<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-------------------------
FORM 10-Q
(Mark One)
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
X OF THE SECURITIES EXCHANGE ACT OF 1934
---
For the quarterly period ended June 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 June 30, 1998 was 13,200,831.
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
TABLE OF CONTENTS
PART I - Financial Information
Item Page
- ---- ----
1. Financial Statements:
Consolidated Balance Sheets
June 30, 1998 (Unaudited) and
December 31, 1997 3
Consolidated Statements of Operations
(Unaudited) - Three and Six Months Ended
June 30, 1998 and 1997 5
Consolidated Statements of Stockholders' Equity
Six Months Ended June 30, 1998 (Unaudited)
and Year Ended December 31, 1997 6
Consolidated Statements of Comprehensive
Income (Loss) (Unaudited) - Three and Six Months Ended
June 30, 1998 and 1997 7
Consolidated Statements of Cash Flows
(Unaudited) - Six Months Ended June 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 15
PART II - Other Information
1. Legal Proceedings 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>
June 30, December 31,
ASSETS 1998 1997
------ ------------------ -----------------
(Unaudited)
<S> <C> <C>
Investments:
Fixed income securities - available-for-sale, at fair
value (amortized cost of $1,063,514 at 6/30/98 and
$1,132,249 at 12/31/97) $1,097,712 1,166,585
Equity securities, at fair value (cost of $3,204 at
6/30/98 and $1,410 at 12/31/97) 3,687 1,554
Other invested assets, at cost 3,211 4,061
---------- ---------
Total investments 1,104,610 1,172,200
Cash and cash equivalents 57,713 60,717
Premiums in course of collection, net 71,984 84,977
Premiums due under retrospective policies 133,884 130,150
Receivable from reinsurers 748,669 723,114
Prepaid reinsurance premiums 8,333 24,451
Funds on deposit with reinsurers 21,125 20,172
Net deferred tax asset 66,778 64,043
Accrued investment income 15,534 16,459
Deferred policy acquisition costs 33,121 32,313
Other assets 43,935 38,060
---------- ---------
Total assets $2,305,686 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>
June 30, December 31,
LIABILITIES AND STOCKHOLDERS' EQUITY 1998 1997
------------------------------------ -------------- --------------
(Unaudited)
<S> <C> <C>
Loss and loss adjustment expense reserves $1,591,270 1,605,374
Unearned premiums 153,984 173,411
Senior bank debt 65,000 65,000
Convertible subordinated debentures 56,622 56,229
Funds held 28,096 24,023
Accounts payable and accrued liabilities 81,154 113,326
---------- ---------
Total liabilities 1,976,126 2,037,363
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized;
13,200,831 issued and outstanding in 1998; 13,187,273 issued
and outstanding in 1997 132 132
Additional paid-in capital 223,590 223,460
Retained earnings 83,542 84,888
Accumulated other comprehensive income 22,296 20,813
---------- ---------
Total stockholders' equity 329,560 329,293
---------- ---------
Total liabilities and stockholders' equity $2,305,686 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 Six Months
Ended June 30, Ended June 30,
-------------------- --------------------
1998 1997 1998 1997
--------- -------- -------- ---------
<S> <C> <C> <C> <C>
Revenues:
Net premiums earned $ 85,652 78,675 168,882 108,390
Net investment income 18,890 18,428 39,683 31,285
Net realized investment gains 3,420 620 6,450 1,104
-------- ------- ------- -------
Total revenues 107,962 97,723 215,015 140,779
-------- ------- ------- -------
Expenses:
Loss and loss adjustment expense incurred 81,532 66,499 140,561 94,330
Underwriting expenses 36,095 31,253 72,238 40,777
Debt interest and amortization expense 3,068 2,612 6,139 4,410
Other expenses, net 516 180 835 534
-------- ------- ------- -------
Total expenses 121,211 100,544 219,773 140,051
-------- ------- ------- -------
Income (loss) before income tax (13,249) (2,821) (4,758) 728
Income tax expense (benefit) (5,517) (553) (3,412) 39
-------- ------- ------- -------
Net income (loss) $ (7,732) (2,268) (1,346) 689
======== ======= ======= =======
Earnings (loss) per common share:
Basic $ (.59) (.18) (.10) .06
Diluted $ (.59) (.18) (.10) .05
======== ======= ======= =======
Weighted average number of common shares outstanding:
Basic 13,197 12,556 13,196 12,004
Diluted 13,197 12,556 13,196 14,125
======== ======= ======= =======
</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>
June 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 130 31,187
-------- -------
Balance, end of period 223,590 223,460
-------- -------
Retained earnings:
Balance, beginning of year 84,888 68,052
Net income (loss) (1,346) 16,836
-------- -------
Balance, end of period 83,542 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 1,402 19,242
-------- -------
Balance, end of period 23,680 22,278
-------- -------
Deferred compensation on restricted stock:
Balance, beginning of year (1,465) --
Net forfeitures (issuance) of restricted stock 81 (1,465)
-------- -------
Balance, end of period (1,384) (1,465)
-------- -------
Accumulated other comprehensive income:
Balance, beginning of year 20,813 3,036
Net change for the period 1,483 17,777
-------- -------
Balance, end of period 22,296 20,813
-------- -------
Total stockholders' equity $329,560 329,293
======== =======
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
6
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(Dollars in Thousands)
<TABLE>
<CAPTION>
Three Months Six Months
Ended June 30, Ended June 30,
------------------- --------------------
1998 1997 1998 1997
--------- ------- ------- ----------
<S> <C> <C> <C> <C>
Net income (loss) $(7,732) (2,268) (1,346) 689
--------- ------- ------- ----------
Other comprehensive income, net of taxes:
Change in unrealized gain on investments 4,487 12,446 1,402 8,908
Change in deferred compensation on restricted stock 81 -- 81 --
--------- ------- ------- ----------
Other comprehensive income, net of taxes 4,568 12,446 1,483 8,908
--------- ------- ------- ----------
Comprehensive income (loss) $(3,164) 10,178 137 9,597
========= ======= ======= ==========
</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>
Six Months Ended
June 30,
-----------------------
1998 1997
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $ (1,346) 689
--------- -------
Adjustments to reconcile net income (loss) to net cash (used in) provided by
operating activities:
Depreciation and amortization 1,559 142
Net realized investment gains (6,450) (1,104)
Change in:
Premiums in course of collection 12,993 52,663
Premiums due under retrospective policies (3,734) 346
Receivable from reinsurers (25,555) 11,898
Prepaid reinsurance premiums 16,118 (25,657)
Funds on deposit with reinsurers (953) (5,538)
Net deferred tax asset (3,490) (63)
Deferred policy acquisition costs (808) 1,625
Loss and loss adjustment expense reserves (14,104) (36,247)
Unearned premiums (19,427) (12,873)
Funds held 4,073 5,174
Other operating assets and liabilities (36,993) 12,405
--------- -------
Total adjustments (76,771) 2,771
--------- -------
Net cash (used in) provided by operating activities (78,117) 3,460
--------- -------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale 156,565 14,700
Equity securities 986 4,717
Other invested assets 842 1,341
Maturities or calls:
Fixed maturity securities available-for-sale 119,146 68,077
Fixed maturity securities held-to-maturity -- 5,972
Investment purchases:
Fixed maturity securities available-for-sale (200,420) (53,938)
Equity securities (1,125) --
Net additions to property and equipment (1,093) 652
Purchase of subsidiary, net of cash acquired -- 5,124
Payment of acquisition expenses -- (3,631)
Other proceeds -- 92
--------- -------
Net cash provided by investing activities 74,901 43,106
--------- -------
</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>
Six Months Ended
June 30,
------------------------------------
1998 1997
-------------- -------------
<S> <C> <C>
Cash flows from financing activities:
Issuance of common stock 212
Proceeds from senior bank debt -- 65,000
Repayment of acquired bank debt -- (35,638)
Payment for debt issuance expense -- (1,017)
-------------- -------------
Net cash provided by financing activities 212 28,345
-------------- -------------
Net (decrease) increase in cash and cash equivalents (3,004) 74,911
Cash and cash equivalents at beginning of period 60,717 49,484
-------------- -------------
Cash and cash equivalents at end of period $ 57,713 124,395
============== =============
Supplemental disclosure of cash flow information:
Interest paid $ 5,382 3,365
============== =============
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
June 30, 1998
1. Basis of Presentation
The accompanying consolidated financial statements as of June 30, 1998 and for
both the three and six months ended June 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.
10
<PAGE>
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.
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 six months ended June 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.
Six Months Ended
June 30, 1997
--------------------
(In thousands, except per share data)
Revenues $ 255,856
Net income $ 2,084
Basic earnings per share $ .17
Diluted earnings per share $ .15
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. Earnings Per Share
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 Six Months Ended
June 30, June 30,
-------------------- ---------------------
1998 1997 1998 1997
---------- ------- --------- ----------
<S> <C> <C> <C> <C>
NUMERATOR:
Net income (loss), as reported $ (7,732) (2,268) $ (1,346) 689
Effect of dilutive securities - after tax debt expense applicable to
convertible subordinated debentures -- -- -- --
---------- ------- --------- ----------
Income (loss) available to common stockholders after
assumed conversions $ (7,732) (2,268) $ (1,346) 689
========== ======= ========= ==========
DENOMINATOR:
Denominator for basic earnings per share - weighted average shares
outstanding 13,197 12,556 13,196 12,004
Common stock warrants and outstanding stock options (based on
treasury stock method) -- -- -- 2,121
Convertible subordinated debentures -- -- -- --
---------- ------- --------- ----------
Adjusted weighted average shares and assumed
conversions 13,197 12,556 13,196 14,125
========== ======= ========= ==========
Basic earnings (loss) per share $ (.59) (.18) $ (.10) .06
Diluted earnings (loss) per share $ (.59) (.18) $ (.10) .05
</TABLE>
The common stock warrants and outstanding stock options are not included in the
computation of diluted earnings per share in periods with a net loss. 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 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 six months
ended June 30, 1998 was 7.3%.
12
<PAGE>
7. Comprehensive Income
The following summaries present the components of comprehensive income, other
than net income, for the three and six months ended June 30, 1998 and 1997 (in
thousands):
<TABLE>
<CAPTION>
Three Months Ended June 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 $ 10,323 3,613 6,710 19,768 6,919 12,849
Less: reclassification adjustment
for realized gains included in net
income 3,420 1,197 2,223 620 217 403
-------- ----------- --------- -------- ---------- ----------
Net change in unrealized
gains on investments 6,903 2,416 4,487 19,148 6,702 12,446
Change in deferred compensation
on restricted stock 81 -- 81 -- -- --
-------- ----------- --------- -------- ---------- ----------
Total other comprehensive income $ 6,984 2,416 4,568 19,148 6,702 12,446
======== =========== ========= ======== ========== ==========
</TABLE>
<TABLE>
<CAPTION>
Six Months Ended June 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 $ 8,607 3,012 5,595 14,809 5,183 9,626
Less: reclassification adjustment
for realized gains included in net
income 6,450 2,257 4,193 1,104 386 718
-------- ----------- --------- -------- ---------- ----------
Net change in unrealized
gains on investments 2,157 755 1,402 13,705 4,797 8,908
Change in deferred compensation
on restricted stock 81 -- 81 -- -- --
-------- ----------- --------- -------- ---------- ----------
Total other comprehensive income $ 2,238 755 1,483 $ 13,705 4,797 8,908
======== =========== ========= ======== ========== ==========
</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 second quarter and six months ended June 30, 1998
reduced the exercise price by $.74 per share.
9. Contingent Liabilities:
The information set forth in Item 1 of Part II of this report is incorporated
herein by reference.
13
<PAGE>
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.
14
<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 Company is managed in two divisions - The Highlands Division and the
American Reliance Division. 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.
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 date of acquisition. The American
Reliance Division consists of business managed by the Company's Lawrenceville,
New Jersey office.
15
<PAGE>
The results of the Company's consolidated operations for the periods indicated
are set forth below:
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------------------- --------------------------------------
1998 1997 1998 1997
----------------- ------------------ ------------------ -----------------
<S> <C> <C> <C> <C>
(Dollars in millions)
Consolidated Results:
Gross premiums written $ 92.5 86.3 184.8 17.3
Net premiums written $ 83.4 69.4 165.1 97.3
====== ===== ===== =====
Net premiums earned:
Highlands Division $ 23.1 28.4 43.6 57.9
American Reliance Division 62.5 49.9 125.1 49.9
Discontinued Lines .1 .4 .2 .6
------ ----- ----- -----
$ 85.7 78.7 168.9 108.4
====== ===== ===== =====
Underwriting (loss):
Highlands Division $(13.1) (15.6) (15.8) (21.6)
American Reliance Division (18.4) (2.1) (27.1) (2.1)
Discontinued Lines (.4) (1.4) (1.0) (3.0)
------ ----- ----- -----
(31.9) (19.1) (43.9) (26.7)
Net investment income 18.9 18.4 39.7 31.3
Net realized investment gains 3.4 .6 6.4 1.1
Debt interest and amortization expense (3.1) (2.6) (6.1) (4.4)
Other expenses, net (.5) (.2) (.8) (.5)
------ ----- ----- -----
Income (loss) before income taxes (13.2) (2.9) (4.7) .8
Income tax benefit (expense) 5.5 .6 3.4 (.1)
------ ----- ----- -----
Net income (loss) $ (7.7) (2.3) (1.3) .7
====== ===== ===== =====
Ratios:
Loss 95.2% 84.5% 83.2% 87.0%
Expense 42.1% 39.7% 42.8% 37.6%
----- ----- ----- -----
Combined 137.3% 124.2% 126.0% 124.6%
===== ===== ===== =====
</TABLE>
Net premiums earned amounted to $85.7 million and $168.9 million for the second
quarter and six months ended June 30, 1998, respectively, an increase of $7.0
million and $60.5 million compared with the same 1997 periods. The increases
result from the additional earned premium from the American Reliance Division
which was acquired on April 30, 1997.
16
<PAGE>
Underwriting losses of $ 31.9 million and $43.9 million for the second quarter
and the six months ended June 30, 1998, respectively, increased $12.8 million
and $17.2 million compared with the same 1997 periods. The increase in
underwriting losses for both the three months and six months of 1998 includes an
increase in the American Reliance Division underwriting losses and a reduction
in the Highlands Division underwriting losses from 1997. The American Reliance
Division underwriting loss for both the three months and six months ended June
30, 1998 includes $10.5 million of losses related to severe weather catastrophe
losses that adversely impacted the entire industry. Highlands' underwriting
loss includes $8.0 million and $6.1 million of loss reserve increases related to
California construction defect claims in 1998 and 1997, respectively. Also see
"Highlands Division", "American Reliance Division" and "Discontinued Lines" for
additional comments.
Net investment income for the six months ended June 30, 1998 and 1997 was $39.7
million and $31.3 million, respectively. Net investment income increased $8.4
million from 1997 due to the inclusion of the American Reliance Division. Net
realized investment gains increased $5.3 million to $6.4 million for the six
months ended June 30, 1998 compared to $1.1 million for the six months ended
June 30, 1997.
Debt interest and amortization expense for the six months ended June 30, 1998
compared with the same period for 1997 increased $1.7 million as a result of the
$65 million Credit Agreement used to finance the purchase of American Reliance.
Highlands Division
- ------------------
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------- ---------------
1998 1997 1998 1997
---------- ------- ------ -------
<S> <C> <C> <C> <C>
(Dollars in millions)
Gross premiums written $ 22.9 27.8 45.5 58.2
Net premiums written $ 20.9 25.1 41.1 53.0
====== ===== ===== =====
Net premiums earned $ 23.1 28.4 43.6 57.9
Loss and loss adjustment expense
incurred (28.2) (31.2) (43.6) (57.5)
Underwriting expenses (8.0) (12.8) (15.8) (22.0)
------ ----- ----- -----
Underwriting (loss) $(13.1) (15.6) (15.8) (21.6)
====== ===== ===== =====
Ratios:
Loss 122.1% 109.9% 100.0% 99.3%
Expense 34.6% 45.1% 36.2% 38.0%
------ ----- ----- -----
Combined 156.7% 155.0% 136.2% 137.3%
====== ===== ===== =====
</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.
Period to Period Comparison of Underwriting Results of the Highlands Division
Gross Premiums Written. Gross premiums written for the three months and six
months ended June 30, 1998 and 1997 were $22.9 million and $45.5 million and
$27.8 million and $58.2 million, respectively. The decrease of $4.9 million and
$12.7 million or 18% and 22% for the three months and the six months ended June
30, respectively, is primarily attributable to
17
<PAGE>
decreases from 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 price increases, all of which have
contributed to declines in gross premiums written in the Commercial Insurance
Unit. The declines have been partially offset by premium increases in the Marine
Unit. Also contributing to declines in gross premiums written is the continued
highly competitive pricing environment as insurers compete to retain business.
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 and should 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 six months
ended June 30, 1998 and 1997 were $20.9 million and $41.1 million and $25.1
million and $53.0 million, respectively. The decrease of $4.2 million and $11.9
million or 17% and 22% for the three months and the six months ended June 30,
respectively, is primarily related to the same issues affecting gross premiums
written.
Net Premiums Earned. Net premiums earned for the three months and six months
ended June 30, 1998 and 1997 were $23.1 million and $43.6 million and $28.4
million and $57.9 million, respectively. The decrease of $5.3 million and $14.3
million or 19% and 25% for the three months and six months ended June 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 six months ended June 30, 1998 and 1997
amounts to $28.2 million and $43.6 million and $31.2 million and $57.5 million,
respectively. The decrease of $3.0 million and $13.9 million or 10% and 24% for
the three months and six months ended June 30, 1998 and 1997, respectively, is
related to the declining premium volume. The second quarter 1998 decrease of
$3.0 million is net of increased loss and loss adjustment expenses incurred of
$1.9 million ($8.0 million in 1998 compared to $6.1 million in 1997) related to
California construction defect claims.
Underwriting Expenses. Underwriting expenses for the three months and six
months ended June 30, 1998 and 1997 amounted to $8.0 million and $15.8 million
and $12.8 million and $22.0 million, respectively. The decline for the three
months and six months ended June 30, 1998 compared to the same 1997 periods was
primarily due to accrued expenses of $3.5 million 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>
American Reliance Division
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------- --------------------------
1998 1997 1998 1997
------------ -------------- ----------- ------------
(Dollars in millions)
<S> <C> <C> <C> <C>
Gross premiums written $ 69.1 57.8 138.8 57.8
Net premiums written $ 62.4 43.8 123.8 43.8
====== ===== ===== =====
Net premiums earned $ 62.5 49.9 125.1 49.9
Loss and loss adjustment expense incurred (53.4) (34.4) (96.8) (34.4)
Underwriting expenses (27.5) (17.6) (55.4) (17.6)
------ ----- ----- -----
Underwriting (loss) $(18.4) (2.1) (27.1) (2.1)
====== ===== ===== =====
Ratios:
Loss 85.4% 68.9% 77.4% 68.9%
Expense 44.0% 35.3% 44.3% 35.3%
------ ----- ----- -----
Combined 129.4% 104.2% 121.7% 104.2%
====== ===== ===== =====
</TABLE>
American Reliance was acquired on April 30, 1997 and accounted for as a
purchase. Accordingly, the above results are for the three and six months ended
June 30, 1998 and the two months ended June 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 six
months ended June 30, 1998 were $69.1 million and $138.8 million, respectively.
Although gross premiums written prior to the acquisition are not presented,
gross premiums written have declined approximately 18% and 24% for the three
months and six months ended June 30, respectively, due to servicing problems
associated with the implementation of a new policy issuance system, stricter
underwriting standards and increased price competition.
Net Premiums Written. Net premiums written for the three months and six months
ended June 30, 1998 were $62.4 million and $123.8 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 six months
ended June 30, 1998 were $62.5 million and $125.1 million, respectively. Net
premiums earned have been impacted by the same factors affecting gross and net
premiums written.
Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense
incurred for the three months and six months ended June 30, 1998 were $53.4
million and $96.8 million, respectively. The three months ended June 30, 1998
includes a charge of $10.5 million related to severe weather catastrophe losses
as compared to $1.7 million for the three months ended June 30, 1997. Although
the period prior to the acquisition is not presented, loss and loss adjustment
expense incurred has declined due to the decrease in premium volume.
Underwriting Expenses. Underwriting expenses for the three months and six
months ended June 30, 1998 were $27.5 million and $55.4 million, respectively.
The expenses for the period are higher than planned due to additional expenses
associated with implementation of the new policy issuance system.
19
<PAGE>
Discontinued Lines
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------- --------------------------
1998 1997 1998 1997
-------- ------- ------- ------
<S> <C> <C> <C> <C>
(Dollars in millions)
Gross premiums written $ .5 .7 .5 1.3
Net premiums written $ .1 .4 .2 .5
===== ==== ==== ====
Net premiums earned $ .1 .4 .2 .6
Loss and loss adjustment expense
incurred .1 (.9) (.2) (2.4)
Underwriting expenses (.6) (.9) (1.0) (1.2)
----- ---- ---- ----
Underwriting (loss) $ (.4) (1.4) (1.0) (3.0)
===== ==== ==== ====
</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 six months ended June 30,1998 compared to 1997
decreased by $1.0 million and $2.2 million, respectively. The decline in loss
and loss adjustment expense for the second quarter 1998 reflects minor reserve
movements.
Liquidity and Capital Resources
Highlands Group is a holding company, the principal assets of which at June 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. 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. The Company's Board of Directors authorized a share repurchase of
up to $4 million of the Company's common stock in open market purchases and a
limited number of privately negotiated transactions. Purchases will be made
from time-to-time as market conditions warrant. Repurchased shares will be held
in Treasury.
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
20
<PAGE>
insurance regulatory authorities. Dividend payments to Highlands Group from its
insurance subsidiaries are currently limited to $18.1 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
Highlands Division. The Highlands Division is creating a new processing
platform for its business. A by-product of this will be a processing platform
that is year 2000 compliant. The new platform will be composed of three major
sub-systems: policy administration; claim administration; and management and
financial reporting. The policy administration component, in part internally
developed but substantially purchased, will permit the processing of year 2000
business on a new and renewal basis starting in the fourth quarter of 1998.
Conversion to the new system will take approximately one year. The claim
administration component will also be purchased and is planned for full
conversion during the second quarter of 1999. The management and financial
reporting system is made up of a series of deliverables starting with the
implementation of a new general ledger in 1996 and concluding with a full
reporting system in the second half of 1999.
Based on the foregoing schedule, the Company believes that the new processing
platform for the Highlands Division will be fully operational by the end of
1999.
American Reliance Division. 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 and
subsequent business and related claims. 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 on a new and renewal business basis. The American Reliance
Division is currently processing business on this new platform. Implementation
of Phase One is scheduled to be completed between August and 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 balance of the Division's business, is expected to commence implementation
in October 1998 and is scheduled to be completed by October 1999. Based on this
schedule, the Company believes that the new processing platform for the American
Reliance Division will be completely operational by the end of 1999.
The American Reliance Division will use the financial reporting system being
implemented by the Highlands Division, once the system is operational. The cost
of the above items relates to replacing the Company's legacy systems. The cost
of addressing year 2000 specific issues is not expected to be material.
The Company believes that with modifications to existing software and converting
to new software, the year 2000 issue 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 issue could have a material impact on the operations of the Company.
21
<PAGE>
Part II Other Information
Item 1. Legal Proceedings
None
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: August 14, 1998 By /s/ Richard M. Haverland
----------------------------
Richard M. Haverland
Chairman, President and Chief
Executive Officer
(Authorized Signatory)
Date: August 14, 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> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> JUN-30-1998
<DEBT-HELD-FOR-SALE> 0
<DEBT-CARRYING-VALUE> 1,097,712
<DEBT-MARKET-VALUE> 1,097,712
<EQUITIES> 3,687
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,104,610
<CASH> 57,713
<RECOVER-REINSURE> 748,669
<DEFERRED-ACQUISITION> 33,121
<TOTAL-ASSETS> 2,305,686
<POLICY-LOSSES> 1,591,270
<UNEARNED-PREMIUMS> 153,984
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 121,622
0
0
<COMMON> 132
<OTHER-SE> 329,428
<TOTAL-LIABILITY-AND-EQUITY> 2,305,686
168,882
<INVESTMENT-INCOME> 39,683
<INVESTMENT-GAINS> 6,450
<OTHER-INCOME> 0
<BENEFITS> 140,561
<UNDERWRITING-AMORTIZATION> 72,238
<UNDERWRITING-OTHER> 0
<INCOME-PRETAX> (4,758)
<INCOME-TAX> (3,412)
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 0
<EPS-PRIMARY> (.10)
<EPS-DILUTED> (.10)
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 0
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
