<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, 1999
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, 1999 was 13,925,527.
================================================================================
1
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
TABLE OF CONTENTS
PART I - Financial Information
<TABLE>
<CAPTION>
Item Page
- ---- ----
<S> <C>
1. Financial Statements:
Consolidated Balance Sheets
June 30, 1999 (Unaudited) and
December 31, 1998 3
Consolidated Statements of Operations
(Unaudited) - Three and Six Months Ended
June 30, 1999 and 1998 5
Consolidated Statements of Stockholders' Equity
Six Months Ended June 30, 1999 (Unaudited)
and Year Ended December 31, 1998 6
Consolidated Statements of Comprehensive Income
(Unaudited) - Three and Six Months Ended
June 30, 1999 and 1998 7
Consolidated Statements of Cash Flows
(Unaudited) - Six Months Ended June 30,
1999 and 1998 8
Condensed Notes to Unaudited Consolidated
Financial Statements 9
2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 12
PART II - Other Information
1. Legal Proceedings 17
4. Submission of Matters to a Vote of Security Holders 17
6. Exhibits and Reports on Form 8-K 17
Signatures 18
</TABLE>
2
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
<TABLE>
<CAPTION>
June 30, December 31,
ASSETS 1999 1998
------ --------------- --------------
(Unaudited)
<S> <C> <C> <C>
Investments:
Fixed income securities - available-for-sale, at fair
value (amortized cost of $896,286 at
6/30/99 and $975,858 at 12/31/98) $ 883,435 1,001,236
Equity securities, at fair value (cost of $27,686 at
6/30/99 and $20,585 at 12/31/98) 26,787 21,057
Other investments, at cost 3,107 3,107
-------------- --------------
Total investments 913,329 1,025,400
Cash and cash equivalents 72,368 70,747
Premiums in course of collection, net 57,255 51,138
Premiums due under retrospective policies 138,386 144,613
Receivable from reinsurers 787,608 787,344
Prepaid reinsurance premiums 1,591 2,523
Funds on deposit with reinsurers 16,846 17,873
Net deferred tax asset 82,912 70,433
Accrued investment income 12,389 13,916
Deferred policy acquisition costs 30,982 31,537
Other assets 53,240 49,519
-------------- --------------
Total assets $2,166,906 2,265,043
============== ==============
</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 1999 1998
------------------------------------ --------------- ---------------
(Unaudited)
<S> <C> <C>
Loss and loss adjustment expense reserves $1,533,561 1,603,548
Unearned premiums 134,323 137,353
Senior bank debt 60,000 65,000
Convertible subordinated debentures 57,416 57,017
Funds held 2,135 14,049
Accounts payable and accrued liabilities 76,157 69,522
---------- ---------
Total liabilities 1,863,592 1,946,489
---------- ---------
Commitments and contingent liabilities
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized;
13,925,527 issued and outstanding in 1999; 13,235,316 issued and
outstanding in 1998 139 132
Additional paid-in-capital 231,182 223,976
Treasury stock, at cost (739,400 shares in 1999; 724,400 shares
in 1998) (9,459) (9,268)
Accumulated other comprehensive (loss) income (8,937) 16,803
Deferred compensation on restricted stock (3,147) (1,074)
Retained earnings 93,536 87,985
---------- ---------
Total stockholders' equity 303,314 318,554
---------- ---------
Total liabilities and stockholders' equity $2,166,906 2,265,043
========== =========
</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,
---------------------------------- ----------------------------------
1999 1998 1999 1998
------------- ------------ ------------ ------------
<S> <C> <C> <C> <C>
Revenues:
Net premiums earned $78,158 85,652 159,863 168,882
Net investment income 17,185 18,890 34,941 39,683
Net realized investment gains 1,291 3,420 1,794 6,450
------- ------- ------- -------
Total revenues 96,634 107,962 196,598 215,015
------- ------- ------- -------
Expenses:
Loss and loss adjustment expense incurred 55,924 81,532 116,670 140,561
Underwriting expenses 33,511 36,095 65,928 72,238
Debt interest and amortization expense 2,965 3,068 5,888 6,139
Other expenses, net 634 516 925 835
------- ------- ------- -------
Total expenses 93,034 121,211 189,411 219,773
------- ------- ------- -------
Income (loss) before income tax 3,600 (13,249) 7,187 (4,758)
Income tax expense (benefit) 801 (5,517) 1,636 (3,412)
------- ------- ------- -------
Net income (loss) $ 2,799 (7,732) 5,551 (1,346)
======= ======= ======= =======
Earnings (loss) per common share:
Basic $ .22 (.59) .44 (.10)
Diluted $ .20 (.59) .40 (.10)
======= ======= ======= =======
Weighted average number of common shares
outstanding:
Basic 12,881 13,197 12,688 13,196
Diluted 13,797 13,197 13,946 13,196
======= ======= ======= =======
</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,
1999 1998
----------------- ------------------
(Unaudited)
<S> <C> <C>
Common stock:
Balance, beginning of year $ 132 132
Issuance of common stock, par value 7 -
-------- -------
Balance, end of period 139 132
-------- -------
Additional paid-in-capital:
Balance, beginning of year 223,976 223,460
Issuance of common stock, paid in capital 7,206 516
-------- -------
Balance, end of period 231,182 223,976
-------- -------
Treasury stock, at cost:
Balance, beginning of year (9,268) -
Acquisition of treasury stock (191) (9,268)
-------- -------
Balance, end of period (9,459) (9,268)
-------- -------
Accumulated other comprehensive (loss) income:
Balance, beginning of year 16,803 22,278
Changes in net unrealized gain (loss), net of tax (25,740) (5,475)
-------- -------
Balance, end of period (8,937) 16,803
-------- -------
Deferred compensation on restricted stock:
Balance, beginning of year (1,074) (1,465)
Net (issuance) forfeitures of restricted stock (2,073) 391
-------- -------
Balance, end of period (3,147) (1,074)
-------- -------
Retained earnings:
Balance, beginning of year 87,985 84,888
Net income 5,551 3,097
-------- -------
Balance, end of period 93,536 87,985
-------- -------
Total stockholders' equity $303,314 318,554
======== =======
</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 Six Months
Ended June 30, Ended June 30,
------------------------------------ --------------------------------
1999 1998 1999 1998
----------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Net income (loss) $ 2,799 (7,732) 5,551 (1,346)
-------- ------- -------- -------
Other comprehensive income, net of taxes:
Change in unrealized gain (loss) on
investments net of taxes of $(8,153),
$3,613, $(13,232) and $3,012 for the
three months and six months ended
June 30, 1999 and 1998, respectively (15,141) 6,710 (24,574) 5,594
Less: reclassification adjustments for
realized gains in net income, net of
taxes of $452, $1,197, $628, and
$2,258 for the three months and six
months ended June 30, 1999 and 1998,
respectively (839) (2,223) (1,166) (4,192)
-------- ------- -------- -------
Other comprehensive income,
net of taxes (15,980) 4,487 (25,740) 1,402
-------- ------- -------- -------
Comprehensive income (loss) $(13,181) $(3,245) $(20,189) $ 56
======== ======= ======== =======
</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,
------------------------------------
1999 1998
----------------- ----------------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $ 5,551 (1,346)
--------- --------
Adjustments to reconcile net income (loss) to net cash used in
operating activities:
Depreciation and amortization 885 1,559
Net realized investment gains (1,794) (6,450)
Change in:
Premiums in course of collection (6,117) 12,993
Premiums due under retrospective policies 6,227 (3,734)
Receivables from reinsurers (264) (25,555)
Prepaid reinsurance premiums 932 16,118
Funds on deposit with reinsurers 1,027 (953)
Net deferred tax asset 1,623 (3,490)
Deferred policy acquisition costs 555 (808)
Loss and loss adjustment expense reserves (69,987) (14,104)
Unearned premiums (3,030) (19,427)
Funds held (11,914) 4,073
Other operating assets and liabilities 4,722 (36,993)
--------- --------
Total adjustments (77,135) (76,771)
--------- --------
Net cash used in operating activities (71,584) (78,117)
--------- --------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale 96,122 156,565
Equity securities 2,260 986
Other invested assets - 842
Maturities or calls:
Fixed maturity securities available-for-sale 108,838 119,146
Investment purchases:
Fixed maturity securities available-for-sale (123,237) (200,420)
Equity securities (9,188) (1,125)
Net additions to property and equipment (1,539) (1,093)
--------- --------
Net cash provided by investing activities 73,256 74,901
--------- --------
Cash flows from financing activities:
Issuance of common stock 5,140 212
Acquisition of treasury stock (191) -
Repayment of debt (5,000) -
--------- --------
Net cash (used in) provided by financing activities (51) 212
--------- --------
Net increase (decrease) in cash and cash equivalents 1,621 (3004)
Cash and cash equivalents at beginning of period 70,747 60,717
--------- --------
Cash and cash equivalents at end of period $ 72,368 57,713
========= ========
Supplemental disclosure of cash flow information:
Interest paid $ 5,081 5,382
========= ========
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
8
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 1999
1. Basis of Presentation
The accompanying consolidated financial statements as of June 30, 1999 and for
both the three and six months ended June 30, 1999 and 1998 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, 1998.
Highlands Group is an insurance holding company for Highlands Insurance
Company and its subsidiaries ("Highlands"), American Reliance, Inc. and its
subsidiaries ("American Reliance"), 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. For reporting
purposes, the Company considers all of its property and casualty insurance
operations as one segment. All material intercompany accounts and transactions
have been eliminated.
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. Changes in Accounting Principles
In December 1997, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants (AcSEC) issued Statement of Position
(SOP) 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related
Assessments." This statement provides guidance for the recording of a liability
for insurance-related assessments. The statement requires that a liability be
recorded when all of the following conditions have been met: an assessment has
been imposed or it is probable that an assessment will be imposed; the event
obligating an entity to pay an imposed or probable assessment has occurred on or
before the date of the financial statements; and the amount of the assessment
can be reasonably estimated. The Company adopted SOP 97-3 as of January 1,
1999. The adoption of the provisions of SOP 97-3 did not have a material impact
on results of operations, financial condition or cash flows.
In March 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." This statement specifies the
types of costs that must be capitalized and amortized over the software's
expected useful life and the types of costs which must be immediately recognized
as expense. For purposes of this SOP, internal-use software is software
acquired, internally developed or modified solely to meet the entity's internal
needs for which no substantive plan exists or is being developed to market the
software externally during the software's development or modification. Certain
internal and external costs incurred to develop internal-use computer software
that relate to system design, software configuration and interfaces, coding,
testing and installation to hardware should generally be capitalized. The
Company adopted SOP 98-1 as of January 1, 1999. The adoption of the provisions
of SOP 98-1 did not have a material impact on results of operations, financial
condition or cash flows.
9
<PAGE>
3. Earnings Income Per Share
The following tables set forth the computation of basic and diluted earnings
(loss) per share (in thousands, except per share data):
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- ----------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
NUMERATOR:
Net income (loss), as reported and for
basic earnings per share $ 2,799 (7,732) 5,551 (1,346)
Effect of dilutive securities - after tax
debt expense applicable to convertible
subordinated debentures, - - - -
------- ------ ------ ------
Numerator for diluted earnings per
common share - income (loss)
available to common stockholders
after assumed conversions, if
appropriate $ 2,799 (7,732) 5,551 (1,346)
------- ------ ------ ------
DENOMINATOR:
Denominator for basic earnings per
share - weighted average shares
outstanding 12,881 13,197 12,688 13,196
Effect of dilutive securities:
Common stock warrants and
outstanding stock options (based
on treasury stock method) 916 - 1,258 -
Convertible subordinated
debentures, if appropriate - - - -
------- ------ ------ ------
Denominator for diluted earnings per
share - adjusted weighted
average shares and assumed
conversions 13,797 13,197 13,946 13,196
======= ====== ====== ======
Basic earnings (loss) per share $ .22 (.59) .44 (.10)
Diluted earnings (loss) per share $ .20 (.59) .40 (.10)
======= ====== ====== ======
</TABLE>
The Debentures, which are convertible into approximately 3.9 million shares,
were outstanding during 1998 and 1999, but were not included in the computation
of diluted earnings per share because the assumed conversion would be
antidilutive.
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. For
the three and six months ended June 30, 1999, respectively, 797,800 and 810,814
stock options were not included in earnings per share calculations as they were
antidilutive.
4. 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
10
<PAGE>
adjustment increased the exercise price by $0.23 and $0.19 per share during
the three and six months ended June 30, 1999, respectively.
5. Stock Compensation Plans
During the first quarter of 1999, the Company gave its employees the
opportunity to exchange stock options and restricted stock for new stock options
and restricted stock with a current market price. Employees taking advantage of
this opportunity forfeited all vesting to date and 25% of their shares subject
to option. The newly issued stock options fully vest after three years with the
opportunity for accelerated vesting if certain performance measures are met.
The vesting of the restricted stock is based on performance measures, but in any
event vest at the end of three years.
6. 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.
11
<PAGE>
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
RESULTS OF OPERATIONS
The results of the Company's consolidated operations for the periods indicated
are set forth below (dollars in thousands, except per share amounts):
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------------------- -------------------------------------
1999 1998 1999 1998
---------------- ---------------- -------------- ----------------
<S> <C> <C> <C> <C>
Consolidated Results:
Gross premiums written $ 86,935 92,530 171,766 184,789
Net premiums written 80,566 83,424 157,764 165,053
======== ======= ======== ========
Net premiums earned $ 78,158 85,652 159,863 168,882
Loss and loss adjustment expense (55,924) (81,532) (116,670) (140,561)
Underwriting expenses (33,511) (36,095) (65,928) (72,238)
-------- ------- -------- --------
Underwriting loss (11,277) (31,975) (22,735) (43,917)
Net investment income 17,185 18,890 34,941 39,683
Net realized investment gains 1,291 3,420 1,794 6,450
Debt interest and amortization expense (2,965) (3,068) (5,888) (6,139)
Other expenses, net (634) (516) (925) (835)
-------- ------- -------- --------
Income (loss) before income taxes 3,600 (13,249) 7,187 (4,758)
Income tax expense (benefit) 801 (5,517) 1,636 (3,412)
-------- ------- -------- --------
Net income (loss) $ 2,799 (7,732) 5,551 (1,346)
======== ======= ======== ========
Earnings (loss) per share:
Basic $ .22 (.59) .44 (.10)
======== ======= ======== ========
Diluted $ .20 (.59) .40 (.10)
======== ======= ======== ========
Ratios:
Loss 71.5% 95.2% 73.0% 83.2%
Expense 42.9% 42.1% 41.2% 42.8%
-------- ------- -------- --------
Combined 114.4% 137.3% 114.2% 126.0%
======== ======= ======== ========
</TABLE>
PERIOD TO PERIOD COMPARISONS
Gross Premiums Written. Gross premiums written for the three months and six
months ended June 30, 1999 and 1998 were $86.9 million and $92.5 million and
$171.8 million and $184.8 million, respectively. The decrease of $5.6 million
and $13.0 million or 6.1% and 7.0% for the three months and six months ended
June 30, respectively, is due primarily to three factors. First, the Company
continues to focus on underwriting standards and adequate pricing. The current
pricing environment is highly competitive in both commercial and personal lines
as insurers compete to retain business. Second, service disruption in early
1998 associated with the implementation of a new policy issuance system at the
end of 1997 negatively impacted new and renewal policy processing and agents'
willingness to place business with the Company. The Company believes that the
continued decline of premium production due to the disruptions has diminished in
1999 due to the elimination of service disruptions. Finally, the reduction in
the A.M. Best rating of Highlands Insurance Company to B++ from A-, announced by
A.M. Best in June 1998 has caused a decline in premium production.
12
<PAGE>
In 1998, the Company entered into agreements with insurance companies which
provide certain of the Company's customers access to A+ paper. These agreements
were entered into to limit the future loss of business due to A.M. Best's
downgrade of Highlands Insurance Company.
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 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 written and net premiums earned to fluctuate significantly from period
to period. Experience rated contracts reduce but do not eliminate risk to the
insurer.
Net Premiums Written. Net premiums written for the three months and six months
ended June 30, 1999 and 1998 were $80.6 million and $83.4 million and $157.8
million and $165.1 million, respectively. The decrease of $2.9 million and
$7.3 million or 3.4% and 4.4% for the three months and six months ended June 30,
respectively, is 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, 1999 and 1998 were $78.2 million and $85.7 million and $159.9
million and $168.9 million, respectively. The decrease of $7.5 million and $9.0
million or 8.8% and 5.3% for the three months and six months ended June 30,
respectively, is related to the same items affecting gross and net premiums
written.
Loss and Loss Adjustment Expenses Incurred. Loss and loss and adjustment
expenses incurred for the three months and six months ended June 30, 1999 and
1998 were $55.9 million and $81.5 million and $116.7 million and $140.6 million,
respectively. The loss and loss adjustment expense ratio for the three months
and six months ended June 30, 1999 and 1998 was 71.5% and 95.2% and 73.0% and
83.2%, respectively. The decrease in the ratio was primarily attributable to
higher incurred losses in 1998 and some favorable development on prior year loss
reserves in 1999. The three months ended June 30, 1998 included a charge of
$10.5 million related to severe weather catastrophe losses plus a reserve
increase of $8.0 million related to California construction defect claims.
Underwriting Expenses. Underwriting expenses for the three months and six
months ended June 30, 1999 and 1998 were $33.5 million and $36.1 million and
$65.9 million and $72.2 million, respectively. The underwriting expense ratio
for the three months and six months ended June 30, 1999 and 1998 was 42.9% and
42.1% and 41.2% and 42.8%, respectively. The Company realized expense savings
in the three months and six months ended June 30, 1999 compared to the same
period in 1998 due to the termination of an Aggregate Excess of Loss Reinsurance
Agreement ("Stop Loss Agreement") in the fourth quarter of 1998. However, the
savings were somewhat offset by additional expenses associated with the
Company's system integration projects.
Investment Results. Net investment income for the three months and six months
ended June 30, 1999 and 1998 was $17.2 million and $18.9 million and $34.9
million and $39.7 million, respectively. For the three months and six months
ended June 30, 1999 net investment income decreased $1.7 million and $4.7
million from 1998 due to the declining premium volume, continued reduction in
the size of the investment portfolio due to runoff of old reserves, and the
repurchase of Company Common Stock during 1998. Net realized investment gains
for the Company were $1.3 million and $3.4 million and $1.8 million and $6.5
million for the three months and six months ended June 30, 1999 and 1998,
respectively.
Debt Interest and Amortization Expense. Debt interest and amortization
expense for the three months and six months ended June 30, 1999 and 1998 was
$3.0 million and $3.1 million and $5.9 million and $6.1 million, respectively.
Other Expenses, Net. Other expenses consist of parent company expenses and
miscellaneous expenses from the insurance subsidiaries offset by miscellaneous
income.
13
<PAGE>
Income Taxes. The Company provides for income taxes on its statements of
operations pursuant to Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes" (SFAS 109). The total tax expense (benefit) for
the three months and six months ended June 30, 1999 and 1998 was $.8 million and
$(5.5) million and $1.6 million and $(3.4) million, respectively. The Company's
effective tax rate reflects the amount of net investment income from tax
advantaged fixed income securities and the magnitude of the underwriting loss in
relation to net taxable investment income.
LIQUIDITY AND CAPITAL RESOURCES
Highlands Group is a holding company, the principal assets of which at June
30, 1999 are 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
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. 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.
As a 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 the
Company are not expected to be material. The annual cash interest requirements
relating to the Company's outstanding 10% convertible subordinated debentures
(the "Debentures") and the loan under the Credit Agreement are approximately
$10.7 million. During the second quarter 1999, Highlands Group reduced the loan
under the Credit Agreement by $5 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. During 1998, Highlands Group
repurchased 293,500 shares of its Common Stock at an aggregate cost of $4
million. Such repurchased shares are held in treasury.
Highlands Group's principal sources of funds are dividends and tax sharing
payments from its subsidiaries, 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 limited to $39.9 million
in 1999 without prior regulatory approval. Both the issuance of additional debt
and the issuance of additional equity securities at a price less than current
market price would require the consent of the holders of a majority in interest
of the Debentures pursuant to the covenants contained in the Debentures.
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 loss payments
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 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
14
<PAGE>
are influenced significantly by product mix. Future catastrophe claims, the
timing and amount of which are inherently unpredictable, may create increased
liquidity requirement 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.
During the fourth quarter of 1998, the Board of Directors authorized a share
repurchase of up to $20 million of the Company's Common Stock to be conducted by
two of the Company's insurance subsidiaries, Highlands Insurance Company and
Northwestern National Casualty Company, through March 31, 1999. No company
common shares were repurchased in the first and second quarters of 1999. During
the quarter ended March 31, 1999, 15,000 shares of company common stock settled
at an average price of $12.75 per share.
YEAR 2000
The Company is dependent on computers to process and report its business.
Information technology ("IT") systems are used for issuing policies, billing and
collecting premiums, 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 the 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. 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.
Although several of the estimated completion dates set forth below are later
than originally planned, the Company believes the revised completion dates will
not adversely affect its overall Year 2000 compliance program.
The Company began installing a new financial and management reporting IT
system during 1998. This system, which is expected to be completed in August
1999, will receive financial information from compliant processing platforms
described below which are scheduled to be in production in September and October
1999.
The Company's new, Year 2000 compliant processing platform for most of its
Texas business is composed of policy administration and claim administration
subsystems. The policy administration component, in part internally developed
but substantially purchased, has been partially implemented and commenced
processing of business on a new and renewal basis in May 1998. The balance of
the Texas business will be processed through an internally developed, server-
based, Year 2000 compliant platform which is scheduled to be implemented in
August 1999. The claim processing component is planned for implementation in
August 1999. The conversion of historical policy and claim files is expected to
be completed in September 1999.
American Reliance, which was acquired in April 1997, has policy issuance and
processing IT systems discrete from the rest of the Company. 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. This processing platform was
implemented in November 1998. Although the processing system for claims under
the new American Reliance system is Year 2000 compliant, the processing systems
for claims under the old systems are not. Data for open claims from the old
systems are scheduled to be converted to Year 2000 compliant systems at the end
of October 1999.
The Company has conducted extensive tests on each platform or application
prior to its placement in production. The Company intends to continue testing
these platforms and applications through the end of 1999. A test of the entire
American Reliance system (enterprise test) is scheduled for September 1999. An
enterprise test for the Houston operation is scheduled for early October 1999.
The Company has spent approximately $2.4 million through June 30, 1999 to make
its IT systems and non-IT systems Year 2000 compliant (excluding $16.0 million
of costs associated with the development of the two primary processing
platforms). The Company expects to incur an additional $1.0 million in 1999 in
this process. The
15
<PAGE>
Company's insurance subsidiaries have been funding 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 is also analyzing supplemental software products and files used by
certain of its units, which historically have not been supported by the
Information Technology Department. An analysis of such programs and files and
the effort needed to renovate them was completed in June 1999. The Company is
modifying or replacing such programs and files as needed.
The Company's assessment of non-IT systems such as elevator, heating,
ventilation and air conditioning systems, telephones and other facility related
systems was substantially completed in April 1999. Where necessary, the Company
has replaced or modified these systems or will do so prior to year-end.
The Company relies on third party vendors for other material services such as
energy, banking and reinsurance. The Company identified the entities which are
material to its operations and assessed whether they will be Year 2000 compliant
through questionnaires and affirmations of Year 2000 compliance. The initial
assessment of responses was substantially complete as of April 30, 1999.
Although the Company is making additional inquiries of a few entities, its
material vendors have indicated that they are, or will, be sufficiently Year
2000 compliant.
Through the first half of 1999, the Company's efforts have focused on
renovating its IT systems, rather than on preparing contingency plans if it
fails in such renovation efforts. In July 1999, the Company retained a
consultant to prepare a formal business continuity plan covering essential
operations in the event of a disruption due to the Year 2000. This plan is to
be completed in September 1999. Contingency plans for other systems and third
party vendors which may not be Year 2000 compliant in time will be made on a
case-by-case basis.
The Company has made and will continue to make significant efforts to ensure
that it and its material 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.
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 primarily 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
any such losses and expenses pursuant to policies it issues 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
estimates, which were 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 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.
16
<PAGE>
PART II Other Information
ITEM 1. Legal Proceedings
None
ITEM 4. Submission of Matters to a Vote of Security Holders
None
ITEM 6. Exhibits and Reports on Form 8-K
(a) Exhibits
(27) Financial Data Schedule (Filed Electronically)
17
<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)
<TABLE>
<CAPTION>
<S> <C> <C> <C>
Date: August 13, 1999 By /s/ Willis T. King, Jr.
----------------------------------------
Willis T. King, Jr.
Chairman, President and Chief
Executive Officer
(Authorized Signatory)
Date: August 13, 1999 By /s/ Charles J. Bachand
----------------------------------------
Charles J. Bachand
Vice President, Treasurer and
Principal Accounting Officer
(Authorized Signatory)
</TABLE>
18
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> JUN-30-1999
<DEBT-HELD-FOR-SALE> 0
<DEBT-CARRYING-VALUE> 883,435
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<EQUITIES> 26,787
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<TOTAL-INVEST> 913,329
<CASH> 72,368
<RECOVER-REINSURE> 787,608
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<TOTAL-ASSETS> 2,166,906
<POLICY-LOSSES> 1,533,561
<UNEARNED-PREMIUMS> 134,323
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0
0
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159,863
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