). Upon consummation of the Distribution, the Company sold
an aggregate of $60 million in principal amount of the Company's 10%
Convertible Subordinated Debentures, together with detachable Common Stock
Subscription Warrants, Series A and Series B (respectively, the "Series A
Warrants" and the "Series B Warrants" and collectively, the "Warrants"), due
December 31, 2005 (the "Debentures") to Insurance Partners, L.P. ("IP") and
Insurance Partners Offshore (Bermuda), L.P. ("IP Bermuda") and collectively
with IP, the "Investors") and to certain members of the Company's management
team pursuant to the terms of an Investment Agreement dated October 10, 1995,
as amended (the "Investment Agreement"). See "Certain Relationships and
Related Transactions--Management Securities."
PURPOSE OF THE MEETING
At the Meeting, the holders of shares of Common Stock will be asked to
consider and vote upon (i) the election of two persons to serve on the Board
of Directors of the Company as Class I directors, each for a two-year term;
(ii) the election of two persons to serve on the Board of Directors of the
Company as Class II directors, each for a three-year term; (iii) a proposal to
ratify the Highlands Insurance Group, Inc. 1995 Stock Option Plan (the "1995
Stock Option Plan"); (iv) a proposal to amend the 1995 Stock Option Plan to
increase the number of shares of Common Stock with respect to which options
may be granted thereunder from 350,000 to 800,000; (v) a proposal to approve
the Highlands Insurance Group, Inc. Annual Incentive Plan (the "Annual
Incentive Plan"); (vi) a proposal to ratify the Board of Directors'
appointment of KPMG Peat Marwick LLP as independent certified public
accountants for the Company and its subsidiaries for fiscal year 1997; and
(vii) such other proposals as may properly come before the Meeting or any
adjournment(s) or postponement(s) thereof.
RECORD DATE AND OUTSTANDING SHARES
The Board of Directors of the Company has fixed the close of business on
March 25, 1997 (the "Record Date") as the date for the determination of
stockholders of record entitled to notice of and to vote at the Meeting and
any adjournment(s) or postponement(s) thereof.
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On the Record Date, there were approximately 22,000 holders of record of
Common Stock with 11,451,541 shares of Common Stock issued and outstanding.
Each share of Common Stock entitles the holder thereof to one vote on each
matter submitted for stockholder approval. See "Stock Ownership of Certain
Beneficial Owners and Management" for information regarding persons known to
the management of the Company to be the beneficial owners of more than 5% of
the outstanding Common Stock.
VOTING AND REVOCATION OF PROXIES
All properly executed proxies that are not revoked will be voted at the
Meeting, as applicable, in accordance with the instructions contained therein.
If a holder of Common Stock executes and returns a proxy and does not specify
otherwise, the shares represented by such proxy will be voted (i) FOR the
Board of Directors' nominees for directors, (ii) FOR the proposal to ratify
the 1995 Stock Option Plan, (iii) FOR the proposal to amend the 1995 Stock
Option Plan, (iv) FOR the proposal to approve the Annual Incentive Plan and
(v) FOR the proposal to ratify the Board of Directors' appointment of KPMG
Peat Marwick LLP as the Company's independent public accountants for fiscal
year 1997. If any other matters should properly come before the Meeting, it is
intended that the shares represented by proxies will be voted with respect to
such matters in accordance with the judgment of the persons voting such
proxies. At the date of this Proxy Statement, the Board of Directors of the
Company does not know of any business to be presented at the Meeting other
than as set forth in the notices accompanying this Proxy Statement.
As a matter of policy, proxies, ballots and voting tabulations that identify
individual stockholders will be kept private by the Company. Such documents
are available for examination only by the inspectors of the election and
certain personnel associated with processing proxy cards and tabulating the
vote at the Meeting.
A stockholder of the Company who has executed and returned a proxy may
revoke it at any time before it is voted at the Meeting by (x) executing and
returning a proxy bearing a later date, (y) filing written notice of such
revocation with the Secretary of the Company, as appropriate, stating that the
proxy is revoked or (z) attending the Meeting and voting in person (although
attendance at the Meeting will not, in and of itself, constitute a revocation
of a proxy). Any written notice revoking a proxy should be sent to the
Secretary of the Company at the Company's principal executive offices, 10370
Richmond Avenue, Houston, Texas 77042.
QUORUM; VOTE REQUIRED
The presence at the Meeting, in person or by proxy, of the holders of a
majority of the outstanding shares of Common Stock entitled to vote thereat
will constitute a quorum for the transaction of business. Under the Amended
and Restated Bylaws of the Company and applicable laws and regulations, the
affirmative vote of the holders of at least a majority of the shares of Common
Stock represented at the Meeting, in person or by proxy, is required for the
approval of each of the proposals to be considered and voted upon at the
Meeting. In determining whether each of the proposals voted upon has received
the requisite number of affirmative votes, abstentions and broker nonvotes
will have the same effect as a vote against such proposal. With respect to the
election of directors, the nominees, up to the number of directors to be
elected, receiving the highest number of votes cast by the holders of Common
Stock represented at the Meeting, in person or by proxy, will be elected.
SOLICITATION OF PROXIES
The cost of this proxy solicitation will be borne by the Company. It is
expected that the solicitation of proxies will be primarily by mail, telephone
and telegraph. The Company has arranged for ChaseMellon Shareholder Services,
L.L.C. to solicit proxies in such manner at an estimated cost of $4,000, plus
out-of-pocket expenses. Proxies may also be solicited personally by directors,
officers and other regular employees of the Company in the ordinary course of
business and at nominal cost. Proxy materials will be provided for
distribution through brokers, custodians and other nominees or fiduciaries to
beneficial owners of Common Stock. The Company expects to reimburse such
parties for their reasonable out-of-pocket expenses incurred in connection
with such distribution.
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ANNUAL REPORT
Attached to this Proxy Statement is the Company's 1996 Annual Report which
includes a brief description of the Company's business indicating its general
scope and nature during 1996, together with the audited financial statements
and certain other information contained in the Company's 1996 report to the
Securities and Exchange Commission on Form 10-K. A COPY OF THE COMPANY'S FORM
10-K IS AVAILABLE TO STOCKHOLDERS ON REQUEST BY WRITING: CHARLES J. BACHAND,
VICE PRESIDENT AND TREASURER, HIGHLANDS INSURANCE GROUP, INC., 10370 RICHMOND
AVENUE, HOUSTON, TEXAS 77042.
FORWARD LOOKING INFORMATION
The statements included in this Proxy Statement and 1996 Annual Report
regarding future financial performance and results and the other statements
that are not historical facts are forward-looking statements. The words
"expect," "project," "estimate," "predict," "anticipate," "believes" and
similar expressions are also intended to identify forward-looking statements.
Such statements are subject to numerous risks, uncertainties and assumptions,
including but not limited to, the uncertainties relating to industry and
market conditions, natural disasters and other catastrophes, and other risks
and uncertainties described in this Proxy Statement and 1996 Annual Report and
in the Company's other filings with the Securities and Exchange Commission.
Should one or more of these risks or uncertainties materialize, or should
underlying assumptions prove incorrect, actual outcomes may vary materially
from those indicated.
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CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
MANAGEMENT SECURITIES
At the time of the Distribution, the Investors assigned to Richard M.
Haverland and certain members of management (collectively, the "Management
Investors") the rights of the Investors to acquire $2.85 million in principal
amount of Debentures, together with a proportionate amount of Series A
Warrants and Series B Warrants. On January 23, 1996, Mr. Haverland entered
into an agreement with Kenneth D. Javor which provides that Mr. Javor has the
option to acquire from Mr. Haverland $100,000 in principal amount of
Debentures, together with a proportionate amount of Series A Warrants and
Series B Warrants. Such agreement provides that the option is exercisable on
May 21, 1997 and January 22, 1998, at which times Mr. Javor may elect to
purchase $50,000 in principal amount of Debentures.
In addition, the Company has issued to the Management Investors an
additional $2.85 million in principal amount of the Company's 10% Convertible
Subordinated Debentures due December 31, 2005, Series 2 (the "Management
Debentures") together with detachable Common Stock Subscription Warrants,
Series A-2 and Series B-2 (the "Management Warrants, and collectively with the
Management Debentures, the "Management Securities"). The Management Securities
contain terms and provisions substantially similar to the Debentures, the
Series A Warrants and the Series B Warrants.
The Management Securities were issued pursuant to a Purchase, Redemption and
Bonus Agreement (the "Purchase Agreement") among the Company and each
Management Investor. The consideration paid by the Management Investors for
the Management Securities consists of individual promissory notes (each, a
"Note" and, collectively, the "Notes") in the aggregate principal amount of
$2.85 million made by the individual Management Investors without personal
liability and secured by a pledge of the Management Securities. The Notes have
a term of five years and bear interest at a rate of 10%, payable annually on
the anniversary date of the issuance thereof. The Notes may be prepaid at any
time without penalty.
The Purchase Agreement provides that the Management Securities of any
Management Investor may be redeemed by the Company at the fair market value
thereof (as determined by the Board of Directors of the Company in good faith,
reflecting in such value any discount for lack of liquidity or the fact that
the Management Securities represent a minority interest in the Company) in the
event such Management Investor's employment with the Company is terminated (i)
for cause (as defined in the Purchase Agreement), (ii) without cause at any
time before the third anniversary of the Purchase Agreement, or (iii) by the
resignation of such Management Investor at any time prior to the third
anniversary of the Purchase Agreement.
The Purchase Agreement further provides for a bonus to be paid to each
Management Investor on the fifth anniversary of the Purchase Agreement if the
average closing price of the Common Stock is equal to or greater than prices
expressed as a percentage of the exercise price of the Series A Warrants (as
adjusted from time to time) and specified in the Purchase Agreement (the
"Bonus Trigger Stock Price"). The amount of the bonus is stated as a
percentage of a maximum bonus amount separately determined for each Management
Investor and equal to the aggregate principal amount of each Management
Investor's Note. If the Bonus Trigger Stock Price is at least 1.40 times (but
less than 1.50 times) the Series A Warrant exercise price, the bonus is 25% of
the maximum bonus amount, 50% if the Bonus Trigger Stock Price is at least
1.50 times (but less than 1.61 times) the Series A Warrant exercise price and
100% if the Bonus Trigger Stock Price is 1.61 times the Series A Warrant
exercise price or higher. Such bonus amounts may be subject to the $1.0
million annual deduction limitation imposed by Section 162(m) of the Internal
Revenue Code of 1986, as amended (the "Code"), on compensation payable to
certain executives.
9
<PAGE>
Assuming conversion and exercise of the Management Investors' Debentures,
Management Debentures, Warrants and Management Warrants, the Management
Investors will acquire an aggregate of 712,800 shares of Common Stock,
representing on a fully diluted basis 5.9% of the outstanding Common Stock.
<TABLE>
<CAPTION>
DEBENTURES TOGETHER MANAGEMENT
NAME WITH WARRANTS SECURITIES TOTAL
---- ------------------- ---------- ----------
<S> <C> <C> <C>
Richard M. Haverland................. $2,100,000 $2,100,000 $4,200,000
Charles J. Bachand................... 190,000 190,000 380,000
W. Dale Montgomery................... 185,000 185,000 370,000
Michael A. Weberpal.................. 92,000 92,000 184,000
Robert C. Resch...................... 65,000 65,000 130,000
Other Management Investors........... 218,000 218,000 436,000
---------- ---------- ----------
Total................................ $2,850,000 $2,850,000 $5,700,000
========== ========== ==========
</TABLE>
INDEBTEDNESS OF MANAGEMENT
The following table sets forth certain information regarding each director
nominee and executive officer whose indebtedness to the Company exceeded
$60,000 at any time during 1996.
<TABLE>
<CAPTION>
LARGEST
AGGREGATE AMOUNT
AMOUNT OUTSTANDING
NAME AND OUTSTANDING NATURE OF NATURE OF TRANSACTION AS OF INTEREST
RELATIONSHIP DURING 1996 INDEBTEDNESS IN WHICH INCURRED MARCH 21, 1997 RATE
- -------------------- ----------- --------------- --------------------- -------------- --------
<S> <C> <C> <C> <C> <C>
Richard M. Haverland $2,100,000 Promissory note Purchase of $2,100,000 10%
Director Nominee; Management Securities
Executive Officer
Charles J. Bachand 190,000 Promissory note Purchase of 190,000 10%
Executive Officer Management Securities
W. Dale Montgomery 185,000 Promissory note Purchase of 185,000 10%
Executive Officer Management Securities
Michael A. Weberpal 92,000 Promissory note Purchase of 0(1) 10%
Executive Officer Management Securities
Robert C. Resch 65,000 Promissory note Purchase of 65,000 10%
Executive Officer Management Securities
</TABLE>
- --------
(1) On February 24, 1997, Mr. Weberpal resigned from the Company and repaid
his Note to the Company. Prior to such time, the interest rate on such
Note was 10%.
CERTAIN EXPENSES AND FEES IN CONNECTION WITH THE DISTRIBUTION
The Investment Agreement provided that each party was to be responsible for
its own fees and expenses and the fees and expenses of advisors retained by
such party. At the Closing, however, the Company paid approximately $3.4
million for fees and expenses of the Investors' attorneys, accountants,
actuaries, financial advisors and consultants (including due diligence
expenses) incurred in connection with the Distribution from the inception of
the transaction through the Closing, and also paid the Investors a transaction
fee in the amount of $2.32 million.
Robert A. Spass, a Director of the Company, is a Managing Director of
Insurance Partners Advisors, L.P., the investment adviser to the Investors.
Bradley E. Cooper, a Director of the Company, is a Principal of Insurance
Partners Advisors, L.P. Richard M. Haverland, the Company's Chairman,
President and Chief Executive Officer, is an investor in and consultant to the
Investors.
10
<PAGE>
STOCK OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information with respect to persons or groups
who, to the Company's knowledge own, or have the right to acquire, more than
five percent of the Common Stock at March 21, 1997.
<TABLE>
<CAPTION>
AMOUNT AND
NATURE OF
BENEFICIAL PERCENT OF
NAME AND ADDRESS OF BENEFICIAL OWNER OWNERSHIP(1)(2) CLASS(1)(2)
------------------------------------ --------------- -----------
<S> <C> <C>
Insurance Partners, L.P. (3)........................ 4,607,457(4) 28.7%
201 Main Street
Fort Worth, TX 76102
Insurance Partners Offshore
(Bermuda) L.P.(5)................................... 3,020,726(6) 20.9%
Cedar House
41 Cedar Avenue
P.O. Box HM1179
Hamilton, HMEX, Bermuda
Neuberger & Berman, LLC (7)......................... 1,670,125 14.6%
605 Third Avenue
New York, NY 10158
FMR Corp. (8)....................................... 1,141,870 10.0%
82 Devonshire Street Boston, MA 02109
</TABLE>
- --------
(1) Calculated pursuant to Rule 13d-3(d) of the Exchange Act. Unless otherwise
stated below, each such person has sole voting and investment power with
respect to all such shares.
(2) Based on the 11,451,541 shares of Common Stock outstanding at the close of
business on March 21, 1997.
(3) The general partner of Insurance Partners, L.P. is Insurance GenPar L.P.,
a Delaware limited partnership; the general partner of the latter is
Insurance GenPar MGP, L.P., a Delaware limited partnership; and the
general partner of the latter is Insurance GenPar MGP, Inc., a Delaware
corporation. Forty percent of the voting stock of Insurance GenPar MGP,
Inc. is owned by Robert A. Spass (a director of the Company), and Steven
Gruber and Daniel Doctoroff each own 30% of such voting stock.
(4) Represents the number of shares of Common Stock issuable upon conversion
of the Debentures and exercise of the Series A Warrants owned of record by
Insurance Partners, L.P.
(5) The general partner of Insurance Partners Offshore (Bermuda), L.P. is
Insurance GenPar (Bermuda), L.P., a Bermuda limited partnership; the
general partner of the latter is Insurance GenPar (Bermuda) MGP, L.P.; and
the general partner of the latter is Insurance GenPar (Bermuda) MGP, Ltd.,
a Bermuda corporation. Forty percent of the voting stock of Insurance
GenPar (Bermuda) MGP, Ltd. is owned by Robert A. Spass (a director of the
Company), and Steven Gruber and Daniel Doctoroff each own 30% of such
voting stock.
(6) Represents the number of shares of Common Stock issuable upon conversion
of the Debentures and exercise of the Series A Warrants owned of record by
IP Bermuda. Shares acquirable by IP Bermuda upon conversion or exercise of
Debentures or Warrants will be Series B Common Stock, which have reduced
voting rights until such shares are transferred by IP Bermuda or the
occurrence of certain events.
(7) Such shares are held by various of Neuberger & Berman's mutual funds in
the ordinary course of their business, for which funds Neuberger & Berman,
LLC and Neuberger & Berman Management Inc. serve as sub-adviser and
investment manager, respectively. Of such shares, Neuberger & Berman, LLC
has sole power to vote or direct the voting of 315,449 shares, shared
power to vote or direct the voting of 735,000 shares, and shared power to
dispose or direct the disposition of all 1,670,125 shares. Neuberger &
Berman Management Inc. shares with Neuberger & Berman, LLC the power to
make decisions whether to retain or dispose of the shares. No other
Neuberger & Berman, LLC advisory clients has an interest of more than 5%
in shares of Common Stock. Neuberger & Berman, LLC disclaims beneficial
ownership of 9,000 shares of Common Stock owned by various principals of
Neuberger & Berman, LLC in their own personal securities accounts. Each
such partner has exclusive voting and dispositive power over such shares
held in their respective accounts.
11
<PAGE>
(8) Such shares are beneficially owned as follows: Fidelity Management &
Research Company ("Fidelity")-- 942,760; and Fidelity Management Trust
Company ("FMTC")--199,110. Fidelity's beneficial ownership of 942,760
shares of Common Stock is as a result of its acting as investment adviser
to various investment companies (the "Fidelity Funds"). One such Fidelity
Fund, Fidelity Equity-Income Fund, owns 747,690 shares of Common Stock.
Edward C. Johnson 3d (the Chairman of FMR Corp. and a significant holder
of the voting securities of FMR Corp.), FMR Corp., through its control of
Fidelity, and each Fidelity Fund has sole power to dispose of the 942,760
shares of Common Stock owned by the Fidelity Funds. The Board of Trustees
of each Fidelity Fund has the sole power to direct the vote of shares of
Common Stock held by each Fund. Edward C. Johnson 3d and FMR Corp.,
through its control of FMTC, each has sole dispositive power over 199,110
shares of Common Stock and sole power to vote or to direct the voting of
156,850 shares, and no power to vote or direct the voting of 42,260 shares
owned by the institutional account(s) for which FMTC serves as investment
manager.
The following table sets forth information with respect to the numbers of
shares of Common Stock that the following persons own, or have the right to
acquire: (i) each director of the Company, (ii) each executive officer of the
Company named in the table entitled "Summary Compensation Table" and (iii) all
executive officers and directors of the Company as a group at March 21, 1997:
<TABLE>
<CAPTION>
NUMBER OF SHARES PERCENT OF
NAME BENEFICIALLY OWNED(1) CLASS(1)
- ---- --------------------- ----------
<S> <C> <C>
Richard M. Haverland.......................... 611,519(2) 5.1%
Robert A. Spass............................... --(3) --
Bradley E. Cooper............................. --(3) --
W. Bernard Pieper............................. 9,363 *
Kenneth S. Crews.............................. 3,333 *
Philip J. Hawk................................ 3,333 *
Robert W. Shower.............................. 3,333 *
Charles J. Bachand............................ 54,348(2) *
W. Dale Montgomery............................ 53,175(2) *
Kent B. Peden................................. 5,002(2) *
Kenneth D. Javor.............................. 5,000 *
All Directors and executive officers as a
group (15 persons)........................... 768,995(2) 6.3%
</TABLE>
- --------
* Less than 1%.
(1) Based on the 11,451,541 shares of Common Stock outstanding at the close of
business on March 21, 1997.
(2) Includes the following numbers of shares of Common Stock issuable upon
exercise of the Series A Warrants and Series A-2 Warrants and conversion
of the Debentures and Management Debentures, respectively, held by the
following members of management: Richard M. Haverland--132,660, 132,660,
129,950 and 129,950; Charles J. Bachand--12,003, 12,003, 11,757 and
11,757; W. Dale Montgomery--11,687, 11,687, 11,448 and 11,448; and Kent B.
Peden--631, 631, 619 and 619.
(3) Does not include shares owned beneficially by Insurance Partners, L.P. and
Insurance Partners Offshore (Bermuda), L.P. See the prior table under
"Stock Ownership of Certain Beneficial Owners and Management."
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), requires the Company's directors, executive officers and
holders of more than 10% of the Company's Common Stock to file with the
Commission initial reports of ownership and reports of changes in ownership of
Common Stock and other equity securities of the Company. The Company believes
that during the fiscal year ended December 31, 1996, its officers, directors
and holders of more than 10% of the Company's Common Stock complied with all
Section 16(a) filing requirements.
12
<PAGE>
BOARD OF DIRECTORS
ELECTION OF DIRECTORS
The Board of Directors of the Company consists of seven directors divided
into three classes serving staggered terms of three years each. Three of the
Company's current directors are serving in Class III with terms that continue
beyond the Meeting and such directors are not subject to election at the
Meeting. Two directors serve in Class I with a term that expired on December
31, 1996 because the Company did not hold an Annual Meeting in 1996. Upon such
expiration, the remaining directors filled the vacancies in the Board by
extending the term of the Class I directors to the date of the Meeting. Two
directors serve in Class II with a term that expires at the Meeting. Both the
Class I and II directors are nominees for reelection at the Meeting.
Each of the Class I directors to be elected at the Meeting will serve a term
of two years to expire at the 1999 Annual Meeting of Stockholders of the
Company or until his successor is elected and qualified. The Class II
directors to be elected at the Meeting will serve a term of three years to
expire at the 2000 Annual Meeting of Stockholders of the Company or until
their successors are elected and qualified. The nominees, up to the number of
directors to be elected, receiving the highest number of votes cast by holders
of Common Stock, in person or by proxy, will be elected.
It is intended that proxies received from holders of Common Stock, in the
absence of contrary instructions, will be voted at the Meeting for the
election of W. Bernard Pieper and Philip J. Hawk as Class I directors and
Richard M. Haverland and Robert W. Shower as Class II directors. Although the
Company does not contemplate that any of the nominees will be unable to serve,
decline to serve or otherwise be unavailable as a nominee at the time of the
Meeting, in such event, the proxies will be voted in accordance with the
authority granted therein for such other candidate or candidates as may be
nominated by the Board of Directors of the Company.
The Board of Directors met seven times in 1996.
Further information concerning the nominees for election as directors at the
Meeting, including their business experience during the past five years,
appears below.
Nominees for Class I With Terms of Office Expiring at the 1999 Annual Meeting
of Stockholders
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE DURING PAST
NAMES OF NOMINEES FOR CLASS I(1) AGE FIVE YEARS AND OTHER INFORMATION
-------------------------------- --- --------------------------------
<C> <C> <S>
W. Bernard Pieper..................... 64 Vice Chairman of Halliburton, 1992
to January 1996; President and
Chief Executive Officer of Brown
& Root, Inc., 1990-1992. Mr.
Pieper was a director of
Highlands prior to the
Distribution. Mr. Pieper is
presently a director of the
Company.
Philip J. Hawk........................ 42 President and Chief Executive
Officer of EOTT Energy Corp.,
1993 to present; Chief Operating
Officer, Goodman Manufacturing
Company, L.P., 1991-1992;
Partner, McKinsey & Company,
Inc., 1990-1991. Mr. Hawk is
presently a director of the
Company.
</TABLE>
13
<PAGE>
Nominees for Class II Directors With Terms of Office Expiring at the 2000
Annual Meeting of Stockholders
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE DURING
PAST
FIVE YEARS AND OTHER
NAMES OF NOMINEES FOR CLASS II(1) AGE INFORMATION
--------------------------------- --- --------------------------
<C> <C> <S>
Richard M. Haverland.................. 55(1) Chairman, President and Chief
Executive Officer of the
Company and of Highlands
Insurance Company
("Highlands"), January 1996
to present; Insurance
Consultant, December 1994 to
present; Vice Chairman, Chief
Executive Officer Designate,
Continental Corporation
October-December 1994;
Executive Vice President--
Insurance Operations,
American Premier
Underwriters, Inc., 1991-
1994. Mr. Haverland is
presently a director of the
Company.
Robert W. Shower...................... 59 Executive Vice President and
Chief Financial Officer,
Seagull Energy Corporation,
1994 to April 1996; Senior
Vice President and Chief
Financial Officer, Seagull
Energy Corporation, 1992-
1993; Senior Vice President,
Corporate Development, Albert
Fisher, Inc., 1991-1992; Vice
President Finance and Chief
Financial Officer, AmeriServ
Food Company, 1990-1991. Mr.
Shower is a director of Lear
Corporation and Edge
Petroleum Corporation. Mr.
Shower is presently a
director of the Company.
</TABLE>
Continuing Class III Directors With Terms of Office Expiring at the 1998
Annual Meeting of Stockholders
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE DURING PAST
FIVE YEARS AND OTHER
NAMES OF CLASS III DIRECTORS(1) AGE INFORMATION
------------------------------- --- -------------------------------
<C> <C> <S>
Robert A. Spass 40(1) Managing Partner of Insurance
Partners Advisors, L.P., 1994
to present; President and
Chief Executive Officer of
International Insurance
Advisors, Inc., 1990-1994. Mr.
Spass is a director of
Superior National Insurance
Group, Inc. and Unionamerica
Holding plc; he served as
director of NACOLAH Holding
Corporation until March 1996
and of National Re Corporation
until October 1996.
Bradley E. Cooper 30(1) Principal of Insurance Partners
Advisors, L.P., 1994 to
present; Vice President of
International Insurance
Advisors, Inc., 1990-1994. Mr.
Cooper is also a director of
Superior National Insurance
Group, Inc.
Kenneth S. Crews 48 Managing Director, Dillon Read
& Co., Inc., 1992 to present;
Managing Director, Lehman
Brothers Incorporated, 1990-
1992.
</TABLE>
- --------
(1) The Debentures obligate the Company to nominate, and recommend the
election of, persons designated by a majority in interest of the holders
of the Debentures so that the number of persons so designated will at all
times constitute, if elected, at least 28% of the Board of Directors.
Messrs. Haverland, Spass and Cooper were elected to the Board of Directors
of the Company pursuant to the terms of the agreement under which the
Debentures were sold.
THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR EACH OF THE DIRECTOR NOMINEES.
14
<PAGE>
COMPENSATION OF DIRECTORS
Directors who are employees of the Company are not paid any fees or
additional compensation for service as members of the Board or any committee
thereof. Directors who are not employees of the Company ("Non-Employee
Directors"), other than Messrs. Spass and Cooper, receive an annual retainer
fee of $10,000, payable annually, as well as a fee of $750 per day for
attendance at meetings of the Board and any committee meetings held on the
same day as a Board meeting and a fee of $500 per day for attendance at
committee meetings not held on the same day as a Board meeting. In addition,
all Directors are reimbursed for reasonable out-of-pocket expenses incurred in
connection with traveling to any Board or committee meeting. Messrs. Spass and
Cooper have waived any right to receive compensation as Directors in the form
of cash or stock and, accordingly, although they are not employees of the
Company, the term Non-Employee Directors defined above is deemed not to
include such individuals. Each Non-Employee Director of the Company as of the
Distribution was granted an option to purchase 10,000 shares of Common Stock
under the 1995 Directors' Stock Plan. Moreover, under the 1995 Directors'
Stock Plan, commencing with the first annual meeting of the Board of Directors
of the Company after the Distribution, and at each annual meeting thereafter,
each Non-Employee Director is automatically granted shares of Common Stock
having a fair market value at the time of grant of $10,000.
The Board of Directors of the Company and Halliburton, its sole stockholder
at the time, have approved the Company's 1995 Directors' Stock Plan (the
"Directors' Plan" or the "Plan"). The purposes of the Directors' Plan are to
(i) encourage the Directors, including any participating Directors who are
also employees, to own shares of Common Stock and thereby align their
interests more closely with the interests of other stockholders of the
Company, (ii) encourage the highest level of Director performance by providing
the Directors with a direct interest in the Company's attainment of its
financial goals and continuing success, and (iii) provide a financial
incentive that will help attract and retain the most qualified Directors.
Pursuant to the Directors' Plan, the Company may grant options and issue
restricted stock with respect to an aggregate of up to 400,000 shares. No
individual recipient will receive more than 300,000 shares of Common Stock in
the aggregate upon the issuance of restricted stock and/or the exercise of
options granted under the Directors' Plan. Options granted under the
Directors' Plan will be non-qualified stock options ("Options") and shares of
Common Stock issued under the Directors' Plan will be from authorized and
unissued shares. Non-Employee Directors will be awarded restricted stock
annually.
As noted above, Messrs. Spass and Cooper have elected not to participate in
any stock awards to Directors of the Company. An agreement among the Company,
IP and IP Bermuda provides that, in the event of election of certain
individuals associated with the Investors to the Board of Directors pursuant
to the terms of the Investment Agreement and Debentures, such individuals will
not be entitled to participate in the 1995 Directors' Plan or any similar
plan. Such persons are collectively referred to as "Non-Participating
Directors."
Pursuant to the Directors' Plan, options to purchase shares of Common Stock
have been granted to the following Directors: Messrs. Haverland (300,000),
Crews (10,000), Hawk (10,000), Pieper (10,000) and Shower (10,000). The
exercise price of the options is equal to $14.69 per share. Except for options
granted to Mr. Haverland, options granted under the Directors' Plan will vest
and become exercisable as to 33 1/3%, 66 2/3% and 100% of the shares of Common
Stock subject thereto on each of the first, second and third anniversaries of
the option grant. Options granted under the Directors' Plan to Mr. Haverland
will vest and become exercisable as to 25%, 50%, 75% and 100% of the shares of
Common Stock subject thereto on each of the first, second, third and fourth
anniversaries, respectively, of the option grant.
Each option will be evidenced by a stock option agreement which may contain
such terms and conditions as may be determined by the Committee and are not
inconsistent with the Directors' Plan. The term of the option will be ten
years from the date of grant. During a Directors' lifetime, an option granted
pursuant to the Directors' Plan will be exercisable only by the Director. The
option will not be transferable by such Director other than by will or the
laws of descent and distribution.
15
<PAGE>
COMMITTEES OF BOARD OF DIRECTORS
The Board of Directors has the following standing committees:
Audit Committee. The functions of the Audit Committee include:
recommendations to the Board of Directors regarding the appointment of
independent auditors; approvals of the scope of the independent auditors'
examination reviews of, and recommendations to the Board of Directors
regarding the Company's financial policies and accounting systems and
controls; and approvals of the duties and compensation of the independent
auditors, both with respect to audit and non-audit services. The Committee
also reviews the Company's compliance with its code of business conduct. The
Committee meets from time to time with the independent auditors outside the
presence of Company management or other employees, to discuss matters of
concern, to receive recommendations or suggestions for change and to exchange
relevant views and information. The Audit Committee consists of four non-
employee directors: Messrs. Pieper, Crews, Hawk and Shower (Chairman). The
committee met three times in 1996.
Compensation Committee. Duties of the Compensation Committee include
developing and approving an overall compensation philosophy consistent with
corporate objectives and stockholder interests; acting as a salary and
promotions committee with respect to officers of the Company and certain
officers of subsidiaries; administering and granting options pursuant to the
1995 Stock Option Plan; administering and making awards under Company
incentive plans; and acting as a committee for administration of other forms
of non-salary compensation. The Compensation Committee consists of Messrs.
Pieper, Crews, Hawk and Spass (Chairman). The committee met twice in 1996.
Investment Committee. Duties of the Investment Committee include reviewing
and making recommendations to the Board of Directors regarding the nature and
composition of the investments of the Company in all forms of financial
securities and obligations, denominated in any and all currencies, issued by
banks or companies domiciled inside or outside of the United States of
America, including, but not limited to, stocks, bonds, notes, certificates of
deposit and non-negotiable time deposits. The Investment Committee consists of
the Messrs. Cooper, Haverland and Shower (Chairman). The committee met two
times in 1996.
The Board of Directors of the Company may, from time to time, establish
certain other committees to facilitate its work.
16
<PAGE>
EXECUTIVE OFFICERS
GENERAL
Set forth below are the names, ages and titles of the executive officers of
the Company:
<TABLE>
<CAPTION>
TITLE AND BUSINESS EXPERIENCE
NAME AGE DURING LAST FIVE YEARS
---- --- -----------------------------
<C> <C> <S>
Richard M. Haverland............. 55 Chairman, President and Chief Executive
Officer of the Company; see also
"Election of Directors--Nominees for
Class II Directors With Terms of
Office Expiring at the 2000 Annual
Meeting of Stockholders" for
additional business experience.
Charles J. Bachand............... 44 Vice President and Treasurer of the
Company; Senior Vice President and
Chief Financial Officer of Highlands,
November 1993 to present; Partner,
KPMG Peat Marwick, 1988 to October
1993.
Michael A. Weberpal.............. 45 Vice President and Secretary of the
Company; Vice President, General
Counsel and Secretary of Highlands,
1993 to February 24, 1997 (the date on
which Mr. Weberpal resigned from the
Company); Senior Attorney,
Halliburton, 1990-1993.
W. Dale Montgomery............... 40 Executive Vice President, Operations
and President, Special Accounts
Division of Highlands, 1996 to
present; Executive Vice President,
Operations, Highlands, 1994-1996;
Senior Vice President, Actuarial,
Highlands, 1990-1994.
Kenneth D. Javor................. 48 President, Commercial Insurance
Division of Highlands, January 1996 to
present; TIG Insurance Company, 1993-
1995, Managing Director and Vice
President; Maryland Casualty Company,
Regional Vice President, 1990-1993.
Kent B. Peden.................... 38 President of Insurance Services
Division of Highlands, January 1996 to
present; Vice President, Casualty,
Highlands, 1994-1995; Assistant Vice
President, Casualty, Highlands, 1991-
1994.
Robert C. Resch.................. 52 Vice President, Chief Information
Officer of Highlands, July 1995 to
present; Aetna Life & Casualty
Company--Director of Commercial
Processing Systems and Personal Lines
Business Center Systems, 1990 to June
1995.
Betty H. Connelly................ 42 Vice President, Human Resources,
Highlands, 1996 to present; Assistant
Vice President, Highlands, 1994-1996;
Director of Human Resources, Melissa
Rice & Company, 1993-1994; Director of
Human Resources, Revlon, Inc., 1990-
1992.
William V. Fehlis................ 50 President, Marine Division of
Highlands, January 1997 to present;
General Manager, Marine, Highlands,
1996-1997; Assistant Vice President,
Highlands, 1990-1996.
</TABLE>
17
<PAGE>
EXECUTIVE COMPENSATION
Summary Compensation Table. The following table sets forth information
concerning compensation for services in all capacities to the Company and its
subsidiaries during each of the last two years of those persons who were the
Company's Chief Executive Officer and its other four most highly compensated
executive officers during 1996, (collectively, the "named executive
officers"):
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG TERM
COMPENSATION
---------------------
ANNUAL
COMPENSATION RESTRICTED SECURITIES
------------------ STOCK UNDERLYING ALL OTHER
YEAR SALARY($) BONUS($) AWARDS($) OPTIONS(#) COMPENSATION($)(3)
---- --------- -------- ---------- ---------- ------------------
<S> <C> <C> <C> <C> <C> <C>
Richard M. Haverland.... 1996 $485,371 $500,000(1) -- 300,000(2) $ 4,750
Chairman, President and
Chief Executive Officer
of the Company and
Highlands
Harold G. Duble (4)..... 1996 15,529 -- -- -- 169,778
President and Chief
Executive 1995 255,000 -- -- -- 35,103
Officer of Highlands
Charles J. Bachand...... 1996 169,945 12,000 -- 20,000 167,685
Vice President and
Treasurer of the 1995 164,328 -- -- -- 22,343
Company; Senior Vice
President and Chief
Financial Officer of
Highlands
W. Dale Montgomery...... 1996 167,923 10,000 -- 20,000 179,095
Executive Vice
President,Operations 1995 161,250 -- -- -- 22,271
of Highlands; President
Special Accounts
Division, Highlands
Kenneth D. Javor........ 1996 137,378 30,000 -- 25,000(5) 3,881
President, Commercial
Insurance Division,
Highlands
Kent B. Peden........... 1996 97,533 90,000 -- 7,500 21,816
President of Insurance
Services Division 1995 79,397 -- -- -- 9,187
of Highlands
</TABLE>
- --------
(1) Includes $250,000 in Common Stock awarded in 1997 at the market price,
when 1996 bonuses were paid, of $22 1/8 per share for a total of 11,299
shares.
(2) Awarded under the Company's 1995 Directors Stock Plan.
(3) For 1996, Messrs. Haverland and Javor received 401(k) matching
contributions to their accounts under the Employees' Retirement and
Savings Plan of $4,750 and $3,881, respectively. For 1996 and 1995,
respectively, Messrs. Duble, Bachand, Montgomery and Peden received 401(k)
matching contributions to their accounts under the Employees' Retirement
and Savings Plan of $466, $4,750, $4,750 and $2,816, respectively; and
$4,620, $4,620, $4,620 and $2,382, respectively. For 1996 and 1995,
respectively, Messrs. Duble, Bachand, Montgomery and Peden received
defined contribution plan contributions to their accounts under the
Employees' Retirement and Savings Plan of $637, $6,150, $6,150 and $4,000,
respectively; and $13,014, $13,014, $13,014 and $6,805, respectively. For
1995, Messrs. Duble, Bachand and Montgomery received ERISA offset benefit
accruals of $17,469, $4,709 and $4,637, respectively. In connection with
the Distribution, each of Messrs. Duble, Bachand, Montgomery, and Peden,
respectively, received one-time payments of $41,175, $73,200, $86,925 and
$0, respectively, with respect to Halliburton restricted stock and/or
options forfeited by them in connection with the Distribution and of
$127,500, $83,585, $81,270 and $15,000, respectively.
(4) Mr. Duble retired from employment with the Company following the
Distribution.
(5) Includes 10,000 shares of Common Stock underlying options granted in 1997
as part of Mr. Javor's 1996 compensation.
18
<PAGE>
Option Grants. The following table contains certain information concerning
options granted to the named executive officers during the year ended December
31, 1996.
STOCK OPTION GRANTS IN LAST FISCAL YEAR
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
--------------------------------------------
POTENTIAL REALIZABLE
VALUE AT ASSUMED
PERCENT OF TOTAL EXERCISE ANNUAL RATES OF STOCK
OPTIONS OR BEST PRICE APPRECIATION
GRANTED TO PRICE FOR OPTION TERM(2)
OPTIONS EMPLOYEES IN PER EXPIRATION ---------------------
NAME GRANTED 1996 SHARE(1) DATE 5% 10%
---- ------- ---------------- -------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Richard M. Haverland.... 300,000 62.24% $14.69 01/04/06 $2,772,000 $7,023,000
Charles J. Bachand...... 20,000 4.15% 14.69 01/11/06 184,800 468,200
W. Dale Montgomery...... 20,000 4.15% 14.69 01/11/06 184,800 468,200
Kenneth D. Javor........ 15,000 3.11% 21.13 02/26/06 199,350 505,200
Kent B. Peden........... 7,500 1.56% 14.69 01/11/06 69,300 175,575
</TABLE>
- --------
(1) Prior to the Distribution and prior to the existence of a public market
for the Common Stock, options were granted with an exercise price of
$14.69 which represents the estimated fair market value of the underlying
Common Stock as of the date of grant as determined by the Board of
Directors.
(2) Calculated based upon the indicated rates of appreciation, compounded
annually, from the date of grant to the end of the option term. Actual
gains, if any, on stock option exercises and Common Stock holdings are
dependent on the actual performance of the Common Stock. There can be no
assurance that the amounts reflected in this table will be achieved.
Option Exercises and Year-End Option Holdings. The following table
summarizes the number and value of the unexercised options to purchase Common
Stock held by the named executive officers at December 31, 1996.
1996 OPTION EXERCISES YEAR-END OPTION VALUES
<TABLE>
<CAPTION>
NUMBER OF SHARES OF
COMMON STOCK UNDERLYING VALUE OF UNEXERCISED IN-
UNEXERCISED OPTIONS HELD THE-MONEY OPTIONS HELD AT
AT DECEMBER 31, 1996 DECEMBER 31, 1996
------------------------- -------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Richard M. Haverland........ -- 300,000 -- $1,668,000
Charles J. Bachand.......... -- 20,000 -- 111,200
W. Dale Montgomery.......... -- 20,000 -- 111,200
Kenneth D. Javor............ -- 15,000 -- --
Kent B. Peden............... -- 7,500 -- 41,700
</TABLE>
Employees' Retirement and Savings Plan. Pursuant to the Highlands Insurance
Company Employees' Retirement and Savings Plan (the "Retirement Plan"),
Highlands Insurance Company may make annual contributions to the Retirement
Plan for the benefit of qualified employees. The amount of each year's
contribution, if any, is determined by the Highlands Insurance Company Board
of Directors in its discretion. In addition, participants may make
contributions to the Retirement Plan on either a before-tax or after-tax
basis. Before-tax contributions up to a contribution level of 6% of
compensation are matched by the Company at a 50% rate. Contributions under the
Retirement Plan for the years ended December 31, 1995 and 1996, are set forth
in a footnote to the Summary Compensation Table. It is not possible to
estimate the amount of benefits payable at retirement under the Retirement
Plan to Messrs. Haverland, Bachand, Montgomery, Javor and Peden because of
some or all of the following: (i) amounts contributed in the future will be
contingent on future discretionary contributions by Highlands Insurance
Company as well as contribution levels of the participant, (ii) amounts
allocated from forfeited accounts will vary, (iii) earnings on trust fund
assets will vary, (iv) trust fund assets may appreciate or depreciate in
value, (v) the compensation of the individual may vary, (vi) age at date of
retirement may vary, and (vii) the Retirement Plan may be changed or
discontinued.
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<PAGE>
1995 Stock Option Plan. For a description of the Company's 1995 Stock Option
Plan and the benefits for which the named executive officers are eligible
thereunder, see "Other Meeting Items--Ratification of 1995 Stock Option Plan."
Employment Contract. The Company has entered into a three-year Employment
Agreement with Richard M. Haverland, an investor in and consultant to IP,
under which Mr. Haverland became and serves as Chairman and Chief Executive
Officer of the Company. Under the terms of the Employment Agreement, Mr.
Haverland will be paid an annual salary of $525,000 per year, and for the
fiscal years ended 1996 and 1997, an annual bonus of no less than $250,000, to
be determined by the Board of Directors of the Company. Pursuant to the
Employment Agreement, the Company has granted Mr. Haverland options to
purchase 300,000 shares of Company Common Stock at an exercise price equal to
$14.69 per share. Pursuant to the Employment Agreement, the Company sold to
Mr. Haverland (i) $2,100,000 in principal amount of the Company's 10%
Convertible Subordinated Debentures due December 31, 2005, together with
Series A and Series B Common Stock Warrants and (ii) Management Debentures,
together with Common Stock Subscription Warrants, Series A-2 and Common Stock
Subscription Warrants, Series B-2 in exchange for a promissory note in the
principal amount of $2,100,000. Such promissory note is without personal
recourse and is secured by a pledge of the Management Securities purchased
thereby. See "Certain Relationships and Related Transactions--Management
Securities." Should Mr. Haverland's employment with the Company terminate
other than for cause, death, disability or as a result of his voluntary
termination, he will receive severance benefits in installments on the same
basis as salary and bonus would otherwise be payable to him for a period of
the greater of two years or the period equal to the remaining term of the
Employment Agreement. In the event of his death, disability or resignation,
Mr. Haverland will be entitled to an amount equal to the salary and prorated
bonus that would be otherwise payable in respect of periods prior to such
death, disability or resignation.
REPORT OF THE COMPENSATION COMMITTEE
The Company applies a consistent philosophy for all employees, including
senior management. This philosophy is based on the premise that the
achievements of the Company result from the coordinated efforts of all
individuals working toward common objectives. The Company strives to achieve
these objectives through teamwork that is focused on meeting the expectations
of customers and stockholders.
The goals of the compensation program are to align compensation with
business objectives and performance, and to enable the Company to attract,
retain and reward executive officers whose contributions are critical to the
long-term success of the Company. The Company's compensation program for
executive officers is based on the same two principles applicable to
compensation decisions for all employees of the company.
.The Company pays competitively.
The Company is committed to maintaining a pay program that helps attract and
retain the best people in the industry. To ensure that pay is competitive, the
Company will regularly compare its pay practices with those of other regional
companies and set its pay parameters based on this review.
.The Company pays for sustained performance.
Executive officers are rewarded based upon corporate performance or business
unit performance and individual performance. Corporate performance and
business unit performance are primarily evaluated by determining the extent to
which annually established accident year combined operating ratios are met.
Individual performance is evaluated by reviewing performance against set
objectives and goals and the degree to which Company values are fostered.
COMPENSATION VEHICLES
The Company's compensation program consists of cash- and equity-based
compensation. The Company believes that having such a compensation program
allows the Company to attract and retain key employees, which in turn permits
the Company to provide useful products and services to customers, enhance
stockholder
20
<PAGE>
value, motivate technological innovation, foster teamwork and adequately
reward employees. The Company's compensation vehicles are as follows:
Cash-based Compensation--Salary and Bonus. The Company establishes salary
ranges for employees by reviewing the aggregate of base salary and annual
bonus for competitive positions in the market. In 1996, the Company engaged an
outside consultant to assist in the assessment of individual positions in an
effort to identify appropriate market salary ranges for all positions. The
Company attempts to set its competitive salary midpoint for an executive
officer position above the median level compared to those companies it
surveys. The range allows an executive officer to be placed above or below the
midpoint, according to that officer's overall individual performance. As
described above, overall individual performance is measured against the
achievement of specific goals, including profitability goals for those
individuals controlling key profit centers.
Equity-based Compensation--Stock Option Program. The purpose of this program
is to provide additional incentives to employees to work to maximize
stockholder value. The Company also recognizes that a stock incentive program
is a necessary element of a competitive compensation package for its
employees. The program utilizes vesting periods to encourage key employees to
continue in the employ of the Company and thereby acts as a retention device
for key employees. The Company believes that the program encourages employees
to maintain a long-term perspective. The Company grants stock options to a
broad-based group. As of March 21, 1997, approximately 13% percent of all
Company employees had been granted options.
In determining the size of an option award for an executive officer, the
Compensation Committee's primary considerations are the "grant value" of the
award and the expected or actual performance of the officer measured against
the same performance criteria described above under "Cash-based Compensation"
which is used to determine salary and bonus. In addition to considering the
grant value and the officer's performance, the Compensation Committee also
considers the number of outstanding unvested options which the officer holds
and the size of previous option awards to that officer. The Compensation
Committee does not assign specific weights to these items.
OTHER CONSIDERATIONS
Certain Limitations on Deductibility of Executive Compensation. Section
162(m) of the Internal Revenue Code, enacted in 1993, generally disallows a
tax deduction to public companies for compensation over $1 million paid to the
Company's Chief Executive Officer or any of the four other most highly
compensated executive officers. Certain performance-based compensation,
however, is specifically exempt for the deduction limit. The Company does not
have a policy that requires or encourages the Compensation Committee to
qualify stock options or restricted stock awarded to executive officers for
deductibility under Section 162(m) of the Internal Revenue Code. However, the
Company is seeking approval of the 1995 Stock Option Plan, an amendment
increasing the number of shares subject to options under the 1995 Stock Option
Plan and the Annual Incentive Plan for purposes of Section 162(m), among other
things. In addition, the Compensation Committee does consider the net cost to
the Company in making all compensation decisions.
CEO COMPENSATION
Richard M. Haverland has been President, Chief Executive Officer and
Chairman of the Company since January 23, 1996. The Compensation Committee
used the same compensation policy described above for all employees to
determine Mr. Haverland's fiscal 1996 overall compensation.
In setting both the cash-based and the equity-based elements of Mr.
Haverland's overall compensation, the Compensation Committee made an overall
assessment of Mr. Haverland's leadership in achieving the Company's long-term
strategic and business goals.
COMPENSATION COMMITTEE
Robert A. Spass (Chairman)
Kenneth S. Crews
Philip J. Hawk
W. Bernard Pieper
21
<PAGE>
PERFORMANCE GRAPH
COMPARISON OF 1996 CUMULATIVE TOTAL RETURN*
OF HIGHLANDS INSURANCE GROUP, INC., S&P 500 INDEX
AND S&P INSURANCE (PROPERTY-CASUALTY) INDEX
Set forth below is a line graph comparing the 1996 cumulative stockholder
return on the Common Stock, based on the market price of the Common Stock, with
the cumulative total return on the Standard & Poor's 500 Stock Index and the
Standard & Poor's Insurance (Property-Casualty) Index:
[GRAPH APPEARS HERE]
JANUARY 12, DECEMBER 31,
1996* 1996
----------- ------------
Highlands Insurance Group, Inc. .... 100 96
S&P 500............................. 100 123
S&P Insurance (Property-Casualty)... 100 122
- -------
* Total assumes $100 invested on January 12, 1996 in Common Stock or on
December 31, 1995 in the Standard & Poor's 500 Index and the Standard &
Poor's Insurance (Property-Casualty) Index, including reinvestment of
dividends with respect to the two indices. The Company did not pay dividends
in 1996. No public market existed for shares of Common Stock prior to January
12, 1996.
Neither the foregoing Compensation Committee Report nor the foregoing
Performance Graph will be deemed incorporated by reference into any other
filing, absent an express reference thereto.
22
<PAGE>
OTHER MEETING ITEMS
RATIFICATION OF THE 1995 STOCK OPTION PLAN
The 1995 Stock Option Plan is currently subject to a transitional rule
exception to the application of the annual $1 million deduction limitation
imposed by Section 162(m) of the Code with respect to compensation paid to
certain executives. Because such transitional rule exception generally only
applies to options granted before the first regularly scheduled meeting of
shareholders of the Company which occurs more than one year after the
Distribution, the Board of Directors has determined that it is in the best
interests of the Company to obtain stockholder approval of the 1995 Stock
Option Plan so that options granted under the 1995 Stock Option Plan during
its entire term are eligible to qualify for an exception from the compensation
deduction limitation imposed by Section 162(m) of the Code. The brief summary
of certain aspects of the 1995 Stock Option Plan set forth herein does not
purport to be complete and is qualified in its entirety by reference to the
1995 Stock Option Plan, a copy of which is attached to this Proxy Statement as
Appendix B and is incorporated herein by reference. Stockholders of the
Company are urged to read the 1995 Stock Option Plan carefully in its
entirety. The ratification of the 1995 Stock Option Plan includes the
ratification of the 1995 Stock Option Plan as amended by the proposal to
increase from 350,000 to 800,000 the number of shares of Common Stock
available for issuance upon the exercise of options granted under the 1995
Stock Option Plan, if such proposal is approved.
Inception. In January 1996, prior to the Distribution, the Board of
Directors of the Company and Halliburton, the Company's sole stockholder at
the time, approved the 1995 Stock Option Plan. The purposes of the 1995 Stock
Option Plan are to: (i) provide incentives to key employees of the Company to
remain in the service of the Company, (ii) give such employees an opportunity
to acquire an ownership interest in the Company and thereby create in such
persons an increased interest in and greater concern for the welfare of the
Company, (iii) aid the Company in attracting able persons to enter the service
of the Company and (iv) secure and retain the services of persons capable of
filling key positions with the Company and its subsidiaries. Pursuant to the
1995 Stock Option Plan, the Company may grant options with respect to an
aggregate of up to 350,000 shares of Common Stock. No individual optionee will
receive more than 100,000 shares of Common Stock in the aggregate upon the
exercise of options granted under the 1995 Stock Option Plan. Options granted
pursuant to the plan may be either incentive stock options ("ISOs") or non-
qualified stock options ("NQSOs"). Shares of Common Stock subject to options
may be either authorized and unissued shares or previously issued shares
acquired or to be acquired by the Company and held in its treasury.
Prior to the Distribution, the Company granted to its employees options to
acquire an aggregate of 150,000 shares of Common Stock under the Plan. The
exercise price of the options is equal to $14.69 per share, which price
represents the fair market of the underlying Common Sock, as determined by the
Board of Directors, prior to the Distribution and prior to the existence of a
public market for the Common Stock. The exercise price for all other options
granted under the 1995 Stock Option Plan is the market price of the Common
Stock on the date of grant of the option.
Vesting. Options granted under the 1995 Stock Option Plan vest and become
exercisable as to 33 1/3%, 66 2/3% and 100% of the shares of Common Stock
subject thereto on each of the first, second and third anniversaries,
respectively, of the option grant.
Administration. The 1995 Stock Option Plan is administered by the
Compensation Committee of the Board of Directors of the Company. See "Board of
Directors--Committees of Board of Directors--Compensation Committee." The
authority of the Compensation Committee includes, among other things,
determining the persons to whom options are granted, the timing of any option
grants, the number of shares subject to each option, the period of
exercisability, the designation of options as ISOs or NQSOs and the other
terms and provisions thereof.
Officers of the Company subject to Section 16(a) of the Exchange Act may
not, and the Compensation Committee also has the authority to require, as a
condition to any grant, that any other grantee also may not, sell or otherwise
dispose of shares acquired pursuant to the exercise of an option within six
months of the date an option is granted.
23
<PAGE>
Option Eligibility. Options may be granted only to salaried key employees of
the Company or any subsidiary or parent corporation of the Company now
existing or subsequently formed or acquired whom the Compensation Committee
identifies as having a direct and significant effect on the performance of
such corporations.
Grant, Terms and Conditions of Options. Upon the grant of options, the
Company will not receive any monetary consideration.
The exercise price for each share subject to an option is an amount that the
Compensation Committee determines in its good faith judgment. In the case of
ISOs, the exercise price per share may not be less than the amount the
Compensation Committee determines, in its good faith judgment, to be not less
than 100% of the fair market value of the Common Stock on the date the option
is granted; provided, however, that in the case of ISOs granted to a key
employee of the Company who owns prior to the date of such grant capital stock
of the Company representing more than 10% of the voting power of the Company,
the exercise price for each share subject thereto will be in an amount that
the Compensation Committee determines, in its good faith judgment, to be not
less than 110% of the fair market value of the Common Stock on the date the
ISO is granted.
Payment for shares purchased upon the exercise of options may be in cash or,
if the terms of an option so provide, with other shares of Common Stock or, in
the case of NQSOs, by the withholding of shares of Common Stock into which the
option is exercisable.
Options granted under the 1995 Stock Option Plan are exercisable at such
times, in such amounts and during such period or periods as the Compensation
Committee may determine at the date the option is granted. ISOs, however, are
not exercisable after ten years from the date of grant and, in the case of a
person who at the date of grant owns capital stock of the Company representing
10% or more of the voting power of the Company, are not exercisable after five
years from the date of grant. If the aggregate fair market value of shares
subject to ISOs exercisable for the first time in any calendar year exceeds
$100,000 (based on the fair market value on the date of grant of the shares),
such options with respect to shares in excess of such $100,000 limitation will
be treated as NQSOs.
In addition, the Compensation Committee has the right to accelerate, in
whole or in part, from time to time, conditionally or unconditionally, the
right to exercise any option granted under the 1995 Stock Option Plan.
In general, upon termination of employment, any unexercised option becomes
null and void. In the event of death, disability, retirement or termination by
the Company of employment other than for cause, special rules will apply
regarding the exercisability of options unless the terms of the option
agreement specify otherwise.
Options may not be transferred except by will or the laws of descent or
distribution. Options are only exercisable during the lifetime of a holder by
such holder.
In the event of a "change in control" of the Company, all options then
outstanding under that 1995 Stock Option Plan shall immediately become
exercisable. The Compensation Committee, in its sole discretion, may determine
that, upon the occurrence of a "change in control," each option outstanding
under the 1995 Stock Option Plan shall terminate within a specified number of
days after notice to the holder, and such holder shall receive, with respect
to each share subject to such option, an amount in cash or other property, or
any combination thereof, equal to the excess of the aggregate fair market
value at the time of such transaction of the shares subject to such option
over the aggregate exercise price therefor. The foregoing provision does not
apply to options granted to officers subject to Section 16(a) of the Exchange
Act within six months prior to a change in control, unless an exemption from
liability under Section 16(b) of the Exchange Act is otherwise available.
Effect of Change in Common Stock. In the event of any change in the Common
Stock through merger, consolidation, reorganization, recapitalization, stock
dividend, stock split, split-up, split-off, spin-off, combination of shares,
exchange of shares, or other like change in capital structure of the Company,
an adjustment will be made to each outstanding option so that such option
thereafter is exercisable for such securities, cash and/or property as would
have been received had such option been exercised in full immediately
24
<PAGE>
prior to such transaction and been exchanged in such transaction. An
adjustment will be made successively each time any such change occurs.
Amendment or Termination. The Board of Directors of the Company may at any
time amend or terminate the 1995 Stock Option Plan, provided that no such
action affects or impairs the rights of an optionee under any previously
granted option. Notwithstanding the foregoing, without the approval of the
Company's stockholders, no amendment or change may be made (a) increasing the
total number of shares of Common Stock reserved for options under the plan
(other than an increase resulting from an adjustment), (b) reducing the
exercise price of any ISO, (c) modifying the provisions of the 1995 Stock
Option Plan relating to eligibility or (d) materially increasing the benefits
accruing to participants under the 1995 Stock Option Plan.
Certain Federal Income Tax Consequences. The statements in the following
paragraphs are based on federal income tax law and interpretational
authorities as of the date of this Proxy Statement, which are subject to
change at any time. The law is technical and complex and the statements
represent only a general summary of some of the applicable provisions.
Incentive Options. ISOs under the 1995 Stock Option Plan are intended to
meet the definitional requirements of Section 422(b) of the Code for
"incentive stock options."
Under the Code, the grantee of an ISO generally is not subject to regular
income tax upon the receipt or exercise of such ISO (except that the
alternative minimum tax may apply). If after exercising an ISO, an employee
disposes of the shares of Common Stock so acquired after the longer of two
years from the date of grant or one year from the date of transfer of shares
of Common Stock pursuant to the exercise of such ISO (the "applicable holding
period"), the employee will normally recognize a long-term capital gain or
loss equal to the difference between the amount received for the shares of
Common Stock over the exercise price. If, however, an employee does not hold
the shares of Common Stock so acquired for the applicable holding period, the
disposition is normally a "disqualifying disposition," and the employee would
recognize income in the year of the disqualifying disposition equal to the
excess of the amount received for the shares of Common Stock over the exercise
price. Of that income, the portion equal to the excess of the fair market
value of the shares at the time the ISO was exercised over the exercise price
will be ordinary income and the balance, if any, will be long-term or short-
term capital gain depending on whether the holding period for the shares of
Common Stock exceeded one year and provided that the employee held such shares
as a capital asset at such time.
If, in a disqualifying disposition, the employee sells the shares of Common
Stock at a price that is below the fair market value of the shares of Common
Stock at the time the ISO was exercised, the amount of ordinary income will be
limited to the amount by which the amount realized on the sale exceeds the
exercise price.
An employee who exercises an ISO by delivering shares previously acquired
pursuant to the exercise of an ISO is treated as making a "disqualifying
disposition" of such shares if the employee delivers such shares before the
expiration of the applicable holding period with respect to such shares. Upon
the exercise of an ISO with previously acquired shares as to which no
disqualifying disposition occurs, the employee likely would not recognize gain
or loss with respect to such previously acquired shares.
A deduction will not be allowed to the Company for federal income tax
purposes with respect to the grant or exercise of an ISO or the disposition,
after the applicable holding period, of the shares of Common Stock acquired
upon exercise of an ISO. In the event of a disqualifying disposition, a
federal income tax deduction generally will be allowed to the Company in an
amount equal to the ordinary income to be recognized by the optionee, provided
that such amount constitutes an ordinary and necessary business expense to the
Company and is reasonable.
Non-Qualified Options. A NQSO is an option that does not qualify as an
"incentive stock option" under Section 422(b) of the Code. An individual who
receives a NQSO will not recognize any taxable income upon the grant of such
NQSO. Generally, upon exercise of a NQSO, an individual will be treated as
having received
25
<PAGE>
ordinary income in an amount equal to the excess of the fair market value of
the shares of Common Stock at the time of exercise over the exercise price.
In view of recent amendments to Section 16(b) of the Exchange Act and the
rules and regulations thereunder that are related thereto, any optionee who is
an officer of the Company or a beneficial owner of more than 10% of any class
of registered equity securities of the Company should consult with his or her
tax advisor as to whether the timing of income recognition is deferred for any
period following the exercise of a NQSO (i.e., the "Deferral Period"). If
there is a Deferral Period, absent a written election (pursuant to Section
83(b) of the Code) filed with the IRS within 30 days after the date of
transfer of the shares of Common Stock pursuant to the exercise of the option
to include in income, as of the transfer date, the excess (on such date) of
the fair market value of such shares of Common Stock over their exercise
price, recognition and measurement of income by the individual will be
deferred until the expiration of the Deferral Period.
The ordinary income recognized with respect to the transfer of shares of
Common Stock or receipt of cash upon exercise of a NQSO under the 1995 Stock
Option Plan will be subject to both wage withholding and employment taxes. The
Company may require that the withholding tax liabilities that arise upon the
exercise of a NQSO be satisfied with cash. Additionally, an individual may
elect to satisfy the withholding liability in whole or in part by directing
the Company to withhold shares of Common Stock from those that would otherwise
be issuable to the individual or by tendering other shares of Common Stock
owned by the individual. Individuals who, by virtue of their positions with
the Company, are subject to Section 16(b) of the Exchange Act may elect this
method of satisfying the withholding obligation only during certain restricted
periods.
An individual's tax basis in the shares of Common Stock received on exercise
of a NQSO will be equal to the amount of any cash paid on exercise, plus the
amount of ordinary income recognized by such individual as a result of the
receipt of such shares of Common Stock. The holding period for such shares
would begin just after the transfer of shares of Common Stock or, in the case
of an officer or beneficial owner of more than 10% of any class of registered
equity securities of the Company who does not elect to be taxed as of the
exercise date, just after the expiration of the Deferral Period, if any. A
deduction for federal income tax purposes generally will be allowed to the
Company in an amount equal to the ordinary income taxable to the individual,
provided that such amount constitutes an ordinary and necessary business
expense and is reasonable.
If an individual exercises a NQSO by delivering shares to the Company, other
than shares previously acquired pursuant to the exercise of an ISO which is
treated as a "disqualifying disposition" as described above, the individual
will not recognize gain or loss with respect to the exchange of such shares,
even if their then fair market value is different from the individual's tax
basis. The individual, however, will be taxed as described above with respect
to the exercise of the NQSO as if he or she had paid the exercise price in
cash, and the Company likewise generally will be entitled to an equivalent tax
deduction. So long as the individual receives a separate identifiable stock
certificate therefor, the tax basis and the holding period for that number of
shares of Common Stock received on such exercise that is equal to the number
of shares surrendered on such exercise will be equal to the tax basis and
include the holding period of those shares surrendered. The individual's tax
basis and holding period for the additional shares received on exercise of a
NQSO paid for, in whole or in part, with shares will be the same as if the
individual had exercised the NQSO solely for cash.
Change in Control. As described above, upon a "change in control" of the
Company, all the then outstanding options shall immediately become
exercisable. In general, if the total amount of payments to optionees that are
contingent upon a "change of control" of the Company (as defined in Section
280G of the Code), including payments upon the exercise of options under the
1995 Stock Option Plan that vest upon a "change in control," equals or exceeds
three times the recipient's "base amount" (generally, such recipient's average
annual compensation for the five years preceding the change in control), then,
subject to certain exceptions, the payments may be treated in part as
"parachute payments" under the Code, in which case a portion of such
"parachute payments" would be non-deductible to the Company and the recipient
would be subject to a 20% excise tax on such portion of the payments.
26
<PAGE>
Certain Limitations on Deductibility of Executive Compensation. With certain
exceptions, Section 162(m) of the Code limits the Company's deduction for
compensation paid to certain executive officers in excess of $1 million per
executive per taxable year (including any deduction with respect to the
exercise of a NQSO or the disqualifying disposition of stock purchased
pursuant to an ISO). Pursuant to Treasury Regulations issued under Section
162(m) of the Code, the deduction limitation of Section 162(m) of the Code
should not apply in the case of options granted, if any, to certain executive
officers under the 1995 Stock Option Plan to date, provided that the exercise
price of such options is not less than 100% of the fair market value of the
shares of Common Stock subject to the option on the date of grant and the
Compensation Committee consists solely of two or more "outside directors" for
purposes of Section 162(m) of the Code. However, in the absence of obtaining
stockholder approval of the 1995 Stock Option Plan, the deduction limitation
of Section 162(m) of the Code would generally apply to options granted under
the 1995 Stock Option Plan after the first regularly scheduled meeting of
stockholders of the Company that occurs after January 4, 1997. Upon the
ratification of the 1995 Stock Option Plan by the stockholders of the Company,
the deduction limitation of Section 162(m) generally should not apply to
options granted under the 1995 Stock Option Plan that have an exercise price
which is not less than 100% of the fair market value of the shares of Common
Stock subject to the option on the date of grant, as long as the Compensation
Committee consists solely of two or more "outside directors" for purposes of
Section 162(m) of the Code. THE BOARD OF DIRECTORS BELIEVES THAT THE TERMS OF
THE 1995 STOCK OPTION PLAN ARE FAIR AND IN THE BEST INTERESTS OF ALL
STOCKHOLDERS, AND RECOMMENDS A VOTE FOR THE APPROVAL OF THE 1995 STOCK OPTION
PLAN.
AMENDMENT TO THE 1995 STOCK OPTION PLAN
As stated, 350,000 shares of Common Stock are the maximum number of shares
authorized for issuance upon the exercise of stock options awarded under the
1995 Stock Option Plan. As of the date of this Proxy Statement, a total of
178,500 shares of Common Stock are subject to issuance upon the exercise of
options granted under the 1995 Stock Option Plan and 171,500 shares remain
available for future issuances.
The Board of Directors of the Company believes that the 1995 Stock Option
Plan is an important factor in retaining and attracting the highest caliber of
officers, employees and others who may provide services to the Company. The
Board further believes that the number of shares available for issuance under
the 1995 Stock Option Plan should be increased to ensure that sufficient
shares are available for the granting of options to achieve the purposes of
the plan. However, stockholders should bear in mind that stock options
inherently provide option holders with the ability, in the event that the
market price of the Common Stock is higher than or rises above the exercise
price of the options, to acquire shares of Common Stock at prices that are
dilutive to the equity interests and voting power of existing stockholders.
The Board has adopted by the unanimous vote of six directors present (with
one director absent), subject to stockholder approval, an amendment to the
1995 Stock Option Plan to increase the number of shares of Common Stock
available for issuance upon the exercise of options granted under such plan by
450,000 shares. If the amendment is approved by the stockholders, the maximum
number of authorized shares that could be issued in the future in connection
with options awarded under the 1995 Stock Option Plan is 800,000, representing
approximately 7.0% of the Common Stock outstanding as of the Record Date. THE
BOARD OF DIRECTORS BELIEVES THAT AMENDING THE 1995 STOCK OPTION PLAN TO
INCREASE THE NUMBER OF SHARES OF COMMON STOCK AVAILABLE FOR ISSUANCE UPON THE
EXERCISE OF OPTIONS GRANTED THEREUNDER IS FAIR AND IN THE BEST INTEREST OF ALL
STOCKHOLDERS, AND RECOMMENDS A VOTE FOR THE APPROVAL OF THE AMENDMENT TO THE
1995 STOCK OPTION PLAN.
RATIFICATION OF ANNUAL INCENTIVE PLAN
General. The Board of Directors of the Company approved and adopted the
Annual Incentive Plan on July 22, 1996. The Annual Incentive Plan provides
annual bonus opportunities with respect to the years 1997 through 2001, unless
the term of the plan is otherwise extended by the Board of Directors of the
Company. The brief summary of certain aspects of the Annual Incentive Plan set
forth herein does not purport to be complete and is
27
<PAGE>
qualified in its entirety by reference to the Annual Incentive Plan, a copy of
which is attached to this Proxy Statement as Appendix C and is incorporated
herein by reference. Stockholders of the Company are urged to read the Annual
Incentive Plan carefully in its entirety.
Purpose. The Board of Directors of the Company and the Compensation
Committee believe that cash incentives to certain executive officers and key
employees of the Company, its Commercial Insurance, Insurance Services and
Special Accounts divisions and any other division designated by the Board of
Directors (each a "Division" and collectively, the "Divisions") and the
Company's insurance subsidiaries designated by the Board of Directors (each an
"Insurance Subsidiary" and collectively, the "Insurance Subsidiaries"), upon
their attainment of specific performance goals will help to reinforce the
mutuality of interests among executive officers, key employees and
stockholders of the Company and improve the value of the Company. Approval of
the Annual Incentive Plan will enable the Company (i) to continue to provide
such short-term bonus incentive compensation to certain senior executive
officers of the Company, the Divisions and the Insurance Subsidiaries and (ii)
to qualify such compensation for the performance-based compensation exception,
under Section 162(m)(4) of the Code, to the limitation, under Section 162(m)
of the Code, on the Company's ability to deduct, for federal income tax
purposes, compensation in excess of $1 million paid to certain executive
officers, so long as the performance goals are not substantially certain of
being attained at the time they are established by the Compensation Committee
and such goals are established within the first ninety days of the year. If
the stockholders of the Company do not approve the Annual Incentive Plan, the
Company's Board of Directors will continue to have discretion to award cash
incentive compensation to executive officers of the Company, the Divisions and
the Insurance Subsidiaries, but such awards will be subject to the Section
162(m) limitation on deductibility.
Eligibility. The Annual Incentive Plan authorizes the Compensation Committee
of the Board of Directors of the Company or any subcommittee thereof comprised
of two or more directors, each of whom is an "outside director" within the
meaning of Section 162(m) of the Code, (the "Compensation Committee") to award
annual incentive compensation to executive officers and key employees of the
Company, the Divisions and the Insurance Subsidiaries (each, an "Eligible
Participant"). The number of Eligible Participants in the Annual Incentive
Plan will vary from year to year at the discretion of the Compensation
Committee.
Notice and Rating. An Eligible Participant will be advised of his or her
maximum bonus, which shall be expressed as a percentage of his or her salary
as of January 1 of the applicable year. The Eligible Participant will also be
provided with a schedule that shows the percentage of the maximum bonus that
may be earned in a year based upon the extent to which the applicable Combined
Ratio (as defined below) target is achieved. The maximum cash bonus award that
may be made to any Eligible Participant under the Annual Incentive Plan for a
year is generally equal to the lesser of a specified percentage of such
participant's annual base salary in effect as of January 1 of each applicable
year or $925,000, provided that such percentage must be specified by the
Compensation Committee in writing within the first 90 days of the applicable
year. In order to be eligible to receive an annual bonus, the otherwise
Eligible Participant must receive a performance evaluation for that year with
a rating of 2.0 ("effective") or higher. If the Eligible Participant does not
receive a performance rating at this level or higher in a given year, he or
she will not qualify for or receive a bonus in that year or any portion
thereof.
Performance Criteria. The bonuses of those Eligible Participants who are not
Division employees or who are not employed by a single Insurance Subsidiary,
or whose principal activities are not tied to a Division or Insurance
Subsidiary, will be based on a target Combined Ratio for the Company. The
bonuses of an Eligible Participant of a single Division or Insurance
Subsidiary will be based on a target Combined Ratio for the respective
Division or Insurance Subsidiary, in each case determined as follows.
On or before the ninetieth day of each year (or such other date as may be
required or permitted under Section 162(m) of the Code), the Compensation
Committee will annually establish targets with respect to the combined ratio
for the Company, each Division and, as appropriate, each Insurance Subsidiary,
as determined
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<PAGE>
by the Board of Directors of the Company for each accident year (the "Combined
Ratio"), for years beginning on or after January 1, 1997, that must be
attained in order for the Company to pay the maximum bonuses under the Annual
Incentive Plan. As used herein with respect to the Annual Incentive Plan,
Combined Ratio means, for any accident year, the combined ratio (accident year
loss ratio plus calendar year expense ratio for such year) of such entity or
Division, as determined by the Company for such accident year based on the
books and records of the Company, its Divisions and its Insurance
Subsidiaries, as applicable, and as reflected on the basis of the generally
accepted accounting principles and as approved by the Company's Board of
Directors.
Payment of Annual Awards. If the Company, a Division or an Insurance
Subsidiary attains its Combined Ratio target set by the Compensation Committee
for the applicable year, the Compensation Committee may make cash bonus awards
to the applicable Eligible Participants. The Compensation Committee has full
discretion to award less than the maximum amount to any Eligible Participant
(including the discretion to decline to make any award to an Eligible
Participant notwithstanding that the Company, Division or Insurance Subsidiary
on which such Eligible Participant's bonus is based attained its Combined
Ratio target). In deciding whether to award less than the maximum amount, the
Compensation Committee may consider any individual performance or such other
criteria as the Compensation Committee shall deem relevant.
If the Company, a Division or an Insurance Subsidiary does not achieve its
Combined Ratio target with respect to the applicable year, the Compensation
Committee may award less than the maximum permitted bonus amount for such year
on the extent to which the actual Combined Ratio exceeds the applicable
Combined Ratio target. Such bonus amounts, if any, shall be determined
pursuant to a schedule or schedules established in writing by the Compensation
Committee on or before the ninetieth day of the applicable year (or by such
other date as may be required or permitted under Section 162(m) of the Code).
All bonuses earned under the Annual Incentive Plan shall be payable in four
equal annual installments, subject to adjustment as described below,
commencing no later than 90 days after the end of the applicable year. Within
three months of the end of each applicable year, the appropriate actuarial
department(s) of the Company's subsidiary(ies) selected by the Compensation
Committee, will report to the Compensation Committee the Combined Ratio for
the Company, each Division and each Insurance Subsidiary, and, upon
determination of the Combined Ratio by the Compensation Committee, the first
installment of the bonuses for that year will be paid. The aggregate bonus
amount due with respect to a given year shall be adjusted annually during a
four year period based on an annual recalculation of the Combined Ratio for
each year, and the annual installments for a given year will be adjusted
accordingly. Therefore, if the actual Combined Ratio for a given year, as
determined initially, does not achieve the target level, but after the annual
recalculation the Combined Ratio for such year achieves the target level, the
aggregate bonus amounts payable in subsequent years with respect to such year
will generally be greater and the annual installments will be increased
accordingly, subject to the maximum permitted bonus amount set forth above.
If, however, there is an adverse development for a given year's actual
Combined Ratio, it is possible that no additional bonus installment payments
may become due in subsequent years. In addition, an adverse development for a
given year may create a situation in which there is a payment that should not
have been made in a prior year. In such event, an Eligible Participant will
have a deficit that will be offset against subsequent years' bonuses payable
under the Annual Incentive Plan, if any. No such deficit would be collected
from any Eligible Participant.
In order to receive an annual installment, an Eligible Participant must be
an employee of the Company or one or more of its subsidiaries, or retired from
such employment, at the time of each such payment.
Administration. The Compensation Committee, which shall at all times be
comprised of at least two directors, each of whom is an "outside director" for
purposes of Section 162(m) of the Code, shall administer and interpret the
Annual Incentive Plan. In all events, the Annual Incentive Plan shall be
interpreted in a manner which is consistent with the requirements to qualify
the payments made thereunder as performance-based compensation under Section
162(m) of the Code. Subject to the express provisions of the Annual Incentive
Plan, the Compensation Committee shall have the authority to select the
executive officers and key employees eligible
29
<PAGE>
to participate in the Annual Incentive Plan, to establish the Combined Ratio
targets for each year, to establish the amounts payable, if any, if the
applicable Combined Ratio does not achieve the target level, and to reduce the
amount that may be paid to any participant from the maximum amount otherwise
payable pursuant to the Annual Incentive Plan. Prior to making any payment to
any executive officer pursuant to the Annual Incentive Plan, the Compensation
Committee shall be required to certify that such executive officer has
attained the applicable performance objectives.
Amendment and Termination. The Board of Directors of the Company or the
Compensation Committee may at any time amend, terminate or suspend the Annual
Incentive Plan, except that no such action shall, without the consent of an
Eligible Participant, adversely effect the rights of any Eligible Participant
with respect to any award with respect to any calendar year which already
commenced, and no such action shall be effective without approval by the
stockholders of the Company to the extent that such approval is required to
continue to qualify the payments under the Annual Incentive Plan for treatment
as performance-based compensation under Section 162(m) of the Code. The Annual
Incentive Plan shall be effective for calendar years beginning on or after
January 1, 1997 and shall terminate on or before December 31, 2001, unless the
term thereof is otherwise extended by action of the Board of Directors of the
Company.
The Board has adopted the Annual Incentive Plan by the unanimous vote of
five directors present (with two directors absent). THE BOARD BELIEVES THAT
THE TERMS OF THE ANNUAL INCENTIVE PLAN ARE IN THE BEST INTERESTS OF THE
COMPANY AND ITS STOCKHOLDERS AND RECOMMENDS A VOTE FOR THE APPROVAL OF THE
ANNUAL INCENTIVE PLAN.
RATIFICATION OF APPOINTMENT OF INDEPENDENT PUBLIC ACCOUNTANTS
The Board of Directors of the Company has appointed KPMG Peat Marwick LLP as
independent certified public accountants for the Company and it subsidiaries
for fiscal year 1997. It is intended that such appointment be submitted to the
stockholders for ratification at the Meeting. Although the submission of this
matter to the stockholders is not required, the Board of Directors will
reconsider its selection of independent certified public accountants if this
appointment is not ratified by the stockholders. Ratification will require the
affirmative vote of the majority of shares of Common Stock represented at the
meeting, in person or by proxy. THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR
THE APPROVAL OF KPMG PEAT MARWICK LLP AS INDEPENDENT CERTIFIED PUBLIC
ACCOUNTANTS FOR THE COMPANY AND ITS SUBSIDIARIES FOR FISCAL YEAR 1997.
It is expected that representatives of KPMG Peat Marwick LLP will be present
at the Meeting with an opportunity to make a statement should they desire to
do so and to respond to appropriate questions from stockholders.
OTHER MATTERS
While management has no reason to believe that any other business will be
presented at the Meeting, if any other matters should properly come before the
Meeting, the proxies will be voted as to such matters in accordance with the
best judgment of the proxy holders. The approval of such other matters will
require the affirmative vote of the majority of the shares of Common Stock
represented at the Meeting, in person or by proxy.
30
<PAGE>
STOCKHOLDERS' PROPOSALS
Pursuant to the Exchange Act and the regulations promulgated thereunder,
individual stockholders of the Company have a limited right to propose for
inclusion in the Company's proxy statement a single proposal for action to be
taken at the Annual Meeting of the Stockholders of the Company. Any proposals
of stockholders intended to be presented at the Annual Meeting to be held in
1998 must be received at the Company's principal executive offices no later
than November 21, 1997. Such proposals may be addressed to the Secretary of
the Company at 10370 Richmond Avenue, Houston, Texas 77042.
31
<PAGE>
----------------
HIGHLANDS INSURANCE GROUP, INC.
1996 ANNUAL REPORT
----------------
<PAGE>
THE COMPANY
Highlands Insurance Group, Inc. (the "Company") is a regional insurance
holding company that, through Highlands Insurance Company ("Highlands") and
its other insurance subsidiaries (collectively, the "Insurance Subsidiaries",
and other than Highlands Insurance Company (U.K.) Limited ("Highlands (UK)"),
the "U.S. Insurance Subsidiaries,"), is primarily engaged in the commercial
property and casualty insurance business. Until January 23, 1996, the Company
was a wholly-owned subsidiary of Halliburton Company ("Halliburton"). On such
date, the shares of the Company's common stock (the "Company Common Stock")
were distributed to holders of record of common stock of Halliburton on
January 4, 1996 in the form of a dividend (the "Distribution"). Pursuant to
the Distribution, one share of Company Common Stock was distributed for each
ten shares of Halliburton common stock owned by the Halliburton stockholders.
Upon consummation of the Distribution, the Company sold an aggregate of $60
million in principal amount of the Company's 10% Convertible Subordinated
Debentures, together with detachable Common Stock Subscription Warrants,
Series A and Series B (respectively, the "Series A Warrants" and the "Series B
Warrants" and collectively, the "Warrants"), due December 31, 2005 (the
"Debentures") to Insurance Partners, L.P. and Insurance Partners Offshore
(Bermuda), L.P. (collectively, the "Investors") and to certain members of the
Company's management team pursuant to the terms of an Investment Agreement
dated October 10, 1995, as amended (the "Investment Agreement").
The Company's principal product lines are workers' compensation insurance
(representing 38% of gross premiums written in 1996), general liability
insurance (representing 20% of gross premiums written in 1996), commercial
automobile liability insurance (representing 15% of gross premiums written in
1996) and ocean and inland marine insurance (representing 11% of gross
premiums written in 1996) and certain others, principally bonds, commercial
property insurance and assumed reinsurance, which represented in the aggregate
16% of gross premiums written in 1996. The principal customers of the Company
are Halliburton and its affiliates ("Insurance Services"), relatively large
third party and smaller complex commercial accounts ("Special Accounts") and
medium to small third party commercial accounts ("Commercial Insurance") and
commercial marine products ("Marine").
Highlands was incorporated in 1957 as a Texas domiciled insurer to write
workers' compensation insurance for Brown & Root, Inc., an engineering and
construction company that Halliburton acquired in 1962. In 1964, Highlands
expanded its operations to offer insurance coverage to third parties. Since
then, the proportion of the Company's business derived from unaffiliated
parties has dramatically increased, but Halliburton and its affiliates
continue to be the Company's largest customer, representing 19% of the
Company's gross premiums written in 1996. In connection with the Distribution,
the Company and Halliburton negotiated a four year Insurance Products and
Services Agreement covering the retention and pricing of coverages written for
Insurance Services.
Special Accounts include a group of relatively large commercial customers
(standard premium over $1 million) engaged in heavy industries, including oil
and gas exploration and production, construction, engineering, and certain
other smaller but complex commercial accounts. Special Accounts represented
21% of the Company's gross premiums written in 1996. Because of the Company's
relationship with Halliburton, its Special Accounts division has developed
particular expertise in underwriting, pricing and providing the specialized
service and products required by complex commercial accounts. The policies
written for these customers often have high deductibles or are retrospectively
rated, which results in significant risk retention by the insured. However, on
less complex risks, a guaranteed cost program is available.
To take advantage of its knowledge of large, heavy industry risks, the
Company devotes significant resources to writing Commercial Insurance that
have risks similar to those of Insurance Services and Special Accounts.
Commercial Insurance business is sold through independent insurance agents.
Because the coverage and servicing needs of small and medium-sized commercial
accounts are somewhat different from those of large commercial customers, in
1996 the Company established a separate business unit for small and medium-
sized customers with its own underwriting, claims, actuarial and marketing
personnel. Commercial Insurance represented 39% of the Company's gross
premiums written in 1996.
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Marine coverage insures business against losses related to waterborne
vessels and their cargo. The Company offers ocean marine coverage which can be
divided into four categories: (i) ocean marine hull which provides physical
damage coverage for the ship itself, (ii) ocean marine cargo for coverage of
goods while in transit, (iii) ocean marine freight which protects the insured
against loss of shipping costs and (iv) ocean marine protection and indemnity,
which provides marine liability insurance. Ocean marine is underwritten mainly
on the West Coast of the United States, including Hawaii and Alaska, and along
the Gulf of Mexico.
The remainder of 1996 gross premiums written was derived from bonds and
assumed reinsurance.
The Company is licensed to write property and casualty insurance in all 50
states, but currently focuses on companies headquartered in Texas and
Louisiana. For the year ended December 31, 1996, approximately 60% and 10% of
the Company's gross premiums written related to Texas and Louisiana,
respectively.
The Company has discontinued or curtailed three of its previous product
lines (the "Discontinued Lines"): (i) business originated by the Company's
London operations, (ii) an umbrella/excess liability policy program and (iii)
assumed casualty and property reinsurance contracts. The Company has ceased to
write the Discontinued Lines.
The U.S. Insurance Subsidiaries share Highlands' "A-"(Excellent) rating
assigned by A.M. Best.
A-2
<PAGE>
SELECTED FINANCIAL DATA
The following table summarizes certain selected historical consolidated
financial data with respect to the Company and is based upon the historical
consolidated financial statements of the Company. The information set forth
below should be read in conjunction with "Management's Discussion and Analysis
of Financial Condition and Results of Operations," and the Consolidated
Financial Statements and related notes thereto included elsewhere herein.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------------------
1996 1995 1994 1993 1992
--------- --------- --------- --------- ---------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENTS OF OPERATIONS
DATA:
Revenues:
Net premiums earned... $ 152,048 201,446 241,676 275,300 237,387
Net investment income. 50,988 48,529 46,720 46,485 53,402
Net realized
investment gains..... 1,199 2,618 1,910 2,702 7,384
--------- --------- --------- --------- ---------
Total revenues...... 204,235 252,593 290,306 324,487 298,173
Expenses:
Losses and loss
adjustment expenses
incurred............. 156,589 300,253 224,315 310,029 231,062
Underwriting expenses. 56,487 73,905 65,022 56,649 72,867
Interest expense and
debt amortization.... 6,903 -- -- -- --
Other expenses
(income), net........ 1,697 (823) (1,314) (795) 5,086
--------- --------- --------- --------- ---------
Total expenses...... 221,676 373,335 288,023 365,883 309,015
Income (loss) before
income tax benefits and
cumulative effect of
change in accounting
principle(1)........... (17,441) (120,742) 2,283 (41,396) (10,842)
Income tax benefit(2)... 12,098 -- -- -- --
Cumulative effect of
change in accounting
principle(3)........... -- -- -- -- (439)
--------- --------- --------- --------- ---------
Net income (loss)(1)(2). $ (5,343) (120,742) 2,283 (41,396) (11,281)
========= ========= ========= ========= =========
Earnings (loss) per
share(4)............... $ (.47) (10.55) .20 (3.62) (.99)
========= ========= ========= ========= =========
BALANCE SHEET DATA (AT
END OF PERIOD):
Investments, cash and
cash equivalents....... $ 760,618 720,746 683,020 673,913 688,529
Receivable from
reinsurers(5).......... 556,900 602,380 561,474 622,473 839,718
Total assets.......... 1,566,031 1,636,091 1,539,418 1,625,815 1,832,352
Loss and loss adjustment
expense reserves(5).... 1,156,824 1,253,627 1,149,173 1,225,242 1,393,352
Stockholders' equity.... 263,475 267,110 295,808 288,800 299,708
CERTAIN FINANCIAL RATIOS
AND OTHER DATA:
GAAP:
Loss ratio............ 103.0% 149.0% 92.8% 112.6% 97.3%
Expense ratio......... 37.1 36.7 26.9 20.6 30.7
--------- --------- --------- --------- ---------
Combined ratio....... 140.1% 185.7% 119.7% 133.2% 128.0%
========= ========= ========= ========= =========
Statutory(6):
Loss ratio............ 102.2% 136.9% 90.2% 98.9% 91.4%
Expense ratio......... 31.7 29.0 27.3 19.3 24.0
--------- --------- --------- --------- ---------
Combined ratio....... 133.9% 165.9% 117.5% 118.2% 115.4%
========= ========= ========= ========= =========
Statutory surplus....... $ 188,527 180,020 257,953 248,673 257,090
Net premiums written to
policyholder surplus... 0.8x 1.1x 0.9x 0.9x 0.8x
</TABLE>
- --------
(1) The Company recorded a charge to pre-tax earnings during the year ended
December 31, 1995 of $125 million as more fully discussed under
"Management's Discussion and Analysis of Financial Condition and Results
of Operation--Results of Operations."
(2) The Company provides for income taxes in its statements of operations
pursuant to Financial Accounting Standards Board Statement of Financial
Accounting Standards No. ("SFAS") 109, "Accounting for Income Taxes,".
With respect to losses for periods preceding the Distribution, no tax
benefits were recorded in the statements of operations pursuant to SFAS
109 and the Company's tax-sharing agreement with its
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<PAGE>
former parent, Halliburton. Tax receipts under its intercompany tax-sharing
arrangements with Halliburton were recorded as additions to stockholders'
equity for the periods preceding the Distribution. For further information
regarding federal and foreign taxes, see Note (5) of the Notes to
Consolidated Financial Statements.
(3) In 1992, the Company adopted SFAS 106, "Employers' Accounting for
Postretirement Benefits Other Than Pensions," which requires accrual,
during the years that the employee renders the services, of the expected
cost of providing postretirement benefits. As of January 1, 1992, the
Company recognized a transition obligation of $439,000 which was recorded
as a cumulative effect of change in accounting principle. Prior to
adoption of SFAS 106, the Company expensed its contributions as paid.
(4) Earnings (loss) per share has been computed based upon the 11,448,208
shares of Company Common Stock distributed on January 23, 1996.
(5) In 1992, the Company adopted SFAS 113, "Accounting and Reporting for
Reinsurance of Short-Duration and Long-Duration Contracts," which requires
presenting loss and loss adjustment expense reserves before reinsurance
recoverables and reinsurance recoverables as receivables from reinsurers.
(6) Relates only to U.S. Insurance Subsidiaries.
A-4
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Industry
The property and casualty insurance industry's profitability may be affected
significantly by the availability of insurance coverage, which varies
according to levels of surplus in the industry, volatile and unpredictable
developments, including natural and man-made disasters (such as hurricanes,
windstorms, earthquakes, blizzards, fires and explosions), fluctuations in
interest rates and other changes in the investment environment that affect
market prices of insurance companies' investments and the income from those
investments, inflationary pressures that may tend to affect the size of losses
and judicial, legislative and regulatory decisions affecting insurers'
liabilities. The demand for property and casualty insurance can also vary
significantly, generally rising as the overall level of economic activity
increases and falling as such activity decreases. Price competition has also
been enhanced by a flight of commercial insureds to alternative risk
mechanisms, often including a degree of self-insurance.
The industry has experienced the effects of a number of well publicized
catastrophic events in recent years, some of which have affected the Company
(primarily through its curtailed assumed reinsurance operations). Growth in
liabilities related to asbestos and environmental risks has also adversely
affected the industry and are of significance to the Company. See "--Results
of Operations--1995 Third Quarter Charge--Environmental Reserves (Including
Asbestos)" below.
Property and casualty insurers are regulated by the various state insurance
departments that coordinate their efforts through the National Association of
Insurance Commissioners ("NAIC"). Regulation includes rate and policy form
approval, licensing of insurance agents and companies and solvency oversight.
As a result of recent legislative changes in the Texas insurance market,
beginning with Senate Bill 1 aimed at workers' compensation reform, which
became effective January 1, 1991, the Texas insurance climate has become more
attractive to insurers.
Discontinued Lines
For reporting purposes, the Company has three lines of business which are
considered Discontinued Lines: (i) business originated by the Company's London
reinsurance operations (Highlands (UK)), (ii) an umbrella/excess liability
policy program and (iii) assumed casualty and property reinsurance contracts.
The Company has ceased to write these Discontinued Lines. Although the Company
has discontinued other lines of business, primarily its Florida and Texas
personal lines and probate bonding business, the Company has included the
financial results of those lines in underwriting results excluding
Discontinued Lines for consistency purposes.
The Discontinued Lines percentage of gross premiums written to the Company
totals for the years ended December 31, 1996, 1995 and 1994 were 4.5%, 8.1%
and 15.4%, respectively, while the percentage of underwriting losses to the
Company totals for the same time periods were 22.6%, 55.1% and 84.9%,
respectively.
London-Originated Business. The Company participated in the London insurance
markets from 1972 until 1982 through a branch office in London (the "Highlands
London Branch"). The primary business of the Highlands London Branch was the
direct writing and reinsurance of general liability risks for insureds in the
United States and London market marine and aviation risks. The Highlands
London Branch ceased doing business in the United Kingdom when Highlands (UK)
was formed in 1982 in order to withdraw from direct writing of marine and
aviation risks and significantly reduce the direct writing and reinsurance of
U.S. general liability risks in the London market. Highlands (UK) served as an
insurer and reinsurer in London markets primarily by participating in excess
of loss reinsurance liability policies, which included coverage for
catastrophe losses of customers in excess of policy limits of other applicable
policies. Highlands (UK) ceased writing new policies in early 1993.
Accordingly, the Company's continuing exposure on the business of the
Highlands London Branch is generally attributable to adverse loss reserve
development on asbestos and environmental
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claims, whereas the ongoing exposure of Highlands (UK) is primarily related to
adverse loss reserve development on the high levels and severity of
catastrophe claims (such as the Piper Alpha explosion, the Exxon Valdez oil
spill and Hurricane Hugo) that have occurred since 1988 and have been slow to
emerge in the London market.
Umbrella/Excess Liability Program. Beginning in the early 1970s, Highlands
wrote policies that provided the customer with umbrella and excess liability
coverage with respect to losses which exceeded another insurer's primary and
excess policy coverages. The threshold at which coverage commenced under such
policies underwritten by the Company varied from $300,000 to $100 million and
above. The limits of coverage under the Company's excess liability policies
were generally up to $10 million (in excess of underlying policies) and the
Company generally limited its exposure through substantial reinsurance. The
program was canceled and underwriting operations ceased effective December 31,
1985. The Company's adverse loss experience on these policies has primarily
emanated from asbestos and environmental pollution claims.
Assumed Casualty and Property Reinsurance. Highlands participated in
approximately 200 assumed casualty reinsurance agreements per year (primarily
written from 1969 through 1974) as an excess of loss reinsurer with
participation percentages that varied from contract to contract. A majority of
assumed casualty treaties were nonrenewed by the end of 1976. All remaining
casualty contracts were canceled by December 31, 1996. The Company
participated at levels of $50,000 to $250,000 per contract on hundreds of
assumed property reinsurance contracts per year from 1969 through 1994. Loss
development on the assumed casualty treaties has primarily emanated from
product liability, asbestos and environmental pollution liability,
particularly for accident years 1971 through 1974. Development on the assumed
property reinsurance agreements has primarily related to catastrophe
exposures. For 1992 and prior periods, Highlands was a direct writer of
Florida commercial and personal homeowners lines and acted as a fronting
company for the Southern Underwriters Inc. Quota Share Facility (the "Southern
Underwriters Facility"), which reinsured substantially all of this risk. Due
to Highlands' participation (approximately 6.5%) as a reinsurer of the
Southern Underwriters Facility, this business was managed as and included with
the assumed property reinsurance business. Subsequent to the termination of
the Southern Underwriters Facility in 1993, the Company's Florida direct
business has been (and will continue to be) managed as and included with the
assumed property reinsurance business. In 1996, as permitted by the laws of
the State of Florida, the Company ceased writing the Florida personal
homeowners line of business.
A-6
<PAGE>
RESULTS OF OPERATIONS
The results of the Company's consolidated operations for the periods
indicated are set forth below:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER
31,
---------------------
1996 1995 1994
------ ------ -----
(DOLLARS IN
MILLIONS)
<S> <C> <C> <C>
Consolidated Results:
Gross premiums written.......................... $158.5 234.3 292.8
Net premiums written............................ $135.1 201.6 243.2
====== ====== =====
Net premiums earned:
Excluding Discontinued Lines.................... $144.9 187.2 208.6
Discontinued Lines.............................. 7.1 14.3 33.1
------ ------ -----
$152.0 201.5 241.7
====== ====== =====
Underwriting loss:
Excluding Discontinued Lines.................... $(47.0) (77.5) (7.2)
Discontinued Lines.............................. (14.0) (95.2) (40.4)
------ ------ -----
$(61.0) (172.7) (47.6)
====== ====== =====
Net investment income............................. $ 51.0 48.5 46.7
====== ====== =====
Net realized investment gains..................... $ 1.2 2.6 1.9
====== ====== =====
Interest expense and debt amortization............ $ 6.9 -- --
====== ====== =====
Other expense (income), net....................... $ 1.7 (.8) (1.3)
====== ====== =====
Net income (loss)................................. $ (5.3) (120.7) 2.3
====== ====== =====
Ratios:
Loss............................................ 103.0% 149.0% 92.8%
Expense......................................... 37.1 36.7 26.9
------ ------ -----
Combined...................................... 140.1% 185.7% 119.7%
====== ====== =====
</TABLE>
A $125 million pre-tax charge is reflected in the Company's results of
operations for the year ended December 31, 1995. See "--1995 Third Quarter
Charge." The Company's consolidated results have been significantly influenced
by the underwriting results of the Discontinued Lines. In order to indicate
the magnitude of those influences, underwriting results exclusive of the
Discontinued Lines and with respect to the Discontinued Lines are presented
and discussed separately below. Also see "--Discontinued Lines".
Net investment income for the years ended December 31, 1996, 1995 and 1994
amounted to $51.0 million, $48.5 million and $46.7 million, respectively. Net
investment income for 1996 increased from 1995 primarily as a result of the
additional investable funds from the issuance of the Debentures and tax
proceeds from the Company's former parent. The income is partially offset by
lower investment rates in 1996. The increase between 1994 and 1995 reflects an
increase in average invested assets and a higher investment yield during 1995
as a result of moving to taxable investments. Net realized investment gains
have not been a significant portion of revenue for the Company and amount to
$1.2 million, $2.6 million and $1.9 million for the years ended December 31,
1996, 1995 and 1994, respectively.
Interest expense and debt amortization for the year ended December 31, 1996
compared with the same period for 1995 increased as a result of net interest
expense ($5.6 million), amortization of debt discount ($.8 million) and debt
acquisition costs ($.5 million) related to the Debentures.
Other expenses for the year ended December 31, 1996 compared with the same
period for 1995 increased due to additional expenses associated with being a
public company.
A-7
<PAGE>
The Company provides for income taxes on its statements of operations
pursuant to Statement of Financial Accounting Standards No. 109, "Accounting
for Income Taxes" (SFAS 109). Total tax benefit for the year ended December
31, 1996 amounted to $12.1 million. With respect to losses for periods
preceding the Distribution (January 23, 1996), no tax benefit was recorded in
the statements of operations pursuant to SFAS 109 and the Company's tax-
sharing arrangement with its former parent, Halliburton. Tax receipts under
its intercompany tax-sharing arrangements with Halliburton were recorded as
additions to stockholders' equity for the periods preceding the Distribution.
Gross premiums written and net premiums written have been redefined for all
periods presented to include the effects of changes in premiums due under
retrospective policies. Such changes were previously recorded only as net
premiums earned.
UNDERWRITING LOSS EXCLUDING DISCONTINUED LINES
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
----------------------
1996 1995 1994
------ ------ ------
(DOLLARS IN
MILLIONS)
<S> <C> <C> <C>
Gross premiums written................................. $151.4 215.2 247.6
Net premiums written................................... $130.7 189.4 211.9
====== ====== ======
Net premiums earned.................................... $144.9 187.2 208.6
Losses and loss adjustment expenses incurred........... (139.5) (196.9) (168.6)
Underwriting expenses.................................. (52.4) (67.8) (47.2)
------ ------ ------
Underwriting loss.................................. $(47.0) (77.5) (7.2)
====== ====== ======
Ratios:
Loss................................................. 96.3% 105.2% 80.8%
Expense.............................................. 36.2 34.9 22.7
------ ------ ------
Combined........................................... 132.5% 140.1% 103.5%
====== ====== ======
</TABLE>
The underwriting results excluding Discontinued Lines primarily consist of
relatively large commercial accounts (Special Accounts), medium to small
commercial accounts (Commercial Insurance), insurance for Halliburton
(Insurance Services), commercial marine products (Marine Division) and surety
products (Surety Division).
Period to Period Comparisons of Underwriting Results Excluding Discontinued
Lines
Gross Premiums Written. Gross premiums written for the years ended December
31, 1996, 1995 and 1994 amounted to $151.4 million, $215.2 million and $247.6
million, respectively. The decrease of $63.8 million or 29.6% in 1996 is
attributable to several factors. The Company began its underwriting
initiatives in March 1996 and continues to focus on stricter underwriting
standards and price increases both of which have contributed to declines in
gross premiums written. Also contributing to declines in gross premiums
written is the highly competitive market conditions for Special Accounts
customers. In this highly competitive market, Special Accounts has become more
selective in its initial underwriting as well as renewal activity. Finally,
Insurance Services' mix of business continues to change from retrospectively
rated policies to high deductible policies which produce lower gross premiums.
Gross written premiums written for 1996 were negatively impacted by a
reduction of $6.9 million of accrued premium adjustments and $3.1 million of
improperly classified accrued premiums on retrospectively rated policies.
Gross premiums written for 1996 were also impacted by the decision to exit
the probate bonding business. On March 1, 1996, the Company reinsured 100% of
its inforce policies, subject to a profit sharing arrangement. The year ended
December 31, 1996 includes $6.2 million of probate bonding gross premiums
written compared
A-8
<PAGE>
to $7.1 million for the comparable 1995 period. The decrease in probate
bonding gross premiums written is expected to continue in 1997.
Gross premiums written for retrospectively rated policies may be adjusted up
or down, subject to certain limitations contained in the policy, based on the
estimated loss experience of the insured during the policy period. The Company
estimates ultimate losses for retrospectively rated policies and then adjusts
gross premiums written and premiums due from policyholders under
retrospectively rated policies for changes in the estimated ultimate loss and
loss adjustment expense from the date of the prior valuation. These
adjustments may cause gross premiums written to fluctuate significantly from
period to period. Gross premiums written for the year ended December 31, 1996
compared to the like period in 1995 were also impacted by a $4.9 million
decrease in written premium on Insurance Services retrospectively rated
policies. Experience rated contracts reduce but do not eliminate risk to the
insurer.
Net Premiums Written. Net premiums written for the years ended December 31,
1996, 1995 and 1994 amounted to $130.7 million, $189.4 million and $211.9
million, respectively. The decrease of $58.7 million or 31% in 1996 is
primarily related to the same issues affecting gross premiums written.
However, net premiums written in 1996 were increased by an adjustment to ceded
premiums written of $1.4 million related to prior years reinsurance treaties.
The 1995 decrease from 1994 in net premiums written amounted to $22.5 million
and was due to the cessation of California-sourced business in April 1994 and
the loss of two Special Accounts customers.
The decision to exit the probate bonding business also significantly
impacted net premiums written due to the ceding of 100% of the business. The
year ended December 31, 1996 includes $1.0 million of probate bond net
premiums written compared to $6.7 million for the comparable 1995 period.
Net Premiums Earned. Net premiums earned for the years ended December 31,
1996, 1995 and 1994 amounted to $144.9 million, $187.2 million and $208.6
million, respectively. The decrease of $42.3 million or 23% in 1996 is related
to the same issues affecting gross and net premiums written. The decline of
$21.4 million or 10% in 1995 reflects the cessation of California-sourced
business and the loss of two Special Accounts customers.
Losses and Loss Adjustment Expenses Incurred. Losses and loss adjustment
expenses incurred for the years ended December 31, 1996, 1995 and 1994
amounted to $139.5 million, $196.9 million and $168.6 million, respectively.
The decrease in 1996 of $57.4 million or 29% less than 1995 and the 1995
increase of $28.3 million over 1994 can be primarily attributed to net reserve
re-estimates in 1996, 1995 and 1994 of $10 million, $46.7 million and $21.4
million, respectively. See "--Loss and Loss Adjustment Expense Reserves".
Additionally, the year ended December 31, 1996 reflects the lower incurred
losses subject to retrospectively rated policies and the impact of declining
premium volume.
Underwriting Expenses. Underwriting expenses for the years ended December
31, 1996, 1995 and 1994 amounted to $52.4 million, $67.8 million and $47.2
million, respectively. The 1996 decrease of $15.4 million is related to
declining premium volume and lower reserve increases for litigation and
administrative proceedings against the Company. The year ended December 31,
1996 includes $2 million of legal reserve increases as compared to $10.5
million recorded in the same period for 1995.
The year ended December 31, 1996 underwriting expenses included two other
unusual items of significance amounting to $2.4 million. The Company
implemented a plan under which it recorded a $1.3 million restructuring charge
as part of its strategic and financial assessment of the Company's business.
Additionally, a charge of $1.1 million was recorded for underaccrued premium
taxes.
A-9
<PAGE>
The 1995 increase in underwriting expenses from 1994 amounted to $20.6
million and was due largely to $10.5 million of legal reserve increases, of
which $8.0 million was included in the 1995 Third Quarter Charge. See "--1995
Third Quarter Charge". Additionally, 1994 underwriting expenses were reduced
by the receipt of an $8.4 million refund from the Texas Workers' Compensation
Insurance Facility.
UNDERWRITING LOSS OF DISCONTINUED LINES
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
---------------------
1996 1995 1994
------ ------ -----
(DOLLARS IN
MILLIONS)
<S> <C> <C> <C>
Gross premiums written............................ $ 7.1 19.1 45.2
Net premiums written.............................. $ 4.4 12.2 31.3
====== ====== =====
Net premiums earned............................... $ 7.1 14.3 33.1
Losses and loss adjustment expenses incurred...... (17.1) (103.3) (55.7)
Underwriting expenses............................. (4.0) (6.2) (17.8)
------ ------ -----
Underwriting loss............................. $(14.0) (95.2) (40.4)
====== ====== =====
</TABLE>
For reporting purposes, the Company has three lines of business which are
considered Discontinued Lines, specifically business originated by the
Company's London reinsurance operations (Highlands (UK)), an umbrella/excess
liability policy program and assumed casualty and property reinsurance
contracts. The Company has ceased to write these Discontinued Lines and
cancelled all remaining assumed casualty and property reinsurance contracts
during 1996.
Period to Period Comparisons of Underwriting Results of Discontinued Lines
Net Premiums Earned. Net premiums earned were $7.1 million, $14.3 million
and $33.1 million in 1996, 1995 and 1994, respectively. The decline is due to
the runoff of canceled assumed reinsurance and the declining premiums from
Highlands (UK), which ceased writing new business in 1993. However, due to the
nature of the Company's policies and reinsurance contracts, small premium
adjustments can continue subsequent to cancellation.
Losses and Loss Adjustment Expenses Incurred. Losses and loss adjustment
expenses amounted to $17.1 million, $103.3 million and $55.7 million for the
years ended December 31, 1996, 1995 and 1994, respectively. The decrease for
the year ended December 31, 1996 compared to the same period for 1995 is
primarily the result of the 1995 third quarter loss and loss adjustment
expense charge of $81.3 million. See "--Loss and Loss Adjustment Expense
Reserves" and "--1995 Third Quarter Charge". The decline for 1996 also
reflects the decline in premium volume offset by development on prior year
loss reserve. The prior year reserve strengthening in 1996 related to:
asbestos, environmental and other toxic torts of $3.8 million; assumed
reinsurance workers' compensation of $3.0 million; and all other of $6.1
million. In addition, the Company's participation in an assumed reinsurance
contract resulted in a $.5 million loss from the ValuJet catastrophe and a $.5
million loss from the TWA flight 800. Losses and loss adjustment expenses
incurred in 1994 reflect loss development on the significant catastrophe
losses that have plagued the industry since 1988 and incurred losses related
to asbestos and environmental exposures. The Company's catastrophe losses for
1994 were primarily experienced through Highlands (UK) and the assumed
property reinsurance business. Losses and loss adjustment expenses incurred
for Highlands (UK) amounted to $13.6 million in 1994 and included net loss
development of approximately $9.3 million ($44.5 million before deducting
reinsurance) related to catastrophe claims. The catastrophe claims include
Hurricane Andrew, European Storms, Pan Am Lockerbie and Kuwait Airlines.
A-10
<PAGE>
In addition to catastrophe losses, the Company began to experience asbestos
and environmental losses and responded by increasing its estimate of ultimate
loss levels by $3.8 million, $61.2 million and $12.4 million for 1996, 1995
and 1994, respectively. See "--Loss and Loss Adjustment Expense Reserves" and
"--1995 Third Quarter Charge--Environmental Reserves (Including Asbestos)"
below.
Loss and Loss Adjustment Expense Reserves
Underwriting results of the property and casualty industry are significantly
influenced by estimates of loss and loss adjustment expense reserves. (See
Note (8) of the Notes to Consolidated Financial Statements included elsewhere
herein). These reserves are an accumulation of the estimated amounts necessary
to settle and pay all outstanding and unreported claims including loss
adjustment expenses, net of estimated claim recoveries. The case reserve
estimates for reported claims are based upon the facts of each case and the
Company's experience with similar cases. Consideration is given to historical
trends regarding reserving patterns, loss payments, and the effects of court
decisions, economic conditions and public attitudes. The process of
establishing reserves is an imprecise science involving significant judgment
and assumptions. As information develops that varies from experience, provides
additional data or, in some cases, augments data that previously was not
considered sufficient for use in determining reserves, changes in the
Company's estimate of ultimate liabilities may be required. Changes in prior
year reserve estimates (net of reinsurance), which may be material, are
reflected in the results of operations in the period such changes are
determined to be required.
During the last several years, the Company has experienced significant
adverse development on prior year net ultimate loss estimates. The following
table sets forth the amount of the adverse development split between lines
other than Discontinued Lines and Discontinued Lines for the periods
indicated.
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
----------------
1996 1995 1994
----- ----- ----
(DOLLARS IN
MILLIONS)
<S> <C> <C> <C>
Net reserve re-estimates due to:
Lines other than Discontinued Lines:
Asbestos and environmental................................ $ 2.8 10.6 1.0
All other................................................. 7.2 36.1 20.4
Discontinued Lines:
Asbestos and environmental................................ 3.8 61.2 12.4
Highlands (UK)--primarily catastrophes.................... 1.5 18.6 13.6
All other................................................. 7.6 17.1 17.5
----- ----- ----
Net adverse development....................................... $22.9 143.6 64.9
===== ===== ====
</TABLE>
As a result of changes in estimates of insured events in prior years,
primarily asbestos and environmental claims as well as catastrophe claims, the
provision for losses and loss adjustment expenses incurred (net of reinsurance
recoveries of $(22.0) million, $152.9 million and $123.5 million for 1996,
1995 and 1994, respectively) increased by $22.9 million in 1996, $143.6
million in 1995 and $64.9 million in 1994. The emergence of environmental and
asbestos claims over the last few years and the difficulty in accurately
estimating the necessary reserves have significantly contributed to the
Company's loss reserve development over this period. For additional details
regarding environmental claims emergence and reserves, see "--1995 Third
Quarter Charge--Environmental Reserves (Including Asbestos)." The Company's
exposure to future catastrophe claims has been significantly reduced as a
result of curtailing the Company's cessation of its Highlands (UK) business.
For the year ended December 31, 1996, the Company's loss and loss adjustment
expense reserves were reviewed by external independent actuaries in order to
establish the Company's reserve position.
1995 Third Quarter Charge
In the third quarter of 1995, the Company and its external actuaries
conducted a review of its loss and loss adjustment expense reserves to assess
the Company's reserve position. As a result of such review, the Company
recorded a charge to pre-tax earnings during the nine months ended September
30, 1995 of $125.0 million. Of
A-11
<PAGE>
this amount, $117.0 million related to loss and loss adjustment expense
reserves ($242.5 million before deducting reinsurance) and $8 million
represents an increase in reserves related to litigation proceedings against
the Company. Of the $117 million amount for loss and loss adjustment expense
reserves, adjustments of risks arising from (i) environmental claims
constitute $59.5 million ($125.5 million before deducting reinsurance), (ii)
assumed reinsurance claims constitute $13.1 million ($27.7 million before
deducting reinsurance), and (iii) increased losses from catastrophes reinsured
by Highlands (UK) constitute $12.0 million ($50.7 million before deducting
reinsurance). An additional $13.0 million ($13.0 million before deducting
reinsurance) was added to unallocated loss adjustment expense reserves to
reflect additional costs related to the settlement of claims and run-off costs
related to Highlands (UK), and the remaining $19.4 million ($25.6 million
before deducting reinsurance) reflects changes to reserves for unreported
losses in order to reflect the current evaluation of overall loss and loss
adjustment expense reserves. Each of these is discussed in more detail below.
Environmental Reserves (Including Asbestos). Approximately $59.5 million of
the increase in the net loss and loss adjustment expense reserves ($125.5
million before deducting reinsurance) of the Company is related to increased
provisions for environmental claims (including asbestos claims). Environmental
claims for this purpose are those claims arising from long term and other
exposure to asbestos and chemicals, and those claims arising from the handling
and/or disposal of pollutants such as chemicals and toxic waste. Also included
in the review of environmental matters for purposes of excess liability
policies was potential exposure relating to litigation over breast implants.
Highlands has a dedicated environmental claims unit responsible for handling
these types of claims.
Environmental claims have arisen in three of the Company's product lines,
two of which are Discontinued Lines described above. The ongoing product line
involving increased environmental loss exposure is the general liability
policies written by the Company as primary insurance provider for its various
commercial customers since 1965. The Discontinued Lines that are sources of
increased environmental claim exposure are the Company's umbrella/excess
liability program (as to which new underwriting activities ceased at the end
of 1985) and its participation in the assumed casualty reinsurance
marketplace, both in London (1972 through 1982) and the United States (most of
which were nonrenewed by the end of 1976).
The third quarter of 1995 reserve review reevaluated the Company's potential
environmental exposure, including a review of possible exposure under policies
provided to specific high-profile or "target" potential defendants (companies
identified as being primarily involved in the creation of environmental risks,
such as asbestos manufacturers), without regard to whether claims have been
reported under such policies; the segmentation of environmental and asbestos
data on the U.S. portion of assumed reinsurance; and the review and discussion
of the conclusions of the examination with the Company's external independent
actuaries.
The difficulties inherent in the establishment of loss and loss adjustment
expense reserves for property and casualty companies are magnified when
estimating exposure from environmental claims. Estimation of exposure in
regard to such claims involves a large number of variables which are difficult
to establish with precision, including determining the actual scope of
coverage under existing policies, fixing the date of an occurrence of a
covered loss, estimating the ultimate proportion of pollution clean-up costs
that will be borne by liable parties, evaluating the potential for and nature
of legislative relief and other similar items. The Company's historical
estimates of reserves for environmental claims for two of the Discontinued
Lines and the primary general liability line have relied primarily upon loss
payment and emergence patterns without regard to the year of occurrence
separated between asbestos and pollution claims. The assumptions employed in
the recent loss review involved lengthening the assumed loss payment and
emergence patterns for pollution claims, which resulted in increased indicated
reserves related to these claims across all three business product lines
affected by environmental risks.
Primary General Liability. The bulk of the Company's general liability
policies as primary insurer are written for companies headquartered in the
geographic region in which the Company's activities are focused (currently,
principally Texas and Louisiana). As a result of its regional focus and
typical customer profile (which has included relatively few large national
companies), the Company's primary general liability coverage has not included
many companies identified as principal "targets" of major environmental
litigation at this time. Certain
A-12
<PAGE>
of the Company's insureds do, however, have environmental and asbestos loss
exposure, even if not as a "target" defendant. One result of insuring
potential secondary defendants is that the likely exposure with regard to
environmental claims for these insureds takes longer to assess, because
claimants often exhaust the potential for recovery from "target" defendants
before actively pressing claims from defendants involved to a lesser degree in
the alleged pollution. The Company believes this to be true, particularly for
asbestos claims. The current adjustment to reserves for unreported losses for
asbestos claims relating to primary general liability operations recognizes
that the Company may experience a somewhat slower reporting pattern on these
claims due to the nature of the Company's exposure on policies written for
insureds that have been to date predominantly secondary defendants. The
overall increase to primary general liability reserves for environmental
claims was $8.0 million ($40.8 million before deducting reinsurance).
Umbrella Excess Liability. The Company's umbrella/excess liability program
consisted of participation in the overall U.S. excess liability marketplace
from 1969 through 1985. In general, larger enterprises were the purchasers of
high limits of excess liability protection. Consequently, the Company insured
many large industrial companies, some of which have or may become the
potential primary defendants with regard to significant environmental claims.
The inherent difficulty described above in estimating ultimate loss levels for
environmental claims is further complicated with regard to excess of loss
policies because the Company has no contractual exposure until the policy
limits of the insured's underlying coverage are reached. The loss threshold at
which coverage under the excess liability policies issued by the Company
commences ranged from $300,000 to in excess of $100 million. Accordingly,
estimation of the Company's loss exposure with regard to these policies also
involves a difficult evaluation of whether aggregate claims will be made (and
proven) under other insurers' policies to trigger the coverage threshold of
the policies issued by the Company. The third quarter of 1995 loss review
involved an evaluation of policies issued by the Company to approximately 85
insureds who were potential principal defendants for environmental claims
without regard to whether any claims had been filed under these policies. Also
included in the analysis was the identification of any policies for which the
Company might incur losses or loss adjustment expenses related to breast
implants. The resulting reserve increase on the umbrella/excess liability
program related to unreported losses for environmental and breast implant
claims was approximately $4.4 million ($23.0 million before deducting
reinsurance).
Assumed Reinsurance--London and U.S. Markets. Net environmental reserves
related to the London market were increased by approximately $11.8 million
($22.7 million before deducting reinsurance). The London market historically
has demonstrated very slow claim recognition, reporting and payment. The
increase in reserves stems primarily from a specific adjustment to the
reserves for unreported losses relating to London market claims based on the
application of asbestos payment and emergence patterns to the Company's
reported losses to date. In addition, the lengthening of loss payment and
emergence patterns for unreported pollution claims assumed in the loss reserve
review indicated the appropriateness of an increase in the reserve for
pollution claims.
In the U.S. market, the Company participated in approximately 200 assumed
casualty reinsurance contracts per year between 1969 and 1974 before the
product line was substantially discontinued. As a participant with other
reinsurers, the Company generally assumed a small percentage of each
reinsurance placement. The majority of the Company's exposure for
environmental claims on these agreements relates to risks reinsured in the
early to mid-1970s.
The information on these contracts currently provided to the Company by the
ceding companies varies substantially. Some companies provide individual claim
detail with clear identification of environmental claims as well as actuarial
estimates of ultimate loss levels. For other companies, very little (if any)
detail regarding individual claims is provided to the Company and
environmental claims are not separately identified. Some of the ceding
companies are no longer in business and the loss information is now provided
by a third-party that was not originally involved in the reinsurance
placement.
In past evaluations, reserves for U.S. assumed reinsurance contracts were
aggregated and the Company made no specific estimation or segregation of
reserves for environmental claims. During the first nine months of 1995, the
Company reviewed the individual treaties with the intent to segregate these
treaties into relevant groups for actuarial analysis, identified environmental
claims to the extent possible with existing information, compiled
A-13
<PAGE>
loss data related to pre-1973 periods and separately analyzed the resulting
treaty groups and environmental data. The treaties were divided into the two
groups: those as to which the Company has been able to identify environmental
claims and those as to which it has not been able to specifically identify
environmental claims.
As a result of this analysis, the Company increased the reserve (net of
reinsurance) for unreported losses relating to environmental claims for all of
the U.S. assumed casualty reinsurance agreements by $30.3 million ($34.0
million before deducting reinsurance). Of this amount, $20.3 million relates
to the group of treaties for which the Company has been able to identify
environmental claims. For the treaty group that currently does not explicitly
provide information to identify environmental claims, the Company has
established a net provision of $10.0 million ($13.7 million before deducting
reinsurance) for unreported environmental losses. This provision is based on
the likelihood that a significant portion of the current payments and incurred
loss emergence observed for this treaty group is related to environmental
claims activity. During the Company's third quarter of 1995 reserve review of
the U.S. assumed casualty reinsurance, it was noted that for contracts
reporting environmental claims, approximately 80% of the current year's
payments and reserve emergence were related to environmental claims. The
Company believes that the treaties not identifying environmental claims have a
lower exposure to these claims than the treaties that have reported
environmental claims and thus has assumed that approximately 50% of the
observed payments and reserve emergence on assumed casualty reinsurance
contracts not identifying environmental claims are actually related to
environmental claims activity. The Company has also assumed that the survival
ratios (outstanding reserves to average annual payments) for the treaties not
reporting environmental claims are similar to the survival ratios implied for
the treaty group reporting environmental claims. These assumptions combined
with the partial reliance on industry loss reporting patterns excluding
environmental and asbestos claims produced the $10.0 million reserve for
unreported environmental claims for this treaty group.
Due to the increases in reserve estimates for environmental claims, the
Company also increased unallocated loss adjustment expense reserves by $5.0
million in recognition of additional costs related to the settlement of these
claims. The 1995 Third Quarter Charge resulted in direct outstanding reserves
for environmental claims increasing by $75.5 million. This increase is related
to the primary general liability and the umbrella/excess liability programs.
The Company utilizes a traditional industry methodology for determining
unallocated loss adjustment expense reserves based on calendar year paid
unallocated loss adjustment expense to direct paid loss ratios, case and
incurred but not reported reserves outstanding and the 50/50 assumption (50%
of the unallocated loss adjustment expense is paid when a claim is opened and
50% is paid upon closing). Since unallocated loss adjustment expense has a
positive relationship with outstanding reserves, the $75.5 million reserve
increase indicated an additional $5.0 million of unallocated loss adjustment
expense reserve was appropriate.
Non-Environmental Exposure on Assumed Reinsurance, Catastrophe Losses and
Other Insurance Related Reserves. The Company also established an additional
reserve of $13.1 million ($27.7 million before deducting reinsurance) for
unreported losses relating to the non-environmental exposures for the two
assumed reinsurance treaty groups described above. This estimate was developed
in reliance upon historical emergence patterns for Highlands' assumed
reinsurance treaties, reported development patterns compiled by the
Reinsurance Association of America, actuarial estimates provided by the ceding
companies and management's judgment as to the likely effects of these factors
on the Company's loss exposure.
The remaining $44.4 million ($89.3 million before deducting reinsurance) of
the increase in reserves was spread over several lines of business. Included
in this amount was $13.0 million of additional unallocated loss adjustment
expense reserves, which were established primarily for additional costs
related to the settlement of claims and run-off costs related to Highlands
(UK). Loss reserves with regard to Highlands (UK) were increased by $12.0
million ($50.7 million before deducting reinsurance) in recognition of
continuing loss realization from catastrophes occurring in the 1987 through
1990 underwriting years. The remaining reserve increases were not related to
specific events, but were deemed to be appropriate adjustments to previous
reserve estimates in light of the most recent available data regarding
projected expected loss and loss adjustment expense from existing policies.
A-14
<PAGE>
Litigation Reserves. As indicated above, the Company increased its reserves
for litigation and administrative proceedings against the Company by $8.0
million during the third quarter of 1995 and by an additional $2.5 million in
the fourth quarter of 1995. In addition, litigation reserves were increased by
$2.0 million in 1996.
On May 15, 1991, Weatherford Roofing Company and other plaintiffs commenced
an action against Employers National Insurance Company in the 116th Texas
State District Court in Dallas County, Texas, alleging that they had been
overcharged for workers' compensation insurance. On April 23, 1992, the
plaintiffs amended their petition to allege a class action on behalf of all
employers overcharged for workers' compensation insurance purchased between
1987 and 1992 to cover Texas employees. On April 18, 1994, Highlands and
Highlands Underwriters Insurance Company were added to the action as named
defendants. The lawsuit, styled Weatherford Roofing Company, et al. v.
Employers National Insurance Company (Case No. 91-05637), alleges among other
things that the defendants conspired to charge rates of premium for
retrospectively rated insurance policies that exceeded rates then permitted
under applicable Texas law and regulations. On July 2, 1996, the named
plaintiffs and a group of 14 insurance company defendants, including the
Company, entered into a settlement agreement (the "Settlement Agreement"), and
said agreement has received preliminary approval of the court. Pursuant to the
terms of the Settlement Agreement, in July of 1996, notification of the
settlement was published in several Texas newspapers and mailed to all
insureds within the settlement class. The insureds that have elected to opt-
out of the settlement will not impact Highlands or terminate the Settlement
Agreement.
Final approval of the agreement settlement was granted by the court in the
fourth quarter of 1996 and the distribution of the settlement fund is now
expected to occur in the first quarter of 1997. The time to appeal the
approval of the Settlement Agreement has now expired. The Company's liability,
pursuant to the terms of the Settlement Agreement, is not in excess of current
legal reserves and is not expected to have a material adverse effect on the
financial position of the Company.
In November 1988, the State of California adopted by ballot initiative
Proposition 103, a comprehensive system of regulation applicable to all
property and casualty insurance written in California. Proposition 103 does
not apply to workers' compensation insurance or reinsurance. Proposition 103
provided, among other things, that rates for automobile and certain other
insurance policies issued or renewed on or after November 8, 1988 be rolled
back to levels of November 8, 1987 and then reduced by an additional 20%. In
January 1995, the State of California Department of Insurance ("DOI") notified
the Company that it believed that the Company had a premium rollback
obligation to policyholders under Proposition 103. On April 18, 1995, the DOI
issued a Notice of Hearing Re Proposition 103 Rollback Exemption Application
In the Matter of the Rate Rollback Liability of Highlands and Highlands
Underwriters Insurance Company. Subsequent to the issuance of the Notice of
Hearing there was a Prehearing Conference Order and several motions regarding
the extent and nature of discovery. On June 30, 1995, Highlands and Highlands
Underwriters Insurance Company mailed a settlement offer to the Insurance
Commissioner of the State of California, which was rejected by the
Commissioner on July 18, 1995. In December of 1995, a decision was entered in
the matter of Amwest Surety Insurance Company v. Pete Wilson, et al. In that
case, the Supreme Court of the State of California determined that surety
insurance would be subject to Proposition 103. There were hearings pursuant to
the above-referenced Notice of Hearing during May and June of 1996 at which
the DOI asserted that the rollback obligation of Highlands and Highlands
Underwriters Insurance Company was $3.9 million, plus interest, for a total
amount of $6.5 million. In connection with such hearing, the administrative
law judge was expected to render a decision regarding the Company's rollback
liability during the last quarter of 1996. Subsequent to the June of 1996
hearing, the Company re-evaluated its legal reserves, and such reserves were
increased in the third quarter of 1996 by $1 million to reflect the Company's
current estimate of its most probable loss. Settlement negotiations occurred
during the fourth quarter of 1996, and as a result of the status of such
negotiations, legal reserves were increased $1 million in the fourth quarter
of 1996.
On February 3, 1997, this matter was settled for $5.7 million and such
amount is not in excess of current legal reserves and is not expected to have
a material adverse effect on the financial condition of the Company. The
settlement will be submitted to the Administrative Law Judge and the
Commissioner of Insurance for their approval, and the Company has no reason to
believe at this time that the settlement will not be approved. In the event
the settlement is not approved, the Company will continue to defend this
matter vigorously.
A-15
<PAGE>
The remaining portion of the legal reserves relates to various claims and
legal actions arising in the ordinary course of the Company's business.
LIQUIDITY AND CAPITAL RESOURCES
The Company is a holding company, the principal assets of which are all of
the capital stock of Highlands and $47.0 million of fixed maturities and cash
and cash equivalent investments at December 31, 1996. The Company's property
and casualty insurance business is conducted by Highlands and the other
Insurance Subsidiaries. The liquidity and capital resource considerations for
the Company and its Insurance Subsidiaries are different.
Holding Company
Immediately following the Distribution, the Company issued $62.85 million in
principal amount of Debentures for $60.0 million in cash and $2.85 million of
notes. Of such proceeds, the Company invested $10.0 million in the U.S.
Insurance subsidiaries as a contribution to surplus, paid approximately $5.7
million in transactions fees and for reimbursement of out-of-pocket expenses
incurred in connection with the issuance of the Debentures and Warrants and
retained the remaining approximately $44.4 million for general corporate
purposes.
Prior to the Distribution, the Company was included in the Halliburton
consolidated U.S. federal tax return. An intercompany tax-sharing arrangement
between the Company and Halliburton resulted in the Company receiving from or
paying to Halliburton a cash payment for U.S. federal income taxes based on
financial reporting (book) income rates that were determined by Halliburton.
The Company was not charged more U.S. federal income tax than it would have
paid on a separate return basis. Pursuant to SFAS 109, the Company provided
for income taxes on its statements of operations as if it had filed separate
tax returns in each taxing jurisdiction (separate return method). Differences
between income tax provisions calculated using the separate return method and
amounts calculated under the intercompany tax-sharing arrangements are
reflected as additions or reductions to stockholders' equity, as appropriate.
In 1996 the Company received from Halliburton and forwarded to its Insurance
Subsidiaries approximately $42.2 million in cash related to the tax benefit of
the significant tax losses incurred in 1995 which are utilizable by
Halliburton.
The tax-sharing agreement resulted in Halliburton acquiring the domestic
deferred tax assets and liabilities from its U.S. subsidiaries. In
contemplation of Halliburton's distribution of the Company's shares,
Halliburton contributed to the Company in 1995 the net deferred tax assets
attributable to the Company which the Company recorded as a contribution to
capital. Based on the tax-free nature of the spin off, the deferred tax asset
attributes are available to the Company.
The Company's other principal sources of funds are dividend and tax sharing
payments from Highlands, if any, and funds that may be raised from time to
time from the issuance of additional debt or equity securities. The payment of
dividends by Highlands is subject to restrictions and limitations imposed by
the insurance laws of the State of Texas. The maximum dividend payable by
Highlands in 1997 without approval is approximately $18.0 million. Both the
issuance of additional debt and the issuance of additional equity securities
at a price less than current market price would require the consent of the
holders of a majority in interest of the Debentures pursuant to the covenants
contained in the Debentures.
As a holding company, the Company's principal requirements for funds are to
pay operating expenses, to pay franchise and other taxes, to pay debt service
and to pay dividends. Operating expenses and franchise and other taxes imposed
on the Company are not expected to be material. The annual cash interest
requirements relating to the debentures will be approximately $6.0 million.
The Company does not currently intend to pay dividends on the Company Common
Stock. In light of the Company's corporate strategy, an additional use of
funds may be to invest in other insurance companies or other insurance
operations.
A-16
<PAGE>
On June 21, 1996, the Company entered into an agreement to acquire Vik
Brothers Insurance, Inc. ("VBII"). VBII is an insurance holding company that
primarily writes commercial property and casualty business for small to medium
sized companies and, to a lesser extent, personal lines business.
On February 13, 1997, the Company signed an amended and restated agreement
and plan of merger which revised the terms of the agreement originally entered
into June 21, 1996. On March 10, 1997, the Company entered into an amendment
to the February 13, 1997 agreement. Under the revised terms, the Company will
acquire VBII for aggregate consideration of approximately $97 million
consisting of the issuance of 1.4 million shares of Company Common Stock
valued at $21.50 per share representing 12.5% of the then outstanding Company
Common Stock, the refinancing of $40 million in debt, the issuance of $21.4
million of preferred stock and $4 million of cash.
Following completion of the acquisition, the Company intends to contribute
up to a maximum of $42 million of capital to the VBII insurance subsidiaries,
which will be funded by $25 million of additional debt and $17 million in
cash. The Company is currently negotiating a $65 million revolving credit
facility in connection with this acquisition.
Consummation of the acquisition is subject to certain consents, waivers or
other agreements from certain securityholders of VBII and other third parties,
as well as regulatory approval. The transaction is expected to be completed in
the second quarter of 1997.
Insurance Subsidiaries
Insurance Operations. The principal sources of funds for the Insurance
Subsidiaries are premiums and amounts earned from the investment of such
premiums. The principal uses of funds by these subsidiaries are the payment of
claims and related expenses, underwriting expenses, other operating expenses
and dividends and tax sharing payments to the Company.
In the insurance industry, liquidity refers to the ability of an enterprise
to generate adequate amounts of cash from its normal operations, including
from its investment portfolio, in order to meet its financial commitments,
which are principally obligations under the insurance policies it has written.
Liquidity requirements of insurance companies are influenced significantly by
product mix. Future catastrophe claims, the timing and amount of which are
inherently unpredictable, may create increased liquidity requirements for the
Insurance Subsidiaries.
The liquidity requirements of the Insurance Subsidiaries are met by that
portion of the investment portfolio that is held in cash and highly liquid
short-and intermediate-term securities. Prior to the Distribution, liquidity
requirements of the Insurance Subsidiaries were also provided for by the
payments made by Halliburton to the Company and the Insurance Subsidiaries
under the income tax sharing arrangements for losses generated by the Company
and its subsidiaries. These tax sharing arrangements were terminated in
connection with the Distribution and resulted in the Insurance Subsidiaries
receiving $42.2 million from Halliburton in 1996.
In 1994, Highlands (UK) had a liability of $21.5 million for cash advances
received from an affiliate of Halliburton. During 1994, this liability was
exchanged for a capital contribution to Highlands (UK). Accordingly, the
Company recorded additional paid-in capital of $21.5 million in 1994.
Statutory Surplus. Maintenance of appropriate levels of statutory surplus of
the Company's U.S. Insurance Subsidiaries is a primary objective of the
Company and is also important to regulatory authorities and rating agencies.
In addition, increased public and regulatory concerns regarding the financial
stability of participants in the insurance industry have caused greater
emphasis to be placed by current and potential customers upon the ratings
assigned to property and casualty insurance companies. Each of the U.S.
Insurance Subsidiaries and Highlands have been assigned an "A-" (Excellent)
rating by A.M. Best.
The NAIC has adopted risk based capital ("RBC") requirements that require
insurance companies to calculate and report information under a risk-based
formula which measures statutory capital and surplus needs based on a
regulatory definition of risk with respect to a company's mix of products and
its balance sheet.
A-17
<PAGE>
Highlands' authorized control level RBC, as defined by the NAIC, was $56.6
million on December 31, 1996 which was substantially below Highlands' existing
capital of $187.0 million. The other U.S. Insurance Subsidiaries have an RBC
amount above the authorized control level RBC as defined by the NAIC.
The NAIC's Insurance Regulatory Information System ("IRIS") was developed by
a committee of state insurance regulators primarily to assist state insurance
departments in executing their statutory mandate to oversee the financial
condition of insurance companies operating in their respective states. IRIS
helps to identify those companies that merit the highest priority in the
allocation of the regulators' resources on the basis of eleven financial
ratios which are calculated annually from financial information obtained from
insurers' statutory annual statements. A "usual range" of results for each
ratio is used as a benchmark. The ratios and benchmark comparisons are
calculated within defined parameters and are not intended to replace the
Insurance Commissioners' own in-depth financial analysis or on-site
examinations. Departure from the usual range on four or more of the ratios
could lead to inquiries from individual Commissioners.
An annual range of ratio results has been established from studies of the
ratios for companies that have become insolvent or have experienced financial
difficulties falling outside the usual range. The analytical phase is a review
of annual statements and the financial ratios. Companies that receive
financial ratio values outside the usual range generally are analyzed in order
to identify those companies that appear to require immediate regulatory
attention. A more comprehensive review of the ratio results in an insurer's
annual statement is performed later to confirm that an insurer's situation in
fact calls for increased and closer regulatory attention. If the review
confirms that the insurer's situation should be accorded the highest priority
in the Insurance Commissioner's surveillance process, the insurer receives a
"first priority" designation. Highlands received "first priority" designation
as a result of the review of its financial ratio results and statutory annual
statements for 1995. The primary reason Highlands received a "first priority"
designation was due to the large reserve increase it recorded in 1995.
Highlands' statutory surplus decreased by $75.4 million in 1995, principally
as a result of a third quarter charge (see "1995 Third Quarter Charge"), and
was $178.7 million as of December 31, 1995.
The following table sets forth certain information with respect to the
Company's statutory surplus (U.S. Insurance Subsidiaries) at the dates
indicated.
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1995 1994
------ ----- -----
(DOLLARS IN
MILLIONS)
<S> <C> <C> <C>
Statutory surplus................................... $188.5 180.0 258.0
Net premiums written to surplus ratio............... 0.8x 1.1x 0.9x
</TABLE>
Reinsurance Receivables. The Company monitors the financial condition of the
reinsurance companies with which it places significant reinsurance coverage
and strives to place current reinsurance coverages with financially sound
reinsurance companies. In the past, the Company has placed reinsurance
coverage with several hundred reinsurance companies. It monitors the financial
condition of many of such companies only on a periodic basis. A number of such
companies are in run-off or have ceased writing reinsurance and some have
become insolvent. The Company's ability to monitor the financial condition of
some reinsurance companies is limited because of the difficulty of acquiring
accurate information.
Based on the Company's evaluation of the financial condition of its
reinsurers, the Company has established reserves for potentially uncollectible
reinsurance which amounted to $2.4 million and $4.6 million as of December 31,
1996 and 1995, respectively. Additionally, the Company has retained net $20.1
million and $18.6 million of ceded reserves related to potentially
uncollectible reinsurance at December 31, 1996 and 1995. With respect to
carriers that are not authorized reinsurers as determined by the Texas
Department of Insurance, the Company often receives collateral primarily in
the form of bank letters of credit generally securing the reinsurance
recoverable regarding reported losses and in some instances unreported losses.
At December 31, 1996 such collateral totaled approximately $14.8 million. The
Company's three largest reinsurance recoverable exposures at December 31, 1996
were approximately $111.2 million with underwriting syndicates at Lloyds
(Highlands (U.K.) $90.2 million and U.S. Insurance Subsidiaries $21.0
million), $84.2 million with American
A-18
<PAGE>
Re-insurance Company and $55.0 million with General Reinsurance Company.
American Re-insurance Company and General Reinsurance Company are rated by A.
M. Best and carry "A+" and "A++" ratings, respectively.
MARKET FOR COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company Common Stock is listed on the New York Stock Exchange ("NYSE")
under the trading symbol "HIC". Until January 23, 1996 Halliburton owned all
of the outstanding shares of Company Common Stock. In connection with the
Distribution, approximately 11.4 million shares of Company Common Stock were
issued, and on March 21, 1997 approximately the same number of shares of the
Company Common Stock was issued and outstanding. In addition 750,000 shares of
Company Common Stock are reserved for issuance pursuant to restricted stock
grants and options granted or to be granted pursuant to the 1995 Stock Option
Plan and the 1995 Directors' Stock Plan.
The following table sets forth, for the calendar periods indicated, the high
and low per share sale prices of Company Common Stock as reported in NYSE-
Composite Transactions.
<TABLE>
<CAPTION>
YEAR 1996 HIGH LOW
--------- ------ ------
<S> <C> <C>
First Quarter............................................... $24.25 $18.75
Second Quarter.............................................. $20.00 $17.63
Third Quarter............................................... $20.12 $17.13
Fourth Quarter.............................................. $21.38 $19.00
</TABLE>
The approximate number of holders of Common Stock as of March 21, 1997,
based upon the number of record holders, was 22,000. The closing sale price of
Company Common Stock on March 21, 1997, the last full trading day before the
printing of this Annual Report, was $22 per share.
Dividends. The Company has not previously paid any dividends and currently
does not intend to pay dividends on the Company Common Stock. This policy,
however, will be reconsidered from time to time by the Board of Directors of
the Company. The Company's ability to pay dividends in the future will depend
upon its financial performance and other factors not now determinable.
Additionally, the Debentures contain covenants restricting the payment of
dividends in excess of specified amounts.
Moreover, the payment of dividends to the Company by the U.S. Insurance
Subsidiaries is subject to certain limitations under Texas insurance laws.
Texas insurance law permits a Texas domiciled insurance company to pay
dividends in any year in an amount not exceeding the greater of (y) 10% of
statutory surplus as of the end of the preceding year, and (z) its net income
for the prior year. Larger dividends may be paid only with prior regulatory
approval. These restrictions and any additional subsequently imposed
restrictions may in the future adversely affect the Company's ability to pay
its expenses and any cash dividends to its stockholders.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE
On August 30, 1996, the Board of Directors of the Company, retained KPMG
Peat Marwick LLP ("KPMG") as its principal accountant in lieu of Arthur
Andersen LLP ("Arthur Andersen"). The decision to change accountants was
recommended by the Audit Committee and approved by the Board of Directors of
the Company.
During the two most recent fiscal years and subsequent interim periods
preceding the retention of KPMG, there were no disagreements between the
Company and Arthur Andersen on accounting and financial disclosure matters.
There have been no disagreements with KPMG on accounting and financial
disclosure matters since the retention of KPMG.
A-19
<PAGE>
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
<TABLE>
<S> <C>
Audited Financial Statements
Report of Independent Public Accountants................................ A-21
Consolidated Balance Sheets as of December 31, 1996 and 1995............ A-22
Consolidated Statements of Operations for the years ended December 31,
1996, 1995 and 1994.................................................... A-23
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1996, 1995 and 1994....................................... A-24
Consolidated Statements of Cash Flows for the years ended December 31,
1996, 1995 and 1994.................................................... A-25
Notes to Consolidated Financial Statements.............................. A-26
</TABLE>
A-20
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
The Board of Directors
Highlands Insurance Group, Inc.:
We have audited the accompanying consolidated balance sheet of Highlands
Insurance Group, Inc. and subsidiaries (the Company) as of December 31, 1996
and the related consolidated statements of operations, stockholders' equity,
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 did not audit the consolidated financial
statements of the Company for the years ended December 31, 1995 and 1994. The
consolidated financial statements of the Company as of December 31, 1995 and
for each of the years in the two-year period ended December 31, 1995 were
audited by other auditors whose report thereon dated March 8, 1996 expressed
an unqualified opinion on those statements.
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.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Highlands
Insurance Group, Inc. and subsidiaries as of December 31, 1996 and the results
of their operations and their cash flows for the year ended December 31, 1996
in conformity with generally accepted accounting principles.
KPMG PEAT MARWICK LLP
Houston, Texas
February 25, 1997
A-21
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1996 AND 1995
(IN THOUSANDS)
<TABLE>
<CAPTION>
1996 1995
---------- ---------
<S> <C> <C>
ASSETS
Investments:
Fixed maturity securities:
Available for sale, at fair value (amortized cost of
$320,909 in 1996 and $216,093 in 1995)................. $ 324,905 227,509
Held to maturity, at amortized cost (fair value of
$367,446 in 1996 and $396,729 in 1995)................. 355,492 374,364
Equity securities, at fair value (cost of $26,293 in
1996 and $31,966 in 1995).............................. 26,967 33,697
Other invested assets, at cost.......................... 3,770 --
---------- ---------
Total investments..................................... 711,134 635,570
Cash and cash equivalents................................. 49,484 85,176
Premiums in course of collection, net..................... 24,048 40,959
Premiums due under retrospective policies................. 121,276 134,428
Receivable from reinsurers................................ 556,900 602,380
Funds on deposit with reinsurers.......................... 14,456 15,449
Deferred taxes............................................ 37,126 29,534
Receivable from former affiliates......................... 250 41,255
Accrued investment income................................. 12,600 11,131
Deferred policy acquisition costs......................... 6,436 11,744
Other assets.............................................. 32,321 28,465
---------- ---------
Total assets.......................................... $1,566,031 1,636,091
========== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Loss and loss adjustment expense reserves................. $1,156,824 1,253,627
Unearned premiums......................................... 31,474 52,571
Convertible subordinated debentures....................... 55,452 --
Funds held................................................ 16,475 22,702
Payable to former affiliates.............................. -- 676
Accounts payable and accrued liabilities.................. 42,331 39,405
---------- ---------
Total liabilities..................................... 1,302,556 1,368,981
---------- ---------
Commitments and contingent liabilities
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares
authorized, 11,448,208 shares issued and outstanding in
1996 ($1,000 par value; 10,000 shares authorized, 1,000
shares issued and outstanding in 1995)................. 114 1,000
Additional paid-in capital.............................. 192,273 184,168
Net unrealized gain on investments...................... 3,036 8,547
Retained earnings....................................... 68,052 73,395
---------- ---------
Total stockholders' equity............................ 263,475 267,110
---------- ---------
Total liabilities and stockholders' equity............ $1,566,031 1,636,091
========== =========
</TABLE>
The accompanying notes to consolidated financial statements are an integral
part of these statements.
A-22
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(IN THOUSANDS, EXCEPT PER COMMON SHARE DATA)
<TABLE>
<CAPTION>
1996 1995 1994
-------- -------- -------
<S> <C> <C> <C>
Revenues:
Net premiums earned............................. $152,048 201,446 241,676
Net investment income........................... 50,988 48,529 46,720
Net realized investment gains................... 1,199 2,618 1,910
-------- -------- -------
Total revenues................................ 204,235 252,593 290,306
-------- -------- -------
Expenses:
Losses and loss adjustment expenses incurred.... 156,589 300,253 224,315
Underwriting expenses........................... 56,487 73,905 65,022
Interest expense and debt amortization.......... 6,903 -- --
Other expenses (income), net.................... 1,697 (823) (1,314)
-------- -------- -------
Total expenses................................ 221,676 373,335 288,023
-------- -------- -------
Income (loss) before income tax benefit........... (17,441) (120,742) 2,283
Income tax benefit................................ 12,098 -- --
-------- -------- -------
Net income (loss)................................. $ (5,343) (120,742) 2,283
======== ======== =======
Net income (loss) per common share and common
stock equivalents.............................. $ (.47) (10.55) .20
======== ======== =======
Weighted average number of common shares and
common stock equivalents outstanding........... 11,448 11,448 11,448
======== ======== =======
</TABLE>
The accompanying notes to consolidated financial statements are an integral
part of these statements.
A-23
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(IN THOUSANDS)
<TABLE>
<CAPTION>
1996 1995 1994
-------- --------- -------
<S> <C> <C> <C>
Common Stock:
Balance, beginning of year...................... $ 1,000 1,000 1,000
Change in par value of common stock............ (886) -- --
-------- --------- -------
Balance, end of year............................ 114 1,000 1,000
-------- --------- -------
Additional paid-in capital:
Balance, beginning of year...................... 184,168 110,803 84,261
Addition resulting from issuance of convertible
subordinated debentures with detachable common
stock warrants................................ 7,439 -- --
Change in par value of common stock............ 886 -- --
Contribution from former parent:
Net current tax asset......................... 7,723 39,229 5,064
Net deferred tax asset........................ (7,943) 34,136 --
Investment in Highlands (UK) by former
affiliate.................................... -- -- 21,478
-------- --------- -------
Balance, end of year............................ 192,273 184,168 110,803
-------- --------- -------
Net unrealized gain (loss) on investments:
Balance, beginning of year...................... 8,547 (10,132) 11,685
Changes in net unrealized (loss) gain, net of
applicable federal income tax................. (5,511) 18,679 (21,817)
-------- --------- -------
Balance, end of year............................ 3,036 8,547 (10,132)
-------- --------- -------
Retained earnings:
Balance, beginning of year...................... 73,395 194,137 191,854
Net income (loss).............................. (5,343) (120,742) 2,283
-------- --------- -------
Balance, end of year............................ 68,052 73,395 194,137
-------- --------- -------
Total stockholders' equity....................... $263,475 267,110 295,808
======== ========= =======
</TABLE>
The accompanying notes to consolidated financial statements are an integral
part of these statements.
A-24
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(IN THOUSANDS)
<TABLE>
<CAPTION>
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss).............................. $ (5,343) (120,742) 2,283
-------- -------- --------
Adjustments to reconcile net income (loss) to
net cash (used in) provided by operating
activities:
Depreciation and amortization................. (152) 455 769
Change in deferred policy acquisition costs... 5,308 106 (5,807)
Net realized investment gains................. (1,199) (2,618) (1,910)
Decrease in premiums in course of collection.. 16,911 25,513 5,960
Decrease (increase) in premiums due under
retrospective policies....................... 13,152 (4,811) 12,933
Decrease (increase) in receivables from
reinsurers................................... 45,480 (40,906) 60,999
Decrease in funds on deposit with reinsurers.. 993 4,841 3,831
Increase in deferred taxes.................... (12,098) -- --
Advances from (payments to) former affiliates,
net.......................................... 801 (1,949) 1,251
(Decrease) increase in loss and loss
adjustment expense reserves.................. (96,803) 104,454 (76,069)
(Decrease) increase in unearned premiums...... (21,097) 1,393 (2,325)
(Decrease)increase in funds held.............. (6,227) 1,263 862
Change in other operating assets and
liabilities.................................. 7,633 23,415 5,771
-------- -------- --------
Total adjustments........................... (47,298) 111,156 6,265
-------- -------- --------
Net cash (used in) provided by operating
activities................................. (52,641) (9,586) 8,548
Cash flows from investing activities:
Proceeds from sales--
Fixed maturity securities available for sale.. -- 7,075 40,609
Equity securities............................. 4,726 8,064 839
Maturities or calls--
Fixed maturity securities available for sale.. 27,168 19,324 71,708
Fixed maturity securities held to maturity.... 40,162 45,591 32,692
Investment purchases--
Fixed maturity securities available for sale.. (131,559) (46,923) (139,918)
Fixed maturity securities held to maturity.... (20,220) (7,700) (17,062)
Equity securities............................. (2,282) (4,064) (5,815)
Purchases of property and equipment............ (1,531) (675) (995)
Sales of property and equipment................ 194 29 1,295
Proceeds from disposal of subsidiary, net...... 22 -- --
Cash returned by former affiliates, net........ 3,800 418 16,667
-------- -------- --------
Net cash (used in) provided by investing
activities................................. (79,520) 21,139 20
-------- -------- --------
Cash flows from financing activities:
Proceeds from issuance of convertible
subordinated debentures...................... 60,000 -- --
Payment for debt issuance expense............. (5,705) -- --
Contribution from former parent of net current
tax asset.................................... 42,174 20,834 2,888
-------- -------- --------
Net cash provided by financing activities... 96,469 20,834 2,888
-------- -------- --------
Net (decrease) increase in cash and cash
equivalents.................................... (35,692) 32,387 11,456
Cash and cash equivalents at beginning of year.. 85,176 52,789 41,333
-------- -------- --------
Cash and cash equivalents at end of year........ $ 49,484 85,176 52,789
======== ======== ========
Supplemental disclosure of cash flow
information:
Interest paid................................. $ 5,639 -- --
======== ======== ========
</TABLE>
The accompanying notes to consolidated financial statements are an integral
part of these statements.
A-25
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Basis of Reporting and Operations
The accompanying consolidated financial statements include the accounts of
Highlands Insurance Group, Inc., (HIC) and its subsidiaries (the Company). The
Company is an insurance holding company for Highlands Insurance Company
(Highlands) and its wholly-owned subsidiaries including Highlands Lloyds, a
controlled insurance affiliate, Highlands Insurance Company (U.K.) Limited
(Highlands UK) (a foreign reinsurance company located in the United Kingdom)
and certain other insignificant companies. All material intercompany accounts
and transactions have been eliminated.
HIC was wholly-owned by Halliburton Company (Halliburton) until January 23,
1996 when Halliburton distributed all of the outstanding shares of common
stock of HIC to holders of record of common stock of Halliburton on January 4,
1996 (the Distribution). Holders of record received one share of common stock
of HIC for every ten shares of common stock of Halliburton held on that date.
Approximately 11.4 million common shares of HIC were issued in conjunction
with the Distribution.
The accompanying consolidated financial statements are presented in
accordance with generally accepted accounting principles.
Net Premiums Earned
Insurance premiums on property/casualty insurance contracts are generally
earned ratably over the terms of the policies after estimated adjustments for
retrospectively rated policies and a deduction for ceded insurance.
Loss and Loss Adjustment Expense Reserves
Loss and loss adjustment expense reserves are based on (a) case basis
estimates for claims reported on direct business, adjusted in the aggregate
for ultimate loss expectations, (b) estimates of incurred but not reported
(IBNR) claims based upon past experience, (c) estimates of assumed insurance
losses, (d) estimates of future expenses to be incurred in settlement of
claims and (e) estimates of claim recoveries. In establishing these estimates,
consideration is given to current conditions and trends as well as past
Company and industry experience.
Loss and loss adjustment expense reserves are based on estimates, and the
ultimate liability may vary significantly from such estimates (see note 8).
Any adjustments that are made to the reserves are reflected in the
consolidated statements of operations in the year such adjustments are known.
Deferred Acquisition Costs
Costs of acquiring insurance business which vary with and are primarily
related to the production of such business are deferred. Such costs include
commissions, premium taxes and certain underwriting and policy issuance costs.
Deferred acquisition costs are amortized ratably over the period the related
premiums are earned. Anticipated investment income and business line
profitability is considered in the determination of the recoverability of
deferred acquisition costs.
Investments
Investments classified as held to maturity are carried at amortized cost.
This classification is based upon the Company's intent and ability to hold
these securities to full maturity. Investments classified as available for
sale are carried at fair value. Unrealized gains and losses on available for
sale investments are reported as a separate
A-26
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
component of stockholders' equity, net of applicable deferred taxes. The
Company continually monitors the difference between the cost and estimated
fair value of the investments. When impairment of the value of an investment
is considered other than temporary, the decrease in value is reported in
earnings as a realized investment loss and a new cost basis is established.
Fixed income securities may be sold to take advantage of investment
opportunities generated by changing interest rates, prepayments and tax and
credit considerations, as part of the Company's assets/liability strategy, or
for similar factors. As a result, the Company considers a portion of its fixed
income securities (bonds and redeemable preferred stocks) and all equity
securities as available for sale. The amortized cost of debt securities is
adjusted for amortization of premiums and accretion of discounts to expected
maturity. Such amortization is included in net investment income.
Foreign Operations
Most of the Company's foreign premium income comes from the London insurance
market which is characterized by long delays in reporting of both premium and
loss information. Profits or losses from foreign business are generally
recognized based on projections of ultimate premiums and losses.
Cash and Cash Equivalents
The Company defines cash equivalents as short-term, highly liquid
investments that are readily convertible to known amounts of cash. In general,
only investments with original maturities of three months or less qualify as
cash equivalents.
Debt Issuance Costs
Deferred financing and related costs consist of capitalized fees associated
with the issuance of $62.85 million in principal amount of 10% convertible
subordinated debentures (Debentures). These costs include underwriting, legal
and accounting fees. Debt issuance costs of $4.9 million were capitalized in
connection with the issuance of the Debentures and are amortized on the
straight line basis and charged to income over 10 years.
Net Income (Loss) Per Share
Primary net income (loss) per share amounts are based upon the weighted
average number of common stock shares and common stock equivalents, common
stock warrants and options, outstanding during the period. Fully diluted net
income (loss) per share amounts are based upon the weighted average number of
common stock shares and common stock equivalents outstanding during the period
and the effects of converting the Debentures. The effects of common stock
equivalents and the conversion of the Debentures are considered to be
antidilutive for all periods presented and, therefore, the effects are not
reflected in either primary or fully diluted net income (loss) per share
amounts. The income (loss) per share amounts for the year ended December 31,
1995 and 1994 are based upon the 11,448,208 shares of common stock that were
distributed and outstanding immediately following the Distribution.
Certain Risks and Uncertainties
The preparation of these financial statements requires management to make
estimates and assumptions as of the date of the financial statements that
affect the reported amounts of assets and liabilities as well as disclosures
of contingent assets and liabilities. Management must make estimates and
assumptions that affect amounts of revenues and expenses, primarily losses and
loss adjustment expenses incurred for the reporting period. Management must
also make estimates and assumptions in determining reinsurance collectibility
and in determining litigation accruals. Actual results could differ from these
estimates. Future events, which could impact the estimates used in these
financial statements, include inflationary pressures that may tend to affect
the size of losses, judicial, legislative and regulatory decisions affecting
insurers' liabilities and fluctuations in interest rates.
A-27
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Accounting Standards
In March 1995, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 121 "Accounting for the
Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of"
(SFAS 121). This statement requires that long-lived assets and certain
identifiable intangibles be reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable and an impairment loss must be recognized. The adoption of this
statement was effective January 1, 1996 and did not have an impact on the
results of operations, financial condition or liquidity.
In October 1995, the FASB issued Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation" (SFAS 123). SFAS 123
establishes accounting and reporting standards for stock-based employee
compensation plans. SFAS 123 recommends but does not require entities to adopt
the fair value based method of accounting for all employee stock compensation
plans, under which compensation cost is measured based on the fair value of
the award at the grant date and recognized over the vesting period. Entities
may continue to account for these plans using the intrinsic value based method
of accounting, under which compensation cost is measured as the excess, if
any, of the quoted market price of the stock at the grant date over the amount
an employee must pay to acquire the stock. Entities not adopting the fair
value based method must present proforma disclosures of net income and
earnings per share as if the fair value method of accounting had been applied.
The Company has elected to use the intrinsic value based method of accounting
effective for the year ended December 31, 1996 financial statements.
Reclassification
Certain items in the December 31, 1995 and 1994 consolidated financial
statements have been reclassified to conform to the current year's
presentation.
Gross premiums and net premiums written have been redefined for all periods
presented to include the effects of changes in premiums due under
retrospective policies. Such changes were previously recorded only as net
premiums earned.
2. BUSINESS ACQUISITION
Pending Acquisition
On June 21, 1996, the Company entered into an agreement to acquire Vik
Brothers Insurance, Inc. (VBII). VBII is an insurance holding company that
primarily writes commercial property and casualty business for small to medium
sized companies and, to a lesser extent, personal lines business.
On February 13, 1997, the Company signed an amended and restated agreement
and plan of merger which revised the terms of the agreement originally entered
into June 21, 1996. Under the revised terms, the Company will acquire VBII for
aggregate consideration of approximately $97 million consisting of the
issuance of 1.6 million shares of HIC common stock valued at $21.50 per share
representing 12.5% of the then outstanding common stock, the assumption of $40
million in debt and issuance of $21.4 million of preferred stock.
Following completion of the acquisition, the Company intends to contribute
up to a maximum of $42 million of capital to the VBII insurance subsidiaries,
which will be funded by $25 million of additional debt and $17 million in
cash. The Company is currently negotiating a $65 million revolving credit
facility in connection with this acquisition.
Consummation of the acquisition is subject to certain consents, waivers or
other agreements from certain securityholders of VBII and other third parties,
as well as regulatory approval. The transaction is expected to be completed in
the second quarter of 1997.
A-28
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
3. INVESTMENTS AND INVESTMENT INCOME
Net Investment Income
Net investment income for the years ended December 31, 1996, 1995 and 1994
is comprised of the following (in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------- ------ ------
<S> <C> <C> <C>
Gross investment income:
Fixed maturity securities............................... $43,558 43,500 41,742
Equity securities....................................... 2,180 2,441 2,248
Short-term investments.................................. 5,807 3,197 3,926
Other invested assets................................... 54 -- --
------- ------ ------
Gross investment income............................... 51,599 49,138 47,916
Investment expenses..................................... 611 609 1,196
------- ------ ------
Net investment income................................. $50,988 48,529 46,720
======= ====== ======
</TABLE>
The following is a summary of available for sale and held to maturity
securities at December 31, 1996 and 1995 (in thousands):
<TABLE>
<CAPTION>
GROSS
UNREALIZED
AMORTIZED ------------- FAIR
COST GAINS LOSSES VALUE
--------- ------ ------ -------
<S> <C> <C> <C> <C>
At December 31, 1996--
Fixed maturities available for sale:
United States Government and government
agencies................................... $141,767 1,521 (903) 142,385
States, municipalities and political
subdivisions............................... 31,920 1,683 (3) 33,600
Mortgage-backed securities.................. 25,742 304 (764) 25,282
Corporate securities........................ 115,914 2,647 (723) 117,838
Sinking fund preferred stock................ 5,566 248 (14) 5,800
-------- ------ ------ -------
320,909 6,403 (2,407) 324,905
Equity securities............................ 26,293 1,015 (341) 26,967
-------- ------ ------ -------
$347,202 7,418 (2,748) 351,872
======== ====== ====== =======
Fixed maturities held to maturity:
United States Government and government
agencies................................... $ 10,041 3 (87) 9,957
States, municipalities and political
subdivisions............................... 189,512 15,197 (1) 204,708
Mortgage-backed securities.................. 88,209 876 (2,181) 86,904
Foreign governments......................... 12,862 29 -- 12,891
Corporate securities........................ 54,868 212 (2,094) 52,986
-------- ------ ------ -------
$355,492 16,317 (4,363) 367,446
======== ====== ====== =======
At December 31, 1995--
Fixed maturities available for sale:
United States Government and government
agencies................................... $ 69,636 3,143 -- 72,779
States, municipalities and political
subdivisions............................... 38,499 2,459 -- 40,958
Mortgage-backed securities.................. 26,812 899 (565) 27,146
Corporate securities........................ 73,720 5,137 (4) 78,853
Sinking fund preferred stock................ 7,426 362 (15) 7,773
-------- ------ ------ -------
216,093 12,000 (584) 227,509
Equity securities............................ 31,966 1,996 (265) 33,697
-------- ------ ------ -------
$248,059 13,996 (849) 261,206
======== ====== ====== =======
Fixed maturities held to maturity:
United States Government and government
agencies................................... $ 4,498 110 -- 4,608
States, municipalities and political
subdivisions............................... 217,712 20,504 (3) 238,213
Mortgage-backed securities.................. 87,392 2,071 (718) 88,745
Foreign governments......................... 2,395 26 -- 2,421
Corporate securities........................ 62,367 1,494 (1,119) 62,742
-------- ------ ------ -------
$374,364 24,205 (1,840) 396,729
======== ====== ====== =======
</TABLE>
A-29
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Company is not a trader in bonds and has classified investments into two
categories: available for sale and held to maturity.
The fair value of investments is based on quoted market prices, where
available, or quotes from external pricing sources such as brokers for those
or similar investments and issues. With the exception of the United States
Governments the Company has no investment in any one individual security
issuer exceeding 10 percent of total assets.
The amortized cost and estimated fair value of securities at December 31,
1996, by contractual maturity, are presented below (in thousands). Actual
maturities may differ from contractual maturities as securities may be
restructured, called or prepaid. Securities with multiple maturity dates are
disclosed separately rather than allocated over several maturity groupings.
<TABLE>
<CAPTION>
AMORTIZED FAIR
COST VALUE
--------- -------
<S> <C> <C>
Available for sale:
Within one year....................................... $ 25,773 25,805
After one year through five years..................... 52,113 53,235
After five years through ten years.................... 76,558 79,001
After ten years....................................... 135,157 135,782
Mortgage-backed securities............................ 25,742 25,282
-------- -------
$315,343 319,105
======== =======
Held to maturity:
Within one year....................................... $ 48,425 47,020
After one year through five years..................... 72,760 76,800
After five years through ten years.................... 59,361 64,024
After ten years....................................... 86,737 92,698
Mortgage-backed securities............................ 88,209 86,904
-------- -------
$355,492 367,446
======== =======
</TABLE>
The change in net unrealized capital gains and losses on investments
available for sale is as follows (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
------------------------
1996 1995 1994
------- ------ -------
<S> <C> <C> <C>
Fixed maturity securities..................... $(7,420) 17,999 (16,281)
Equity securities............................. (1,057) 5,282 (5,536)
Deferred income taxes......................... 2,966 (4,602) --
------- ------ -------
Change in net unrealized capital gains and
losses, net of tax......................... $(5,511) 18,679 (21,817)
======= ====== =======
</TABLE>
Due to the facts and circumstances related to accounting for income taxes
under SFAS No. 109 discussed in Note 5, the Company recorded no deferred
income taxes related to unrealized capital gains and losses in 1994.
A-30
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Sales of Securities
Net realized investment gains and proceeds from the sale of investments for
the years ended December 31, 1996, 1995 and 1994 are as follows (in
thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------ ----- ------
<S> <C> <C> <C>
Fixed maturities.................................... $ 658 1,812 1,910
Equity securities................................... (52) 806 --
Other invested assets............................... 593 -- --
------ ----- ------
Net realized investment gains..................... $1,199 2,618 1,910
====== ===== ======
Proceeds from sale of bonds (calls and maturities
excluded).......................................... $ -- 7,075 40,609
====== ===== ======
</TABLE>
The cost of each security sold was specifically identified in computing the
related gain or loss.
4. STOCKHOLDERS' EQUITY
The payment of dividends by Highlands without prior approval of the Texas
Department of Insurance is limited to formula amounts. Accordingly, the net
assets of HIC are similarly restricted. At December 31, 1996, approximately
$18 million was available for the payment of dividends without prior approval
by the Texas Department of Insurance. Dividends in the amount of $3 million
were paid to HIC by Highlands in 1996.
Statutory capital and surplus and net income (loss), determined in
accordance with accounting practices prescribed or permitted by the Texas
Department of Insurance, for Highlands follows (in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
-------- ------- -------
<S> <C> <C> <C>
Statutory capital and surplus.................. $188,527 180,020 257,953
======== ======= =======
Statutory net income (loss).................... $ (2,021) (78,533) 6,310
======== ======= =======
</TABLE>
Statutory capital and surplus and net (loss) for Highlands (UK), determined
in accordance with United Kingdom accounting practices, are as follows (in
thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------ ------- -----
<S> <C> <C> <C>
Statutory capital and surplus...................... $5,778 5,442 7,881
====== ======= =====
Statutory net income (loss)........................ $ 373 (12,276) (192)
====== ======= =====
</TABLE>
After incurring unacceptable underwriting results in 1991 and 1992 and
reviewing the prospects for the future, Highlands (UK) voluntarily ceased
producing new business effective April 1993. The Company received a
Notification of Requirements from the Department of Trade and Industry (DTI)
on October 29, 1993, which included: timely reporting of certain financial
information; restrictions on certain investment activities without prior
approval of the DTI; restrictions relating to transactions with connected
persons; and a provision requiring Highlands (UK) to cease to effect contracts
of insurance except where it has a legal obligation to do so. Capital
infusions for Highlands (UK) were arranged in 1993 but not effected until 1994
due to the Notification of Requirements restriction requiring approval of
connected-person transactions. During 1994, DTI sent an additional
requirements notice to Highlands (UK) requesting a plan for restoration of a
sound financial position because of its failure to maintain a margin of
solvency required by Section 32 of the Insurance Company's Act of 1982 for a
company writing premiums. Highlands (UK) has developed such a plan.
Maintaining a license to write business in the United Kingdom is not essential
and Highlands (UK)'s plan does not anticipate any further
A-31
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
capital contribution to Highlands (UK) beyond the 1995 contribution of $10
million. Management believes that the regulatory matters concerning Highlands
(UK) should not have a material impact on the Company's financial position.
In 1994, Highlands (UK) had a liability of $21.5 million for cash advances
received from an affiliate of Halliburton. In 1994, this liability was
exchanged for a capital contribution to Highlands (UK). Accordingly, the
Company recorded additional paid-in capital of $21.5 million in 1994. The
capital contribution is considered a non-cash financing transaction for the
purposes of the statement of cash flows. Additionally, HIC contributed $10
million to Highlands (UK) on December 20, 1995.
5. FEDERAL AND FOREIGN INCOME TAXES
The Company provides for income taxes on its statements of operations
pursuant to Statement of Financial Accounting Standards 109, "Accounting for
Income Taxes" (SFAS 109). With respect to losses for periods preceding the
Distribution (January 23, 1996), no tax benefit was recorded in the statements
of operations pursuant to SFAS 109 and the Company's tax-sharing arrangement
with its former parent, Halliburton. Tax receipts under its intercompany tax-
sharing arrangements with its former parent were recorded as additions to
stockholders' equity for the periods preceding the Distribution.
The tax-sharing arrangement resulted in Halliburton acquiring the domestic
deferred tax assets and liabilities from its domestic subsidiaries. In
contemplation of Halliburton's distribution of HIC shares, Halliburton
contributed to Highlands the net deferred tax assets attributable to Highlands
which HIC recorded as a contribution to capital in 1995. The contribution of
the net deferred tax asset is considered a non-cash financing transaction for
the purposes of the statement of cash flows. Based upon the tax-free nature of
the Distribution of HIC from Halliburton the deferred tax asset attributes are
available to HIC.
The primary components of the Company's deferred tax assets and liabilities
and the related valuation allowance at December 31, 1996 and 1995,
respectively, follow (in thousands):
<TABLE>
<CAPTION>
1996 1995
------- ------
<S> <C> <C>
Deferred tax assets--
Loss and loss adjustment expense reserves.............. $33,382 42,048
Net operating loss carryforward........................ 20,023 5,204
Legal reserve.......................................... -- 3,675
Unearned premiums...................................... 2,005 3,195
Vacation and employee benefit reserves................. 760 837
Policyholder dividends................................. 350 350
Other.................................................. 1,362 364
------- ------
Gross deferred tax assets............................ 57,882 55,673
Valuation allowance...................................... (5,204) (5,204)
------- ------
Net deferred tax assets.............................. 52,678 50,469
------- ------
Deferred tax liabilities--
Accrued retrospective premiums......................... 8,489 9,410
Deferred acquisition costs............................. 2,253 4,110
Amortized bond discount, net........................... 3,174 2,813
Unrealized investment gains............................ 1,636 4,602
------- ------
Gross deferred tax liabilities....................... 15,552 20,935
------- ------
Net deferred tax asset................................... $37,126 29,534
======= ======
</TABLE>
A-32
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The realization of the net deferred tax asset is dependent upon Highland's
ability to generate sufficient taxable income in future periods. The net
deferred tax asset is net of valuation allowances of $5.2 million at each of
December 31, 1996 and 1995, respectively. The valuation allowances are based
upon management's assessment that it is more likely than not that the portion
of the deferred tax asset related to Highlands (UK)'s net operating loss
carryforwards will not be realized. Based upon the anticipated future
earnings, historical profitability of the domestic operations, projected
reversal of the temporary differences, tax planning strategies available if
required and all other available evidence, both positive and negative,
management has concluded it is more likely than not that the net deferred tax
asset will be realized. Adjustments to the valuation allowance will be made if
there is a change in management's assessment of the amount of the deferred tax
asset that is realizable.
The income tax benefit was different from the amount computed by applying
the federal income tax rate to income (loss) before income taxes for the
following reasons (in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
-------- -------- ------
<S> <C> <C> <C>
Income (loss) before taxes......................... $(17,441) (120,742) 2,283
Tax rate........................................... 35% 35% 35%
-------- -------- ------
Application of the tax rate........................ (6,104) (42,260) 799
Tax effect of--
Tax-exempt interest.............................. (5,889) (6,881) (8,992)
Foreign tax differential......................... (105) 1,537 (1,286)
Other............................................ -- 36 (81)
-------- -------- ------
Income tax benefit before adjustment............... (12,098) (47,568) (9,560)
Net operating loss utilized by former affiliates,
not recognizable by Highlands under separate
return calculation................................ -- 47,568 9,560
-------- -------- ------
Income tax benefit as recorded..................... $(12,098) -- --
======== ======== ======
</TABLE>
At December 31, 1996, the Company had net operating loss carryforwards of
$42.3 million for federal income tax purposes which will expire, if unused, in
the year 2011. In addition, the Company had foreign tax loss carryforwards of
$15.8 million which can be carried indefinitely. For financial reporting
purposes, the valuation allowance offsets the deferred tax asset related to
the foreign tax loss carryforwards.
6. DEBT OUTSTANDING
On January 23, 1996, HIC issued $62.85 million in principal amount of 10%
convertible subordinated debentures (Debentures) due December 31, 2005,
together with Series A and A-2 (collectively the "Series A Warrants") and B
and B-2 (collectively the "Series B Warrants") common stock purchase warrants,
to Insurance Partners, L.P., and Insurance Partners Offshore (Bermuda), L.P.
(collectively "IP") and certain members of the Company's management team
(Management Investors). The Company received $60 million in cash from IP and
the Management Investors and individual promissory notes (each, a "Promissory
Note" and, collectively, the "Promissory Notes") in the aggregate principal
amount of $2.85 million made by the individual Management Investors without
personal liability and secured by a pledge of Debentures. The Debentures
issued in exchange for the Management Investors Promissory Note were issued
pursuant to a Purchase, Redemption and Bonus Agreement (the "Purchase
Agreement").
The carrying values of the Debentures, Series A Warrants and Series B
Warrants at the Distribution date were determined by allocating the $62.85
million purchase price based upon estimated relative fair value of such
securities. The estimated fair value of the Series A Warrants and Series B
Warrants amounting to $8.2 million
A-33
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
was recorded as paid-in capital, net of $.8 million of Debentures' acquisition
costs. The debt discount related to the Series A Warrants and Series B
Warrants is being amortized over the ten-year life of the Debentures and
amounted to $.8 million for the year ended December 31, 1996.
The Debentures are convertible into common stock of HIC after one year from
issuance at the option of the holders. If all of the Debentures are converted
into HIC common stock at the conversion price of $16.16 per share, the holders
would receive approximately 3.9 million shares of HIC common stock and have an
ownership interest in HIC of approximately 25%. Interest on the Debentures is
payable semi-annually in cash at 10% per annum. HIC can redeem the Debentures
at any time after December 3, 2002. Total interest expense incurred and paid
on the Debentures was $5.6 million in 1996. The acquisition costs related to
the Debentures are being amortized over the ten-year life of the Debentures
and amounted to $.5 million for the year ended December 31, 1996.
The detachable Series A Warrants enable the holders to purchase HIC common
stock at an exercise price of $12.89 per share, equal to an additional
ownership interest in HIC of approximately 21% after giving effect to the
assumed conversion of the Debentures and the exercise of the Series A
Warrants. If all of the Series A Warrants were exercised, the holders would
receive approximately 4.0 million shares of common stock of HIC. The exercise
price and the number of shares of HIC common stock into which the Series A
Warrants are exercisable are subject to adjustment related to adverse loss
reserve and uncollectible reinsurance development. Such adjustment reduced the
exercise price by $1.80 per share in 1996. These warrants expire on December
31, 2005.
The detachable Series B Warrants enable the holders to purchase HIC common
stock at an exercise price of $12.89 per share, equal to an additional
ownership interest of 5% after giving effect to the assumed conversion of the
Debentures and the exercise of the Series A and B Warrants. The Series B
Warrants become exercisable by the holders in the event that the average
closing market price of HIC common stock exceeds 1.61 times the exercise price
for any 30 consecutive trading days between January 1, 1999 and December 31,
2000. If all of the Series B Warrants were exercised, the holders would
receive approximately 1.0 million additional shares of HIC common stock. The
exercise price and the number of shares of HIC common stock into which the
Series B Warrants are exercisable are subject to adjustment related to adverse
loss reserve and uncollectible reinsurance development. Such adjustment
reduced the exercise price by $1.80 per share in 1996. The detachable Series B
Warrants expire on December 31, 2005.
The Purchase Agreement further provides for a bonus to be paid to each
Management Investor on the fifth anniversary of the Purchase Agreement if the
average closing price of the Company Common Stock is equal to or greater than
prices expressed as a percentage of the exercise price of the Series A
Warrants (as adjusted from time to time) as specified in the Purchase
Agreement (the "Bonus Trigger Stock Price"). The amount of the bonus is stated
as a percentage of a maximum bonus amount separately determined for each
Management Investor and equal to the aggregate principal amount of each
Management Investor's Promissory Note. If the Bonus Trigger Stock Price is at
least 1.40 times but less than 1.50 times the Series A Warrant exercise price,
the bonus is 25% of the maximum bonus amount, 50% if the Bonus Trigger Stock
Price is a least 1.50 but less than 1.61 times the Series A Warrant exercise
price and 100% if the Bonus Trigger Stock Price is 1.61 times the Series A
Warrant exercise price or higher.
If the Debentures are converted into common stock of HIC and the Series A
and B Warrants are utilized by the holders to purchase common stock of HIC, IP
and the Management Investors will have an ownership interest in HIC of
approximately 44%.
A-34
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
7. REINSURANCE
The Company assumes and cedes insurance with other insurers and reinsurers
and members of various reinsurance pools and associations and syndicates. The
Company utilizes reinsurance arrangements to limit its maximum loss, to
provide greater diversification of risks and to minimize exposures on larger
risks. Generally, reinsurance coverage is on an excess of loss basis. In
addition, the Company has catastrophe coverage for certain types of losses
over stipulated aggregate amounts arising from any one occurrence or event.
The ceding of reinsurance does not discharge the primary liability of the
original insurer. The Company currently places reinsurance with other carriers
only after careful review of the nature of the contract and a thorough
assessment of the reinsurer's current credit quality and claim settlement
performance. Based upon its evaluations of reinsurers, the Company has
established reserves ($2.4 million and $4.6 million as of December 31, 1996
and 1995, respectively) or does not record certain contracts as ceded business
but retains these amounts ($20.1 million and $18.6 million as of December 31,
1996 and 1995, respectively) as loss reserves for potentially uncollectible
reinsurance at such time as an uncollectible amount is probable and the amount
may be reasonably estimated. Because of the difficulty of acquiring accurate
information for certain reinsurers, including Lloyds syndicates and members,
the Company believes that no meaningful range of potentially uncollectible
reinsurance can be established beyond recorded reserves. With respect to its
domestic book of business and reinsurers that are not authorized reinsurers as
determined by the Texas Department of Insurance, the Company often receives
collateral primarily in the form of bank letters of credit generally securing
the reinsurance recoverable regarding reported losses and in some instances
IBNR. At December 31, 1996 such collateral totaled approximately $14.8
million.
The Company's three largest recoverables as of December 31, 1996, were
approximately $111.2 million with Underwriters at Lloyds of London, $84.2
million with American Re-insurance Company and $55.0 million with General
Reinsurance Company. American Re-insurance Company and General Reinsurance
Company are rated by A. M. Best and carry an A+ and A++ rating, respectively.
A-35
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The effects of assumed and ceded reinsurance on net premiums and losses
follows (in thousands):
<TABLE>
<CAPTION>
DIRECT ASSUMED CEDED NET
-------- ------- -------- -------
<S> <C> <C> <C> <C>
Year ended December 31, 1996--
Written premiums--
HIC-US.................................... $147,474 7,892 (20,671) 134,695
HIC-UK.................................... -- 3,180 (2,824) 356
-------- ------- -------- -------
Total.................................... $147,474 11,072 (23,495) 135,051
======== ======= ======== =======
Earned premiums--
HIC-US.................................... $160,776 10,723 (19,807) 151,692
HIC-UK.................................... -- 3,180 (2,824) 356
-------- ------- -------- -------
Total.................................... $160,776 13,903 (22,631) 152,048
======== ======= ======== =======
Losses and loss adjustment expenses
incurred--
HIC-US.................................... $159,611 23,029 (27,580) 155,060
HIC-UK.................................... -- 30,519 (28,990) 1,529
-------- ------- -------- -------
Total.................................... $159,611 53,548 (56,570) 156,589
======== ======= ======== =======
Year ended December 31, 1995--
Written premiums--
HIC-US.................................... $210,052 17,677 (28,145) 199,584
HIC-UK.................................... -- 6,646 (4,665) 1,981
-------- ------- -------- -------
Total.................................... $210,052 24,323 (32,810) 201,565
======== ======= ======== =======
Earned premiums--
HIC-US.................................... $204,508 20,345 (25,388) 199,465
HIC-UK.................................... -- 6,646 (4,665) 1,981
-------- ------- -------- -------
Total.................................... $204,508 26,991 (30,053) 201,446
======== ======= ======== =======
Losses and loss adjustment expenses
incurred--
HIC-US.................................... $273,488 116,413 (108,222) 281,679
HIC-UK.................................... -- 71,676 (53,102) 18,574
-------- ------- -------- -------
Total.................................... $273,488 188,089 (161,324) 300,253
======== ======= ======== =======
Year ended December 31, 1994--
Written premiums--
HIC-US.................................... $234,277 41,288 (43,416) 232,149
HIC-UK.................................... -- 17,210 (6,161) 11,049
-------- ------- -------- -------
Total.................................... $234,277 58,498 (49,577) 243,198
======== ======= ======== =======
Earned premiums--
HIC-US.................................... $233,343 42,958 (45,674) 230,627
HIC-UK.................................... -- 17,210 (6,161) 11,049
-------- ------- -------- -------
Total.................................... $233,343 60,168 (51,835) 241,676
======== ======= ======== =======
Losses and loss adjustment expenses
incurred--
HIC-US.................................... $169,330 48,874 (7,458) 210,746
HIC-UK.................................... -- 161,534 (147,965) 13,569
-------- ------- -------- -------
Total.................................... $169,330 210,408 (155,423) 224,315
======== ======= ======== =======
</TABLE>
A-36
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
8. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
<TABLE>
<CAPTION>
1996 1995 1994
---------- --------- ---------
<S> <C> <C> <C>
Balance at January 1....................... $1,253,627 1,149,173 1,225,242
Less--Reinsurance recoverables........... 599,558 557,096 627,285
---------- --------- ---------
Net balance at January 1................... 654,069 592,077 597,957
---------- --------- ---------
Incurred related to--
Current year............................. 133,717 156,683 159,431
Prior years--
Asbestos............................... 4,645 50,027 10,160
Environmental.......................... 1,912 31,768 15,879
All other.............................. 16,315 61,775 38,845
---------- --------- ---------
Total prior years........................ 22,872 143,570 64,884
---------- --------- ---------
Total incurred......................... 156,589 300,253 224,315
---------- --------- ---------
Paid related to--
Current year............................. 37,020 39,846 45,609
Prior years--
Asbestos............................... 4,871 10,550 2,830
Environmental.......................... 2,984 6,080 3,650
All other.............................. 155,666 181,785 178,106
---------- --------- ---------
Total prior years........................ 163,521 198,415 184,586
---------- --------- ---------
Total paid............................. 200,541 238,261 230,195
---------- --------- ---------
Net balance at December 31............. 610,117 654,069 592,077
Add--Reinsurance recoverables.......... 546,707 599,558 557,096
---------- --------- ---------
Balance at December 31..................... $1,156,824 1,253,627 1,149,173
========== ========= =========
</TABLE>
As a result of changes in estimates of insured events in prior years,
primarily environmental and pollution claims, the provision for losses and
loss adjustment expenses (net of reinsurance recoveries of $(22.0) million,
$152.9 million and $123.5 million for 1996, 1995 and 1994, respectively)
increased by $22.9 million in 1996, $143.6 million in 1995 and $64.9 million
in 1994.
As the result of a review conducted in the third quarter of 1995, the
Company increased loss and loss adjustment expense reserves by $117 million in
the third quarter of 1995. The review process consisted of gathering new
information and refining prior estimates, with a major focus on assumed
reinsurance and overall environmental and asbestos exposures. For the years
ended December 31, 1996, 1995 and 1994, the Company recognized $6.6 million,
$81.8 million and $26.0 million, respectively, of adverse development related
to environmental and asbestos exposures.
Losses incurred related to prior years for all other is primarily related to
Highlands (UK) and assumed casualty reinsurance exposures. Net reserve re-
estimates for Highlands (UK) for 1996, 1995, and 1994 were $1.5 million, $18.6
million and $13.6 million, respectively, and relate primarily to catastrophe
losses. Assumed casualty reinsurance net reserve re-estimates for 1996, 1995,
and 1994 amounted to $3.5 million, $14.3 million, and $15.3 million,
respectively.
A-37
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
9. EMPLOYEE BENEFITS
Highlands has a retirement and savings plan (defined contribution plan) for
employees. All employees are eligible to participate in the plan following the
completion of one year of service. Highlands' contributions are restricted to
amounts authorized annually by the Highlands' board of directors. Employees,
at their option, may contribute a portion of their eligible earnings to the
plan. Retirement benefits are based on the balance in each employee's account,
including the amount vested in employer contributions. The plan may be
canceled at any time at the option of Highlands. Highlands' contributions to
the plan for 1996, 1995 and 1994 were approximately $.6 million, $1.5 million
and $1.6 million, respectively.
10. STOCK COMPENSATION PLANS
At December 31, 1996, the Company had a stock-based compensation plan, which
is described below. The Company applies APB Opinion No. 25 and related
Interpretations in accounting for its plans. Accordingly, compensation cost
has been recognized for the options granted to acquire Company Common Stock
granted prior to the Distribution and prior to a market price for Company
Common Stock. However, no compensation cost has been recognized for shares
issued subsequent to the Distribution which are issued with an exercise price
equal to the market value at date of grant. The compensation cost that has
been charged against income for its stock-based plan was $.7 million for 1996.
Had all compensation cost for the Company's stock-based compensation plan been
determined pursuant to SFAS 123, the Company's net loss and loss per share
would have increased $1.26 million and $.11, respectively, to the pro forma
amounts indicated below (in thousands, except per share data):
<TABLE>
<CAPTION>
1996
-------
<S> <C> <C>
Net (loss).......................................... As reported $(5,343)
Pro forma $(6,609)
Net (loss) per common share......................... As reported $ (.47)
Pro forma $ (.58)
</TABLE>
Pursuant to the Company's 1995 Stock Option Plan, HIC may grant either
incentive stock options (ISO) or non-qualified stock options (NQSO). The
exercise price for each share subject to an option will be an amount that the
Compensation Committee determines, in its good faith judgment. In the case of
ISOs, however, the exercise price per share shall not be less than the amount
the Committee determines, in its good faith judgment, to be not less than 100%
of the fair value of Company common stock on the date the option is granted.
Options are typically exercisable over a period not in excess of ten years.
The options generally vest over three to four years, or in full upon a change
of control of the Company. The maximum number of shares that are reserved for
issuance under all option plans is 750,000 at December 31, 1996. A summary of
the status of the Company's stock option plans at December 31, 1996 and
changes during the year ended on that date is presented below:
<TABLE>
<CAPTION>
1996
-------------------------
SHARES WEIGHTED-AVERAGE
SHARES UNDER OPTION (000) EXERCISE PRICE
------------------- ------- ----------------
<S> <C> <C>
Outstanding at beginning of year.................... -- $ --
Granted............................................. 522,000 15.03
Exercised........................................... -- --
Forfeited........................................... (36,000) 15.02
-------
Outstanding at end of year.......................... 486,000 $15.03
======= ======
Options exercisable at year-end..................... none
Weighted-average fair value of options granted
during the year:
Issued prior to the Distribution.................. $ 9.92
Issued equal to market value...................... $ 7.88
</TABLE>
A-38
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Summarized information with respect to outstanding stock options at December
31, 1996, is as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------------- ----------------------------
RANGE OF NUMBER WEIGHTED AVERAGE NUMBER
EXERCISE OUTSTANDING REMAINING WEIGHTED AVERAGE EXERCISABLE WEIGHTED AVERAGE
PRICES AT 12/31/96 CONTRACTUAL LIFE EXERCISE PRICE AT 12/31/96 EXERCISE PRICE
- -------- ----------- ---------------- ---------------- ----------- ----------------
<S> <C> <C> <C> <C> <C>
$14.69
to
$21.13 486,000 9.0 years $15.03 -- --
</TABLE>
The fair value of stock options granted during the year ended December 31,
1996 was $4.8 million. The fair value of each option is estimated on the date
of the grant using the Black-Scholes option-pricing model.
The following weighted average assumptions were used for grants in 1996:
expected volatility of 15.0%, risk-free interest rate of 6.5%, expected life
of 6.5 years and a dividend yield of 0%.
11. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company has identified certain assets as financial instruments that
require fair value disclosure. The estimated fair value of financial
instruments has been determined by the Company using available market
information and appropriate valuation methodologies. However, considerable
judgment is necessarily required in interpreting market data to develop the
estimates of fair value. Accordingly, the Company's estimates of fair value
are not necessarily indicative of the amounts that the Company could realize
in a current market exchange. Potential taxes and other transaction costs have
not been considered in estimating fair value. As a number of the Company's
significant assets (including deferred policy acquisition costs, property and
equipment, and deferred taxes) and liabilities (loss and loss adjustment
expense reserves) are not considered financial instruments, the disclosures
that follow do not reflect the fair value of the Company as a whole.
The carrying values and estimated fair values of financial instruments at
December 31, 1996 and 1995, were as follows:
<TABLE>
<CAPTION>
1996 1995
---------------- ----------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
-------- ------- -------- -------
<S> <C> <C> <C> <C>
Assets:
Fixed maturity securities................... $680,397 692,351 601,873 624,238
Equity securities........................... 26,967 26,967 33,697 33,697
Other invested assets....................... 3,770 3,770 -- --
Cash and cash equivalents................... 49,484 49,484 85,176 85,176
Premium installment receivables............. 4,145 4,145 8,237 8,237
Accrued invested assets..................... 12,600 12,600 11,131 11,131
Liabilities:
Convertible subordinated debentures......... 55,452 60,000 -- --
</TABLE>
Fair values for fixed maturity securities are based on quoted market prices,
where available. If quoted market prices were not available, fair values were
determined by dealers specializing in those securities. Equity securities are
valued based on quoted market prices. Cash and cash equivalents, premium
installment receivables, accrued investment income and other investments are
valued at their carrying value as they are highly liquid financial assets with
maturities of less than one year. The fair value for convertible subordinated
debentures was estimated using discounted cash flow calculations based upon
HIC's current incremental borrowing for similar types of borrowing
arrangements.
A-39
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
12. CONTINGENT LIABILITIES
Loss and Loss Adjustment Expense Reserves
The Company establishes loss reserves which are estimates of future payments
of reported and unreported claims for losses and the related expenses with
respect to insured events that have occurred. The process of establishing loss
reserves is subject to uncertainties that are normal, recurring and inherent
in the property and casualty business. The process requires reliance upon
estimates based on available data that reflect past experience, current trends
and other information and the exercise of informed judgment. As information
develops that varies from experience, provides additional data or, in some
cases, augments data that previously was not considered sufficient for use in
determining reserves, changes in the Company's estimate of ultimate
liabilities may be required. The effect of these changes, net of reinsurance,
is charged or credited to income for the periods in which they are determined.
Reserving for asbestos, environmental-related and certain other long-term
exposure claims is subject to significant additional uncertainties that are
not generally present for other types of claims. Developed case law and
adequate claim history do not exist for such claims. Highlands and the
insurance industry dispute coverage for certain environmental, pollution and
asbestos liabilities of their policyholders. These claims differ from almost
all others in that it is not often clear that an insurable event has occurred
and which, if any, multiple policy years and insurers will be liable. These
uncertainties prevent identification of applicable policy and policy limits
until after a claim is reported and substantial time is spent (many years in
some cases) resolving contract issues and determining facts necessary to
evaluate the claim. If the courts continue in the future to expand the intent
of the policies and the scope of the coverage as they have in the past,
additional liabilities could emerge for amounts in excess of the current
reserves held.
The Company uses methods and assumptions that are consistent with prevailing
actuarial practice and are modified periodically based on changes in
circumstance. However, estimation of loss reserves for asbestos, environmental
related and other long-term exposure claims is one of the most difficult
aspects of establishing reserves, especially given the above uncertainties.
Because of the significant uncertainties involved and the likelihood that
these uncertainties will not be resolved in the near future, the Company
believes that no meaningful range of loss and loss adjustment expense reserves
beyond recorded reserves can be established.
In management's judgment, information currently available has been
appropriately considered in estimating the Company's loss reserves. However,
future changes in estimates of the Company's liability for insured events may
adversely affect results in future periods although such effects cannot be
reasonably estimated.
Proposition 103
In November 1988, the State of California adopted by ballot initiative
Proposition 103, a comprehensive system of regulation applicable to all
property and casualty insurance written in California. Proposition 103 does
not apply to workers' compensation insurance or reinsurance. Proposition 103
provided, among other things, that rates for automobile and certain other
insurance policies issued or renewed on or after November 8, 1988 be rolled
back to levels of November 8, 1987 and then reduced by an additional 20%. In
January 1995, the State of California Department of Insurance ("DOI") notified
the Company that it believed that the Company had a premium rollback
obligation to policyholders under Proposition 103. On April 18, 1995, the DOI
issued a Notice of Hearing Re Proposition 103 Rollback Exemption Application
In the Matter of the Rate Rollback Liability of Highlands and Highlands
Underwriters Insurance Company. Subsequent to the issuance of the Notice of
Hearing, there was a Prehearing Conference Order and several motions regarding
the extent and nature of discovery. On June 30, 1995, Highlands and Highlands
Underwriters Insurance Company mailed a settlement offer to the Insurance
Commissioner of the State of California, which was rejected by the
Commissioner on July 18, 1995.
A-40
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
In December of 1995, a decision was entered in the matter of Amwest Surety
Insurance Company v. Pete Wilson, et al. In that case, the Supreme Court of
the State of California determined that surety insurance would be subject to
Proposition 103. There were hearings pursuant to the above-referenced Notice
of Hearing during May and June of 1996 at which the DOI asserted that the
rollback obligation of Highlands and Highlands Underwriters Insurance Company
was $3.9 million, plus interest, for a total amount of $6.5 million. In
connection with such hearing, the administrative law judge was expected to
render a decision regarding the Company's rollback liability during the last
quarter of 1996. Subsequent to the June of 1996 hearing, the Company re-
evaluated its legal reserves, and such reserves were increased in the third
quarter of 1996 by $1 million to reflect the Company's current estimate of its
most probable loss. Settlement negotiations occurred during the fourth quarter
of 1996, and as a result of the status of such negotiations, legal reserves
were increased $1 million in the fourth quarter of 1996.
On February 3, 1997, this matter was settled for $5.7 million and such
amount is not in excess of current legal reserves and is not expected to have
a material adverse effect on the financial condition of the Company. The
settlement will be submitted to the Administrative Law Judge and the
Commissioner of Insurance for their approval, and the Company has no reason to
believe at this time that the settlement will not be approved. In the event
the settlement is not approved, the Company will continue to defend this
matter vigorously.
Class Action Lawsuit
On May 15, 1991, Weatherford Roofing Company and other plaintiffs commenced
an action against Employers National Insurance Company in the 116th Texas
State District Court in Dallas County, Texas, alleging that they had been
overcharged for workers' compensation insurance. On April 23, 1992, the
plaintiffs amended their petition to allege a class action on behalf of all
employers overcharged for workers' compensation insurance purchased between
1987 and 1992 to cover Texas employees. On April 18, 1994, Highlands and
Highlands Underwriters Insurance Company were added to the action as named
defendants. The lawsuit, styled Weatherford Roofing Company, et al. v.
Employers National Insurance Company (Case No. 91-05637), alleges, among other
things, that the defendants conspired to charge rates of premium for
retrospectively rated insurance policies that exceeded rates then permitted
under applicable Texas law and regulations.
On July 2, 1996, the named plaintiffs and a group of 14 insurance company
defendants, including the Company, entered into a settlement agreement (the
"Settlement Agreement"), and said agreement has received preliminary approval
of the court. Pursuant to the terms of the Settlement Agreement, in July of
1996, notification of the settlement was published in several Texas newspapers
and mailed to all insureds within the settlement class. The insureds that have
elected to opt-out of the settlement will not impact Highlands or terminate
the Settlement Agreement.
Final approval of the Settlement Agreement was granted by the court in the
fourth quarter of 1996 and the distribution of the settlement fund is now
expected to occur in the first quarter of 1997. The time to appeal the
approval of the Settlement Agreement has now expired. The Company's liability,
pursuant to the terms of the Settlement Agreement, is not in excess of current
legal reserves and is not expected to have a material adverse effect on the
financial position of the Company.
Other
The Company is a party to various claims and legal actions arising in the
ordinary course of its insurance business which, in the opinion of management,
will not have a material effect on the Company's financial position or results
of operations.
A-41
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Leases
At December 31, 1996, the Company was obligated under noncancelable
operating leases, expiring on various dates through 2001, principally for
office space and computer software. Future aggregate minimum rentals on
noncancelable operating leases are as follows: $4.2 million in 1997, $4.0
million in 1998, $3.6 million in 1999, $1.8 million in 2000 and $3.2 million
for all remaining years thereafter.
The Company's gross rental expense was approximately $4.5 million, $5.3
million and $5.1 million for the years ended December 31, 1996, 1995 and 1994,
respectively.
Year 2000
The Company has conducted a comprehensive review of its computer systems to
identify the systems that could be affected by the "Year 2000" issue and is
developing an implementation plan to resolve the issue. The Year 2000 problem
is the result of computer programs being written using two digits (rather than
four) to define the applicable year. Any of the Company's programs that have
time-sensitive software may recognize a date using "00" as the year 1900
rather than the year 2000. This could result in a major system failure or
miscalculations. The Company presently believes that, with modifications to
existing software and converting to new software, the Year 2000 problem will
not pose significant operational problems for the Company's computer systems
as so modified and converted. However, if such modifications and conversions
are not completed timely, the Year 2000 problem may have a material impact on
the operations of the Company.
13. SEGMENT INFORMATION
In the normal course of business, the Company underwrites risks of
Halliburton and various subsidiaries and affiliates of Halliburton. During
1996, 1995 and 1994 , net premiums earned from Halliburton aggregated
approximately $30.7 million, $54.2 million and $41.7 million, respectively.
A portion of this business is retrospectively rated, meaning that ultimate
premiums will approximate ultimate losses plus certain expenses. Premiums due
from Halliburton under these retrospective arrangements were approximately
$68.4 million and $78.3 million at December 31, 1996 and 1995, respectively.
A portion of the Company's business is conducted in the United Kingdom. The
following summary presents the Company's business by geographic segments (in
thousands).
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1996 1995 1994
---------- --------- ---------
<S> <C> <C> <C>
Revenues:
Domestic.............................. $ 199,100 246,376 276,484
United Kingdom........................ 5,135 6,217 13,822
---------- --------- ---------
$ 204,235 252,593 290,306
========== ========= =========
Income (loss) before income taxes:
Domestic.............................. $ (15,954) (94,075) 16,880
United Kingdom........................ (1,487) (26,667) (14,597)
---------- --------- ---------
$ (17,441) (120,742) 2,283
========== ========= =========
Identifiable Assets:
Domestic.............................. $1,315,359 1,353,918 1,273,732
United Kingdom........................ 250,672 282,173 265,686
---------- --------- ---------
$1,566,031 1,636,091 1,539,418
========== ========= =========
</TABLE>
A-42
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
14. QUARTERLY FINANCIAL DATA (UNAUDITED)
The following quarterly financial information for each of the three months
ended March 31, June 30, September 30 and December 31, 1996 and 1995 is
unaudited. However, in the opinion of management, all adjustments (consisting
of normal recurring adjustments) necessary to present fairly the results of
operations for such periods, have been made for a fair presentation of the
results shown.
<TABLE>
<CAPTION>
JUNE DEC.
QUARTER ENDED MARCH 31 30 SEPT. 30 31
------------- -------- ------ -------- ------
<S> <C> <C> <C> <C>
1996
Net premiums earned........................ $46,836 40,018 35,057 30,137
Total revenues............................. 59,963 52,932 47,814 43,526
Total expenses............................. 59,699 57,158 46,333 58,486
Net income (loss).......................... 214 (3,506) 1,233 (3,284)
Net income (loss) per common share......... .02 (.31) .11 (.29)
1995
Net premiums earned........................ $43,519 69,535 51,272 37,120
Total revenues............................. 55,893 81,722 65,838 49,140
Total expenses............................. 53,594 78,843 189,081 51,817
Net income (loss).......................... 2,299 2,879 (123,243) (2,677)
Net income (loss) per common share......... .20 .25 (10.77) (.23)
</TABLE>
A-43
<PAGE>
APPENDIX B
HIGHLANDS INSURANCE GROUP, INC.
1995 STOCK OPTION PLAN
1. PURPOSES
Highlands Insurance Group, Inc., a Delaware corporation (the "Company"), has
adopted this 1995 Stock Option Plan (the "Plan") to provide for the granting
to certain Key Employees (as hereinafter defined) of:
(a) incentive stock options ("Incentive Options") within the meaning of
Section 422 of the Internal Revenue Code of 1986, as amended (the "Code");
and
(b) stock options that do not meet the requirements for Incentive Options
("Non-Qualified Options" and, together with Incentive Options, "Options").
The purpose of the Plan is to provide an incentive for Key Employees to
remain in the service of the Company and its subsidiaries, to extend to them
an opportunity to acquire a proprietary interest in the Company, and thereby
create in such Key Employees an increased interest in and a greater concern
for the welfare of the Company and its subsidiaries, and to aid the Company in
attracting able persons to enter the service of the Company and its
subsidiaries.
The Options offered pursuant to the Plan are a matter of separate inducement
and are not in lieu of any salary or other compensation for the services of
any Key Employee.
The Company makes no warranty as to the qualification of any Option as an
Incentive Option.
2. STOCK SUBJECT TO THE PLAN
Subject to the provisions of Section 11 hereof, the total number of shares
of common stock, $.01 par value per share, of the Company ("Common Stock")
which either may be purchased pursuant to the exercise of Options granted
under the Plan (the "Shares") shall not exceed, in the aggregate, 350,000
Shares, with no individual optionee to receive in excess of 100,000 Shares.
Shares available for issuance under the Plan may be either authorized but
unissued Shares, Shares of issued stock held in the Company's treasury, or
both, at the discretion of the Company. If and to the extent that Options
granted under the Plan expire, are cancelled or terminate without having been
exercised, such Shares may again be subject to issuance under the Plan.
As used in the Plan, the term "parent corporation" and "subsidiary
corporation" shall mean a corporation within the definitions of such terms
contained in Sections 424(e) and 424(f) of the Code, respectively.
3. ADMINISTRATION
The board of directors of the Company (the "Board of Directors") shall
designate from among its members a committee, which may also be any other
committee of the Board of Directors (the "Committee"), to administer the Plan.
The Committee shall consist of no fewer than two (2) members of the Board of
Directors, each of whom shall be (i) a "disinterested person" within the
meaning of Rule 16b-3 (or any successor rule or regulation) promulgated under
the Securities Exchange Act of 1934, as amended (the "Exchange Act") and (ii)
an "outside director" within the meaning of Section 162(m) of the Code. A
majority of the members of the Committee shall constitute a quorum and the act
of a majority of the members of the Committee shall be the act of the
Committee. Any member of the Committee may be removed at any time either with
or without cause by resolution adopted by the Board of Directors and any
vacancy on the Committee at any time may be filled by resolution adopted by
the Board of Directors.
Any and all powers and functions of the Committee may be exercised at any
time and from time to time by the Board of Directors or an executive committee
of the Board of Directors (the "Executive Committee";
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<PAGE>
references below to the Committee shall be deemed to include references to the
Board of Directors and the Executive Committee, except as the context
otherwise requires); provided, however, that all of the members of the Board
of Directors or the Executive Committee, as the case may be, shall be (i)
"disinterested persons" within the meaning of Rule 16b-3 (or any successor
rule or regulation) promulgated under the Exchange Act and (ii) "outside
directors" within the meaning of Section 162(m) of the Code.
Subject to the express provisions of the Plan, the Committee shall have the
authority, in its sole discretion, to determine the Key Employees to whom
Options shall be granted, the time when such persons shall be granted Options,
the number of Shares which shall be subject to each Option, the purchase price
of each Share which shall be subject to each Option, the period(s) during
which such Options shall be exercisable (whether in whole or part), and the
other terms and provisions thereof (which need not be identical).
Subject to the express provisions of the Plan, the Committee also shall have
the authority to construe the Plan and the Options granted hereunder, to
prescribe, amend and rescind rules and regulations relating to the Plan, to
determine the terms and provisions of the Options (which need not be
identical) and to make all other determinations necessary or advisable for
administering the Plan. The Committee also shall have the authority to
require, in its discretion, as a condition of the granting of any such Option,
that the Key Employee agree (a) not to sell or otherwise dispose of Shares
acquired pursuant to the exercise of such Option for a period of six (6)
months following the date of the acquisition of such Option and (b) that in
the event of termination of employment of such employee, other than as a
result of dismissal without cause or Termination For Good Reason (as defined
in Section 7 herein), such employee will not, for a period to be fixed at the
time of the grant of the Option, enter into any other employment or
participate directly or indirectly in any other business or enterprise which
is competitive with the business of the Company or any subsidiary corporation
or parent corporation of the Company, or enter into any employment in which
such employee will be called upon to utilize special knowledge obtained
through employment with the Company or any subsidiary corporation or parent
corporation thereof. Any officer of the Company or any subsidiary corporation
or parent corporation who is subject to the reporting requirements of Section
16(a) of the Exchange Act (or any successor provision) shall not be entitled
to sell or otherwise dispose of any Shares acquired upon the exercise of any
Option for a period of six (6) months from the date such Option was granted.
Any determination of the Committee on the matters referred to in this
Section 3 shall be conclusive.
The Committee may employ such legal or other counsel, consultants and agents
as it may deem desirable for the administration of the Plan and may rely upon
any opinion or computation received from any such counsel, consultant or
agent. Expenses incurred by the Committee in the engagement of such counsel,
consultant or agent shall be paid by the Company or such subsidiary
corporation or parent corporation of the Company whose employees have
benefitted from the Plan, as determined by the Committee. No member or former
member of the Board of Directors, the Executive Committee or the Committee
shall be liable for any action or determination made in good faith with
respect to the Plan or any Options granted hereunder.
4. ELIGIBILITY
Options may be granted only to employees (including officers but not
directors) of the Company or any subsidiary corporation or parent corporation
of the Company now existing or hereafter formed or acquired, whom the
Committee identifies as having a direct and significant effect on the
performance of the Company or any subsidiary corporation or parent corporation
of the Company now existing or hereafter formed or acquired (a "Key
Employee"). In determining the Key Employees to whom Options shall be granted
and the number of Shares for which Options are to be granted to each Key
Employee, the Committee shall give due consideration to the length of service,
performance, the amount of earnings and the responsibilities and duties of
such person.
The Plan does not create a right in any person to participate in, or be
granted Options under, the Plan.
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<PAGE>
5. OPTION PRICE AND PAYMENT
The price for each Share purchasable under any Non-Qualified Option granted
hereunder shall be determined by the Committee in its good faith judgment.
The price for each Share purchasable under any Incentive Option granted
hereunder shall be determined by the Committee in its good faith judgment, but
shall not be less than one hundred percent (100%) of the Fair Market Value per
Share at the date the Option is granted; provided, however, that in the case
of an Incentive Option granted to a Key Employee who, at the time such Option
is granted, owns shares of the Company or any subsidiary corporation or parent
corporation representing more than ten percent (10%) of the total combined
voting power of all classes of stock of the Company or any subsidiary
corporation or parent corporation, the purchase price for each Share shall be
not less than one hundred ten percent (110%) of the Fair Market Value per
Share at the date the Incentive Option is granted. In determining the stock
ownership of a Key Employee for any purpose under the Plan, the rules of
Section 424(d) of the Code shall be applied, and the Committee may rely on
representations of fact made to it by the Key Employee and believed by it to
be true.
For purposes of the Plan, Fair Market Value, with respect to any date of
determination, means:
(i) if the Shares are listed or admitted to trading on a national
securities exchange in the United States or reported through the National
Association of Securities Dealers Automated Quotation System--National
Market System ("NASDAQ-NMS"), then the closing sale price on such exchange
or NASDAQ-NMS on such date or, if no trading occurred or quotations were
available on such date, then on the closest preceding date on which the
Shares were traded or quoted; or
(ii) if not so listed or reported but a regular, active public market for
the Shares exists (as determined in the sole discretion of the Committee,
whose decision shall be conclusive and binding), then the average of the
closing bid and ask quotations per Share in the over-the-counter market for
such Shares in the United States on such date or, if no such quotations are
available on such date, then on the closest date preceding such date. For
purposes of the foregoing, a market in which trading is sporadic and the
ask quotations generally exceed the bid quotations by more than 15% shall
not be deemed to be a "regular, active public market."
If the Committee determines that a regular, active public market does not
exist for the Shares, the Committee shall determine the Fair Market Value of
the Shares in its good faith judgment based on the total number of shares of
Common Stock then outstanding, taking into account all outstanding options,
warrants, rights or other securities exercisable or exchangeable for, or
convertible into, shares of Common Stock.
Upon the exercise of an Option granted hereunder, the Company shall cause
the purchased Shares to be issued only when it shall have received the full
purchase price therefor in cash; provided, however, that in lieu of cash, the
holder of an Option may, if the terms of such Option so provide and to the
extent permitted by applicable law, exercise an Option in whole or in part,
(i) by delivering to the Company shares of Common Stock of the Company (in
proper form for transfer and accompanied by all requisite stock transfer tax
stamps or cash in lieu thereof) owned by such holder, or (ii) in the case of
an Option which is not an Incentive Option, by the withholding of shares of
Common Stock of the Company for which an Option is exercisable, in either case
having a Fair Market Value equal to the cash exercise price applicable to that
portion of the Option being exercised, the Fair Market Value of the shares of
Common Stock so delivered or withheld to be determined as of the date
immediately preceding the date of exercise, or as otherwise may be required to
comply with or conform to the requirements of any applicable law or
regulations.
6. TERMS OF OPTIONS AND LIMITATIONS ON THE RIGHT OF EXERCISE
Any Option granted hereunder shall be exercisable at such times, in such
amounts and during such period or periods as the Committee shall determine at
the date of the grant of such Option; provided, however, that an Incentive
Option shall not be exercisable after the expiration of ten (10) years from
the date such Option is
B-3
<PAGE>
granted; provided, further, that in the case of an Incentive Option granted to
a person who, at the time such Incentive Option is granted, owns stock of the
Company or any subsidiary corporation or parent corporation of the Company
representing more than ten percent (10%) of the total combined voting power of
all classes of stock of the Company or of any subsidiary corporation or parent
corporation of the Company, such Incentive Option shall not be exercisable
after the expiration of five (5) years from the date such Incentive Option is
granted.
The Committee shall have the right to accelerate, in whole or in part, from
time to time, conditionally or unconditionally, rights to exercise any Option
granted hereunder.
To the extent that an Option is not exercised within the period of
exercisability specified therein, it shall expire as to the then unexercised
part.
Except as otherwise provided under the Code, to the extent that the
aggregate Fair Market Value of stock for which Incentive Options (under all
stock option plans of the Company and of any parent corporation or subsidiary
corporation of the Company) are exercisable for the first time by an employee
during any calendar year exceeds one hundred thousand dollars ($100,000), such
Options shall be treated as Non-Qualified Options. For purposes of this
limitation, (a) the Fair Market Value of stock is determined as of the time
the Option is granted and (b) the limitation will be applied by taking into
account Options in the order in which they were granted.
In no event shall an Option granted hereunder be exercised for a fraction of
a Share or for less than one hundred (100) Shares (unless the number purchased
is the total balance for which the Option is then exercisable).
A person entitled to receive Shares upon the exercise of an Option shall not
have the rights of a shareholder with respect to such Shares until the date of
issuance of a stock certificate to him or her for such Shares; provided,
however, that until such stock certificate is issued, any holder of an Option
using previously acquired shares of Common Stock in payment of an Option
exercise price shall continue to have the rights of a shareholder with respect
to such previously acquired shares of Common Stock.
7. TERMINATION OF EMPLOYMENT
Upon termination of employment of any Key Employee with the Company and all
subsidiary corporations and parent corporations of the Company, any Option
previously granted to such employee, unless otherwise specified by the
Committee in the Option shall, to the extent not theretofore exercised,
terminate and become null and void; provided, however, that:
A. if any Key Employee shall die while in the employ of such corporation
or during either the one (1) year or three (3) month period, whichever is
applicable, specified in clauses (B) and (C) below, any Option granted
hereunder, unless otherwise specified by the Committee in the Option, shall
be exercisable for any or all of such number of Shares that such employee
is entitled to exercise at the time of death, by the legal representative
of such employee or such person who acquired such Option by bequest or
inheritance or by reason of the death of such employee, at any time up to
and including one (1) year after the date of death;
B. if the employment of any Key Employee shall terminate by reason of
such employee's disability (as described in Section 22(e)(3) of the Code),
any Option granted hereunder, unless otherwise specified by the Committee
in the Option, shall be exercisable for any or all of such number of Shares
that such employee is entitled to exercise at the effective date of
termination of employment by reason of disability, at any time up to and
including one (1) year after the effective date of such termination of
employment;
C. if the employment of any Key Employee shall terminate (i) by reason of
the employee's retirement (at such age or upon such conditions as shall be
specified by the Committee) or (ii) by the employer other than for cause
(as defined below), such Option, unless otherwise specified by the
Committee in the Option, shall be exercisable for any or all of such number
of Shares that such employee is entitled to exercise at the effective date
of termination of employment, at any time up to and including three (3)
months after the effective date of such termination of employment; and
B-4
<PAGE>
None of the events described above shall extend the period of exercisability
of the Option beyond the expiration date thereof.
If an Option granted hereunder shall be exercised by the legal
representative of a deceased grantee or by a person who acquired an Option
granted hereunder by bequest or inheritance or by reason of the death of any
employee or former employee, written notice of such exercise shall be
accompanied by a certified copy of letters testamentary or equivalent proof of
the right of such legal representative or other person to exercise such
Option.
For purposes of the Plan, the term "for cause" shall mean (a) with respect
to an employee who is a party to a written employment agreement with, or,
alternatively, participates in a compensation or benefit plan (other than the
Plan) of, the Company or a subsidiary corporation or parent corporation of the
Company, which agreement or plan contains a definition of "for cause" or
"cause" (or words of like import) for purposes of termination of employment or
services thereunder by the Company or such subsidiary corporation or parent
corporation of the Company, "for cause" or "cause" as defined therein (if an
employee is both party to an employment agreement and participates in such a
plan, the definition contained in such employment agreement shall control); or
(b) in all other cases, as determined by the Committee, in its sole
discretion, (i) the willful commission by an employee of an act that causes or
may cause substantial damage to the Company or a subsidiary corporation or
parent corporation of the Company; (ii) the commission by an employee of an
act of fraud in the performance of such employee's duties on behalf of the
Company or a subsidiary corporation or parent corporation of the Company;
(iii) conviction of the employee for commission of a felony in connection with
the performance of his duties on behalf of the Company or a subsidiary
corporation or parent corporation of the Company; or (iv) the continuing
failure of an employee to perform the duties of such employee to the Company
or a subsidiary corporation or parent corporation of the Company that has not
been cured within 15 days after written notice thereof has been given to the
employee by the Committee.
For purposes of the Plan, an employment relationship shall be deemed to
exist between an individual and a corporation if, at the time of
determination, the individual was an "employee" of such corporation for
purposes of Section 422(a) of the Code. If an individual is on leave of
absence taken with the consent of the corporation by which such individual was
employed, or is on active military service, and is determined to be an
"employee" for purposes of the exercise of an Option, such individual shall
not be entitled to exercise such Option during such period and while the
employment is treated as continuing intact unless such individual shall have
obtained the prior written consent of such corporation, which consent shall be
signed by the chairman of the board of directors, the president, a senior
vice-president or other duly authorized officer of such corporation.
A termination of employment shall not be deemed to occur by reason of (i)
the transfer of an employee from employment by the Company to employment by a
subsidiary corporation or a parent corporation of the Company or (ii) the
transfer of an employee from employment by a subsidiary corporation or a
parent corporation of the Company to employment by the Company or by another
subsidiary corporation or parent corporation of the Company.
8. EXERCISE OF OPTIONS
Subject to the limitations on exercise referred to in Sections 6 and 7
hereof, Options granted under the Plan shall be exercised by the optionee as
to all or part of the Shares covered thereby by giving written notice of
exercise to the Corporate Secretary of the Company at the principal business
office of the Company, specifying the number of Shares to be purchased and
specifying a business day not more than ten (10) days from the date such
notice is given for the payment of the purchase price against delivery of the
Shares being purchased. Subject to the terms of Sections 13, 14 and 15 hereof,
the Company shall cause certificates for the Shares so purchased to be
delivered at the principal business office of the Company, against payment of
the full purchase price, on the date specified in the notice of exercise.
9. USE OF PROCEEDS
The cash proceeds of the sale of Shares subject to the Options granted
hereunder are to be added to the general funds of the Company and used for its
general corporate purposes as the Board of Directors shall determine.
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<PAGE>
10. NON-TRANSFERABILITY OF OPTIONS
An Option granted hereunder shall not be transferable, whether by operation
of law or otherwise, other than by will or the laws of descent and
distribution, and any Option granted hereunder shall be exercisable, during
the lifetime of the holder, only by such holder or such holder's legal
representative if such holder is incapacitated. Except to the extent provided
above, Options may not be assigned, transferred, pledged, hypothecated or
disposed of in any way (whether by operation of law or otherwise) and shall
not be subject to execution, attachment or similar process.
11. ADJUSTMENT OF SHARES; EFFECT OF CERTAIN TRANSACTIONS
Notwithstanding any other provision contained herein, in the event of any
change in the Shares subject to the Plan or to any Option granted under the
Plan (through merger, consolidation, reorganization, recapitalization, stock
dividend, stock split, split-up, split-off, spin-off, combination of shares,
exchange of shares, or other like change in the capital structure of the
Company), an adjustment shall be made to each outstanding Option such that
each such Option shall thereafter be exercisable for such securities, cash
and/or other property as would have been received in respect of the Shares
subject to such Option had such Option been exercised in full immediately
prior to such change, and such an adjustment shall be made successively each
time any such change shall occur; provided, however, no adjustments will be
made with respect to any of the matters mentioned herein which result from
transactions contemplated by the Distribution Agreement dated October 10,
1995, by and between Halliburton Company and the Company, or the Investment
Agreement dated October 10, 1995, by and among Halliburton Company, the
Company, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda),
L.P. The term "Shares" after any such change shall refer to the securities,
cash and/or property then receivable upon exercise of an Option. In addition,
in the event of any such change, the Committee shall make any further
adjustment to the maximum number of Shares which may be acquired under the
Plan pursuant to the exercise of Options, the maximum number of Shares for
which Options may be granted to any one employee and the number of Shares and
price per Share subject to outstanding Options as shall be equitable to
prevent dilution or enlargement of rights under such Options, and the
determination of the Committee as to these matters shall be conclusive and
binding on the optionee; provided, however, that (a) each such adjustment with
respect to an Incentive Option shall comply with the rules of Section 424(a)
of the Code (or any successor provision) and (b) in no event shall any
adjustment be made which would render any Incentive Option granted hereunder
other than an "incentive stock option" as defined in Section 422 of the Code.
In the event of a "change in control" of the Company, all then outstanding
Options shall immediately become exercisable. For purposes of the Plan, a
"change in control" of the Company shall occur if (a) any person or other
entity (other than any of the Company's subsidiaries), including any person as
defined in Section 13(d)(3) of the Exchange Act, becomes the beneficial owner,
as defined in Rule 13d-3 of the Exchange Act, directly or indirectly, of more
than fifty percent (50%) of the total combined voting power of all classes of
capital stock of the Company normally entitled to vote for the election of
directors of the Company (the "Voting Stock"), (b) the Board of Directors
approves the sale of all or substantially all of the property or assets of the
Company, or (c) the Board of Directors approves a consolidation or merger of
the Company with another corporation (other than with any of the Company's
subsidiaries), the consummation of which would result in the shareholders of
the Company immediately before the occurrence of the consolidation or merger
owning, in the aggregate, less than 50% of the Voting Stock of the surviving
entity.
The Committee, in its sole discretion, may determine that, upon the
occurrence of a transaction described in the preceding paragraph, each Option
outstanding hereunder shall terminate within a specified number of days after
notice to the holder, and such holder shall receive, with respect to each
Share subject to such Option, an amount equal to the excess of the fair market
value of such Shares immediately prior to the occurrence of such transaction
over the exercise price per Share of such Option; such amount shall be payable
in cash, in one or more of the kinds of property payable in such transaction,
or in a combination thereof, as the Committee in its discretion shall
determine. The provisions contained in the preceding sentence shall be
inapplicable to an Option granted within six (6) months before the occurrence
of a change in control if the holder of such Option is subject
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<PAGE>
to the reporting requirements of Section 16(a) of the Exchange Act and no
exemption from liability under Section 16(b) is otherwise available to such
holder.
12. RIGHT TO TERMINATE EMPLOYMENT
The Plan shall not impose any obligation on the Company or on any subsidiary
corporation or parent corporation thereof to continue the employment or
directorship of any holder of an Award and it shall not impose any obligation
on the part of any holder of an Award to remain in the employ or service of
the Company or of any subsidiary corporation or parent corporation thereof.
13. PURCHASE FOR INVESTMENT
Except as hereinafter provided, the Committee may require the holder of an
Award granted hereunder, as a condition of exercise of such Option, in the
event the Shares subject to such Option are not registered pursuant to an
effective registration statement under the Securities Act, and applicable
state securities laws, to execute and deliver to the Company a written
statement, in form satisfactory to the Committee, in which such holder (1)
represents and warrants that such holder is purchasing or acquiring the Shares
acquired thereunder for such holder's own account, for investment only and not
with a view to the resale or distribution thereof in violation of any federal
or state securities laws, and (2) agrees that any subsequent resale or
distribution of any of such Shares shall be made only pursuant to either (i)
an effective registration statement under the Securities Act covering such
Shares and under applicable state securities laws or (ii) specific exemptions
from the registration requirements of the Securities Act and any applicable
state securities laws, based on a written opinion of counsel, in form and
substance satisfactory to counsel for the Company, as to the application
thereto of any such exemptions.
Nothing herein shall be construed as requiring the Company to register
Shares issued pursuant to an Award under the Securities Act or any state
securities law and, to the extent deemed necessary by the Company, Shares
issued pursuant to an Award may contain a legend to the effect that
registration rights had not been granted with respect to such Shares.
14. ISSUANCE OF STOCK CERTIFICATES; LEGENDS; PAYMENT OF EXPENSES
Upon any exercise of an Option granted hereunder and payment of the purchase
price therefor, a certificate or certificates representing the Shares shall be
issued by the Company in the name of the person exercising the Option and
shall be delivered to or upon the order of such person.
The Company may endorse such legend or legends upon the certificates for
Shares issued pursuant to the Plan and may issue such "stop transfer"
instructions to its transfer agent in respect of such Shares as the Committee,
in its sole discretion, determines to be necessary or appropriate to (a)
prevent a violation of, or to comply with the procedures for an exemption
from, the registration requirements of the Securities Act, (b) implement the
provisions of the Plan and any agreement between the Company and the grantee
with respect to such Shares or (c) permit the Company to determine the
occurrence of a disqualifying disposition, as described in Section 421(b) of
the Code, of Shares transferred upon exercise of an Incentive Option granted
under the Plan.
The Company shall pay all issue or transfer taxes with respect to the
issuance or transfer of Shares, as well as all fees and expenses necessarily
incurred by the Company in connection with such issuance or transfer, except
fees and expenses which may be necessitated by the filing or amending of a
registration statement under the Securities Act, which fees and expenses shall
be borne by the recipient of the Shares unless such registration statement has
been filed by the Company for its own corporate purposes (and the Company so
states) in which event the recipient of the Shares shall bear only such fees
and expenses as are attributable solely to the inclusion of the Shares a
grantee receives in the registration statement.
All Shares issued as provided herein shall be fully paid and nonassessable
to the extent permitted by law.
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<PAGE>
15. WITHHOLDING TAXES
The Company may require an employee exercising a Non-Qualified Option
granted hereunder or disposing of Shares acquired pursuant to the exercise of
an Incentive Option in a disqualifying disposition (within the meaning of
Section 421(b) of the Code), to reimburse the corporation which employs such
employee for any taxes required by any governmental regulatory authority to be
withheld or otherwise deducted and paid by such corporation in respect of the
issuance or disposition of such Shares. In lieu thereof, the corporation which
employs such employee shall have the right to withhold the amount of such
taxes from any other sums due or to become due from such corporation to the
employee upon such terms and conditions as the Committee shall prescribe. The
corporation that employs such employee may, in its discretion, hold the stock
certificate to which such employee is entitled upon the exercise of an Option
as security for the payment of such withholding tax liability, until cash
sufficient to pay that liability has been accumulated. In addition, at any
time that the Company becomes subject to a withholding obligation under
applicable law with respect to the exercise of a Non-Qualified Option (the
"Tax Date"), except as set forth below, a holder of a Non-Qualified Option may
elect to satisfy, in whole or in part, the holder's related personal tax
liabilities (an "Election") by (a) directing the Company to withhold from
Shares issuable in the related exercise or grant, as applicable, either a
specified number of Shares or Shares having a specified value (in each case
not in excess of the related personal tax liabilities), (b) tendering shares
of the Company's Common Stock owned by the holder or (c) combining any or all
of the foregoing Elections in any fashion. An Election shall be irrevocable.
The withheld Shares and other shares of Common Stock tendered in payment shall
be valued at their Fair Market Value on the Tax Date. The Committee may
disapprove of any Election, suspend or terminate the right to make Elections
or provide that the right to make Elections shall not apply to particular
Shares or exercises. The Committee may impose any additional conditions or
restrictions on the right to make an Election as it shall deem appropriate. In
addition, the Company shall be authorized, without the prior written consent
of the employee, to effect any such withholding upon exercise of a Non-
Qualified Option by retention of Shares issuable upon such exercise having a
Fair Market Value at the date of exercise (as determined under Section 5)
which is equal to the amount to be withheld; provided, however, that the
Company shall not be authorized to effect such withholding without the prior
written consent of the employee if such withholding would subject such
employee to liability under Section 16(b) of the Exchange Act. The Committee
may prescribe such rules as it determines with respect to employees and
directors subject to the reporting requirements of Section 16(a) of the
Exchange Act to effect such tax withholding in compliance with the Rules
established by the Securities and Exchange Commission (the "Commission") under
Section 16 of the Exchange Act and the positions of the staff of the
Commission thereunder expressed in no-action letters exempting such tax
withholding from liability under Section 16(b) of the Exchange Act.
16. LISTING OF SHARES AND RELATED MATTERS
If at any time the Committee shall determine that the listing, registration
or qualification of the Shares subject to an Award on any securities exchange
or under any applicable law, or the consent or approval of any governmental
regulatory authority, is necessary or desirable as a condition of, or in
connection with, the granting of an Award, or the issuance of Shares
thereunder, such Award may not be exercised in whole or in part unless such
listing, registration, qualification, consent or approval shall have been
effected or obtained free of any conditions not acceptable to the Committee.
17. AMENDMENT OF THE PLAN
The Board of Directors may, from time to time, amend the Plan, provided that
no amendment shall be made, without the approval of the shareholders of the
Company, that will (a) increase the total number of Shares reserved for
Options under the Plan or the maximum number of Shares for which Options may
be granted to any one individual (other than an increase resulting from an
adjustment provided for in Section 11 hereof), (b) reduce the exercise price
of any Incentive Option granted hereunder, (c) modify the provisions of the
Plan relating to eligibility, or (d) materially increase the benefits accruing
to participants under the Plan. The Committee shall be authorized to amend the
Plan and the Options granted thereunder to permit the Incentive Options
granted thereunder to qualify as "incentive stock options" within the meaning
of Section 422 of the Code and the
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Treasury Regulations promulgated thereunder. The rights and obligations under
any Award granted before amendment of the Plan or any portion of such Award
that remains unexercised or subject to restriction, as applicable, shall not
be adversely affected by amendment of the Plan or the Award without the
consent of the holder of such Award.
18. TERMINATION OR SUSPENSION OF THE PLAN
The Board of Directors may at any time suspend or terminate the Plan. The
Plan, unless sooner terminated under Section 22 or by action of the Board of
Directors, shall terminate at the close of business on the Termination Date.
Options may not be granted while the Plan is suspended or after it is
terminated. Rights and obligations under any Award granted while the Plan is
in effect shall not be altered or impaired by suspension or termination of the
Plan, except upon the consent of the person to whom the Award was granted. The
power of the Committee to construe and administer any Options under Section 3
that are granted prior to the termination or suspension of the Plan shall
continue after such termination or during such suspension.
19. SAVINGS PROVISION
With respect to persons subject to Section 16 of the Exchange Act,
transactions under the Plan are intended to comply with all applicable
conditions of Rule 16b-3 (or any successor provision) under the Exchange Act.
To the extent any provision of the Plan or action by the Committee fails to so
comply, it shall be deemed null and void to the extent permitted by law and
deemed advisable by the Committee.
20. GOVERNING LAW
All questions arising with respect to the provisions of the Plan shall be
determined by application of the laws of the State of Delaware, without giving
effect to any conflict of law provisions thereof, except to the extent
Delaware law is preempted by federal law. Questions arising with respect to
the provisions of an agreement whereby an Option is granted that are matters
of contract law shall be governed by the laws of the State of Texas, without
giving effect to any conflict of law provisions, except to the extent Delaware
corporate law conflicts with the contract law of the State of Texas, in which
event Delaware corporate law, without giving effect to any conflict of law
provisions thereof, shall govern.
21. PARTIAL INVALIDITY
The invalidity or illegality of any provision herein shall not be deemed to
affect the validity of any other provision.
22. EFFECTIVE DATE; DURATION
The Plan shall become effective on the date on which it is approved by the
Board of Directors of the Company or, if earlier, the date it is approved by
the stockholders of the Company (the "Effective Date"); provided, however,
that if the Plan is not approved by a vote of the shareholders of the Company
at an annual meeting or any special meeting within twelve (12) months before
or after the Effective Date, the Plan and any Options granted thereunder shall
terminate. No Options may be granted hereunder after the date that is ten (10)
years after the Effective Date.
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APPENDIX C
HIGHLANDS INSURANCE GROUP, INC.
ANNUAL INCENTIVE PLAN
(EFFECTIVE AS OF JANUARY 1, 1997)
1. Purpose.
The purposes of the Plan are to enable the Company, its Divisions and its
Insurance Subsidiaries (as each such term is defined below) to attract,
retain, motivate and reward the best qualified executive officers and key
employees by providing them with the opportunity to earn competitive
compensation directly linked to the performance of the Company, its Divisions
and its Insurance Subsidiaries. The Plan is designed to assure that amounts
paid to certain executive officers of the Company and its subsidiaries will
not fail to be deductible by the Company for federal income tax purposes
because of the limitations imposed by Section 162(m).
2. Definitions.
Unless the context requires otherwise, the following words as used in the
Plan shall have the meanings ascribed to each below, it being understood that
masculine, feminine and neuter pronouns are used interchangeably and that each
comprehends the others.
(a) "Adjusted Bonus Amount" shall mean, with respect to each annual bonus
payable to a Participant under Section 5, an amount equal to the annual bonus
as determined under Sections 4(a) and 4(b) based upon the applicable Combined
Ratio as adjusted by the Company based on actual claims experience no later
than 90 days after the end of each year, such adjustment, if any, to be made
in each of the three years following the year in which such Combined Ratio is
initially determined.
(b) "Board" shall mean the Board of Directors of the Company.
(c) "Bonus Attainment Percent Schedule" shall mean, with respect to any
year, a schedule established by the Committee pursuant to Section 4(a) which
shall set forth the annual bonus, if any, that will be payable hereunder to a
Participant or group of Participants based on the extent to which the actual
applicable Combined Ratio exceeds the applicable COR Target for such year.
(d) "Combined Ratio" shall mean, with respect to the Company, a Division or
an Insurance Subsidiary and for any accident year, the combined ratio
(accident year loss ratio plus calendar year expense ratio for such year) of
such entity as determined by the Company for such accident year based on the
books and records of the Company, its Divisions and its Insurance
Subsidiaries, as applicable, and as reflected on the basis of generally
accepted accounting principles and as approved by the Board.
(e) "Committee" shall mean the Compensation Committee of the Board (or such
other committee of the Board that the Board shall designate from time to time)
or any subcommittee thereof comprised of two or more directors each of whom is
an "outside director" within the meaning of Section 162(m).
(f) "Company" shall mean Highlands Insurance Group, Inc.
(g) "COR Target" shall mean, with respect to the Company, a Division or an
Insurance Subsidiary and for any year, the target Combined Ratio established
by the Committee pursuant to Section 4(a) that must be achieved in order for
an applicable Participant to receive the maximum bonus for such year.
(h) "Covered Employee" shall have the meaning set forth in Section 162(m).
(i) "Divisions" shall mean the Commercial Insurance, Insurance Services and
Special Accounts divisions of the Company and any other business unit of the
Company designated as a Division by the Board (each, a "Division").
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(j) "Insurance Subsidiaries" shall mean any subsidiary of the Company which,
either directly or through subsidiaries, is engaged in the insurance business
and has been designated as an Insurance Subsidiary by the Board (each, an
"Insurance Subsidiary").
(k) "Participant" shall mean each executive officer or key employee of the
Company, a Division or an Insurance Subsidiary who the Committee designates as
a participant under the Plan.
(l) "Plan" shall mean the Highlands Insurance Group, Inc. Annual Incentive
Plan, as set forth herein and as amended from time to time.
(m) "Section 162(m)" shall mean Section 162(m) of the Internal Revenue Code
of 1986, as amended, and any regulations promulgated thereunder (including any
proposed regulations).
3. Administration.
The Committee shall administer and interpret the Plan, provided that, in no
event, shall the Plan be interpreted in a manner which would cause any amount
payable under the Plan to any Covered Employee to fail to qualify as
performance-based compensation under Section 162(m). The Committee shall
establish the COR Target with respect to the Company, each Division and each
Insurance Subsidiary for any calendar year in accordance with Section 4 and
certify whether and the extent to which such objective has been attained. Any
determination made by the Committee under the Plan shall be final and
conclusive. The Committee may employ such legal counsel, consultants and
agents (including counsel or agents who are employees of the Company or its
subsidiaries) as it may deem desirable for the administration of the Plan and
may rely upon any opinion received from any such counsel or consultant or
agent and any computation received from such consultant or agent. All expenses
incurred in the administration of the Plan, including, without limitation, for
the engagement of any counsel, consultant or agent, shall be paid by the
Company. No member or former member of the Board or the Committee shall be
liable for any act, omission, interpretation, construction or determination
made in connection with the Plan other than as a result of such individual's
willful misconduct.
4. Bonuses.
(a) COR Targets and Bonus Attainment Percent Schedules. On or before the
ninetieth day of each year (or such other date as may be required or permitted
under Section 162(m)), the Committee shall establish and set forth in writing,
the COR Target for each of the Company, each Division and each Insurance
Subsidiary and the Bonus Attainment Percent Schedule for each Participant or
group of Participants based on the applicable COR target. Unless otherwise
provided pursuant to the terms of a written contract between a Participant and
the Company or one of its subsidiaries, the applicable COR Target with respect
to a Participant (i) who is an employee of a single Division or a single
Insurance Subsidiary, or whose principal activities are tied to a single
Division or Insurance Subsidiary, shall be the COR Target of the applicable
Division or Insurance Subsidiary, (ii) who is employed in a capacity in which
the Participant's responsibilities include more than one Division or Insurance
Subsidiary, shall be the combined COR Target for two or more Divisions or
Insurance Subsidiaries as designated by the Board or the Committee and (iii)
otherwise, shall be the COR Target of the Company. The Committee shall notify
each Participant of the COR Target and the Bonus Attainment Percent Schedule
applicable to him or her.
(b) Maximum Amount Payable. If the Committee certifies in writing that a COR
Target established for the applicable year under Section 4(a) has been
achieved, each applicable Participant shall be entitled to receive an annual
bonus in an amount equal to the lesser of (i) $925,000 or (ii) a specified
percentage of such Participant's annual base salary as in effect as of January
1 of such calendar year, which percentage shall have been specified by the
Committee within the first 90 days of such year, subject to the provisions of
Section 5(a). If the actual Combined Ratio for the applicable year is greater
than the applicable COR Target for such year as certified in
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writing by the Committee, each such Participant shall be entitled to receive
an annual bonus, if any, as determined pursuant the Bonus Attainment Percent
Schedule for such year, which bonus shall not exceed the lesser of (i)
$925,000 or (ii) the applicable percentage of such Participant's annual base
salary as in effect at the beginning of such calendar year, subject to the
provisions of Section 5(a).
(c) Negative Discretion. Notwithstanding anything else contained in Section
4(b) to the contrary, the Committee shall have the right, in its absolute
discretion, (i) to reduce or eliminate the amount otherwise payable to any
Participant under Section 4(b) based on individual performance or any other
factors that the Committee, in its discretion, shall deem appropriate and (ii)
to establish rules or procedures that have the effect of limiting the amount
payable to each Participant to an amount that is less than the maximum amount
otherwise authorized under Section 4(b).
(d) Performance Evaluation. Notwithstanding any other provision in the Plan
to the contrary, a Participant must receive a performance evaluation for the
applicable year with a rating of 2.0 ("effective") or higher in order to be
eligible to receive an annual bonus for that year or any portion thereof and
the Committee, in its absolute discretion, shall have the right to reduce the
amount payable to a Participant pursuant to Section 4(e) if such Participant
received a rating less than 4.0 ("exceptional").
5. Payment.
(a) Installments. Each Participant's annual bonus shall be payable in four
equal annual installments, subject to certain adjustments set forth in Section
5(b), commencing no later than 90 days after the end of the applicable year;
provided that such Participant is an employee of the Company or any of its
subsidiaries, or has terminated employment due to retirement under the terms
of any retirement plan maintained by the Company or any of its subsidiaries,
at the time each such installment is to be paid.
(b) Adjusted Bonus Amount. Notwithstanding anything to the contrary
contained herein, prior to the payment of the second, third and fourth annual
installments of each Participant's annual bonus, the Adjusted Bonus Amount
will be determined by the Committee after consultation with the appropriate
actuarial department(s) of the Company's subsidiary(ies), subject in each case
to the maximum set forth in Section 4(b) above. Subject to Sections 4(c) and
4(d), the second annual installment payable to the Participant shall be equal
to the excess, if any, of (i) 50% of the Adjusted Bonus Amount over (ii) the
first installment actually paid to such Participant. Subject to Sections 4(c)
and 4(d), the third annual installment payable to the Participant shall be
equal to the excess, if any, of (i) 75% of the Adjusted Bonus Amount over (ii)
the aggregate of the first and second installments actually paid to such
Participant. Subject to Sections 4(c) and 4(d), the fourth annual installment
payable to the Participant shall be equal to the excess, if any, of (i) the
Adjusted Bonus Amount over (ii) the aggregate of the first, second and third
installments actually paid to such Participant.
(c) Deficit. To the extent that any excess bonus payments have been made to
a Participant with respect to a given year based on the Adjusted Bonus Amount
for such year, such excess payments may be offset against bonus installments
due with respect to subsequent years.
6. General Provisions.
(a) Effectiveness of the Plan. The Plan shall be effective with respect to
calendar years beginning on or after January 1, 1997 and ending on or before
December 31, 2001, unless the term hereof is extended by action of the Board.
(b) Amendment and Termination. Notwithstanding Section 6(a), the Board or
the Committee may at any time amend, suspend, discontinue or terminate the
Plan; provided, however, that no such amendment, suspension, discontinuance or
termination shall, without the consent of the applicable Participant,
adversely affect the rights
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of any Participant in respect of any calendar year which has already
commenced, and no such amendment shall be effective without approval by the
shareholders of the Company to the extent necessary to continue to qualify the
amounts payable hereunder to Covered Employees as performance-based
compensation under Section 162(m).
(c) Designation of Beneficiary. Each Participant may designate a beneficiary
or beneficiaries (which beneficiary may be an entity other than a natural
person) to receive any payments which may be made following the Participant's
death. Such designation may be changed or cancelled at any time without the
consent of any such beneficiary. Any such designation, change or cancellation
must be made in a form approved by the Committee and shall not be effective
until received by the Committee. If no beneficiary has been named, or the
designated beneficiary or beneficiaries shall have predeceased the
Participant, the beneficiary shall be the Participant's spouse or, if no
spouse survives the Participant, the Participant's estate. If a Participant
designates more than one beneficiary, the rights of such beneficiaries shall
be payable in equal shares, unless the Participant has designated otherwise.
(d) No Right of Continued Employment. Nothing in this Plan shall be
construed as conferring upon any Participant any right to continue in the
employment of the Company or any of its subsidiaries.
(e) No Limitation on Corporate Actions. Nothing contained in the Plan shall
be construed to prevent the Company or any of its subsidiaries from taking any
corporate action which is deemed by it to be appropriate or in its best
interest, whether or not such action would have an adverse effect on any
awards made under the Plan. No employee, beneficiary or other person shall
have any claim against the Company or any of its subsidiaries as a result of
any such action.
(f) Nonalienation of Benefits. Except as expressly provided herein, no
Participant or beneficiary shall have the power or right to transfer,
anticipate, or otherwise encumber the Participant's interest under the Plan.
The Company's obligations under this Plan are not assignable or transferable
except to (i) a corporation which acquires all or substantially all of the
Company's assets or (ii) any corporation into which the Company may be merged
or consolidated. The provisions of the Plan shall inure to the benefit of each
Participant and the Participant's beneficiaries, heirs, executors,
administrators or successors in interest.
(g) Withholding. Any amount payable to a Participant or a beneficiary under
this Plan shall be subject to any applicable Federal, state and local income
and employment taxes and any other amounts that the Company or any of its
subsidiaries is required at law to deduct and withhold from such payment.
(h) Severability. If any provision of this Plan is held unenforceable, the
remainder of the Plan shall continue in full force and effect without regard
to such unenforceable provision and shall be applied as though the
unenforceable provision were not contained in the Plan.
(i) Governing Law. The Plan shall be construed in accordance with and
governed by the laws of the State of Delaware, without reference to the
principles of conflict of laws.
(j) Headings. Headings are inserted in this Plan for convenience of
reference only and are to be ignored in a construction of the provisions of
the Plan.
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----------------
The Company's transfer agent for
this Proxy Statement is:
ChaseMellon Shareholder Services, L.L.C.
85 Challenger Road
Overpeck Centre
Ridgefield Park, New Jersey 07660-2104
1-800-635-9270
----------------
TO OBTAIN A COPY OF THE COMPANY'S 1996 ANNUAL REPORT ON FORM 10-K (INCLUDING
FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES) AS FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION, PLEASE SEND A WRITTEN REQUEST TO CHARLES J.
BACHAND, VICE PRESIDENT AND TREASURER, HIGHLANDS INSURANCE GROUP, INC., 10370
RICHMOND AVENUE, HOUSTON, TEXAS 77042.
<PAGE>
[FORM OF PROXY CARD]
Highlands Insurance Group, Inc.
This Proxy is Solicited on Behalf of the Board of Directors
The undersigned hereby (1) acknowledges receipt of the Notice of Annual
Meeting of Stockholders of Highlands Insurance Group, Inc., a Delaware
corporation (the "Company"), to be held at the Adam's Mark Hotel located at 2900
Briarpark Drive, Houston, Texas on Friday, May 9, 1997, at 10:00 a.m. local time
(the "Meeting"), and the Proxy Statement in connection therewith and (2)
appoints Charles J. Bachand and Dwayne D. Hallman, and each of them, as the
undersigned's Proxies with full power of substitution for and in the name, place
and stead of the undersigned, to vote upon and act with respect to all of the
shares of Common Stock standing in the name of the undersigned, or with respect
to which the undersigned is entitled to vote and act, at the Meeting and at any
adjournment(s) or postponement(s) thereof.
The undersigned hereby revokes any proxy heretofore given to vote or act
with respect to the Common Stock and hereby ratifies and confirms all that the
Proxies, their substitutes, or any of them may lawfully do by virtue hereof.
THIS PROXY, WHEN PROPERLY EXECUTED, WILL BE VOTED IN THE MANNER DIRECTED
HEREIN BY THE UNDERSIGNED STOCKHOLDER. IF NO DIRECTION IS MADE, THIS PROXY WILL
BE VOTED (1) FOR THE BOARD OF DIRECTORS' NOMINEES FOR CLASS I DIRECTORS, EACH TO
SERVE UNTIL THE 1999 ANNUAL MEETING OF STOCKHOLDERS AND UNTIL THEIR SUCCESSORS
ARE ELECTED AND QUALIFIED; (2) FOR THE BOARD OF DIRECTORS' NOMINEES FOR CLASS II
DIRECTORS, EACH TO SERVE UNTIL THE 2000 ANNUAL MEETING OF STOCKHOLDERS AND UNTIL
THEIR SUCCESSORS ARE ELECTED AND QUALIFIED; (3) FOR RATIFICATION OF THE 1995
STOCK OPTION PLAN; (4) FOR AN AMENDMENT TO THE 1995 STOCK OPTION PLAN TO
INCREASE THE NUMBER OF SHARES OF COMMON STOCK WITH RESPECT TO WHICH OPTIONS MAY
BE GRANTED THEREUNDER FROM 350,000 TO 800,000; (5) FOR RATIFICATION OF THE
ANNUAL INCENTIVE PLAN; (6) FOR RATIFICATION OF THE APPOINTMENT OF KPMG PEAT
MARWICK LLP AS INDEPENDENT PUBLIC ACCOUNTANTS FOR THE COMPANY AND ITS
SUBSIDIARIES FOR FISCAL YEAR 1997; AND (7) FOR THE TRANSACTION OF SUCH OTHER
BUSINESS AS MAY PROPERLY COME BEFORE THE MEETING OR ANY ADJOURNMENT(S) OR
POSTPONEMENT(S) THEREOF IN ACCORDANCE WITH THE DISCRETION OF THE PERSONS
DESIGNATED ABOVE WITH RESPECT TO ANY OTHER BUSINESS PROPERLY BEFORE THE MEETING.
(THIS PROXY MUST BE DATED AND SIGNED ON THE REVERSE SIDE.)
1
<PAGE>
(REVERSE SIDE)
PLEASE MARK YOUR VOTES
AS INDICATED IN THIS EXAMPLE [X]
Item 1. For the election as a Class I director of all NOMINEES, W. Bernard
Pieper and Philip J. Hawk, each to serve until the 1999 Annual Meeting
of Stockholders and until their successors are elected and qualified:
FOR all nominees listed above WITHHOLD AUTHORITY to
(except as marked to the vote for all nominees listed
contrary) [ ] below [ ]
Item 2. For the election as a Class II director of all NOMINEES, Richard M.
Haverland and Robert W. Shower, each to serve until the 2000 Annual
Meeting of Stockholders and until their successors are elected and
qualified:
FOR all nominees listed above WITHHOLD AUTHORITY to
(except as marked to the vote for all nominees listed
contrary) [ ] below [ ]
Item 3. To ratify the 1995 Stock Option Plan.
FOR [ ] AGAINST [ ] ABSTAIN [ ]
Item 4. To amend the 1995 Stock Option Plan to increase the number of shares of
Common Stock with respect to which options may be granted thereunder
from 350,000 to 800,000.
FOR [ ] AGAINST [ ] ABSTAIN [ ]
Item 5. To ratify the Annual Incentive Plan.
FOR [ ] AGAINST [ ] ABSTAIN [ ]
Item 6. To ratify the appointment of KPMG Peat Marwick LLP as independent public
accountants for the Company and its subsidiaries for fiscal year 1997.
FOR [ ] AGAINST [ ] ABSTAIN [ ]
Item 7. To transact such other business as may properly come before the Meeting
or any adjournment(s) or postponement(s) thereof.
[ ] I PLAN TO ATTEND THE MEETING
INSTRUCTION: To withhold authority to
vote for individual nominees, write their
name(s) in the space below:
- -------------------------------------------
Please sign exactly as your name(s) appear(s)
on your stock certificate(s). When signing
as attorney, executor, administrator,
trustee, or guardian, please give full
title as such. If a corporation, please
sign in full corporate name by President
or other authorized officer. If a partnership,
please sign in partnership name by
authorized person.
DATED:
--------------------------------------
Signature
- --------------------------------------------
Signature if held jointly
Please mark, sign, date and promptly return
this proxy card in the enclosed envelope.
No postage is required.
2
