<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 March 31, 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 reports), and (2) has been subject to 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 March 31, 1999 was 12,933,075.
================================================================================
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
TABLE OF CONTENTS
PART I - Financial Information
Item Page
- ---- ----
1. Financial Statements:
Consolidated Balance Sheets
March 31, 1999 (Unaudited) and
December 31, 1998 3
Consolidated Statements of Operations
(Unaudited) - Three Months Ended
March 31, 1999 and 1998 5
Consolidated Statements of Stockholders' Equity
Three Months Ended March 31, 1999 (Unaudited)
and Year Ended December 31, 1998 6
Consolidated Statements of Comprehensive Income
(Unaudited) Three Months Ended
March 31, 1999 and 1998 7
Consolidated Statements of Cash Flows
(Unaudited) - Three Months Ended March 31,
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
3. Quantitative and Qualitative Disclosures About Market Risk 16
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
2
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
<TABLE>
<CAPTION>
March 31, December 31,
ASSETS 1999 1998
------ ---------- ------------
(Unaudited)
<S> <C> <C>
Investments:
Fixed maturity securities available-for-sale, at fair
value (amortized cost of $936,861 at 3/31/99 and
$975,858 at 12/31/98) $ 947,442 1,001,236
Equity securities, at fair value (cost of $25,692 at
3/31/99 and $20,585 at 12/31/98) 25,946 21,057
Other investments, at cost 3,104 3,107
---------- ---------
Total investments 976,492 1,025,400
Cash and cash equivalents 70,259 70,747
Premiums in course of collection, net 60,927 51,138
Premiums due under retrospectively rated policies 131,130 144,613
Receivable from reinsurers 776,382 787,344
Prepaid reinsurance premiums 1,995 2,523
Funds on deposit with reinsurers 17,875 17,873
Net deferred tax asset 75,065 70,433
Accrued investment income 12,222 13,916
Deferred policy acquisition costs 30,405 31,537
Other assets 50,726 49,519
---------- ---------
Total assets $2,203,478 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>
March 31, December 31,
LIABILITIES AND STOCKHOLDERS' EQUITY 1999 1998
------------------------------------ ------------------- -----------
(Unaudited)
<S> <C> <C>
Loss and loss adjustment expense reserves $1,567,014 1,603,548
Unearned premiums 132,319 137,353
Senior bank debt 65,000 65,000
Convertible subordinated debentures 57,217 57,017
Funds held 9,386 14,049
Accounts payable and accrued liabilities 61,087 69,522
---------- ---------
Total liabilities 1,892,023 1,946,489
---------- ---------
Commitments and contingent liabilities
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized;
13,226,602 issued and outstanding in 1999; 13,235,316 issued and
outstanding in 1998 132 132
Additional paid-in capital 223,607 223,976
Treasury stock, at cost (739,400 shares in 1999; 724,400 shares in 1998) (9,459) (9,268)
Accumulated other comprehensive income 7,043 16,803
Deferred compensation on restricted stock (605) (1,074)
Retained earnings 90,737 87,985
---------- ---------
Total stockholders' equity 311,455 318,554
---------- ---------
Total liabilities and stockholders' equity $2,203,478 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)
Three Months
Ended March 31,
------------------------
1999 1998
------- -------
Revenues:
Net premiums earned $81,705 83,230
Net investment income 17,756 20,793
Net realized investment gains 503 3,030
------- -------
Total revenues 99,964 107,053
------- -------
Expenses:
Loss and loss adjustment expense incurred 60,746 59,029
Underwriting expenses 32,417 36,143
Debt interest and amortization expense 2,923 3,071
Other expenses (income), net 291 319
------- -------
Total expenses 96,377 98,562
------- -------
Income before income tax 3,587 8,491
Income tax expense 835 2,105
------- -------
Net income $ 2,752 6,386
======= =======
Earnings per common share:
Basic $.22 .48
Diluted $.20 .37
======= =======
Weighted average number of common shares
outstanding:
Basic 12,494 13,195
Diluted 14,110 20,194
======= =======
See Condensed Notes to Unaudited Consolidated Financial Statements.
5
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Dollars in thousands)
<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
------------- ---------------
(Unaudited)
<S> <C> <C>
Common stock:
Balance, beginning of year $ 132 132
Issuance of common stock, par value -- --
-------- -------
Balance, end of period 132 132
-------- -------
Additional paid-in capital:
Balance, beginning of year 223,976 223,460
(Retirement) issuance of common stock, net (369) 516
-------- -------
Balance, end of period 223,607 223,976
-------- -------
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 income:
Balance, beginning of year 16,803 22,278
Changes in net unrealized gain, net of tax (9,760) (5,475)
-------- -------
Balance, end of period 7,043 16,803
-------- -------
Deferred compensation on restricted stock:
Balance, beginning of year (1,074) (1,465)
Net forfeitures of restricted stock 469 391
-------- -------
Balance, end of period (605) (1,074)
-------- -------
Retained earnings:
Balance, beginning of year 87,985 84,888
Net income 2,752 3,097
-------- -------
Balance, end of period 90,737 87,985
-------- -------
Total stockholders' equity $311,455 318,554
======== =======
</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
Ended March 31,
----------------------------------
1999 1998
------------- ------------
<S> <C> <C>
Net income $ 2,752 6,386
-------- ------
Other comprehensive income, net of taxes:
Decrease in unrealized gain on investments, net of taxes of $5,079
and $600 (9,433) (1,115)
Less: reclassification adjustments for realized gains in net income,
net of taxes of $176 and $1,060 327 1,970
-------- ------
Other comprehensive income, net of taxes (9,760) (3,085)
-------- ------
Comprehensive income (loss) $ (7,008) 3,301
======== ======
</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>
Three Months Ended
March 31,
------------------------------
1999 1998
--------- -----------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 2,752 6,386
-------- -------
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization 322 881
Net realized investment gains (503) (3,030)
Change in:
Premiums in course of collection (9,789) (1,842)
Premiums due under retrospectively related policies 13,483 (934)
Receivables from reinsurers 10,962 (11,847)
Prepaid reinsurance premiums 528 10,509
Funds on deposit with reinsurers (2) 163
Net deferred tax asset 828 2,105
Deferred policy acquisition costs 1,132 (137)
Loss and loss adjustment expense reserves (36,534) (24,505)
Unearned premiums (5,034) (12,109)
Funds held (4,663) 745
Other operating assets and liabilities (7,890) (21,507)
-------- -------
Total adjustments (37,160) (61,508)
-------- -------
Net cash used in operating activities (34,408) (55,122)
-------- -------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale 45,111 71,710
Equity securities -- 986
Other invested assets -- (5)
Maturities or calls:
Fixed maturity securities available-for-sale 63,314 58,892
Investment purchases:
Fixed maturity securities available-for-sale (68,385) (74,818)
Equity securities (4,944) --
Net additions to property and equipment (1,085) (966)
-------- -------
Net cash (used in) provided by investing activities 34,011 55,799
-------- -------
Cash flows from financing activities:
Issuance of common stock 100 14
Acquisition of treasury stock (191) --
-------- -------
Net cash provided by investing activities (91) 14
-------- -------
Net (decrease) increase in cash and cash equivalents (488) 691
Cash and cash equivalents at beginning of period 70,747 60,717
-------- -------
Cash and cash equivalents at end of period $ 70,259 61,408
======== =======
Supplemental disclosure of cash flow information:
Interest paid $ 1,068 1,209
======== =======
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
8
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 1999
1. Basis of Presentation
The accompanying consolidated financial statements as of March 31, 1999 and
for the three months ended March 31, 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 June 1997, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards Statement No. 131, "Disclosure about Segments
of an Enterprise and Related Information" (SFAS 131). SFAS 131 establishes
standards for public business enterprises to report selected information about
operating segments in annual financial statements. SFAS 131 requires that those
enterprises report selected information about operating segments in interim
financial reports issued to stockholders. SFAS 131 is effective for fiscal years
beginning after December 15, 1997. For reporting purposes, the Company considers
all of its property and casualty insurance operations as one segment.
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. This statement is effective for fiscal years
beginning after December 15, 1998. 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
9
<PAGE>
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. This statement is effective for fiscal years beginning after
December 15, 1998. The adoption of the provisions of SOP 98-1 did not have a
material impact on results of operations, financial condition or cash flows.
3. Earnings Per Share
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
March 31,
----------------------------
1999 1998
--------- ---------
<S> <C>
NUMERATOR:
Net income, as reported and for basic earnings per share $ 2,752 6,386
Effect of dilutive securities - after tax debt expense applicable
to convertible subordinated debentures, if appropriate - 1,157
------- ------
Numerator for diluted earnings per common share - income available
to common stockholders after assumed conversions, if appropriate $ 2,752 7,543
======= ======
DENOMINATOR:
Denominator for basic earnings per share weighted
average shares outstanding 12,494 13,195
Effect of dilutive securities:
Common stock warrants and outstanding stock options
(based on treasury stock method) 1,616 3,110
Convertible subordinated debentures, if appropriate - 3,889
------- ------
Denominator for diluted earnings per share adjusted
weighted average shares and assumed conversions 14,110 20,194
======= ======
Basic earnings per share $ .22 .48
Diluted earnings per share $ .20 .37
======= ======
</TABLE>
The Debentures, which are convertible into approximately 3.9 million shares,
were outstanding during 1999, but were not included in the March 31, 1999
computation of diluted earnings per share because the assumed conversion would
be antidilutive.
For the three months ended March 31, 1999 and 1998, respectively, 795,236 and
119,850 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 adjustment reduced the exercise price by $.04 per share during the three
months ended March 31, 1999.
10
<PAGE>
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. As
a result of employees exchanging stock options during the quarter, 841,920 net
shares subject to options were reduced by 210,400 with no financial statement
impact.
The vesting of the newly issued restricted stock is based only on performance
measures. As a result of employees exchanging restricted stock during the
quarter, 8,714 net shares were retired which resulted in a reduction of deferred
compensation of $469,000.
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:
Three Months Ended
March 31,
-----------------------------
1999 1998
-------- --------
(Dollars in thousands)
Consolidated Results:
Gross premiums written $ 84,831 92,258
Net premiums written $ 77,198 81,630
======== =======
Net premiums earned $ 81,705 83,230
Loss and loss adjustment expense (60,746) (59,029)
Underwriting expenses (32,417) (36,143)
-------- -------
Underwriting loss (11,458) (11,942)
Net investment income 17,756 20,793
Net realized investment gains 503 3,030
Debt interest and amortization expense (2,923) (3,071)
Other (expenses) income, net (291) (319)
-------- -------
Income before income taxes 3,587 8,491
Income tax expense (835) (2,105)
-------- -------
Net income $ 2,752 6,386
======== =======
Earnings per share:
Basic $ .22 .48
======== =======
Diluted $ .20 .37
======== =======
Ratios:
Loss 74.3% 70.9%
Expense 39.7% 43.4%
-------- -------
Combined 114.0% 114.3%
======== =======
PERIOD TO PERIOD COMPARISONS
Gross Premiums Written. Gross premiums written for the three months ended
March 31, 1999 and 1998 were $84.8 million and $92.3 million, respectively. The
$7.5 million or 8.1% decrease in 1999 compared to 1998 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 in premium production due to the
disruptions has diminished in 1999. 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, 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 ended March
31, 1999 and 1998 were $77.2 million and $81.6 million, respectively. The
decrease of $4.4 million or 5.4% in 1999 compared to 1998 is related to the same
issues affecting gross premiums written.
Net Premiums Earned. Net premiums earned for the three months ended March 31,
1999 and 1998 were $81.7 million and $83.2 million, respectively. The decrease
of $1.5 million or 1.8% in 1999 compared to 1998 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 ended March 31, 1999 and 1998 were $60.7
million and $59.0 million, respectively. The loss and loss adjustment expense
ratio for the three months ended March 31, 1999 and 1998 was 74.3% and 70.9%,
respectively. The increase in the ratio was due to higher incurred losses
subject to retrospectively rated policies, increased accident year loss and loss
adjustment expense ratios and minimal development on prior year loss reserves.
Underwriting Expenses. Underwriting expenses for the three months ended March
31, 1999 and 1998 were $32.4 million and $36.1 million, respectively. The
underwriting expense ratio for the three months ended March 31, 1999 and 1998
was 39.7% and 43.4%, respectively. The decline in the underwriting expense
ratio is the result of the Company's previous expense saving initiatives. The
Company realized expense savings in the three months ended March 31, 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 offset by additional expenses
associated with the Company's system integration projects.
Investment Results. Net investment income for the three months ended March
31, 1999 and 1998 was $17.8 million and $20.8 million, respectively. Net
investment income decreased $3.0 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 $.5 million and $3.0 million
for the three months ended March 31, 1999 and 1998, respectively.
Debt Interest and Amortization Expense. Debt interest and amortization
expense for the three months ended March 31, 1999 and 1998 was $2.9 million and
$3.1 million, respectively.
Other Expenses. Other expenses consist of parent company expenses and
miscellaneous expenses from the insurance subsidiaries offset by miscellaneous
income.
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 for the three
months ended March 31, 1999 and 1998 was $.8 million and $2.1 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.
13
<PAGE>
Liquidity and Capital Resources
Highlands Group is a holding company, the principal assets of which at March
31, 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 ("American Reliance"). 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. 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 the third quarter of 1998, the Board of Directors authorized
the first share repurchase of up to $4 million of the Company's Common Stock.
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 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 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.
14
<PAGE>
During the fourth quarter of 1998, the Board of Directors authorized a second
share repurchase program 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. Although no Company Common
Stock was repurchased in the first quarter, 15,000 shares of Company Common
Stock settled at an average price of $12.75 per share during the quarter ended
March 31, 1999. Through March 31, 1999, those insurance subsidiaries had
purchased 445,900 shares of Common Stock at an aggregate cost of $5.5 million.
YEAR 2000
The company is dependent on computers to process and report its business.
Information technology ("IT") systems are used for billing and collecting
premiums, 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 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.
The Company began installing a new financial and management reporting IT
system during 1998. Implementation is expected to be completed by July 1999.
Because American Reliance was acquired in April 1997, it has a discrete policy
issuance and processing IT system from the rest of the Company, the status of
which 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 its 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. The Company has resolved a majority of the problems with Phase One.
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 its business, was implemented with few problems in November
1998. Although the claims processing system for policies issued under the new
American Reliance system is Year 2000 compliant, the claims processing systems
for policies issued under the old systems are not. The loss and claim data from
the old systems are scheduled to be converted to the new system in October 1999.
The Company is developing a new processing platform for its Texas 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
partially implemented and commenced processing of business on a new and renewal
basis in May 1998. Conversion to the new system is expected to be completed by
July 1999. The claim administration component has been purchased and is planned
for completion in September 1999.
The Company has spent approximately $2.1 million through March 31, 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 processing
platforms). The Company expects to incur an additional $1.0 million in 1999 in
this process. The 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 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 is due to be completed by June 30, 1999.
15
<PAGE>
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 has identified the entities which
are material to its operations and is assessing 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.
In cases where responses were ambiguous or insufficient, the Company is making
additional inquiries. It is expected that this assessment process will continue
through June 30, 1999, with recommendations for corrective action, where
necessary, being specified shortly afterward.
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.
The Company's efforts have focused on renovating its IT systems, not on
preparing contingency plans if it fails in such renovation efforts. The Company
has begun developing contingency plans for those systems where renovation will
not be completed when required. 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 such
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
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.
Item 3: Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in the Company's investment strategies,
types of financial instruments held or the risks associated with such
instruments which would materially alter the market risk disclosures made in the
Company's Annual Statement on Form 10-K for the year ended December 31, 1998.
16
<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 10, 1999, the
Stockholders
(a) elected the following directors:
Nominee Shares For Shares Withheld
------- ---------- ---------------
W. Bernard Pieper 10,275,757 66,179
Phillip J. Hawk 10,279,374 62,562
(b) Approved by a vote of 10,321,654 shares for and 15,829 shares against
with 4,453 abstentions a proposal to select KPMG LLP as the independent
public accountants of the Company for 1999.
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)
Date: May 17, 1999 By /s/ Richard M. Haverland
------------------------------
Richard M. Haverland
Chairman, President
and Chief Executive Officer
(Authorized Signatory)
Date: May 17, 1999 By /s/ Charles J. Bachand
------------------------------
Charles J. Bachand
Vice President, Treasurer and
Principal Accounting Officer
(Authorized Signatory)
18
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> MAR-31-1999
<DEBT-HELD-FOR-SALE> 0
<DEBT-CARRYING-VALUE> 947,442
<DEBT-MARKET-VALUE> 947,442
<EQUITIES> 25,946
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 976,492
<CASH> 70,259
<RECOVER-REINSURE> 776,382
<DEFERRED-ACQUISITION> 30,405
<TOTAL-ASSETS> 2,203,478
<POLICY-LOSSES> 1,567,014
<UNEARNED-PREMIUMS> 132,319
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 122,217
0
0
<COMMON> 132
<OTHER-SE> 311,323
<TOTAL-LIABILITY-AND-EQUITY> 2,203,478
81,705
<INVESTMENT-INCOME> 17,756
<INVESTMENT-GAINS> 503
<OTHER-INCOME> 0
<BENEFITS> 60,746
<UNDERWRITING-AMORTIZATION> 32,417
<UNDERWRITING-OTHER> 0
<INCOME-PRETAX> 3,587
<INCOME-TAX> 835
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,752
<EPS-PRIMARY> .22
<EPS-DILUTED> .20
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
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</TABLE>
