<PAGE>
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to ________
HIGHLANDS INSURANCE GROUP, INC.
(Exact Name of Registrant as Specified in its Charter)
1-14028
(Commission File Number)
DELAWARE 75-2370945
(State or Other Jurisdiction (I.R.S. Employer
Of Incorporation Or Organization) Identification Number)
1000 LENOX DRIVE,
LAWRENCEVILLE, NEW JERSEY 08648
(Address of Principal Executive Offices) (Zip Code)
(609) 896-1921
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such filing requirements for the past 90 days.
Yes [X] No [_]
The number of shares of the Registrant's Common Stock, par value $.01 per
share, outstanding at September 30, 1998 was 12,944,926.
================================================================================
1
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
TABLE OF CONTENTS
PART I - Financial Information
Item Page
- ---- ----
1. Financial Statements:
Consolidated Balance Sheets
September 30, 1998 (Unaudited) and
December 31, 1997 3
Consolidated Statements of Operations
(Unaudited) - Three and Nine Months Ended
September 30, 1998 and 1997 5
Consolidated Statements of Stockholders' Equity
Nine Months Ended September 30, 1998 (Unaudited)
and Year Ended December 31, 1997 6
Consolidated Statements of Comprehensive Income
(Unaudited) - Three and Nine Months Ended
September 30, 1998 and 1997 7
Consolidated Statements of Cash Flows
(Unaudited) - Nine Months Ended September 30,
1998 and 1997 8
Condensed Notes to Unaudited Consolidated
Financial Statements 10
2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 14
PART II - Other Information
1. Legal Proceedings 22
4. Submission of Matters to a Vote of Security Holders 22
6. Exhibits and Reports on Form 8-K 22
Signatures 23
2
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
<TABLE>
<CAPTION>
September 30, December 31,
ASSETS 1998 1997
----------- ----------
(Unaudited)
Investments:
<S> <C> <C>
Fixed income securities - available-for-sale, at fair
value (amortized cost of $1,032,590 at 9/30/98 and
$1,132,249 at 12/31/97) $ 1,081,150 1,166,585
Equity securities, at fair value (cost of $13,680 at
9/30/98 and $1,410 at 12/31/97) 13,992 1,554
Other invested assets, at cost 3,211 4,061
----------- ----------
Total investments 1,098,353 1,172,200
Cash and cash equivalents 58,142 60,717
Premiums in course of collection, net 52,755 84,977
Premiums due under retrospective policies 128,308 130,150
Receivable from reinsurers 728,067 723,114
Prepaid reinsurance premiums 8,255 24,451
Funds on deposit with reinsurers 17,291 20,172
Net deferred tax asset 58,951 64,043
Accrued investment income 13,068 16,459
Deferred policy acquisition costs 33,494 32,313
Other assets 41,524 38,060
----------- ----------
Total assets $ 2,238,208 2,366,656
=========== ==========
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
3
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS, (Continued)
(Dollars in thousands)
<TABLE>
<CAPTION>
September 30, December 31,
LIABILITIES AND STOCKHOLDERS' EQUITY 1998 1997
----------- ----------
(Unaudited)
<S> <C> <C>
Loss and loss adjustment expense reserves $ 1,540,295 1,605,374
Unearned premiums 153,369 173,411
Senior bank debt 65,000 65,000
Convertible subordinated debentures 56,819 56,229
Funds held 20,921 24,023
Accounts payable and accrued liabilities 60,736 113,326
----------- ----------
Total liabilities 1,897,140 2,037,363
----------- ----------
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized;
shares issued 1998 - 13,263,204; 1997 - 13,187,273 132 132
Additional paid-in capital 223,937 223,460
Retained earnings 90,267 84,888
Accumulated other comprehensive income 30,732 20,813
Treasury stock, at cost (318,278 shares - 1998 and 0 shares - 1997) (4,000) -
----------- ----------
Total stockholders' equity 341,068 329,293
----------- ----------
Total liabilities and stockholders' equity $ 2,238,208 2,366,656
=========== ==========
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
4
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
-------------------- ---------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues:
Net premiums earned $ 85,027 107,640 253,909 216,030
Net investment income 19,052 22,325 58,735 53,610
Net realized investment gains 6,934 763 13,384 1,867
-------- -------- -------- --------
Total revenues 111,013 130,728 326,028 271,507
-------- -------- -------- --------
Expenses:
Loss and loss adjustment expense incurred 61,013 83,787 201,574 178,117
Underwriting expenses 35,843 35,857 108,080 76,634
Debt interest and amortization expense 3,097 3,001 9,236 7,411
Other expenses, net 895 413 1,730 947
-------- -------- -------- --------
Total expenses 100,848 123,058 320,620 263,109
-------- -------- -------- --------
Income before income tax 10,165 7,670 5,408 8,398
Income tax expense 3,441 926 29 965
-------- -------- -------- --------
Net income $ 6,724 6,744 5,379 7,433
======== ======== ======== ========
Earnings per common share:
Basic $.51 .51 .41 .60
Diluted $.43 .41 .34 .51
======== ======== ======== ========
Weighted average number of common shares outstanding:
Basic 13,122 13,108 13,171 12,377
Diluted 18,485 19,567 15,883 14,730
======== ======== ======== ========
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
5
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Dollars in thousands)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
-------- -------
(Unaudited)
<S> <C> <C>
Common stock:
Balance, beginning of year $ 132 114
Issuance of common stock, par value - 18
-------- -------
Balance, end of period 132 132
-------- -------
Additional paid-in capital:
Balance, beginning of year 223,460 192,273
Issuance of common stock 477 31,187
-------- -------
Balance, end of period 223,937 223,460
-------- -------
Retained earnings:
Balance, beginning of year 84,888 68,052
Net income 5,379 16,836
-------- -------
Balance, end of period 90,267 84,888
-------- -------
Accumulated other comprehensive income:
Net unrealized gain on investments:
Balance, beginning of year 22,278 3,036
Change in net unrealized gain, net of applicable federal
income tax 9,489 19,242
-------- -------
Balance, end of period 31,767 22,278
-------- -------
Deferred compensation on restricted stock:
Balance, beginning of year (1,465)
Net forfeitures (issuance) of restricted stock 430 (1,465)
-------- -------
Balance, end of period (1,035) (1,465)
-------- -------
Accumulated other comprehensive income:
Balance, beginning of year 20,813 3,036
Net change for the period 9,919 17,777
-------- -------
Balance, end of period 30,732 20,813
-------- -------
Treasury stock, at cost:
Balance, beginning of year - -
Acquisition of treasury stock (4,000) -
-------- -------
Balance, end of period (4,000) -
-------- -------
Total stockholders' equity $341,068 329,293
======== =======
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
6
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(Dollars in thousands)
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
-------------------------- -----------------------
1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
Net income $ 6,724 6,744 5,379 7,433
------- ------- ------- -------
Other comprehensive income, net of taxes:
Change in unrealized gain on investments 8,087 8,088 9,489 16,996
Change in deferred compensation on restricted stock 349 - 430 -
------- ------- ------- -------
Other comprehensive income, net of taxes 8,436 8,088 9,919 16,996
------- ------- ------- -------
Comprehensive income $15,160 14,832 15,298 24,429
======= ======= ======= =======
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
7
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Dollars in thousands)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
-------------------------
1998 1997
---- ----
<S> <C> <C>
Cash flows from operating activities:
Net income $ 5,379 7,433
--------- ---------
Adjustments to reconcile net income to net cash used in
operating activities:
Depreciation and amortization 2,963 283
Net realized investment gains (13,384) (1,867)
Change in:
Premiums in course of collection 32,222 12,379
Premiums due under retrospective policies 1,842 (1,992)
Receivable from reinsurers (4,953) 55,576
Prepaid reinsurance premiums 16,196 (23,227)
Funds on deposit with reinsurers 2,881 (3,139)
Net deferred tax asset (18) 243
Deferred policy acquisition costs (1,181) 816
Loss and loss adjustment expense reserves (65,079) (72,877)
Unearned premiums (20,042) (21,424)
Funds held (3,102) 5,840
Other operating assets and liabilities (52,853) 22,384
--------- ---------
Total adjustments (104,508) (27,005)
--------- ---------
Net cash used in operating activities (99,129) (19,572)
--------- ---------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale 294,110 50,757
Equity securities 986 5,217
Other invested assets 842 1,559
Maturities or calls:
Fixed maturity securities available-for-sale 137,292 118,542
Fixed maturity securities held-to-maturity - 5,972
Investment purchases:
Fixed maturity securities available-for-sale (321,591) (168,422)
Equity securities (10,270) -
Net additions to property and equipment (1,646) (5,299)
Purchase of subsidiary, net of cash acquired - 5,124
Payment of acquisition expenses - (3,722)
Other proceeds - 92
--------- ---------
Net cash provided by investing activities 99,723 9,820
--------- ---------
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
8
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS, (Continued)
(Unaudited)
(Dollars in thousands)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
-----------------------------
1998 1997
-------- --------
<S> <C> <C>
Cash flows from financing activities:
Issuance of common stock 831 -
Acquisition of treasury stock (4,000) -
Proceeds from senior bank debt - 65,000
Repayment of acquired bank debt - (35,638)
Payment for debt issuance expense - (1,017)
-------- --------
Net cash (used in) provided by financing activities (3,169) 28,345
-------- --------
Net (decrease) increase in cash and cash equivalents (2,575) 18,593
Cash and cash equivalents at beginning of period 60,717 49,484
-------- --------
Cash and cash equivalents at end of period $ 58,142 68,077
======== ========
Supplemental disclosure of cash flow information:
Interest paid $ 6,602 4,005
======== ========
Reclassification of fixed income securities from held-to-maturity to
available-for-sale $ - 348,130
======== ========
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
9
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 1998
1. Basis of Presentation
The accompanying consolidated financial statements as of September 30, 1998 and
for both the three and nine months ended September 30, 1998 and 1997 are
unaudited and include the accounts of Highlands Insurance Group, Inc.,
("Highlands Group") and its subsidiaries (the "Company"). In the opinion of
management, all adjustments, consisting of normal recurring adjustments
necessary for a fair presentation, have been reflected. The results for the
period are not necessarily indicative of the results to be expected for the
entire year. The accompanying consolidated financial statements should be read
in conjunction with the consolidated financial statements and related notes
included in the Company's Form 10-K for the year ended December 31, 1997.
Highlands Group is an insurance holding company for Highlands Insurance Company
and its subsidiaries ("Highlands"), American Reliance, Inc. and its subsidiaries
("American Reliance") beginning April 30, 1997, and Highlands Holdings (U.K.)
Limited and its subsidiary ("Highlands UK") (a foreign reinsurance company
located in the United Kingdom) and certain other immaterial companies.
Certain financial information that is normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
but is not required for interim reporting purposes has been condensed or
omitted. Certain reclassifications have been made to the prior year's financial
statements to conform to the current year's presentation.
2. Acquisition
On April 30, 1997, Highlands Group acquired Vik Brothers Insurance, Inc. and its
subsidiaries ("VBI"). Immediately after the consummation of the acquisition,
VBI was renamed American Reliance, Inc. The acquisition was accounted for as a
purchase and, accordingly, the financial results of American Reliance are
included in these consolidated financial statements effective April 30, 1997.
The acquisition was financed with a combination of common stock, bank debt,
preferred stock and cash. In connection with the acquisition, Highlands Group
paid approximately $55.4 million in cash (including $35.6 million to repay
American Reliance's outstanding bank debt) and issued 1,656,700 shares of its
common stock (representing approximately 12.6% of Highlands Group's then
outstanding common stock) and 21,366 shares of newly issued series one preferred
stock to the holders of the common stock warrants, preferred stockholders and
creditors of American Reliance. The closing price of Highlands Group's common
stock was $17.625 on April 30, 1997. The preferred stock is currently owned by
a subsidiary of American Reliance and has a preference value of $1,000 per
share. Simultaneously with the closing, Highlands Group contributed
approximately $41.5 million to the capital of the insurance companies within the
American Reliance organization.
In connection with the acquisition, Highlands Group obtained a $65 million
senior revolving credit facility from a consortium of banks led by The Chase
Manhattan Bank (Credit Agreement). Highlands Group funded the cash portion of
the acquisition by utilizing the credit facility and available working capital.
The acquired assets and liabilities of American Reliance were reflected in the
consolidated balance sheet as of April 30, 1997 on a fully consolidated basis at
management's best estimate of their fair values, based on information available
at that time and as subsequently determined.
10
<PAGE>
3. American Reliance Acquisition - Pro forma Results of Operations
The following unaudited pro forma information presents the results of operations
of the Company and American Reliance for the nine months ended September 30,
1997 with pro forma adjustments as if the acquisition and transactions related
to the funding of the acquisition had been consummated as of the beginning of
the period presented. This pro forma information is not necessarily indicative
of what would have occurred had the acquisition and related transactions been
made on the date indicated, or of future results of the Company.
Nine Months
Ended
September 30,
1997
--------
(In thousands, except per share data)
Revenues $386,584
Net income $ 8,969
Basic earnings per share $ .73
Diluted earnings per share $ .61
4. Comprehensive Income
In 1997, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards No. 130, "Comprehensive Income" (SFAS 130). SFAS
130 establishes standards for the reporting and disclosure of comprehensive
income and its components (revenues, expenses, gains and losses). SFAS 130
requires that all items that are required to be recognized under accounting
standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. SFAS 130 requires that an enterprise (a) classify items of other
comprehensive income by their nature in a financial statement and (b) display
the accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in capital in the equity section of the balance
sheet. Comprehensive income consists of net income, unrealized changes in
investment values and deferred compensation on restricted stock. Comprehensive
income amounts have been presented to conform to the SFAS 130 requirements.
5. Stockholders' Equity and Earnings Per Share
The Company repurchased 293,500 shares of its common stock at an aggregate cost
of $4.0 million during the third quarter of 1998. The Company's Board of
Directors has not authorized any additional purchases as of September 30, 1998.
In 1997, FASB issued Statement of Financial Accounting Standards No. 128,
"Earnings Per Share" (SFAS 128). SFAS 128 replaced the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. All earnings
per share amounts for all periods have been presented and, where appropriate,
restated to conform to the SFAS 128 requirements.
11
<PAGE>
The following tables set forth the computation of basic and diluted earnings per
share (in thousands, except per share data):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- ---------------------
1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
NUMERATOR:
Net income, as reported $ 6,724 6,744 5,379 7,433
Effect of dilutive securities - after tax debt expense
applicable to convertible subordinated debentures 1,193 1,193 - -
------- ------- ------- -------
Income available to common
stockholders after assumed conversions $ 7,917 7,937 5,379 7,433
======= ======= ======= =======
DENOMINATOR:
Denominator for basic earnings per share - weighted
average shares outstanding 13,122 13,108 13,171 12,377
Common stock warrants and outstanding stock options
(based on treasury stock method) 1,474 2,570 2,712 2,353
Convertible subordinated debentures 3,889 3,889
------- ------- ------- -------
Adjusted weighted average shares and
assumed conversions 18,485 19,567 15,883 14,730
======= ======= ======= =======
Basic earnings per share $ .51 .51 .41 .60
Diluted earnings per share $ .43 .41 .34 .51
======= ======= ======= =======
</TABLE>
The convertible subordinated debentures, which are convertible into
approximately 3.9 million shares, were outstanding during 1997 and 1998, but
were not included in the computation of diluted earnings per share for the nine
months ended September 30, 1998 and 1997 because the assumed conversion would be
antidilutive.
6. Debt Outstanding
During the second quarter of 1997, the Company entered into a $65 million Credit
Agreement, dated April 30, 1997. The Credit Agreement, which contains customary
terms and restrictions, currently provides for an interest rate of LIBOR plus 75
to 150 basis points based upon a performance grid with the full principal amount
thereunder due on April 30, 2002. The Credit Agreement was used to finance the
purchase of American Reliance. The average interest rate for the nine months
ended September 30, 1998 was 7.3%.
12
<PAGE>
7. Other Comprehensive Income
The following summaries present the components of comprehensive income, other
than net income, for the three and nine months ended September 30, 1998 and 1997
(in thousands):
<TABLE>
<CAPTION>
Three Months Ended September 30,
-----------------------------------------------------------------
1998 1997
-----------------------------------------------------------------
Income Income
Pretax Tax Effect After-tax Pretax Tax Effect After-tax
-------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Net unrealized gains arising
during period $ 19,376 6,782 12,594 13,206 4,622 8,584
Less: reclassification adjustment
for realized gains included in net
income 6,934 2,427 4,507 763 267 496
-------- -------- -------- -------- -------- --------
Net change in unrealized
gains on investments 12,442 4,355 8,087 12,443 4,355 8,088
Change in deferred compensation
on restricted stock 349 - 349 - - -
-------- -------- -------- -------- -------- --------
Total other comprehensive income $ 12,791 4,355 8,436 12,443 4,355 8,088
======== ======== ======== ======== ======== ========
Nine Months Ended September 30,
-----------------------------------------------------------------
1998 1997
-----------------------------------------------------------------
Income Income
Pretax Tax Effect After-tax Pretax Tax Effect After-tax
-------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Net unrealized gains arising
during period $ 27,983 9,794 18,189 28,014 9,804 18,210
Less: reclassification adjustment
for realized gains included in net
income 13,384 4,684 8,700 1,867 653 1,214
-------- -------- -------- -------- -------- --------
Net change in unrealized
gains on investments 14,599 5,110 9,489 26,147 9,151 16,996
Change in deferred compensation
on restricted stock 430 - 430 - - -
-------- -------- -------- -------- -------- --------
Total other comprehensive income $ 15,029 5,110 9,919 $ 26,147 9,151 16,996
======== ======== ======== ======== ======== ========
</TABLE>
8. Warrant Price Adjustment
The exercise price of the Series A, A-2, B and B-2 common stock purchase
warrants which were issued with the convertible subordinated debentures are, for
the life of the stock purchase warrants, subject to adjustment due to adverse
loss reserve and uncollectible reinsurance development for years prior to 1996.
Such adjustment during the third quarter and nine months ended September 30,
1998 amounted to $ (.04) and $ .70, respectively.
9. Contingent Liabilities:
The information set forth in Item 1 of Part II of this report is incorporated
herein by reference.
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.
13
<PAGE>
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
The Results of Operations reflect the consolidated results of operations of the
Company.
The Results of Operations are presented in two divisions - The American Reliance
Division and the Highlands Division. As discussed in Note 2 of the Condensed
Notes to Unaudited Consolidated Financial Statements, on April 30, 1997,
Highlands Group completed the acquisition of Vik Brothers Insurance, Inc.,
renamed American Reliance, Inc. The acquisition was accounted for under the
purchase method of accounting and, accordingly, the consolidated financial
statements include the results of American Reliance's operations only from the
date of acquisition. The American Reliance Division consists of business
managed by the Company's Lawrenceville, New Jersey office.
The Highlands Division consists of business managed by the Company's Houston,
Texas office. In 1995, the Highlands Division classified three of its product
lines as discontinued (the "Discontinued Lines"): business originated by its
London operations; an umbrella/excess liability policy program; and assumed
casualty and property reinsurance contracts. (Please refer to the Company's
1997 Annual Report Form 10-K for a more complete description of the Discontinued
Lines.) Results of the Highlands Division exclude the Discontinued Lines which
are presented separately.
14
<PAGE>
The results of the Company's consolidated operations for the periods indicated
are set forth below:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------- ----------------------------
1998 1997 1998 1997
-------- -------- -------- --------
(Dollars in millions)
<S> <C> <C> <C> <C>
Consolidated Results:
Gross premiums written $ 94.4 124.9 279.2 242.1
Net premiums written $ 84.5 101.5 249.5 198.9
======== ======== ======== ========
Net premiums earned:
American Reliance Division $ 64.7 71.7 189.8 121.6
Highlands Division 20.3 36.2 63.9 94.1
Discontinued Lines - (.3) .2 .3
-------- -------- -------- --------
$ 85.0 107.6 253.9 216.0
======== ======== ======== ========
Underwriting (loss):
American Reliance Division $ (11.1) (7.3) (38.2) (9.5)
Highlands Division (.5) (1.5) (16.3) (23.0)
Discontinued Lines (.2) (3.2) (1.2) (6.2)
-------- -------- -------- --------
(11.8) (12.0) (55.7) (38.7)
Net investment income 19.1 22.3 58.7 53.6
Net realized investment gains 6.9 .7 13.4 1.8
Debt interest and amortization expense (3.1) (3.0) (9.2) (7.4)
Other expenses, net (.9) (.4) (1.7) (.9)
-------- -------- -------- --------
Income before income taxes 10.2 7.6 5.4 8.4
Income tax expense (3.5) (.9) - (1.0)
-------- -------- -------- --------
Net income $ 6.7 6.7 5.4 7.4
======== ======== ======== ========
Ratios:
Loss 71.8% 77.8% 79.4% 82.4%
Expense 42.1% 33.3% 42.6% 35.5%
-------- -------- -------- --------
Combined 113.9% 111.1% 122.0% 117.9%
======== ======== ======== ========
</TABLE>
Net premiums earned for the three months ended September 30, 1998 and 1997
amounted to $85.0 million and $107.6 million, respectively. The decrease of
$22.6 million or 21% is primarily attributable to three factors. First, the
Company continues to focus on stricter underwriting standards and adequate
pricing. The current pricing environment is highly competitive as insurers
compete to retain business. Second, the problems associated with the
implementation of a new policy issuance system in the American Reliance Division
negatively impacted gross premiums written, net premiums written and net
premiums earned. Third, decreases from retrospectively rated policies in the
Highlands Insurance Division. The net premiums earned for the nine months ended
September 30, 1998 and 1997 amounted to $253.9 million and $216.0 million,
respectively. The increase is the result of the additional earned premium from
the American Reliance Division which was acquired on April 30, 1997.
15
<PAGE>
Underwriting losses for the three months and nine months ended September 30,
1998 and 1997 amounted to $11.8 million and $12.0 million and $55.7 million and
$38.7 million, respectively. The underwriting losses decreased $ .2 million or
2% for the three months ended September 30, 1998 compared with the same 1997
period. The increase in underwriting losses of $17.0 million or 44% for the nine
months ended September 30, 1998 compared with the same 1997 period is due to the
inclusion of the American Reliance Division for nine months in 1998 as compared
to five months in 1997 including the catastrophe losses of $10.5 million
incurred in the second quarter of 1998. Also see "American Reliance Division,"
"Highlands Division" and "Discontinued Lines" for additional comments.
Net investment income for the three and nine months ended September 30, 1998 and
1997 was $19.1 million and 22.3 million and $58.7 million and $53.6 million,
respectively. Net investment income increased $5.1 million from 1997 due to the
inclusion of the American Reliance Division for nine months in 1998 as compared
to five months in 1997. Net realized investment gains increased $11.6 million to
$13.4 million for the nine months ended September 30, 1998 compared to $1.8
million for the nine months ended September 30, 1997.
Debt interest and amortization expense for the three and nine months ended
September 30, 1998 and 1997 was $3.1 million and $3.0 million and $9.2 million
and $7.4 million, respectively. Debt interest and amortization expense for the
nine months ended September 30, 1998 compared with the same period for 1997
increased $1.8 million as a result of the $65 million Credit Agreement used to
finance the purchase of American Reliance.
American Reliance Division
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- -------------------------
1998 1997 1998 1997
------ ------ ------ ------
(Dollars in millions)
<S> <C> <C> <C> <C>
Gross premiums written $ 73.8 85.1 212.6 142.9
Net premiums written $ 66.5 65.3 190.3 109.1
====== ====== ====== ======
Net premiums earned $ 64.7 71.7 189.8 121.6
Loss and loss adjustment expense incurred (47.8) (51.9) (144.6) (86.4)
Underwriting expenses (28.0) (27.1) (83.4) (44.7)
------ ------ ------ ------
Underwriting (loss) $(11.1) (7.3) (38.2) (9.5)
====== ====== ====== ======
Ratios:
Loss 73.9% 72.4% 76.2% 71.0%
Expense 43.3% 37.8% 43.9% 36.8%
------ ------ ------ ------
Combined 117.2% 110.2% 120.1% 107.8%
====== ====== ====== ======
</TABLE>
American Reliance was acquired on April 30, 1997 and accounted for as a
purchase. Accordingly, the above results are for the three and nine months
ended September 30, 1998 and the three and five months ended September 30, 1997
and are included in the consolidated results of the Company.
Period to Period Comparisons of Underwriting Results of the American Reliance
Division
Gross Premiums Written. Gross premiums written for three months and the nine
months ended September 30, 1998 were $73.8 million and $212.6 million,
respectively. Gross premiums written for the three months ended September 30,
1998 decreased $11.3 million or 13% compared with the same period for 1997.
Although gross premiums written prior to the acquisition are not presented,
gross premiums written for the nine months ended September 30, 1998 have
decreased approximately 21% compared with the same period for 1997. The
decreases are due to servicing problems associated with the implementation of a
new policy issuance system, stricter underwriting standards and increased price
competition.
16
<PAGE>
Net Premiums Written. Net premiums written for the three months and nine months
ended September 30, 1998 were $66.5 million and $190.3 million, respectively.
Net premiums written have been impacted by the same issues affecting gross
premiums written.
Net Premiums Earned. Net premiums earned for the three months and nine months
ended September 30, 1998 were $64.7 million and $189.8 million, respectively.
Net premiums earned have been impacted by the same factors affecting gross and
net premiums written partially offset by changes in the reinsurance program.
Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense
incurred for the three months and nine months ended September 30, 1998 were
$47.8 million and $144.6 million, respectively. The decrease for the three
months ended September 30, 1998 is related to the overall declining premium
partially offset by increased loss and loss adjustment expense ratios. The nine
months ended September 30, 1998 includes severe weather catastrophe losses of
$15.5 million compared to $ 3.3 million for the five months ended September 30,
1997.
Underwriting Expenses. Underwriting expenses for the three months and nine
months ended September 30, 1998 were $28.0 million and $83.4 million,
respectively. The expenses for the period are higher than planned due to
additional expenses associated with implementation of the new policy issuance
system.
Highlands Division
- ------------------
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
----------------- ----------------
1998 1997 1998 1997
------ ------ ------ ------
(Dollars in millions)
<S> <C> <C> <C> <C>
Gross premiums written $ 20.4 39.8 65.9 97.9
Net premiums written $ 18.0 36.7 59.0 89.8
====== ====== ====== ======
Net premiums earned $ 20.3 36.2 63.9 94.1
Loss and loss adjustment expense
incurred (13.0) (28.8) (56.6) (86.2)
Underwriting expenses (7.8) (8.9) (23.6) (30.9)
------ ------ ------ ------
Underwriting (loss) $ (.5) (1.5) (16.3) (23.0)
====== ====== ====== ======
Ratios:
Loss 64.0% 79.6% 88.6% 91.6%
Expense 38.4% 24.6% 36.9% 32.8%
------ ------ ------ ------
Combined 102.4% 104.2% 125.5% 124.4%
====== ====== ====== ======
</TABLE>
The Highlands Division underwriting results primarily consist of relatively
large commercial accounts ("Special Accounts Unit"), medium to small commercial
accounts ("Commercial Insurance Unit"), insurance for Halliburton Company,
Highlands Group's former parent, ("Insurance Services Unit"), commercial marine
products ("Marine Unit") and surety products ("Surety Unit"). The Highlands
Division excludes the Discontinued Lines which are presented separately below.
17
<PAGE>
Period to Period Comparison of Underwriting Results of the Highlands Division
Gross Premiums Written. Gross premiums written for the three months and nine
months ended September 30, 1998 and 1997 were $20.4 million and $39.8 million
and $65.9 million and $97.9 million, respectively. The decrease of $19.4
million and $32.0 million or 49% and 33% for the three months and the nine
months ended September 30, respectively, is primarily attributable to the
decrease in retrospectively rated policies in the Insurance Services Unit and
production decreases in the Commercial Insurance Unit. The Company continues to
focus on stricter underwriting standards and adequate prices, all of which have
contributed to declines in gross premiums written in the Commercial Insurance
Unit. Also contributing to declines in gross premiums written is the continued
highly competitive pricing environment as insurers compete to retain business.
In addition, the Insurance Services Unit has begun to sell more large
deductible policies versus retrospectively rated policies. The shift in policy
type results in reduced gross premiums written.
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 estimated ultimate losses and loss adjustment
expenses from the date of the prior valuation. These adjustments may cause gross
premiums written and net premiums earned to fluctuate significantly from period
to period. Experience rated contracts reduce but do not eliminate risk to the
insurer.
The Company has put into place a fronting and cut-through endorsement program
which provides certain customers access to A+ paper. This program was put in
place to limit the potential loss of business due to A.M. Best's June 15, 1998
downgrade of Highlands Insurance Company to B++ from A-.
Net Premiums Written. Net premiums written for the three months and nine months
ended September 30, 1998 and 1997 were $18.0 million and $36.7 million and $59.0
million and $89.8 million, respectively. The decrease of $18.7 million and
$30.8 million or 51% and 34% for the three months and the nine months ended
September 30, respectively, is primarily related to the same issues affecting
gross premiums written.
Net Premiums Earned. Net premiums earned for the three months and nine months
ended September 30, 1998 and 1997 were $20.3 million and $36.2 million and $63.9
million and $94.1 million, respectively. The decrease of $15.9 million and
$30.2 million or 44% and 32% for the three months and nine months ended
September 30, respectively, is also related to the same issues affecting gross
and net premiums written.
Loss and Loss Adjustment Expense Incurred. Losses and loss adjustment expenses
incurred for the three months and nine months ended September 30, 1998 and 1997
were $13.0 million and $28.8 million and $56.6 million and $86.2 million,
respectively. The decrease of $15.8 million and $29.6 million or 55% and 34%
for the three months and nine months ended September 30, respectively, is
related to the declining premium volume and less adverse prior year reserve
development.
Underwriting Expenses. Underwriting expenses for the three months and nine
months ended September 30, 1998 and 1997 amounted to $7.8 million and $8.9
million and $23.6 million and $30.9 million, respectively. The decline for the
nine months ended September 30, 1998 compared to the same 1997 period was
primarily due to accrued expenses of $4.0 million in 1997 related to the Texas
Workers' Compensation Facility's final industry assessment and industry
litigation involving surplus from the Facility that was previously received by
the Company. The remaining expense reduction relates to declining premium volume
and previous expense saving initiatives.
18
<PAGE>
Discontinued Lines
- ------------------
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- ---------------------
1998 1997 1998 1997
------- ------- -------- -------
(Dollars in millions)
<S> <C> <C> <C> <C>
Gross premiums written $ .2 - .7 1.3
Net premiums written $ - (0.5) .2 -
======= ======= ======= =======
Net premiums earned $ - (0.3) .3
Loss and loss adjustment expense
incurred (.2) (3.1) (.4) (5.5)
Underwriting expenses - .2 (1.0) (1.0)
------- ------- -------- -------
Underwriting (loss) $ (.2) (3.2) (1.2) (6.2)
======= ======= ======= =======
</TABLE>
For reporting purposes, Highlands Group has three lines of business which are
considered Discontinued Lines, specifically business originated by the Highlands
Group's London operations, an umbrella/excess liability policy program and
assumed casualty and property reinsurance contracts. The Company has ceased to
write these Discontinued Lines and canceled all remaining voluntary assumed
casualty and property reinsurance contracts during 1996.
Period to Period Comparisons of Underwriting Results of Discontinued Lines
Premiums. Due to the nature of the Company's reinsurance contracts, small
premium adjustments can continue long after cancellation of such agreements.
Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense
incurred for the three months and nine months ended September 30,1998 compared
to 1997 decreased by $2.9 million and $5.1 million, respectively.
Liquidity and Capital Resources
Highlands Group is a holding company, the principal assets of which at September
30, 1998 were all of the capital stock of Highlands Insurance Company and
American Reliance, Inc. The Company's property and casualty insurance business
is conducted by its direct and indirect wholly-owned insurance subsidiaries. The
liquidity and capital resource considerations for the Highlands Group are
different than those of the Company's insurance operations.
Holding Company
Highlands Group's principal requirements for funds are to pay operating
expenses, franchise and other taxes, debt service and dividends. Operating
expenses and franchise and other taxes imposed on Highlands Group are not
expected to be material. The annual cash interest requirements relating to the
convertible subordinated debentures and the Credit Agreement are approximately
$11.0 million. Highlands Group does not currently intend to pay dividends on its
Common Stock. Because the Company may seek to grow through acquisition, an
additional use of funds may be to invest in other insurance companies or other
insurance operations. During the third quarter of 1998, the Company repurchased
293,500 shares of its common stock at an aggregate cost of $4.0 million. The
Company's Board of Directors has not authorized any additional purchases as of
September 30, 1998. Repurchased shares are held in Treasury.
19
<PAGE>
Highlands Group's principal sources of funds are dividend and tax sharing
payments from Highlands and American Reliance, 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 the insurance subsidiaries is subject to
restrictions and limitations imposed by the insurance regulatory authorities.
Dividend payments to Highlands Group from its insurance subsidiaries are
currently limited to $12.1 million in 1998 without prior regulatory approval.
Management believes that Highlands Group's liquid assets and access to the
capital markets enable it to meet its liquidity needs.
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
losses and related expenses, underwriting expenses, other operating expenses and
dividends and tax sharing payments to Highlands Group.
In the insurance industry, liquidity refers to the ability of an enterprise to
generate adequate amounts of cash from its 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 securities.
Year 2000
The Company is dependent on computers to process and report its business.
Information Technology ("IT") systems are used for billing and collecting
premium, issuing policies, processing claims, managing assets and reporting
financial results. A failure of the Company's IT systems to function properly
would have a material adverse effect on the Company's financial condition and
results of operations. The process of becoming ready for Year 2000 consists of
(i) identifying and assessing IT systems requiring renovation (whether through
modification or replacement); (ii) renovating systems; (iii) validating or
testing systems for Year 2000 compliance; and (iv) implementing compliance
solutions. To date, the Company's primary focus has been on its own IT systems,
as opposed to its non-IT systems and the readiness of its third party vendors.
The Company has identified and assessed its IT systems which require renovation
to properly process the Year 2000. As described below, with respect to its most
important IT systems, the Company is at various stages of the process ranging
from renovating the system to having implemented a new system.
The Company began installing a new management and financial reporting IT system
during 1998. Implementation is expected to be completed by July 1999.
Because the American Reliance Division was acquired in April 1997, it has a
discrete policy issuance and processing IT system from that of the Company's
Highlands Division. The status of each division's policy issuance and
processing systems is set forth separately. In 1994, American Reliance, working
with an outside vendor, began a project to create a single processing platform
for all of its business that, among other things, would be able to process its
Year 2000 business. In August 1997, Phase One of this project, covering new and
renewal business for a portion of the commercial multiple peril line and the
commercial automobile, general liability and personal lines, representing
approximately 70% of the division's business, began to be implemented. A
combination of internal and vendor related factors such as design errors,
inadequate testing and poor implementation led to problems with this Phase and
contributed to service problems in the Division. The Company has resolved a
majority of the problems with Phase One and is implementing Phase Two in
November 1998. Phase Two of the project, covering the balance of the commercial
multiple peril line and the workers compensation and commercial umbrella lines,
representing the remainder of the Division's business, is expected to be
completed by November 1999.
The Highlands Division is developing a new processing platform for its business
that is Year 2000 compliant. The new platform is composed of policy
administration and claim administration subsystems. The policy administration
component, in part internally developed but substantially purchased, has been
implemented and commenced processing of business on a new and renewal basis in
May 1998. Complete conversion to the new system will take approximately one
year. The claim administration component has been purchased and is planned for
completion in September 1999.
The Company has spent approximately $.3 million through September 30, 1998 to
make its IT systems and non-IT systems Year 2000 compliant (excluding $16
million of costs associated with the development of the two processing
platforms). The Company expects to incur an additional $1 million in the fourth
quarter of 1998 and $2 million in 1999 in this process. The
20
<PAGE>
Company's insurance subsidiaries are expected to fund these costs out of their
operations. Although the Company's Year 2000 efforts have caused it to defer
certain other IT system projects, the Company does not believe such deferral
will have a material adverse effect on its financial position and results of
operations.
The Company has begun identifying and assessing non-IT systems such as
telephones and other facility related systems. The assessment of these systems
will be completed by March 1999. The Company believes that it will be able to
modify, or, where appropriate, replace, these systems by September 1999. The
telephone systems in its Lawrenceville, New Jersey and Raleigh, North Carolina
offices are scheduled to be replaced by February 1999.
The Company relies on third party vendors for many services such as
communications, electricity and energy, banking and reinsurance. The Company
has identified the entities which are material to its operation and is assessing
whether they will be Year 2000 compliant through questionnaires and affirmations
of Year 2000 compliance. The Company has not completed this assessment at this
time.
The Company has made and will continue to make significant efforts to ensure
that it and its third party vendors are Year 2000 compliant. The effect, if
any, on the Company's financial position and results of operations from the
failure of these efforts to become Year 2000 compliant cannot be reasonably
estimated.
The Company's efforts have focused on renovating its IT systems, not on
preparing contingency plans if it fails in such renovation efforts. However,
the Company does have contingency plans for its processing IT systems.
Contingency plans for other systems and material third party vendors which may
not be Year 2000 compliant in time will be made on a case-by-case basis as part
of the assessment process for each system and vendor.
In addition to the Company's systems, the Year 2000 issues may affect its
underlying business. The Company does not believe that Year 2000 occurrences
are covered under property and casualty policies that it issues. The Company's
insurance products are based on those developed by Insurance Services Office,
Inc. ("ISO"), which recently developed policy language that clarifies that there
is no coverage for Year 2000 occurrences. The Company has adopted the ISO
exclusionary language in states where it has been approved. In states not
accepting the ISO exclusionary language, the Company has filed its own
exclusionary language. The Company is attaching either the ISO or its own
exclusionary language to all policies with a rating classification the Company
believes could potentially have Year 2000 losses. The Company's exposure for
losses and expenses pursuant to policies it will issue cannot be reasonably
estimated at this time.
The estimated cost of the Company's Year 2000 efforts and the dates on which it
believes it will complete such efforts are based on management's best estimate
which was derived using numerous assumptions regarding future events, including
the continued availability of certain resources, third party remediation plans
and other factors. There can be no assurance that these estimates will prove
accurate. Actual results could differ materially from those currently
anticipated. Specific factors that could cause such material differences
include; the availability and costs of all personnel trained in Year 2000
issues; the ability to identify, assess, renovate and test all relevant computer
codes and embedded technology; the risk that reasonable testing will not uncover
all Year 2000 problems; and similar uncertainties.
21
<PAGE>
Part II Other Information
Item 1. Legal Proceedings.
None
Item 4. Submission of Matters to a Vote of Security Holders.
At the Annual Meeting of Stockholders held on May 11, 1998, the
Stockholders
(a) elected the following directors:
NOMINEE SHARES FOR SHARES WITHHELD
------- ---------- ---------------
Robert A. Spass 11,913,704 26,974
Bradley E. Cooper 11,910,357 30,321
Kenneth S. Crews 11,927,328 13,350
(b) approved by a vote of 11,373,120 shares for and 92,823 shares
against with 474,735 abstentions a proposal to amend the
Company's 1995 Stock Option Plan to permit options to be
issued to all full-time employees.
(c) approved by a vote of 11,261,949 shares for 200,575 shares
against with 478,154 abstentions a proposal to approve the
Employee Stock and Purchase Plan.
(d) approved by a vote of 11,925,630 shares for and 5,574 shares
against with 9,474 abstentions a proposal to select KPMG Peat
Marwick LLP as the independent public accountants of the
Company for 1998.
Item 6: Exhibits and Reports on Form 8-K.
(a) Exhibits
(27) Financial Data Schedule (Filed Electronically)
22
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HIGHLANDS INSURANCE GROUP, INC.
(Registrant)
Date: November 13, 1998 By /s/ Richard M. Haverland
------------------------------
Richard M. Haverland
Chairman, President and Chief
Executive Officer
(Authorized Signatory)
Date: November 13, 1998 By /s/ Charles J. Bachand
------------------------------
Charles J. Bachand
Vice President, Treasurer and
Principal Accounting Officer
(Authorized Signatory)
23
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> SEP-30-1998
<DEBT-HELD-FOR-SALE> 0
<DEBT-CARRYING-VALUE> 1,081,150
<DEBT-MARKET-VALUE> 1,081,150
<EQUITIES> 13,992
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,098,353
<CASH> 58,142
<RECOVER-REINSURE> 728,067
<DEFERRED-ACQUISITION> 33,494
<TOTAL-ASSETS> 2,238,208
<POLICY-LOSSES> 1,540,295
<UNEARNED-PREMIUMS> 153,369
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 121,819
0
0
<COMMON> 132
<OTHER-SE> 340,936
<TOTAL-LIABILITY-AND-EQUITY> 2,238,208
253,909
<INVESTMENT-INCOME> 58,735
<INVESTMENT-GAINS> 13,384
<OTHER-INCOME> 0
<BENEFITS> 201,574
<UNDERWRITING-AMORTIZATION> 108,080
<UNDERWRITING-OTHER> 0
<INCOME-PRETAX> 5,408
<INCOME-TAX> 29
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 5,379
<EPS-PRIMARY> .41
<EPS-DILUTED> .34
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 0
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
