<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 September 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 September 30, 1999 was 13,957,303.
================================================================================
1
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
TABLE OF CONTENTS
PART I - Financial Information
Item Page
- ---- ----
1. Financial Statements:
Consolidated Balance Sheets
September 30, 1999 (Unaudited) and
December 31, 1998 3
Consolidated Statements of Operations
(Unaudited) - Three and Nine Months Ended
September 30, 1999 and 1998 5
Consolidated Statements of Stockholders' Equity
Nine Months Ended September 30, 1999 (Unaudited)
and Year Ended December 31, 1998 6
Consolidated Statements of Comprehensive Income
(Unaudited) - Three and Nine Months Ended
September 30, 1999 and 1998 7
Consolidated Statements of Cash Flows
(Unaudited) - Nine Months Ended September 30,
1999 and 1998 8
Condensed Notes to Unaudited Consolidated
Financial Statements - September 30, 1999 10
2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 13
PART II - Other Information
1. Legal Proceedings 18
4. Submission of Matters to a Vote of Security Holders 18
6. Exhibits and Reports on Form 8-K 18
Signatures 19
2
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
<TABLE>
<CAPTION>
September 30, December 31,
ASSETS 1999 1998
------ ----------- -----------
(Unaudited)
<S> <C> <C>
Investments:
Fixed income securities - available-for-sale, at fair
value (amortized cost of $862,626 at 9/30/99 and
$975,858 at 12/31/98) $ 837,358 $ 1,001,236
Equity securities, at fair value (cost of $31,635 at
9/30/99 and $20,585 at 12/31/98) 29,011 21,057
Other investments, at cost 3,101 3,107
----------- -----------
Total investments 869,470 1,025,400
Cash and cash equivalents 60,464 70,747
Premiums in course of collection, net 61,694 51,138
Premiums due under retrospective policies 135,372 144,613
Receivable from reinsurers 796,815 787,344
Prepaid reinsurance premiums 1,460 2,523
Funds on deposit with reinsurers 18,870 17,873
Net deferred tax asset 89,934 70,433
Accrued investment income 11,540 13,916
Deferred policy acquisition costs 32,660 31,537
Other assets 55,417 49,519
----------- -----------
Total assets $ 2,133,696 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>
September 30, December 31,
LIABILITIES AND STOCKHOLDERS' EQUITY 1999 1998
------------------------------------ ----------- -----------
(Unaudited)
<S> <C> <C>
Loss and loss adjustment expense reserves $ 1,516,361 1,603,548
Unearned premiums 141,013 137,353
Senior bank debt 59,004 65,000
Convertible subordinated debentures 57,616 57,017
Funds held 476 14,049
Accounts payable and accrued liabilities 68,094 69,522
----------- -----------
Total liabilities 1,842,564 1,946,489
----------- -----------
Commitments and contingent liabilities
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized;
13,957,303 issued and outstanding in 1999; 13,235,316 issued and
outstanding in 1998 140 132
Additional paid-in-capital 231,515 223,976
Treasury stock, at cost (739,400 shares in 1999; 724,400 shares
in 1998) (9,459) (9,268)
Accumulated other comprehensive income (loss) (18,130) 16,803
Deferred compensation on restricted stock (3,147) (1,074)
Retained earnings 90,213 87,985
----------- -----------
Total stockholders' equity 291,132 318,554
----------- -----------
Total liabilities and stockholders' equity $ 2,133,696 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 Nine Months
Ended September 30, Ended September 30,
------------------ ------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues:
Net premiums earned $ 78,091 85,027 237,954 253,909
Net investment income 16,821 19,052 51,762 58,735
Net realized investment gains 1,030 6,934 2,824 13,384
-------- -------- -------- --------
Total revenues 95,942 111,013 292,540 326,028
-------- -------- -------- --------
Expenses:
Loss and loss adjustment expense incurred 65,753 61,013 182,423 201,574
Underwriting expenses 31,923 35,843 97,851 108,080
Debt interest and amortization expense 2,872 3,097 8,760 9,236
Other expenses, net 785 895 1,710 1,730
-------- -------- -------- --------
Total expenses 101,333 100,848 290,744 320,620
-------- -------- -------- --------
Income (loss) before income tax (5,391) 10,165 1,796 5,408
Income tax expense (benefit) (2,068) 3,441 (432) 29
-------- -------- -------- --------
Net income (loss) $ (3,323) 6,724 2,228 5,379
======== ======== ======== ========
Earnings (loss) per common share:
Basic $ (.25) .51 .17 .41
Diluted $ (.25) .43 .16 .34
======== ======== ======== ========
Weighted average number of common shares
and equivalents outstanding:
Basic 13,218 13,122 12,867 13,171
Diluted 13,218 18,485 13,845 15,883
======== ======== ======== ========
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
5
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Dollars in thousands)
<TABLE>
<CAPTION>
September 30, December 31,
1999 1998
-------- --------
(Unaudited)
<S> <C> <C>
Common stock:
Balance, beginning of year $ 132 132
Issuance of common stock, par value 8 -
-------- --------
Balance, end of period 140 132
-------- --------
Additional paid-in-capital:
Balance, beginning of year 223,976 223,460
Issuance of common stock, paid in capital 7,539 516
-------- --------
Balance, end of period 231,515 223,976
-------- --------
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 (loss):
Balance, beginning of year 16,803 22,278
Changes in net unrealized investment gains (losses), net of tax (34,933) (5,475)
-------- --------
Balance, end of period (18,130) 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 2,228 3,097
-------- --------
Balance, end of period 90,213 87,985
-------- --------
Total stockholders' equity $291,132 318,554
======== ========
</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 Nine Months
Ended September 30, Ended September 30,
-------------------- --------------------
1999 1998 1999 1998
--------- -------- --------- --------
<S> <C> <C> <C> <C>
Net income (loss) $ (3,323) 6,724 2,228 5,379
--------- -------- --------- --------
Other comprehensive income (loss), net of taxes:
Change in unrealized investment gains
(losses) net of taxes of $(4,589), $6,781,
$(17,821) and $9,794 for the three months
and nine months ended September 30, 1999
and 1998, respectively (8,523) 12,594 (33,097) 18,189
Reclassification adjustments for realized
gains in net income, net of taxes of $360,
$2,427, $988, and $4,684 for the three
months and nine months ended
September 30, 1999 and 1998, respectively (670) (4,507) (1,836) (8,700)
--------- -------- --------- --------
Other comprehensive income (loss),
net of taxes (9,193) 8,087 (34,933) 9,489
--------- -------- --------- --------
Comprehensive income (loss) $ (12,516) 14,811 (32,705) 14,868
========= ======== ========= ========
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
7
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Dollars in thousands)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
----------------------
1999 1998
---------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 2,228 5,379
---------- --------
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization 1,359 2,963
Net realized investment gains (2,824) (13,384)
Change in:
Premiums in course of collection (10,556) 32,222
Premiums due under retrospective policies 9,241 1,842
Receivables from reinsurers (9,471) (4,953)
Prepaid reinsurance premiums 1,063 16,196
Funds on deposit with reinsurers (997) 2,881
Net deferred tax asset (449) (18)
Deferred policy acquisition costs (1,123) (1,181)
Loss and loss adjustment expense reserves (87,187) (65,079)
Unearned premiums 3,660 (20,042)
Funds held (13,573) (3,102)
Other operating assets and liabilities (3,119) (52,853)
---------- --------
Total adjustments (113,976) (104,508)
---------- --------
Net cash used in operating activities (111,748) (99,129)
---------- --------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale 137,848 294,110
Equity securities 8,311 986
Other invested assets 576 842
Maturities or calls:
Fixed maturity securities available-for-sale 132,459 137,292
Investment purchases:
Fixed maturity securities available-for-sale (154,345) (321,591)
Equity securities (18,940) (10,270)
Net additions to property and equipment (3,731) (1,646)
---------- --------
Net cash provided by investing activities 102,178 99,723
---------- --------
Cash flows from financing activities:
Issuance of common stock 5,474 831
Acquisition of treasury stock (191) (4,000)
Repayment of debt (5,996) -
---------- --------
Net cash used in financing activities (713) (3,169)
---------- --------
Net decrease in cash and cash equivalents (10,283) (2,575)
Cash and cash equivalents at beginning of period 70,747 60,717
---------- --------
Cash and cash equivalents at end of period $ 60,464 58,142
========== ========
Supplemental disclosure of cash flow information:
Interest paid $ 6,161 6,602
========== ========
</TABLE>
See Condensed Notes to Unaudited Consolidated Financial Statements.
8
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 1999
1. Basis of Presentation
The accompanying consolidated financial statements as of September 30, 1999
and for both the three and nine months ended September 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 Nine Months Ended
September 30, September 30,
-------------------- -------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
NUMERATOR:
Net income (loss), as reported and for basic
earnings per share $ (3,323) 6,724 2,228 5,379
Effect of dilutive securities - after tax
debt expense applicable to assumed
conversion of convertible subordinated
debentures, if appropriate - 1,193 - -
-------- -------- -------- --------
Numerator for diluted earnings per
common share - income (loss)
available to common stockholders
after assumed conversions, if appropriate $ (3,323) 7,917 2,228 5,379
======== ======== ======== ========
DENOMINATOR:
Denominator for basic earnings per
share - weighted average shares
outstanding 13,218 13,122 12,867 13,171
Effect of dilutive securities:
Common stock warrants and
outstanding stock options (based
on treasury stock method) - 1,474 978 2,712
Convertible subordinated
debentures, if appropriate - 3,889 - -
-------- -------- -------- --------
Denominator for diluted earnings per
share - adjusted weighted average
shares and assumed conversions 13,218 18,485 13,845 15,883
======== ======== ======== ========
Basic earnings (loss) per share $ (.25) .51 .17 .41
Diluted earnings (loss) per share $ (.25) .43 .16 .34
======== ======== ======== ========
</TABLE>
The 10% Convertible Subordinated Debentures ("Debentures"), which are
convertible into approximately 3.9 million shares of common stock, were
outstanding during 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 nine months ended September 30, 1999, respectively, 949,156 and
817,678 shares purchasable upon exercise of 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 Debentures, are for the life of the stock
purchase warrants, subject to adjustment due to adverse loss
10
<PAGE>
reserve and uncollectible reinsurance development for years prior to 1996. No
adjustment to the exercise price was recorded during the three months ended
September 30, 1999. Such adjustment increased the exercise price by $0.19 per
share during the nine months ended September 30, 1999.
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 Nine Months Ended
September 30, September 30,
------------------- --------------------
1999 1998 1999 1998
--------- -------- -------- --------
<S> <C> <C> <C> <C>
Consolidated Results:
Gross premiums written $ 92,768 94,421 264,534 279,210
Net premiums written 84,913 84,487 242,677 249,540
========= ======== ======== ========
Net premiums earned $ 78,091 85,027 237,954 253,909
Loss and loss adjustment expense (65,753) (61,013) (182,423) (201,574)
Underwriting expenses (31,923) (35,843) (97,851) (108,080)
--------- -------- -------- --------
Underwriting loss (19,585) (11,829) (42,320) (55,745)
Net investment income 16,821 19,052 51,762 58,735
Net realized investment gains 1,030 6,934 2,824 13,384
Debt interest and amortization expense (2,872) (3,097) (8,760) (9,236)
Other expenses, net (785) (895) (1,710) (1,730)
--------- -------- -------- --------
Income (loss) before income taxes (5,391) 10,165 1,796 5,408
Income tax expense (benefit) (2,068) 3,441 (432) 29
--------- -------- -------- --------
Net income (loss) $ (3,323) 6,724 2,228 5,379
========= ======== ======== ========
Earnings (loss) per share:
Basic $ (.25) .51 .17 .41
========= ======== ======== ========
Diluted $ (.25) .43 .16 .34
========= ======== ======== ========
Ratios:
Loss 84.2% 71.8% 76.7% 79.4%
Expense 40.9% 42.1% 41.1% 42.6%
--------- -------- -------- --------
Combined 125.1% 113.9% 117.8% 122.0%
========= ======== ======== ========
</TABLE>
PERIOD TO PERIOD COMPARISONS
Gross Premiums Written. Gross premiums written for the three months and
nine months ended September 30, 1999 and 1998 were $92.8 million and $94.4
million and $264.5 million and $279.2 million, respectively. The decrease of
$1.6 million and $14.7 million or 1.7% and 5.3% for the three months and nine
months ended September 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 these service disruptions have been eliminated in 1999
and the related premium decline has diminished during 1999. Finally, the
reduction in the A.M. Best rating of Highlands 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 an agreement with an insurance company
which provides certain of its customers access to A+ paper. In 1999, the Company
entered into similar agreements with two other companies, one rated A+ and the
other A-. 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 and nine
months ended September 30, 1999 and 1998 were $84.9 million and $84.5 million
and $242.7 million and $249.5 million, respectively. The increase for the three
months ended September 30, 1999 of $.4 million was net of $1.1 million of
additional ceded premium due to catastrophe losses from Hurricane Floyd. The
additional ceded premium was necessary in order to reinstate the Company's
catastrophe reinsurance coverage. The decrease of $6.8 million or 2.7% for the
nine months ended September 30 is related to the same issues affecting gross
premiums written.
Net Premiums Earned. Net premiums earned for the three months and nine
months ended September 30, 1999 and 1998 were $78.1 million and $85.0 million
and $238.0 million and $253.9 million, respectively. The decrease of $6.9
million and $15.9 million or 8.1% and 6.3% for the three months and nine months
ended September 30, respectively, is related to the same items affecting gross
and net premiums written.
Loss and Loss Adjustment Expenses Incurred. Loss and loss adjustment
expenses incurred for the three months and nine months ended September 30, 1999
and 1998 were $65.8 million and $61.0 million and $182.4 million and $201.6
million, respectively. The loss and loss adjustment expense ratio for the three
months and nine months ended September 30, 1999 and 1998 was 84.2% and 71.8% and
76.7% and 79.4%, respectively. Loss and loss adjustment expenses for the three
months ended September 30, 1999 were increased by weather related catastrophe
losses of approximately $6.3 million. Of this amount, Hurricane Floyd
catastrophe losses were approximately $5.3 million and primarily impacted the
Company's personal lines book of business. Weather related catastrophe losses
for the third quarter of 1998 were approximately $1.4 million. For the nine
months ended September 30, 1999 and 1998, weather related catastrophe losses
were $10.2 million and $14.9 million, respectively. The decrease in the
year-to-date loss and loss adjustment expense ratio was primarily attributable
to higher incurred losses in 1998 and some favorable development on prior year
loss reserves in 1999. The nine months ended September 30, 1998 also included a
charge of $8.0 million related to California construction defect claims.
Underwriting Expenses. Underwriting expenses for the three months and nine
months ended September 30, 1999 and 1998 were $31.9 million and $35.8 million
and $97.9 million and $108.1 million, respectively. The underwriting expense
ratio for the three months and nine months ended September 30, 1999 and 1998 was
40.9% and 42.1% and 41.1% and 42.6%, respectively. The decline in the
underwriting expense ratio is the result of the Company's previous expense
saving initiatives. The Company realized expense savings of $.6 million and $1.8
million in the three months and nine months ended September 30, 1999,
respectively, 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 nine
months ended September 30, 1999 and 1998 was $16.8 million and $19.1 million and
$51.8 million and $58.7 million, respectively. For the three months and nine
months ended September 30, 1999 net investment income decreased $2.3 million and
$6.9 million, respectively, 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 $1.0 million and $6.9 million and $2.8
million and $13.4 million for the three months and nine months ended September
30, 1999 and 1998, respectively.
13
<PAGE>
Debt Interest and Amortization Expense. Debt interest and amortization
expense for the three months and nine months ended September 30, 1999 and 1998
was $2.9 million and $3.1 million and $8.8 million and $9.2 million,
respectively. Interest expense was reduced due to the paydown of $6.0 million of
bank debt.
Other Expenses, Net. 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 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
September 30, 1999 are all of the capital stock of Highlands
and American Reliance. 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
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 material. The annual cash interest requirements
relating to the Company's outstanding 10% convertible subordinated debentures
(the "Debentures") and the bank debt ("Credit Agreement") are approximately
$10.7 million. During the nine months ended September 30, 1999, Highlands Group
reduced the loan under the Credit Agreement by $6.0 million. Highlands Group
does not currently intend to pay dividends on its Common Stock.
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 $22.3 million
in 1999 without prior regulatory approval. During the nine months ended
September 30, 1999, Highlands Group has received $10.0 million of dividend
payments from its insurance subsidiaries. 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.
14
<PAGE>
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. The Company believes its sources of fund from its insurance
subsidiaries are sufficient to meet those subsidiaries' liquidity needs.
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. As described below, the Company has identified, assessed and
renovated its material IT systems to properly process the Year 2000. It has
conducted extensive tests on each platform or application to verify that it
correctly processes dates subsequent to 1999. The Company intends to continue
testing through the end of 1999.
The Company placed in production a Year 2000 compliant financial and
management reporting IT system in August 1999 which receives financial
information from several processing platforms, which are now Year 2000
compliant, as described below.
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, was phased into production for the processing of
business on a new and renewal basis in May 1998. The balance of the Texas
business is being processed through an internally developed, Year 2000 compliant
platform that was implemented in October 1999. The claim processing component
was implemented in August 1999. The conversion of data from historical claim
files was implemented in November 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 its old systems were not. Data for open claims from these old
systems were converted to Year 2000 compliant systems during July, October and
November of 1999.
The Company has conducted extensive tests on each platform or application
prior to its placement in production and has verified that each system is
capable of correctly processing dates subsequent to 1999. A test of the entire
American Reliance system (enterprise test) was performed in October 1999 with
satisfactory results. An enterprise test for the Texas operation is scheduled
for November 1999. The Company intends to
15
<PAGE>
continue testing these platforms and applications through the end of 1999. In
addition, in order to verify that its operations are Year 2000 compliant and to
correct unanticipated issues prior to the first business day of 2000, the
Company will process transactions and reports during the New Year holiday on
January 1, 2000, and subsequent days if necessary.
The Company has spent approximately $2.8 million through September 30, 1999
to make its IT systems and non-IT systems Year 2000 compliant (excluding $22.9
million of costs associated with the development of underwriting and claims
processing platforms). The Company expects to incur an additional $600,000 in
the fourth quarter of 1999 in this process. The 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 also analyzed supplemental software products and files not
historically supported by the IT Department which were used by certain of the
Company's units. The 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.
The Company's material vendors have indicated that they are, or will be,
sufficiently Year 2000 compliant.
In September 1999, the Company completed the preparation of a formal
business continuity plan covering essential operations in the event of a
disruption due to the Year 2000. 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)
Date: November 15, 1999 By /s/ Willis T. King, Jr.
Willis T. King, Jr.
Chairman, President and Chief
Executive Officer
(Authorized Signatory)
Date: November 15, 1999 By /s/ Charles J. Bachand
Charles J. Bachand
Vice President, Treasurer and
Principal Accounting Officer
(Authorized Signatory)
18
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<PAGE>
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<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> SEP-30-1999
<DEBT-HELD-FOR-SALE> 0
<DEBT-CARRYING-VALUE> 837,358
<DEBT-MARKET-VALUE> 837,358
<EQUITIES> 29,011
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0
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