<PAGE>
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended December 31, 1999
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
----------------
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)
Securities registered pursuant to Section 12(b) of the Act:
<TABLE>
<CAPTION>
Name of each exchange
Title of each class on which registered
------------------- ---------------------
<S> <C>
Common Stock $.01 Par Value New York Stock Exchange
</TABLE>
Securities registered pursuant to Section 12(g) of the Act:
NONE.
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 [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
The aggregate market value of the voting stock held by nonaffiliates of the
Registrant as of March 13, 2000, was $102,786,952 (based on $8.00 per share).
At March 13, 2000, the Registrant had outstanding 13,663,412 shares of its
Common Stock, par value $.01 per share.
DOCUMENTS INCORPORATED BY REFERENCE
The registrant's definitive proxy statement to be filed with the Securities
and Exchange Commission within 120 days of December 31, 1999 is incorporated
by reference in Part III of this 10-K.
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<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Item Page
---- ----
PART I
<C> <S> <C>
1. Business.......................................................... 1
2. Properties........................................................ 17
3. Legal Proceedings................................................. 17
4. Submission of Matters to a Vote of Security Holders............... 17
PART II
5. Market for Company's Common Stock and Related Stockholder
Matters.......................................................... 18
6. Selected Financial Data........................................... 19
7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 20
7A. Quantitative and Qualitative Disclosures about Market Risk........ 26
8. Financial Statements and Supplemental Data........................ 27
9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure............................................. 27
PART III
10. Directors and Executive Officers of the Registrant................ 28
11. Executive Compensation............................................ 28
12. Security Ownership of Certain Beneficial Owners and Management.... 28
13. Certain Relationships and Related Transactions.................... 28
PART IV
14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.. 29
</TABLE>
<PAGE>
PART I
ITEM 1: Business.
General
Highlands Insurance Group, Inc. (the "Highlands Group") is an insurance
holding company that, through its subsidiaries (collectively, the "Company"),
is engaged in the property and casualty insurance business. Until January 23,
1996, the Highlands Group was a wholly-owned subsidiary of Halliburton Company
("Halliburton"). On that date, the shares of the Highlands Group's common
stock (the "Common Stock") were distributed to holders of common stock of
Halliburton in the form of a dividend (the "Distribution").
On April 30, 1997, the Highlands Group acquired Vik Brothers Insurance,
Inc. and its subsidiaries ("VBI"). Immediately after the consummation of the
acquisition, VBI was renamed American Reliance, Inc. The acquisition was
accounted for as a purchase and, accordingly, the financial results of
American Reliance, Inc. and its subsidiaries ("American Reliance") are
included in the consolidated financial statements effective April 30, 1997.
The Company's home office is in Lawrenceville, New Jersey, where it has one
of its regional offices. It maintains eight other regional offices in Houston,
Texas; Raleigh, North Carolina; Columbus, Ohio; Brookfield, Wisconsin; Des
Moines, Iowa; Denver, Colorado; Nashville, Tennessee; and Woodland Hills,
California. A major accounts business unit is located in Lawrenceville and
Houston to service larger or specialized accounts. The Company's principal
subsidiaries, Highlands Insurance Company, Northwestern National Casualty
Company and Pacific National Insurance Company, are rated "B++" (very good) by
A.M. Best.
The Company's principal product lines, shown as a percentage of gross
premiums written for 1999, are as follows:
<TABLE>
<S> <C>
Commercial multiple-peril.......................................... 27.8%
Workers' compensation.............................................. 19.4
Commercial automobile.............................................. 13.9
Homeowners multiple peril and fire................................. 13.5
General liability.................................................. 11.6
Personal automobile................................................ 8.2
Ocean Marine....................................................... 2.4
Inland Marine...................................................... 2.0
Other.............................................................. 1.2
-----
100.0%
=====
</TABLE>
The Company, which is licensed in all 50 states and the District of
Columbia, writes primarily property and casualty insurance for commercial
customers and certain personal lines. Its commercial policyholders consist of
small to medium-sized customers, such as retailers, wholesalers, contractors,
service businesses and customers in the habitational sector. In addition, the
Company writes insurance through its major accounts unit for medium to large
commercial accounts headquartered in Texas and Louisiana and program groups,
including risk purchasing groups. Its largest customer in 1999 was
Halliburton, the Highlands Group's former parent, which represented 6.3% of
the Company's gross premiums written. The Company provided insurance services
to Halliburton pursuant to an agreement which expired in January 2000. The
Company also wrote ocean marine insurance from its Houston office, mainly
along the Gulf of Mexico and on the West Coast of the United States, including
Hawaii and Alaska, and inland marine insurance, mainly in Texas. The ocean
marine line was discontinued at the end of 1999. The Company's personal lines
focus on homeowners multiple peril, dwelling fire and automobile insurance,
primarily on the East Coast.
Between 1976 and 1996, the Company discontinued three of its product lines
(the "Discontinued Lines") which still generate claims that affect the
Company's results of operations: business originated by its London
1
<PAGE>
operations; an umbrella/excess liability policy program; and assumed casualty
and property reinsurance contracts. The Discontinued Lines represented an
immaterial amount of the Company's gross premiums written in 1999 and 1998.
Products
The Company writes commercial and personal property and casualty coverage.
The commercial lines include primarily commercial multiple peril, workers'
compensation, general liability and commercial automobile insurance.
Frequently, commercial policies are sold on an account basis, including a
combination of these policy coverages. Policies written for large commercial
accounts are generally underwritten on a high deductible or retrospectively
rated basis, with significant risk retention by the insured. Policies written
for small to medium-sized accounts are generally on a fixed premium basis
where the insured has little or no retained risk, although certain workers'
compensation policies provide for profit sharing participation to the insured
in the form of dividends. The personal lines consist of homeowners multiple
peril and dwelling fire and personal automobile insurance. Additionally, the
Company writes ocean and inland marine insurance which is generally unrelated
to the commercial or personal lines property and casualty products. The ocean
marine line was discontinued at the end of 1999.
The following table sets forth the Company's gross premiums written by
product line for the periods indicated.
<TABLE>
<CAPTION>
Years Ended
December 31,
------------------
1999 1998 1997
------ ----- -----
(in millions)
<S> <C> <C> <C>
Commercial multiple peril.............................. $101.4 96.6 80.0
Workers' compensation.................................. 70.8 90.0 69.6
Commercial automobile.................................. 50.5 47.5 40.1
Homeowners multiple peril and fire..................... 49.0 40.2 29.5
General liability...................................... 42.4 26.7 54.8
Personal automobile.................................... 29.9 27.5 19.5
Ocean Marine........................................... 8.6 10.9 20.3
Inland Marine.......................................... 7.2 7.2 7.9
Other.................................................. 3.0 30.5 22.6
Discontinued lines..................................... 1.3 1.0 1.7
------ ----- -----
Total................................................ $364.1 378.1 346.0
====== ===== =====
</TABLE>
The following is a description of the types of insurance products sold by
the Company.
Commercial Multiple Peril. Commercial multiple peril policies insure
businesses and commercial dwellings against property and third party liability
exposures.
Workers' Compensation. Workers' compensation coverage insures employers
against medical and indemnity claims resulting from work related injuries.
Commercial Automobile. Commercial automobile coverage insures businesses
against losses incurred from personal bodily injury, bodily injury to third
parties and property damage to an insured's vehicle, other vehicles and other
property. This product line is primarily offered in connection with the
Company's other primary insurance products.
Homeowners Multiple Peril and Fire. Homeowners multiple peril coverage
insures individuals for losses to their residences and personal property and
against third party liability exposures.
General Liability. General liability coverage insures businesses against
third-party liability from accidents occurring on their premises or arising
out of their operations, such as injuries sustained from products sold.
2
<PAGE>
Personal Automobile. Personal automobile insurance insures individuals
against losses incurred from personal bodily injury, bodily injury to third
parties and property damage to the insured's vehicle, other vehicles and other
property.
Ocean Marine. Ocean marine coverage insures business against property and
liability losses related to the operation of waterborne vessels and their
cargo.
Inland Marine. Inland Marine insures against loss or damage to persons or
property in connection with risks of navigation or transportation on land, air
or water or while being assembled, packed or similarly prepared for or waiting
for shipment. Coverages include marine builders risks; personal property
floaters; precious metals or stones; bridges and tunnels; instrumentalities of
communication; and on all aids to navigation and transportation.
Other. In addition to its primary product lines above, the Company also
underwrites surety bonds and property coverage.
Types of Policies
Approximately 89.0% of the Company's gross premiums written in 1999 related
to policies written on a traditional fixed premium basis whereby the customer
receives stated levels of coverage in return for a fixed premium over the
policy term, including certain workers' compensation policies which provide
for participating dividends. The balance of the Company's insurance premiums
are written on policies subject to retrospective rating or individually
negotiated, high deductible, fixed premium policies.
Premiums for retrospectively rated policies may be adjusted up or down,
subject to certain limitations contained in the policy, based on the actual
loss experience of the insured during the policy period. Loss experience rated
policies reduce but do not eliminate risk to the insurer. The Company
estimates ultimate losses for the retrospectively rated policies and then
adjusts written and earned premiums and premiums due from policyholders for
changes in the estimated ultimate losses from the prior valuation.
High deductible policies are similar to retrospectively rated policies in
terms of the level of risk retention by the insured. Under a high deductible
policy, the insured deposits an estimated deductible amount with the insurer,
which amount is generally adjusted monthly or quarterly to reflect loss
payments under the deductible. Amounts within the deductible limit are not
recorded as premiums or losses. Consequently, premiums on a high deductible
policy generally are significantly lower than on a retrospectively rated
policy. In addition, cash receipts to the Company on high deductible policies
are generally lower than for retrospectively rated policies and, thus, the
opportunity for investment income is reduced.
Geographic Distribution
The following table sets forth the geographic distribution of the Company's
gross premiums written for the periods indicated.
<TABLE>
<CAPTION>
Years Ended
December 31,
------------------
1999 1998 1997
------ ----- -----
(in millions)
<S> <C> <C> <C>
California............................................. $53.0 47.1 33.4
Texas.................................................. 46.7 52.4 79.4
New Jersey............................................. 39.1 51.3 44.6
Pennsylvania........................................... 32.2 31.4 27.2
North Carolina......................................... 23.6 18.3 13.0
Iowa................................................... 14.9 14.4 10.0
New York............................................... 13.3 11.3 10.2
Indiana................................................ 11.7 10.5 8.5
South Carolina......................................... 10.5 11.0 7.7
Wisconsin.............................................. 10.2 9.4 6.9
Other.................................................. 108.9 121.0 105.1
------ ----- -----
$364.1 378.1 346.0
====== ===== =====
</TABLE>
3
<PAGE>
Marketing
The Company sells its insurance products in various regional markets
through a network of approximately 2,200 independent agents. Its ten largest
agents wrote 7.3% of the Company's gross premiums written in 1999.
The Company markets small to medium-sized commercial and personal insurance
through nine regional offices in New Jersey, Texas, North Carolina, Ohio,
Wisconsin, Iowa, Colorado, Tennessee and California. A major accounts unit is
located in Lawrenceville and Houston to service larger or specialized
accounts. The Company has new business offices in Atlanta, Georgia; Dallas,
Texas; Tustin, California; and Providence, Rhode Island.
The Company's small to medium-sized commercial customers (with premium on
policies ranging from $2,500 to $100,000) consist mainly of retailers,
wholesalers, service businesses, funeral homes, office buildings, religious
institutions, franchise and family style restaurants, municipalities, golf
courses, automobile dealers, customers in the habitational sector (such as
apartments, condominiums, motels and hotels), contractors, wholesale durable
goods producers, producers of retail building materials, machine shops and
tool manufacturers.
The personal lines unit, which is headquartered in Raleigh, North Carolina,
focuses on homeowners multiple peril, dwelling fire and, to a lesser extent,
personal automobile coverage, primarily along the East Coast. The Company is
in the process of expanding its personal lines to California, Georgia and
Rhode Island.
The Company sells insurance products, through its major accounts unit in
Houston, Texas, to a limited number of relatively large industrial clients,
headquartered in Texas and Louisiana, engaged in oil lease operations,
construction, engineering, manufacturing and service businesses where
insurance needs require specialized service capabilities and flexible
coverages. The major accounts unit also provided insurance coverages for
Halliburton, comprised mostly of workers' compensation, automobile liability
and general liability insurance written on a high deductible and
retrospectively rated basis. The Company provided this coverage to Halliburton
as substantially service-based business, through an agreement which expired in
January 2000. The Company's major accounts unit in Lawrenceville focuses on
program groups, including risk purchasing groups and other larger accounts.
Because the Company's business is marketed through independent insurance
agents and brokers, it considers its relationship with these agents and
brokers to be critical to its success. Accordingly, the Company seeks to
establish long-term relationships with well-established agencies and brokers
with a proven track record. In selecting agencies and brokers for appointment,
the Company considers the following criteria: a record of profitability and
financial stability; an experienced and professional staff; the existence of a
marketing plan for future growth; and a plan for succession in management. The
Company's agents are primarily medium-sized firms, generally with annual
premium volume estimated at between $2 million and $25 million. Agents are
retained under agency agreements which provide for the payment of commissions
based on a percentage of premiums written by line of business. Some agents are
also eligible to earn contingent commissions based on achieving specified
levels of premium volume with profitable underwriting experience. The Company
continually monitors the performance of its agents and brokers and terminates
relationships in the case of substandard performance.
The success of the Company depends in large part on maintaining a strong
agency network. To increase its responsiveness to agents' needs, the Company
has instituted agency councils on a regional basis to deal with issues that
are important to agents. The Company has also established teams in its regions
which consolidate underwriting, field marketing and agency services into
single units. Specific marketing programs have been established to provide
agents with marketing support, including an agency newsletter to communicate
product marketing information.
The Company, through a stock purchase plan for its independent agents,
permits them to purchase the Company's Common Stock on favorable terms in
order to encourage them to become stockholders in the Company and thereby
increase their identity of interest with the Company.
4
<PAGE>
Underwriting
The underwriting and risk selection process is performed at each of the
regional offices, new business offices and business units. Underwriting
guidelines and criteria are established by corporate underwriting, located in
Lawrenceville, New Jersey. Underwriting audits are performed by the corporate
underwriting staff on an annual basis to ensure compliance with underwriting
directives.
Claim
Claims are processed in five regional claim offices located in
Lawrenceville, New Jersey; Raleigh, North Carolina; Des Moines, Iowa; Houston,
Texas; and Woodland Hills, California. Home office claim support is located in
Lawrenceville, New Jersey, which establishes claim policies and procedures for
the regional claim offices. The home office also provides support on complex
claims, such as environmental/mass tort, asbestos, and construction defect
claims, fraud detection and administration, and conducts an oversight audit
function for each regional claim office. In addition, a centralized salvage
and subrogation unit is located in Raleigh, North Carolina.
The Company primarily uses its own adjusters to settle claims, but also
uses independent adjusters when necessary for claims in remote areas. The
Company uses in-house counsel for a portion of its claims litigation.
Loss Control
The Company maintains a loss control operation in all of its offices in the
field to provide loss prevention service to customers and to assist
underwriters in the risk selection and pricing process. Loss control services
include management consultation and recommendation, on-site inspection and
training using video, audio and written resources. Services provided to
underwriters include inspections, estimation of building replacement costs,
risk assessment and recommendations for improving the loss experience on a
risk.
Discontinued Lines
Between 1976 and 1996, the Company discontinued three lines of business
which still generate claims that affect the Company's results of operations:
(i) business generated by the Company's London operations, which were
initially conducted as a branch office and subsequently by a UK subsidiary
(together "Highlands (UK)") and which were discontinued in 1993; (ii) certain
umbrella/excess liability policies which were discontinued in 1985; and
(iii) assumed casualty and property reinsurance, which was discontinued between
1976 and 1996. The Company has outsourced the claims handling and run-off
management of Highlands (UK) to a professional run-off company doing business in
the United Kingdom. The run-off of the other discontinued lines is being managed
directly by Company personnel in Houston, Texas.
Loss and Loss Adjustment Expense Reserves
Significant periods of time often elapse between the occurrence of an
insured loss, the reporting of the loss to the insurer and the insurer's
payment of that loss. To recognize liabilities for unpaid losses, insurers
establish reserves as balance sheet liabilities representing estimates of
amounts needed to pay reported and unreported losses and the related loss
adjustment expense. The Company's loss and loss adjustment expense reserves
are reviewed quarterly by the Company's internal actuaries and at year end by
the Company's independent actuaries. The Company's independent actuaries
issued opinions on the 1999 loss and loss adjustment expense reserves for the
insurance subsidiaries, as required for their statutory filings with the
various insurance departments.
The process of estimating loss reserves is a difficult and complex exercise
involving many variables and subjective judgments. As part of the reserving
process, insurers review historical data and consider the impact of various
factors such as changes in the Company's operations (such as underwriting or
claims handling), trends in claim frequency and severity, emerging economic
and social trends, inflation and changes in the regulatory and
5
<PAGE>
litigation environments. This process assumes that past experience, adjusted
for the effects of current developments and anticipated trends, is an
appropriate basis for predicting future events. There is no precise method,
however, for evaluating the impact of any specific factor on the adequacy of
reserves, because the eventual deficiency or redundancy of reserves is
affected by many factors.
When a claim is reported to the Company, claim personnel establish a "case
reserve" for the estimated amount of the ultimate liability. This reflects the
informed judgment of such personnel based on general insurance reserving
practices and on the experience and knowledge of such personnel regarding the
nature and value of the specific types of claims. Case reserves are increased
or decreased as deemed necessary by the Company's claim department, after
evaluating, among other things, coverage, liability and the severity of
subsequent developments.
In accordance with industry practice, the Company maintains reserves for
estimated unreported losses and associated adjustment and litigation expenses.
These reserves are established to provide for claims which have been incurred
but not yet reported ("unreported losses") and to provide for adverse
development in case reserves. A significant portion of the Company's loss
reserve is the reserve relating to unreported losses. These reserves, by
definition, are not established for specific claims. In calculating reserves
for unreported losses, therefore, the Company estimates the ultimate net
liability for losses using various techniques. Such reserves are established
based on loss experience and are grouped both by class of business and by
accident year. Reserve adjustments relating to unreported losses are also made
to take into account changes in the volume of business written, claims
frequency and severity, the mix of business, claims processing and other items
that can be expected to affect the Company's liability for losses over time.
During the loss adjustment period, additional facts regarding individual
claims may become known. As the Company becomes aware of additional facts, it
may become necessary for it to refine and adjust liability estimates, and even
after adjustment, the ultimate net liability for claims may be less than or
greater than the revised estimates.
6
<PAGE>
The following table presents a reconciliation of total beginning and ending
reserve balances of the Company for loss and loss adjustment expense for the
periods indicated.
<TABLE>
<CAPTION>
1999 1998 1997
---------- --------- ---------
(in thousands)
<S> <C> <C> <C>
Balance at January 1........................... $1,603,548 1,605,374 1,156,824
Acquisition of American Reliance............... -- -- 520,719
Less--Reinsurance recoverables............... 732,567 692,668 652,449
---------- --------- ---------
Net balance at January 1 870,981 912,706 1,025,094
---------- --------- ---------
Incurred related to--
Current year................................. 247,027 256,528 230,033
Commutation of Aggregate Excess of Loss
Reinsurance Agreement....................... -- 50,000 --
Prior year--
Asbestos and environmental................. 1,795 19,119 5,433
All other.................................. (9,882) 2,753 11,013
---------- --------- ---------
Total prior year............................. (8,087) 21,872 16,446
---------- --------- ---------
Total incurred............................. 238,940 328,400 246,479
---------- --------- ---------
Paid related to--
Current year................................. 101,294 90,635 120,705
Prior year--
Asbestos and environmental................. 15,038 9,712 6,812
All other.................................. 230,240 269,778 231,350
---------- --------- ---------
Total prior year............................. 245,278 279,490 238,162
---------- --------- ---------
Total paid................................. 346,572 370,125 358,867
---------- --------- ---------
Elimination of LMI reserves(1)................. 24,033 -- --
---------- --------- ---------
Net balance at December 31..................... 739,316 870,981 912,706
Add--Reinsurance recoverables................ 614,208 732,567 692,668
---------- --------- ---------
Balance at December 31......................... $1,353,524 1,603,548 1,605,374
========== ========= =========
</TABLE>
- --------
(1) The Company wrote off its investment in LMI Insurance Company ("LMI")
which has been placed in Rehabilitation. See Item 7: "Management's
Discussion and Analysis of Financial Condition and Results of
Operations."
The loss reserve experience of the Company, as reflected on the basis of
generally accepted accounting principles, is shown in the following table,
which represents the development of balance sheet reserves (net of
reinsurance) for 1989 through 1999. The top three lines of the table reconcile
gross loss and loss adjustment expense reserves to net loss and loss
adjustment expense reserves for 1992 through 1999. The upper section of the
table shows the cumulative amount paid with respect to the previously recorded
net reserves as of the end of each succeeding period. The lower portion of the
table shows the re-estimated amount of the previously recorded net reserves
based on experience as of the end of each succeeding period. In addition, the
table also presents the gross re-estimated reserve liability as of the latest
re-estimation period. The Company did not restate data for years prior to 1992
in this table for presentation on a gross of reinsurance basis.
7
<PAGE>
The loss reserve estimate is increased or decreased as more information
becomes known about the frequency and severity of losses for individual years.
The cumulative (deficiency) redundancy represents the aggregate change in the
estimates over all prior periods. This table does not present accident or
policy year development data. Conditions and trends that have affected
development of the reserves in the past may not necessarily occur in the
future. Accordingly, it may not be appropriate to extrapolate deficiencies or
redundancies based on this table.
<TABLE>
<CAPTION>
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
--------- --------- --------- ---------- --------- --------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Gross reserves
for loss and
adjustment
expense........ $ -- -- -- 1,393,352 1,225,242 1,149,173 1,253,627 1,156,824 1,605,374 1,603,548
Deduct:
reinsurance
recoverable.... -- -- -- 827,381 627,285 557,096 599,558 546,707 692,668 732,567
Net reserves for
loss and loss
adjustment
expense........ 493,818 540,818 652,925 565,971 597,957 592,077 654,069 610,117 912,706 870,981
Net paid
(cumulative) as
of:
One year later.. 207,948 236,070 263,755 268,072 184,586 198,415 163,521 135,747 279,490 245,278
Two years
later.......... 344,994 419,791 420,876 395,244 333,366 323,737 266,093 231,409 459,712
Three years
later.......... 448,667 510,739 518,442 513,135 426,022 404,287 348,713 316,905
Four years
later.......... 516,833 573,504 608,865 587,726 488,676 473,059 424,307
Five years
later.......... 555,134 638,963 668,889 639,647 548,333 542,484
Six years
later.......... 605,691 685,578 714,843 692,851 612,998
Seven years
later.......... 641,245 723,905 763,008 753,462
Eight years
later.......... 670,661 764,543 820,177
Nine years
later.......... 704,056 822,346
Ten years
later.......... 767,302
Gross paid
(cumulative) as
of:
One year later.. 583,180 405,885 284,446 279,091 183,701 338,120 333,982
Two years
later.......... 920,199 635,683 522,680 429,250 324,859 590,529
Three years
later.......... 1,113,503 836,921 650,471 556,177 453,634
Four years
later.......... 1,296,333 945,321 762,957 674,906
Five years
later.......... 1,392,285 1,047,819 875,842
Six years
later.......... 1,486,879 1,155,295
Seven years
later.......... 1,587,715
Net liability
re-estimated as
of:
End of year..... 493,818 540,818 652,925 565,971 597,957 592,077 654,069 610,117 912,706 870,951
One year later.. 544,574 653,379 694,248 688,811 662,841 735,647 676,940 626,563 984,578 862,894
Two years
later.......... 627,917 725,661 785,147 772,020 788,454 750,941 702,633 689,107 971,903
Three years
later.......... 667,812 772,614 828,241 894,071 805,313 783,138 765,168 676,970
Four years
later.......... 714,290 824,126 938,216 915,163 835,720 863,781 753,158
Five years
later.......... 765,856 925,216 957,726 943,789 913,664 850,726
Six years
later.......... 863,909 943,067 988,466 1,035,577 900,015
Seven years
later.......... 872,101 971,193 1,084,762 1,023,488
Eight years
later.......... 897,497 1,060,151 1,073,281
Nine years
later.......... 976,982 1,053,600
Ten years
later.......... 975,569
Net (deficiency)
redundancy..... (481,751) (512,782) (420,356) (457,517) (302,058) (258,649) (99,089) (66,853) (59,197) 8,087
Impact of 1995
Third Quarter
Change......... 88,701 90,501 96,640 103,483 107,594 117,000 -- -- -- --
Aggregate Stop
Loss
Adjustment..... 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000
Remaining net
(deficiency)
redundancy..... (343,050) (372,281) (273,716) (304,034) (144,464) (91,649) (49,089) (16,853) (9,197) 8,087
========= ========= ========= ========== ========= ========= ========= ========= ========= =========
Gross re-
estimated
liability as
of:
End of year..... 1,393,352 1,225,242 1,149,173 1,253,627 1,156,824 1,605,374 1,603,548
One year later.. 1,636,022 1,413,673 1,445,913 1,324,315 1,285,772 1,746,580 1,574,814
Two years
later.......... 1,811,827 1,693,009 1,492,471 1,468,762 1,457,923 1,693,237
Three years
later.......... 2,102,378 1,741,108 1,644,068 1,644,067 1,414,284
Four years
later.......... 2,157,078 1,895,541 1,820,250 1,601,476
Five years
later.......... 2,307,982 2,071,815 1,777,438
Six years
later.......... 2,472,233 2,031,628
Seven years
later.......... 2,437,690
Gross cumulative
(deficiency)
redundancy..... (1,044,338) (806,386) (628,265) (347,849) (257,460) (87,863) 28,734
========== ========= ========= ========= ========= ========= =========
Gross re-
estimated
liability...... 2,437,690 2,031,628 1,777,438 1,601,476 1,414,284 1,693,237 1,574,814
Less: re-
estimated
recoverable.... 1,414,202 1,131,613 926,712 848,318 737,314 721,334 590,236
---------- --------- --------- --------- --------- --------- ---------
Net re-estimated
liability...... 1,023,488 900,015 850,726 753,158 676,970 971,903 984,578
========== ========= ========= ========= ========= ========= =========
LMI Gross
Reserves....... 52,759 60,284
LMI Net
Reserves....... 23,626 24,033
Gross re-
estimated
liability
excluding LMI
reserves(1).... 1,640,478 1,514,530
Net re-estimated
liability
excluding LMI
reserves(1).... 948,277 960,545
<CAPTION>
1999
---------
<S> <C>
Gross reserves
for loss and
adjustment
expense........ 1,353,524
Deduct:
reinsurance
recoverable.... 614,208
Net reserves for
loss and loss
adjustment
expense........ 739,316
Net paid
(cumulative) as
of:
One year later..
Two years
later..........
Three years
later..........
Four years
later..........
Five years
later..........
Six years
later..........
Seven years
later..........
Eight years
later..........
Nine years
later..........
Ten years
later..........
Gross paid
(cumulative) as
of:
One year later..
Two years
later..........
Three years
later..........
Four years
later..........
Five years
later..........
Six years
later..........
Seven years
later..........
Net liability
re-estimated as
of:
End of year..... 739,316
One year later..
Two years
later..........
Three years
later..........
Four years
later..........
Five years
later..........
Six years
later..........
Seven years
later..........
Eight years
later..........
Nine years
later..........
Ten years
later..........
Net (deficiency)
redundancy.....
Impact of 1995
Third Quarter
Change.........
Aggregate Stop
Loss
Adjustment.....
Remaining net
(deficiency)
redundancy.....
Gross re-
estimated
liability as
of:
End of year..... 1,353,524
One year later..
Two years
later..........
Three years
later..........
Four years
later..........
Five years
later..........
Six years
later..........
Seven years
later..........
Gross cumulative
(deficiency)
redundancy.....
Gross re-
estimated
liability......
Less: re-
estimated
recoverable....
Net re-estimated
liability......
LMI Gross
Reserves.......
LMI Net
Reserves.......
Gross re-
estimated
liability
excluding LMI
reserves(1)....
Net re-estimated
liability
excluding LMI
reserves(1)....
</TABLE>
- --------
(1) The Company wrote off its investment in LMI which has been placed in
Rehabilitation. See Item 7. "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
The four components which account for the substantial majority of the
indicated historical (1989-1994) reserve deficiencies are: (i) reserving
practices prior to 1991 for unreported losses associated with Halliburton
retrospectively rated policies, (ii) environmental (including asbestos)
claims, (iii) Discontinued Lines business and (iv) inadequate individual claim
reserves.
8
<PAGE>
As the above table illustrates, the Company's net reserves at the end of
1998 developed favorably in 1999 by $8.1 million. This is primarily due to a
favorable development of $11.1 million on previously unbilled construction
defect reinsurance recoverables offset in part by adverse development of $3.0
million which includes $1.8 million adverse development for asbestos and
environmental reserves. For additional discussion regarding loss and loss
adjustment expense reserves, see Item 7: "Management's Discussion and Analysis
of Financial Condition and Results of Operations."
In 1995, the Company and its independent actuary conducted a review of its
loss and loss adjustment expense reserves to assess the Company's reserve
position. As a result of such review, the Company recorded a $117 million
charge to loss and loss adjustment expense incurred which relates to items
(ii) and (iii) in the second preceding paragraph. Loss and loss adjustment
expense reserves were increased by $117 million (net of reinsurance) as
follows: (i) asbestos and environmental reserves were increased by $59.5
million relating to exposures prior to 1986; (ii) assumed casualty reinsurance
reserves were increased by $13.1 million relating to risks reinsured in the
early to mid-1970's; and (iii) catastrophe loss reserves reinsured by
Highlands (UK) were increased by $12.0 million relating primarily to
underwriting years 1988 through 1990. An additional $13.0 million was added to
loss adjustment expense reserves to reflect additional costs related to the
settlement of claims and run-off costs related to Highlands (UK). This reserve
increase impacts the reserve development for 1994 and all prior years. The
remaining $19.4 million reflects changes to reserves for unreported losses in
order to reflect the 1995 evaluation of overall loss and loss adjustment
expense reserves and impacts development for 1994 and various other prior
years.
The Company and the property and casualty insurance industry in general
have experienced substantial adverse reserve development, particularly since
1989, related to asbestos and environmental claims. The areas of exposure for
the Company are discussed in "Management's Discussion and Analysis of
Financial Condition and Results of Operations." For 1999, 1998 and 1997, the
amounts of adverse reserve development related to asbestos and environmental
claims were $1.8 million, $19.1 million and $5.4 million, respectively. Prior
to 1993, the Company did not explicitly identify the amount of unreported loss
reserve related to asbestos and environmental claims.
Prior to the end of 1991, the Company did not establish a reserve for
unreported losses from retrospectively rated policies written for Halliburton
and its affiliated companies. The emergence of these losses was effectively
offset by collection of additional premiums under the policies and thus the
impact on the Company's income statement was minimal. For 1989 to 1991, the
total incurred loss emergence was equal to the adverse reserve development for
these policies and amounted to $170.1 million.
From 1958 until 1986, the Company issued fixed premium (non-retrospectively
rated) insurance policies to a subsidiary of Halliburton. From 1987 on, the
Company's insurance policies with the Halliburton companies have been written
on a retrospectively rated or high-deductible basis. Since the mid-1990's, the
subsidiary which had issued fixed premium policies has received a substantial
number of asbestos claims. Through December 31, 1999, the Company paid
Halliburton $871,000 under the fixed premium policies on account of the
asbestos claims, and billed Halliburton $5.2 million under the retrospectively
rated and high-deductible policies on account of asbestos claims. Halliburton
has not paid this billed amount and has questioned the proper allocation of
the asbestos claims between the fixed premium and the retrospectively rated
and high-deductible policies. The Company has examined this question, and
believes that it is not responsible for a material amount of additional
asbestos liability under the fixed premium policies.
Although the majority of the assumed reinsurance contracts covering
casualty exposures relate to the 1969 through 1974 policy years, losses have
continued to emerge throughout the last ten years. For 1999, 1998 and 1997,
the amounts of general liability assumed reinsurance losses recorded were $2.2
million, $2.4 million and $3.6 million, respectively. From 1989 to 1991, this
line contributed $21.8 million of adverse reserve development averaging
approximately $7.3 million per year. Included within these amounts are losses
related to environmental claims, although enough information to identify these
losses is not always provided by the ceding companies. To the extent
information provided by ceding companies permits, the environmental losses
have been segregated for the Company's reserve analysis.
9
<PAGE>
Net Loss and loss adjustment expense reserves for Highlands (UK) developed
adversely by $1.4 million in 1997. For 1998 and 1999, Highlands (UK) adverse
loss reserve development was less than $100,000. These reserves include
asbestos and environmental exposures and catastrophic claims resulting from
exhaustion of reinsurance coverage relating to the catastrophic claims.
Reinsurance
The Company utilizes reinsurance arrangements to limit its maximum loss, to
provide greater diversification of risks and to minimize exposures on larger
risks. Reinsurance involves an insurance company transferring or ceding all or
a portion of its exposure on insurance policies to a reinsurer. The reinsurer
assumes the exposure in exchange for a portion of the premiums received by the
ceding insurance company. Generally, reinsurance coverage is on an excess of
loss basis, which means that reinsurance coverage commences after losses
exceed a specified dollar amount. Additionally, the Company has catastrophe
coverage for certain types of losses over stipulated aggregate amounts arising
from any one occurrence. Although reinsurance does not legally discharge an
insurer from its primary liability for the full amount of the policies, it
does make the assuming reinsurer liable to the reinsured to the extent of the
reinsurance ceded.
The Company maintained excess of loss reinsurance treaties for each of its
main property, casualty and marine coverages during 1999. On casualty risks,
including workers' compensation, the retention level was $500,000 per
occurrence, with reinsurance coverage up to $30 million per occurrence.
Additional workers' compensation coverage was provided by a second catastrophe
excess of loss arrangement that provides $80 million in addition to the $30
million for total workers' compensation coverage of $109.5 million in excess
of $500,000. On property risks, reinsurers assume liability for 100% in excess
of a retention of $500,000 up to $25 million per risk. For larger limits or
whenever unusual exposures are present, the Company purchases individual
policy reinsurance which is referred to as facultative. In addition, the
Company purchased property catastrophe reinsurance to reduce its exposure to
losses resulting from any single catastrophic event. Under this treaty, which
is effective from July 1, 1999 through June 30, 2000, the Company retains $5
million of a loss occurrence and had protection for 95% of all losses in
excess thereof up to $70 million. On marine business, reinsurers assumed
liability on loss occurrences which exceed $125,000 per occurrence up to $22
million.
The Company monitors the financial condition of the reinsurance companies
with which it places significant reinsurance coverage and strives to place
reinsurance coverage with financially sound reinsurance companies. In the
past, the Company has placed coverage with several hundred reinsurance
companies. It monitors the financial condition of many of such companies only
on a periodic basis. A number of such companies are in run-off or have ceased
writing reinsurance and some have become insolvent. The Company's ability to
monitor the financial condition of some formerly used foreign reinsurance
companies is limited because of the difficulty of acquiring current financial
information.
The following table sets forth by quality of reinsurer (for those domestic
companies rated by A.M. Best) the Company's reinsurance recoverable as of
December 31, 1999.
<TABLE>
<CAPTION>
December 31,
Category 1999
-------- -------------
(in millions)
<S> <C>
A.M. Best Rated:
B++ or better............................................. $315.5
B+ or less................................................ 99.5
Non A.M. Best Rated:
Equitas/Lloyds............................................ 137.9
Other foreign reinsurers.................................. 116.1
Pools and associations.................................... 15.5
------
Total reinsurance recoverable........................... $684.5
======
</TABLE>
Based upon its evaluations of reinsurers, the Company retains the ceded
reserves for potentially uncollectible reinsurance at such time as an
uncollectible amount is probable and the amount may be reasonably
10
<PAGE>
estimated. Because of the difficulty of acquiring current financial
information for certain foreign reinsurers, including Lloyds syndicate
members, the Company believes that no meaningful range of potentially
uncollectible reinsurance can be established beyond recorded reserves. With
respect to certain carriers, including those that are not authorized
reinsurers as determined by an insurance subsidiary's domiciliary department
of insurance, the Company sometimes receives collateral primarily in the form
of bank letters of credit generally securing the reinsurance recoverable for
reported losses and, in some instances, unreported losses. At December 31,
1999, such collateral totaled approximately $41.2 million, of which $13.3
million was received from other foreign reinsurers above. The Company's three
largest reinsurance recoverables at December 31, 1999 were with the
underwriting syndicates at Equitas/Lloyds, amounting to approximately $137.9
million of which approximately $87.2 million is carried by Highlands (UK),
$90.9 million with American Re-Insurance Company and $64.0 million with
General Reinsurance Company. See Item 7: "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Liquidity and Capital
Resources--Reinsurance Receivables."
Investments
The Company invests primarily in fixed maturity investment-grade securities
and manages its portfolio internally. The table below shows the carrying value
and classification of the Company's investments at the dates indicated.
<TABLE>
<CAPTION>
December 31,
-----------------------
1999 1998 1997
------- ------- -------
(in millions)
<S> <C> <C> <C>
Fixed maturities:
United States Government and government agencies...... $116.0 205.5 276.4
States, municipalities and political subdivisions..... 41.3 61.2 189.5
Asset-backed and collateralized securities............ 336.6 415.0 417.5
Corporate securities.................................. 268.6 318.4 282.5
Foreign governments................................... -- .1 .1
Sinking fund preferred stock.......................... -- 1.0 .5
Equity securities....................................... 26.6 21.1 1.6
Other investments....................................... 3.1 3.1 4.1
Cash and cash equivalents............................... 78.3 70.7 60.7
------- ------- -------
$ 870.5 1,096.1 1,232.9
======= ======= =======
</TABLE>
Fixed Maturities. Fixed maturities constituted 87.6% of the Company's
investments at December 31, 1999. The Company determines the mix of its
investment in taxable and tax-exempt securities based on its current and
projected tax position and the relationship between taxable and tax-exempt
investment yields. As of December 31, 1999, taxable bonds accounted for
approximately 96.6% of total fixed maturities. Fixed maturity investments are
classified as available-for-sale and carried on the Company's balance sheet at
estimated fair value, with unrealized gains and losses (net of taxes) recorded
in stockholders' equity as accumulated other comprehensive income. At December
31, 1999, the pre-tax net unrealized losses on available-for-sale fixed
maturities totaled $40.1 million.
The fixed maturities portfolio is managed to provide a reasonable return
while limiting exposure to risk. The following table sets forth the
composition of the Company's portfolio of fixed maturity investments by
National Association of Insurance Commissioners ("NAIC") rating and a
description of the equivalent ratings of Moody's Investor Services, Inc.
("Moody's") at the dates indicated.
<TABLE>
<CAPTION>
Moody's
Equivalent December 31, December 31, December 31,
NAIC Ratings Description 1999 1998 1997
------------ ----------- ------------ ------------ ------------
<S> <C> <C> <C> <C>
1..................... AAA/AA/A 90.9% 91.1% 93.8%
2..................... BAA 8.8 8.2 5.0
3..................... BA 0.3 0.5 0.9
4..................... B -- 0.2 0.3
----- ----- -----
100.0% 100.0% 100.0%
===== ===== =====
</TABLE>
11
<PAGE>
See Notes to Consolidated Financial Statements for a description of the
contractual maturities of the Company's fixed maturities portfolio at December
31, 1999.
Equity Securities. Equity holdings comprised 3.1% of the Company's
investments at December 31, 1999, and consist of a diversified portfolio of
unaffiliated preferred stocks.
Other Investments. Other investments represent amounts invested in limited
partnerships and comprised .4% of total investments at December 31, 1999.
Cash and Cash Equivalents. The Company's portfolio also includes short-term
securities and other miscellaneous investments, which in the aggregate
comprised 9.0% of total investments at December 31, 1999.
The following table sets forth the Company's gross investment income and
the pre-tax yield of its investment portfolio.
<TABLE>
<CAPTION>
Years ended December 31,
----------------------------------------------------------
1999 1998 1997
------------------ ------------------ ------------------
Investment Pre-Tax Investment Pre-Tax Investment Pre-Tax
Income Yield(1) Income Yield(1) Income Yield(1)
---------- ------- ---------- ------- ---------- -------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Fixed maturity
securities:
Taxable............... $60,681 6.75% $66,939 6.95% $53,666 6.97%
Non-taxable(2)........ 2,300 7.13 7,136 5.53 14,408 6.71
Equity securities..... 1,973 7.21 517 5.68 2,073 9.64
Short-term............ 3,343 4.45 3,993 6.48 4,997 6.71
Other invested
assets............... 113 3.76 57 2.82 372 9.48
------- ---- ------- ---- ------- ----
Total............... $68,410 6.60% $78,642 6.75% $75,516 6.95%
======= ==== ======= ==== ======= ====
</TABLE>
- --------
(1) Calculated as gross investment income (including dividend income in the
case of equity securities) divided by the average of the investment
balances at the beginning and end of each quarter. Investment balances are
at amortized cost, except in the case of equity securities for which cost
is used.
(2) For purposes of comparing non-taxable yields to yields on taxable
securities, these yields are equivalent to pre-tax yields of 11.0%, 8.5%
and 10.3% in 1999, 1998 and 1997, respectively, assuming a 35% tax rate.
The disparity between the equivalents of pre-tax yields on non-taxable
fixed maturity securities in comparison with the pre-tax yields on taxable
fixed maturity securities is a function of the differing interest rate
environments in which such securities were acquired.
Competition; Industry Conditions
The property and casualty insurance business is highly competitive, mainly
on the basis of price and service. The Company estimates that there are more
than 3,000 property and casualty insurers nationwide. Many of the Company's
competitors are large national companies with greater financial and other
resources than the Company. In addition to independent insurance companies,
there is increasing competition for commercial business because of
alternatives to traditional insurance such as captive insurers and self-
insurance. Besides traditional insurance products, insurers writing commercial
lines of business now offer products for alternative forms of risk protection.
These products, including high deductible programs and other forms of self-
insurance which utilize captive insurance companies and risk retention groups,
have been instituted and marketed to attract additional business to these
companies. It is not possible to predict how continued growth in alternative
forms of risk protection will affect future operations. The Company competes
on the basis of underwriting expertise, pricing, service and product design.
Management believes its regional market knowledge, flexibility and quality
service to agents and insureds provide a competitive advantage.
Regulation
The Company's insurance subsidiaries are subject to comprehensive
regulation throughout the United States, under statutes that delegate
regulatory, supervisory and administrative powers to state insurance
commissioners. The nature and extent of such regulation vary from jurisdiction
to jurisdiction, but typically involve (i) approval
12
<PAGE>
requirements for premium rates for certain lines of insurance, (ii) standards
of solvency and minimum capital and surplus requirements, (iii) limitations on
amounts and types of investments, (iv) restrictions on the size of risks that
may be insured by a single company, (v) approval requirements for policy
forms, methods of accounting and methods of establishing loss and loss
adjustment expense reserves, (vi) licensing of insurers and agents, (vii)
limitations on the exit of certain classes of business, (viii) required
participation in frequently under-priced underwriting pools, and (ix) filing
requirements for annual and other reports with respect to financial condition
and other matters. Such regulations may impede, or impose burdensome
conditions on, rate increases or other actions that the Company might wish to
take to enhance its operating results. In addition, state regulatory examiners
perform periodic examinations of insurance companies. Such regulations are
generally intended for the protection of policyholders rather than investors.
The Company also is subject to laws governing insurance holding companies
in states where its insurance subsidiaries are domiciled (Texas, North
Carolina, California, Indiana and Wisconsin). These laws, among other things,
(i) require the Company to file periodic information with state regulatory
authorities including information concerning its capital structure, ownership,
financial condition and general business operations; (ii) regulate certain
transactions between the Company, its affiliates and the insurance
subsidiaries, including the amount of dividends and other distributions and
the terms of surplus notes; (iii) and restrict the ability of any one person
to acquire certain levels of the Company's voting securities without prior
regulatory approval.
Highlands Insurance Company ("HIC") and its subsidiaries, Highlands
Underwriters Insurance Company, Highlands Casualty Company and Aberdeen
Insurance Company and Highlands Lloyds, a controlled affiliate, are domiciled
in Texas. Under current Texas law, any dividend or distribution, together with
any dividend or distribution made within the preceding twelve months, is an
"extraordinary dividend" if it exceeds the greater of (a) 10.0% of the
insurer's surplus as regards policyholders as of the preceding December 31, or
(b) the insurer's net income for the preceding year. An extraordinary dividend
may not be paid unless the company reports the extraordinary dividend to the
Texas Insurance Commissioner at least 30 days before payment and the Texas
Insurance Commissioner does not disapprove the extraordinary dividend within
that period. The maximum dividend payable by HIC during 2000 without the prior
approval of the Texas Insurance Commissioner is approximately $29.7 million.
Northwestern National Casualty Company ("NNCC") and its subsidiary, NN
Insurance Company ("NNI"), are domiciled in Wisconsin. Under current Wisconsin
law, any dividend or distribution of cash or other property, together with
that of other dividends paid or credited and distributions made within the
preceding twelve months, is an "extraordinary dividend" if it exceeds the
lesser of (a) 10.0% of the insurer's surplus as regards policyholders as of
the preceding December 31, or (b) the greater of: (i) the net income
(excluding realized capital gains) of the insurer for the calendar year
preceding the date of the dividend or distribution or (ii) the aggregate of
the net income of the insurer for the three calendar years preceding the date
of the dividend or distribution, minus realized capital gains for those
calendar years, and minus dividends paid or credited and distributions made
within the first two of the preceding three calendar years. An extraordinary
dividend may not be paid unless the company reports the extraordinary dividend
to the Wisconsin Insurance Commissioner at least 30 days before payment and
the Wisconsin Insurance Commissioner does not disapprove the extraordinary
dividend within that period. During 2000, NNCC must receive the prior approval
of the Wisconsin Insurance Department to pay any dividends.
Pacific National Insurance Company ("PNIC") and its subsidiary, Pacific
Automobile Insurance Company ("PAIC"), are domiciled in California. Under
current California law, any payment by an insurer of a dividend or
distribution of cash or other property, whose fair market value, together with
that of other dividends or distributions made within the preceding 12 months,
exceeds the greater of (i) 10.0% of the insurer's surplus as regards
policyholders as of the preceding December 31, or (ii) the net income of the
insurer for the 12-month period ending on the preceding December 31 is defined
as an "extraordinary dividend." California law permits an insurer to pay
dividends only from earned surplus. An extraordinary dividend may not be paid
unless it has been approved by the insurance department or the insurance
department has not disapproved the dividend or distribution within 30 days
after notice of the declaration to the department. PNIC can pay dividends of
$1.2 million during 2000 without prior approval of the California Insurance
Department.
13
<PAGE>
The dividend capability of State Capital Insurance Company, which is
domiciled in North Carolina, and American Professionals Insurance Company and
Statesman Insurance Company, which are domiciled in Indiana, are not material
to the Company.
Risk-Based Capital Requirement. In order to enhance the regulation of
insurer solvency, the NAIC adopted a formula and model law to implement risk-
based capital requirements for property and casualty insurance companies.
These risk-based capital requirements are designed to assess capital adequacy
and to raise the level of protection that statutory surplus provides for
policyholder obligations. The risk-based capital model for property and
casualty insurance companies measures three major areas of risk facing
property and casualty insurers: (i) underwriting, which encompasses the risk
of adverse loss developments and inadequate pricing; (ii) declines in asset
values arising from credit risk; and (iii) declines in asset values arising
from investment risks. Insurers having less statutory surplus than required by
the risk-based capital calculation are subject to varying degrees of
regulatory action, depending on the level of capital inadequacy.
The risk-based capital model formula creates four levels of regulatory
action (as defined in the NAIC's model law). The extent of regulatory
intervention and action increases as the level of surplus to risk-based
capital falls. The first level, Company Action Level, requires an insurer to
submit a plan of corrective actions to the regulator if surplus falls below
200% of the Authorized Control Level. The Regulatory Action Level requires an
insurer to submit a plan containing corrective actions and permits the
domiciliary insurance regulator to perform an examination or other analysis
and issue a corrective order if surplus falls below 150% of the Authorized
Control Level. The Authorized Control Level allows the regulator to
rehabilitate or liquidate an insurer in addition to the aforementioned
actions. The fourth action level, Mandatory Control Level, requires the
regulator to rehabilitate or liquidate the insurer if surplus falls below 70%
of the Authorized Control Level. All of the insurance subsidiaries of
Highlands Group are above the Company Action Level.
In connection with the acquisition of American Reliance, Inc., one of its
subsidiaries, LMI Insurance Company ("LMI"), was put into run-off. The Company
has been managing LMI's run-off since the acquisition in 1997. On March 20,
2000, the Court of Common Pleas in Franklin County, Ohio entered an Order
appointing the Superintendent of Insurance of the State of Ohio as the
Rehabilitator of LMI. As Rehabilitator, the Superintendent is by operation of
law vested with control of LMI, including title to all of LMI's assets. The
Company, which is working with the Rehabilitator to continue the run-off of
LMI, has written-off its investment in LMI, resulting in a charge to earnings
of $22.1 million in 1999. The $22.1 million charge consists of write-offs of
the Company's $10.5 million investment in LMI and $11.6 million of associated
deferred tax assets. Management believes that the regulatory matters
concerning LMI will not have a material impact on the Company's ongoing
operations. See Item 7: "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Results of Operations."
The business of Highlands (UK) is subject to regulation under the laws of
the United Kingdom pursuant to the Insurance Companies Act of 1982. After
incurring unacceptable underwriting results in 1991 and 1992 and reviewing the
prospects for the future, Highlands (UK) voluntarily ceased writing new
business effective April 1993. The Company received a Notification of
Requirements from the Department of Trade and Industry ("DTI") in 1993, which
included: timely reporting of certain financial information; restrictions on
certain investment activities without prior approval of the DTI; restrictions
relating to transactions with connected persons; and a provision requiring
Highlands (UK) to cease to effect contracts of insurance except where it has a
legal obligation to do so. Capital infusions for Highlands (UK) were made in
1994 and 1995. During 1994, the DTI sent an additional requirements notice to
Highlands (UK) requesting a plan for restoration of a sound financial position
because of its failure to maintain a margin of solvency required by Section 32
of the Insurance Companies Act of 1982 for a company writing premiums.
Highlands (UK) has developed such a plan. Maintaining a license to write
business in the United Kingdom is not essential and the Highlands (UK) plan
does not anticipate any further capital contribution to Highlands (UK) beyond
the 1995 contribution of $10 million. Management believes that the regulatory
matters concerning Highlands (UK) will not have a material impact on the
Company's results of operations or financial position.
14
<PAGE>
Employees
The Company had 974 employees as of December 31, 1999. The Company believes
that its relations with its employees are satisfactory.
Risk Factors
Loss Reserves. The Company maintains loss reserves for what it expects the
ultimate settlement and administration of its claims will cost. The Company
bases the reserve amounts on facts and circumstances of which it is aware,
predictions of future events, estimates of future trends in claims severity
and frequency and other subjective factors. However, there is no method for
precisely estimating the Company's ultimate liability.
The Company regularly reviews its reserving techniques and its overall
amount of reserves. It also reviews: information regarding each claim for
losses; its loss history and the industry's loss history; legislative
enactments, judicial decisions and legal developments regarding damages;
changes in political attitudes; and trends in general economic conditions,
including inflation.
Reinsurance. The Company transfers its exposure to certain risks to others
through reinsurance arrangements. Under these arrangements, other insurers
assume a portion of the Company's losses and expenses associated with reported
and unreported claims in exchange for a portion of policy premiums. The
availability, amount and cost of reinsurance depend on general market
conditions and may vary significantly. Furthermore, the Company faces a credit
risk with respect to reinsurance. When the Company obtains reinsurance, it is
still liable for those transferred risks if the reinsurer cannot meet its
obligations. Therefore, the inability of the Company's reinsurers' to meet
their financial obligations could materially affect its operations. The
Company's three largest reinsurance credit exposures as of December 31, 1999
are to underwriting syndicates at Equitas/Lloyds of London in the amount of
$137.9 million, to American Reinsurance Company in the amount of $90.9 million
and to General Reinsurance Company in the amount of $64.0 million.
Halliburton. Halliburton Company, the Company's former parent, was the
Company's largest customer in 1999 and 1998, representing $22.9 million or
7.0%, and $53.9 million or 13.9%, respectively, of the Company's net premiums
earned. Halliburton's contract with the Company expired in January 2000. From
1958 until 1986, the Company issued fixed premium (non-retrospectively rated)
insurance policies to a subsidiary of Halliburton. From 1987 on, the Company's
insurance policies with Halliburton and its subsidiary companies have been
written on a retrospectively rated or high-deductible basis. Since the mid-
1990's, the subsidiary which had issued fixed premium policies has received a
substantial number of asbestos claims. Through December 31, 1999, the Company
paid Halliburton $871,000 million under the fixed premium policies on account
of the asbestos claims, and billed Halliburton $5.2 million under the
retrospectively rated and high-deductible policies on account of asbestos
claims. Halliburton has not paid this billed amount and has questioned the
proper allocation of the asbestos claims between the fixed premium and the
retrospectively rated and high-deductible policies. The Company has examined
this question, and believes that it is not responsible for a material amount
of additional asbestos liability under the fixed premium policies.
Catastrophes. Property and casualty insurance companies frequently
experience losses from catastrophes. Catastrophes may have a material adverse
effect on the Company's operations. Catastrophes include windstorms,
hurricanes, earthquakes, tornadoes, hail, severe winter weather and fires. The
Company cannot predict how severe a particular catastrophe may be until after
it occurs. The extent of the Company's losses from catastrophes is a function
of the total amount of losses its clients incur, the number of its clients
affected, the frequency of the events and the severity of the particular
catastrophe. Most catastrophes occur in small geographic areas. However,
windstorms, hurricanes and earthquakes may produce significant damage in
large, heavily populated areas.
Year 2000. Year 2000 issues may affect the Company's underlying business.
The Company does not believe that its property and casualty policies cover
Year 2000 occurrences and it adopted exclusionary language that
15
<PAGE>
clarifies that its policies do not cover Year 2000 occurrences. The Company
attached the language to the policies under which it believes policyholders
may make claims for Year 2000 losses. The Company cannot reasonably estimate
its exposure for losses and expenses for the claims under the policies.
Importance of Rating Agencies. Rating agencies rate insurance companies
based on financial stability and an ability to pay claims, factors more
relevant to policyholders than investors. Ratings are not recommendations to
buy, hold or sell the Company's Common Stock.
Currently, A.M. Best rates the Company's principal insurance subsidiaries
as "B++" (Very Good). Ratings by A.M. Best in the insurance industry range
from "A++" (Superior) to "F" (in Liquidation). According to A.M. Best, an
insurer with a "B++" rating has demonstrated very good financial strength and
operating performance and is considered secure.
The Company cannot be sure that it will maintain its current A.M. Best
rating. The Company's business could be adversely affected if it receives a
downgrade in its rating.
Reliance on Independent Insurance Agents. The Company markets and sells
almost all of its insurance products through independent, non-exclusive
insurance agencies and brokers. The agencies and brokers may also sell
competitors' insurance products. The Company's business depends in part on the
marketing efforts of those agencies and brokers and the Company must offer
insurance products that meet the requirements of their clients. If those
agencies and brokers fail to market the Company's products successfully, the
Company's business may be adversely impacted.
Significant Influence of Investors. Insurance Partners, L.P. and Insurance
Partners Offshore (Bermuda) L.P. own 10% Convertible Debentures together with
Common Stock Warrants in the Company. The Debentures and Warrants represent
significant equity ownership potential. If Insurance Partners and Insurance
Partners (Bermuda) convert the Debentures and exercise the Warrants, they will
own approximately 41% of the Company's Common Stock. In addition, by contract
Insurance Partners designates 28% of the members of the Board of Directors.
Competition. The Company competes with regional and national insurance
companies, including direct writers of insurance coverage. Many of these
competitors are larger and have greater financial, technical and operating
resources. The property and casualty insurance industry is highly competitive
on the basis of both price and service. There are many companies competing for
the same insurance customers in the geographic areas in which the Company
operates. If the Company's competitors price their premiums more aggressively
and the Company meets their pricing, this may adversely affect the Company's
underwriting results. In addition, because the Company's insurance products
are marketed through independent insurance agencies, which represent more than
one insurance company, the Company faces competition within each agency.
The Company also faces competition from the implementation of self-
insurance in the commercial insurance area. Many of the Company's customers
and potential customers are examining the risks of self-insuring as an
alternative to traditional insurance. The Company also faces potential
competition from banks. Recent changes in laws permit banks to engage in non-
banking, financial service businesses, such as the underwriting of insurance.
These changes allow banks to compete directly with the Company by selling
insurance through their own insurance agencies.
Regulation. The Company is subject to extensive supervision and regulation
in the states in which it operates. The supervision and regulation relate to
numerous aspects of its business and financial condition. The primary purpose
of the supervision and regulation is the protection of the Company's insurance
policyholders, and not the Company's shareholders or other investors. The
extent of regulation varies, but generally is derived from state statutes.
These statutes delegate regulatory, supervisory and administrative authority
to state insurance departments. The regulations or the state insurance
departments may impede the Company from obtaining rate increases or taking
other actions the Company might wish to take to increase its profitability.
State insurance
16
<PAGE>
laws require prior approval by state insurance departments of any acquisition
of control of a domestic insurance company or of any company which controls a
domestic insurance company. "Control" is generally presumed to exist through
the ownership of 10% or more of the voting securities of a domestic insurance
company or of any company which controls a domestic insurance company. Any
purchaser of 10% or more of the outstanding shares of the Company's Common
Stock will be presumed to have acquired control of its subsidiaries unless the
relevant insurance commissioner determines otherwise. Accordingly, any
purchase of 10% or more of the Company's outstanding Common Stock would
require prior action by all or some of the insurance commissioners in the home
states of the Company's insurance subsidiaries.
Restrictions on Dividends. As an insurance holding company, the Company's
principal assets consist of the capital stock of its insurance subsidiaries.
The Company cannot declare cash dividends on the Common Stock unless its
insurance subsidiaries can pay cash dividends. The Company's insurance
subsidiaries may only pay dividends if they are permitted to do so under the
insurance regulations of their domiciliary states. All of the domiciliary
states of the Company's insurance subsidiaries regulate the payment of
dividends. In addition, these regulations may adversely affect the Company's
ability to pay its expenses and debts.
Industry. Historically, the property and casualty insurance industry has
been cyclical. Except for certain segments of the industry that have recently
shown signs of a hardening market, the industry generally has been in a
downturn for years, which resulted in a decline in premium rates. The decline
in premium rates adversely affected the Company's underwriting results.
Furthermore, unpredictable developments affect the industry's profitability.
These developments include natural disasters, fluctuations in interest rates
and other changes in the investment environment that affect returns on the
Company's investments, inflationary pressures that affect the size of losses,
and judicial decisions that affect insurers' liabilities. The demand for
property and casualty insurance, particularly commercial lines, can also vary
with the overall level of economic activity.
Certain Anti-takeover Effects. Certain provisions of the Company's
organizational documents may discourage, delay or prevent a change of control
of the Company. These include, among others, provisions in the Company's
Amended and Restated Certificate of Incorporation and Bylaws relating to
staggered terms for directors, notice requirements for stockholders proposing
director nominations or bringing business before stockholder meetings and the
ability of the Board of Directors to issue "blank check" preferred stock
without stockholder approval. These provisions could have the effect of
depriving stockholders of an opportunity to receive a premium over the
prevailing market price in the event of an attempted hostile takeover.
ITEM 2: Properties.
The Company owns its principal executive offices in Lawrenceville, New
Jersey, which has 53,220 square feet of office space. In addition, it leases
its offices in Houston, Texas and has operating leases for its regional
offices. The Company believes that it has adequate space for its current
operations and to accommodate expansion.
ITEM 3: Legal Proceedings.
None.
ITEM 4: Submission of Matters to a Vote of Security Holders.
None.
17
<PAGE>
PART II
ITEM 5: Market for Company's Common Stock and Related Stockholder Matters.
The Company's Common Stock is listed on the New York Stock Exchange
("NYSE") under the trading symbol "HIC." As of March 13, 2000, approximately
13,966,017 shares of Common Stock were issued and outstanding, 302,605 of
which are held by subsidiaries of the Company. In addition, 1,200,000 shares
of Common Stock are reserved for issuance pursuant to restricted stock grants
and options granted or to be granted pursuant to the 1995 Stock Option Plan
and the 1995 Directors' Stock Plan. See Item 11: "Executive Compensation."
The following table sets forth, for the calendar periods indicated, the
high and low per share sale prices of the Common Stock as reported in NYSE--
Composite Transactions.
<TABLE>
<CAPTION>
Period High Low
------------------------------------------------------------- ------ -----
<S> <C> <C>
1998 First Quarter........................................... $28.13 23.38
1998 Second Quarter.......................................... $28.88 17.88
1998 Third Quarter........................................... $18.88 11.81
1998 Fourth Quarter.......................................... $13.19 9.75
1999 First Quarter........................................... $14.94 10.56
1999 Second Quarter.......................................... $13.25 10.25
1999 Third Quarter........................................... $10.94 8.25
1999 Fourth Quarter.......................................... $ 9.69 6.75
</TABLE>
The approximate number of stockholders of record of Common Stock as of
March 13, 2000 was 5,039.
Dividends. The Company has not previously paid any dividends and currently
does not intend to pay dividends on the Common Stock. This policy, however,
will be reconsidered from time to time by the Board of Directors of the
Company. The Company's ability to pay dividends in the future will depend upon
its financial performance and other factors that are not presently
determinable. The Company's Credit Agreement with its lending banks prohibits
the payment of cash dividends by the Company and the Company's 10% Convertible
Subordinated Debentures due December 31, 2005 (the "Debentures") contain
covenants restricting the payment of dividends in excess of specified amounts.
As described above, the payment of dividends to the Company by its U.S.
insurance subsidiaries is subject to certain limitations under insurance laws.
Unregistered Sales of Securities. On May 10, 1999 the Company sold in a
private transaction for cash 454,546 shares of its Common Stock at $11.00 per
share, which was the closing price of the Common Stock on the New York Stock
Exchange, to Willis T. King, Jr., President and Chief Executive Officer of the
Company, pursuant to an Employment Agreement entered into between the Company
and Mr. King. The aggregate price for those shares was $5,000,000 and no
underwriting discounts or commissions were paid. That sale of Common Stock was
exempt from registration under the Securities Act of 1933 pursuant to Section
4(2) as a transaction not involving a public offering.
18
<PAGE>
ITEM 6: Selected Financial Data.
The following table summarizes certain selected historical consolidated
financial data with respect to the Company and is based upon the historical
consolidated financial statements of the Company. The information set forth
below should be read in conjunction with "Management's Discussion and Analysis
of Financial Condition and Results of Operations," and the Consolidated
Financial Statements and related notes thereto included elsewhere herein.
<TABLE>
<CAPTION>
Years Ended December 31,
---------------------------------------------------------
1999 1998 1997 1996 1995(1)
---------- --------- --------- --------- ---------
(dollars in thousands, except per share date)
<S> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Revenues:
Net premiums earned... $ 325,305 388,813 311,993 152,048 201,446
Net investment
income............... 67,684 77,969 74,383 50,988 48,529
Net realized
investment gains..... 22 16,874 5,585 1,199 2,618
---------- --------- --------- --------- ---------
Total revenues...... 393,011 483,656 391,961 204,235 252,593
Expenses:
Loss and loss
adjustment expense
incurred............. 238,940 328,400 246,479 156,589 300,253
Underwriting
expenses............. 130,121 141,788 115,564 56,487 73,905
Debt interest and
amortization
expense.............. 11,753 12,258 10,542 6,903 --
Loss on write-off of
subsidiary........... 10,452 -- -- -- --
Other expenses
(income), net........ 2,210 2,000 857 1,697 (823)
---------- --------- --------- --------- ---------
Total expenses...... 393,476 484,446 373,442 221,676 373,335
Income (loss) before
taxes.................. (465) (790) 18,519 (17,441) (120,742)
Income tax expense
(benefit)(2)........... 12,984 (3,887) 1,683 (12,098) --
---------- --------- --------- --------- ---------
Net income (loss)(2).... $ (13,449) 3,097 16,836 (5,343) (120,742)
========== ========= ========= ========= =========
Earnings (loss) per
common share(3):
Basic................. $ (1.04) .24 1.34 (.47) (10.55)
Diluted............... $ (1.04) .20 1.09 (.47) (10.55)
Balance Sheet Data (at
end of period):
Investments, cash and
cash equivalents....... $ 870,455 1,096,147 1,232,917 760,618 720,746
Receivable from
reinsurers............. $ 684,525 787,344 723,114 556,900 602,380
Total assets.......... $1,961,287 2,265,043 2,366,656 1,566,031 1,636,091
Loss and loss adjustment
expense reserves....... $1,353,524 1,603,548 1,605,374 1,156,824 1,253,627
Mandatorily redeemable
preferred stock........ $ 4,641 -- -- -- --
Stockholders' equity.... $ 264,401 318,554 329,293 263,475 267,110
Certain Financial Ratios
and Other Data:
GAAP:
Loss ratio............ 73.5% 84.4% 79.0% 103.0% 149.0%
Expense ratio......... 40.0 36.5 37.0 37.1 36.7
---------- --------- --------- --------- ---------
Combined ratio...... 113.5% 120.9% 116.0% 140.1% 185.7%
========== ========= ========= ========= =========
Statutory surplus....... $ 270,783 313,542 333,141 188,527 180,020
Net premiums written to
policyholder surplus... 1.2x 1.2x 1.2x(4) 0.8x 1.1x
</TABLE>
- --------
(1) The Company recorded a charge to pre-tax earnings during the year ended
December 31, 1995 of $125 million for loss and loss adjustment expenses
and other legal accruals.
19
<PAGE>
(2) The Company provides for income taxes in its statements of operations
pursuant to Financial Accounting Standards Board Statement of Financial
Accounting Standards No. ("SFAS") 109, "Accounting for Income Taxes." With
respect to losses for periods preceding the Distribution, no tax benefits
were recorded in the statements of operations pursuant to SFAS 109 due to
the Company's tax-sharing agreement with its former parent, Halliburton.
Tax receipts under its intercompany tax-sharing arrangements with
Halliburton were recorded as additions to stockholders' equity for the
periods preceding the Distribution. For further information regarding
federal and foreign income taxes, see Note 7 to Consolidated Financial
Statements.
(3) The earnings per share amounts prior to 1997 have been restated to comply
with SFAS No. 128, "Earnings Per Share." Earnings (loss) per share for
periods preceding the Distribution have been computed based upon the
11,448,208 shares of Company Common Stock distributed on January 23, 1996.
(4) Includes twelve months pro forma net premiums written for American
Reliance.
ITEM 7: Management's Discussion and Analysis of Financial Condition and
Results of Operations.
The Industry
The property and casualty insurance industry's profitability may be
affected significantly by the availability of insurance coverage, which varies
according to levels of surplus in the industry, volatile and unpredictable
developments, including natural and man-made disasters (such as hurricanes,
windstorms, earthquakes, blizzards, fires and explosions), fluctuations in
interest rates and other changes in the investment environment that affect
market prices of insurance companies' investments and the income from those
investments, inflationary pressures that may tend to affect the size of losses
and judicial, legislative and regulatory decisions affecting insurers'
liabilities. The demand for property and casualty insurance can also vary
significantly, generally rising as the overall level of economic activity
increases and falling as such activity decreases. Price competition has also
been enhanced by a flight of commercial insureds to alternative risk
mechanisms, often including a degree of self insurance.
The industry has experienced the effects of a number of well publicized
catastrophic events in recent years, some of which have affected the Company.
Growth in liabilities related to asbestos and environmental risks has also
adversely affected the industry and is of significance to the Company. See "--
Results of Operations--Loss and Loss Adjustment Expense Reserves" below.
Property and casualty insurers are regulated by the various state insurance
departments that coordinate their efforts through the NAIC. See "Business--
Regulation." Regulation includes rate and policy form approval, licensing of
insurance agents and companies and solvency oversight.
20
<PAGE>
Results of Operations
As discussed in Note 2 to the Consolidated Financial Statements, on April
30, 1997, the Company completed the acquisition of Vik Brothers Insurance,
Inc., renamed American Reliance, Inc. ("American Reliance"). The acquisition
was accounted for under the purchase method of accounting and, accordingly,
the consolidated financial statements include the results of American
Reliance's operations only from date of acquisition. The results of the
Company's consolidated operations for the periods indicated are set forth
below:
<TABLE>
<CAPTION>
Years Ended December
31,
-----------------------
1999 1998 1997
------- ------ ------
(dollars in millions,
except per share
data)
<S> <C> <C> <C>
Consolidated Results:
Gross premiums written........................... $ 364.1 378.1 346.0
Net premiums written............................. $ 333.6 374.8 277.7
======= ====== ======
Net premiums earned.............................. $ 325.3 388.8 312.0
Loss and loss adjustment expense................. (238.9) (328.4) (246.5)
Underwriting expenses............................ (130.1) (141.8) (115.6)
------- ------ ------
Underwriting loss................................ (43.7) (81.4) (50.1)
Net investment income............................ 67.7 78.0 74.4
Net realized investment gains.................... -- 16.9 5.6
Debt interest and amortization expense........... (11.8) (12.3) (10.5)
Loss on write-off of subsidiary.................. (10.5) -- --
Other expenses, net.............................. (2.2) (2.0) (0.9)
------- ------ ------
Income (loss) before income taxes................ (0.5) (0.8) 18.5
Income tax expense (benefit)..................... 12.9 (3.9) 1.7
------- ------ ------
Net income (loss)................................ $ (13.4) 3.1 16.8
======= ====== ======
Earnings (loss) per share:
Basic.......................................... $ (1.04) .24 1.34
Diluted........................................ $ (1.04) .20 1.09
Ratios:
Loss........................................... 73.5% 84.4% 79.0%
Expense........................................ 40.0 36.5 37.0
------- ------ ------
Combined....................................... 113.5% 120.9% 116.0%
======= ====== ======
</TABLE>
Period to Period Comparisons
Gross Premiums Written. Gross premiums written for 1999, 1998 and 1997 were
$364.1 million, $378.1 million and $346.0 million, respectively. The decrease
of $14.0 million or 3.7% in 1999 compared to 1998 is due primarily to three
factors. First, the Company continues to focus on underwriting standards and
adequate pricing during a period of competitive pricing in both commercial and
personal lines. Second, service disruptions 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 in 1999 to
place business with the Company. The Company believes that these service
disruptions were eliminated in 1999 and the related premium decline ended
during the second half of 1999. Finally, the reduction in the A.M. Best rating
of Highlands to B++ from A-, announced by A.M. Best in June 1998, caused a
decline in premium production as certain agents were unwilling to use a B++
market. In 1998, the Company entered into an agreement with an insurance
company to provide certain of its customers access to A+ paper, and in 1999
the Company entered into new arrangements with three other companies, rated A+
to A-. These agreements were entered into to mitigate the impact of A.M.
Best's rating change for Highlands.
21
<PAGE>
Gross premiums written for 1998 increased $32.1 million compared to 1997.
The 1998 amount includes an additional $63.4 million of gross premiums written
because the 1997 American Reliance acquisition was accounted for as a purchase
and 1997 included only eight months of its gross premiums written. Using full
year 1997 gross premiums written for American Reliance produces a decline in
1998 of approximately 19.7% due primarily to the same issues impacting the
decline in 1999 gross premiums written, as noted above. The declines were
partially offset by approximately $15.3 million of unusually large increases
in premiums under retrospectively rated policies.
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 insurance policies reduce but do not
eliminate risk to the insurer.
Net Premiums Written. Net premiums written for 1999, 1998 and 1997 were
$333.6 million, $374.8 million, and $277.7 million, respectively. The decrease
in 1999 compared to 1998 is primarily related to a non-recurring additional
premium in 1998 of $34.6 million associated with the Company's termination of
an Aggregate Excess of Loss Reinsurance Agreement ("Stop Loss Agreement"). The
remaining decrease of $6.6 million in 1999 is related to the same issues
affecting gross premiums written.
Net premiums written for 1998 increased $97.1 million compared to 1997 due
to the 1998 non-recurring additional premium associated with the Stop Loss
Agreement and the inclusion of American Reliance for the full year 1998.
Excluding the Stop Loss Agreement and comparing the American Reliance business
on a full-year 1997 basis, net premiums written for 1998 declined 6% compared
to 1997 for the same reasons noted for gross premiums written.
Net Premiums Earned. Net premiums earned for 1999, 1998 and 1997 were
$325.3 million, $388.8 million and $312.0 million, respectively. The decrease
in 1999 compared to 1998 is related to the same items affecting gross and net
premiums written as noted above including the 1998 termination of the Stop
Loss Agreement, which increased reported net earned premiums in 1998 by $34.6
million. Net premiums earned increased in 1998 compared to 1997 due to the
premium associated with the termination of the Stop Loss Agreement and the
inclusion of American Reliance for the full year 1998.
Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense
incurred for 1999, 1998 and 1997 were $238.9 million, $328.4 million and
$246.5 million, respectively. The loss and loss adjustment expense ratios for
1999, 1998, and 1997 were 73.5%, 84.4% and 79.0%, respectively. The decrease
in 1999 of $89.5 million compared to 1998 was primarily attributable to three
factors. First, the 1998 termination of the Stop Loss Agreement noted above
had the effect of increasing loss and loss adjustment expenses reported in
1998 by $50.0 million. Second, in 1999, the Company experienced a decrease in
loss and loss adjustment expenses of $19.1 million related to California
construction defect claims because, in 1999, the Company recorded additional
reinsurance recoverables for previously unbilled paid losses of $11.1 million
related to California construction defect claims, while in 1998, the Company
had $8.0 million of unfavorable reserve development for these claims. Third,
the Company experienced a decrease in loss and loss adjustment expenses of
approximately $4.1 million related to weather related catastrophe losses.
Finally, in 1998, there were higher incurred losses subject to retrospectively
rated policies.
Loss and loss adjustment expenses incurred for 1998 increased $81.9 million
compared to 1997 primarily due to: $50 million of reserve increases associated
with the 1998 termination of the Stop Loss Agreement; an increase in weather
related catastrophe losses of $12.1 million; an increase in California
construction defect losses of $1.9 million; higher incurred losses on
retrospectively rated polices; and the inclusion of American Reliance for the
full year 1998.
22
<PAGE>
Underwriting Expenses. Underwriting expenses for 1999, 1998 and 1997 were
$130.1 million, $141.8 million and $115.6 million, respectively. The
underwriting expense ratio for 1999, 1998 and 1997 was 40.0%, 36.5% and 37.0%,
respectively. Elimination of the 1998 non-recurring additional premium related
to the Stop Loss Agreement and certain unusually large 1998 retrospectively
rated policy adjustments resulted in an adjusted expense ratio of 41.8% for
1998.
The decline in the 1999 underwriting expense ratio, compared to the
adjusted 1998 expense ratio, is the result of the Company's 1999 expense
saving initiatives. During 1999, the Company realized expense savings of $2.4
million due to the 1998 termination of the Stop Loss Agreement and $1.6
million related to restructuring a system vendor agreement. These savings were
partially offset by a restructuring charge in the amount of $780,000 and
additional expenses associated with the Company's 1999 system integration
projects.
The underwriting expense ratio for 1998 increased compared to 1997
(adjusted 41.8% compared to 37%) due to the higher costs associated with
problems relating to the implementation of a policy issuance system and the
resulting decrease in premium volume.
Investment Results. Net investment income for 1999, 1998 and 1997 was $67.7
million, $78.0 million and $74.4 million, respectively. Net investment income
decreased $10.3 million in 1999 compared to 1998 due to declining premium
volume in 1999 and 1998, continued reduction of the investment portfolio due
to the payment of older loss reserves, lower investment yield rates in 1999
and the 1998 repurchase of Company common stock. Net investment income for
1998 increased $3.6 million compared to 1997 due to the inclusion of American
Reliance for the full year 1998. The 1998 investment income was partially
offset by lower interest rates in 1998 and a reduction of the investment
portfolio due to payment of older loss reserves.
Debt Interest and Amortization Expense. Debt interest and amortization
expense for 1999 compared to 1998 decreased approximately $500,000 due to the
mid-year paydown of $6.0 million of senior bank debt offset somewhat by higher
interest rates. Debt and amortization expense increased in 1998 compared to
1997 as a result of the senior bank debt being outstanding for the full year
in 1998 versus eight months in 1997.
Loss on Write-off of Subsidiary. The Company wrote-off its remaining
investment in LMI which has been in run-off since April 1997 when it was
acquired in the purchase of American Reliance. In March 2000, the Court of
Common Pleas in Franklin County, Ohio entered an Order appointing the
Superintendent of Insurance of the State of Ohio as the Rehabilitator of LMI.
As Rehabilitator, the Superintendent is by operation of law vested with
control of LMI, including title to all of LMI's assets.
Other Expenses, Net. Other expenses consist of parent company expenses and
miscellaneous expenses from the insurance subsidiaries offset by miscellaneous
income.
Income Taxes. The total tax expense for 1999 was $13.0 million. The Company
recorded a charge totaling $11.6 million of deferred taxes related to the
write-off of LMI. Based upon the year-end assessment of the value of LMI and
the fact that it will no longer be a member of the Company's consolidated tax
group, it was determined that deferred tax assets associated with LMI would
not be recoverable by the Company. Excluding the write-off of LMI and its
associated deferred tax assets, the Company's effective tax rates for 1999,
1998 and 1997 reflect the amount of investment income from tax advantaged
fixed income securities, the magnitude of the underwriting loss in relation to
net taxable investment income and the impact of alternative minimum tax. The
Company recorded a tax benefit of $3.9 million in 1998 and a tax expense of
$1.7 million in 1997.
23
<PAGE>
Loss and Loss Adjustment Expense Reserves
Underwriting results of the property and casualty industry are
significantly influenced by estimates of loss and loss adjustment expense
reserves. (See Note 11 to the Consolidated Financial Statements.) These
reserves are an accumulation of the estimated amounts necessary to settle and
pay all outstanding and unreported claims including loss adjustment expenses,
net of estimated claim recoveries. The case reserve estimates for reported
claims are based upon the facts of each case and the Company's experience with
similar cases. Consideration is given to historical trends regarding reserving
patterns, changes in the Company's operations (such as underwriting and claims
handling), loss payments, and the effects of court decisions, economic
conditions and public attitudes. The process of establishing reserves is
imprecise involving significant judgment and assumptions. As information
develops that varies from experience, provides additional data or, in some
cases, augments data that previously was not considered sufficient for use in
determining reserves, changes in the Company's estimate of ultimate
liabilities may be required. Changes in prior year reserve estimates (net of
reinsurance), which may be material, are reflected in the results of
operations in the period such changes are determined to be required.
During the last several years, the Company has experienced significant
adverse development on prior years net ultimate loss estimates. The following
table sets forth the amount of the adverse development for the periods
indicated.
<TABLE>
<CAPTION>
Years ended
December 31,
----------------
1999 1998 1997
----- ---- ----
(dollars in
millions)
<S> <C> <C> <C>
Net reserve re-estimates due to:
Stop Loss Agreement.................................... $ -- 50.0 --
Asbestos and environmental............................. 1.8 19.1 5.4
All other.............................................. (9.9) 2.8 11.0
----- ---- ----
Net adverse development................................ $(8.1) 71.9 16.4
===== ==== ====
</TABLE>
As a result of changes in estimates of insured events in prior years,
primarily asbestos and environmental claims, construction defect claims and
catastrophe claims, and the effects of the termination of the Stop Loss
Agreement in 1998, the provision for loss and loss adjustment expense incurred
(net of reinsurance recoveries of $20.6 million, $69.3 million and $112.5
million for 1999, 1998 and 1997, respectively) decreased by $8.1 million in
1999 and increased $71.9 million in 1998 and $16.4 million in 1997. The
principal reason for the loss reserve development in 1998 was the termination
of the Stop Loss Agreement. In addition, the emergence of environmental,
asbestos and construction defect claims over the last few years and the
difficulty in accurately estimating the necessary reserves have significantly
contributed to the Company's loss reserve development over the three year
period.
The Company's loss and loss adjustment expense reserves are reviewed at
each year end by the Company's actuaries and external independent actuaries in
connection with the process of establishing the Company's reserve position.
Liquidity and Capital Resources
Highlands Group is a holding company, the principal assets of which at
December 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.
24
<PAGE>
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 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
$10.0 million. The Company and its lenders have amended the Credit Agreement
to amend certain financial covenants and to provide for the payment of $10.0
million in principal during 2000. The Company is in compliance with the
amended covenants in the Credit Agreement. 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
approximately $30.9 million in 2000 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 tax sharing
payments and dividends available from its subsidiaries will enable it to meet
its liquidity needs for the next year.
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.
Statutory Surplus. Maintenance of appropriate levels of statutory surplus
of the Company's United States domiciled insurance subsidiaries is a primary
objective of the Company and is also important to regulatory authorities and
insurance rating agencies. In addition, increased public and regulatory
concerns regarding the financial stability of participants in the insurance
industry have caused greater emphasis to be placed by current and potential
customers upon the ratings assigned to property and casualty insurance
companies. The Company's principal insurance subsidiaries have been assigned
an A.M. Best secure rating of "B++" (Very Good).
The following table sets forth certain information with respect to the
Company's combined statutory surplus ("U.S. Insurance Subsidiaries") at the
dates indicated.
<TABLE>
<CAPTION>
December 31,
----------------------
1999 1998
---------- ----------
(dollars in millions)
<S> <C> <C>
Statutory surplus................................. $270.8 $313.5
Net premiums written to surplus ratio............. 1.2x 1.2x
</TABLE>
25
<PAGE>
Reinsurance Receivables. The Company monitors the financial condition of
the reinsurance companies with which it places significant reinsurance
coverage and strives to place current reinsurance coverages with financially
sound reinsurance companies. In the past, the Company has placed reinsurance
coverage with several hundred reinsurance companies. It monitors the financial
condition of many of such companies only on a periodic basis. A number of such
companies are in runoff or have ceased writing reinsurance and some have
become insolvent. The Company's ability to monitor the financial condition of
some reinsurance companies is limited because of the difficulty of acquiring
accurate and timely information.
Based on the Company's evaluation of the financial condition of its
reinsurers, the Company has established reserves for potentially uncollectible
reinsurance of $2.2 million and $1.7 million as of December 31, 1999 and 1998,
respectively. Additionally, the Company has retained $22.9 million and $22.3
million of ceded reserves related to potentially uncollectible reinsurance at
December 31, 1999 and 1998. With respect to carriers that are not authorized
reinsurers as determined by the appropriate department of insurance, the
Company often receives collateral primarily in the form of bank letters of
credit generally securing the reinsurance recoverable regarding reported
losses and in some instances unreported losses. At December 31, 1999, such
collateral totaled approximately $15.7 million. The Company's three largest
reinsurance recoverable exposures at December 31, 1999 were approximately
$137.9 million with underwriting syndicates at Equitas/Lloyds (Highlands
(U.K.) $87.2 million and U.S. insurance subsidiaries $50.7 million), $90.9
million with American Re-Insurance Company and $64.0 million with General
Reinsurance Company. American Re-Insurance Company and with General
Reinsurance Company are rated by A. M. Best "A+" and "A++", respectively.
Year 2000
Over the past two years, the Company formalized and implemented a
comprehensive plan to address the Year 2000 problem which encompassed its
products, vendors, customers, technical infrastructure, facilities,
telecommunications and business systems. In this process, the Company expended
approximately $3.4 million. These amounts exclude the cost of system upgrades
that were required to be made to meet other operational requirements.
As of the date of this filing, the Company has not experienced any Year
2000 problems that have materially affected its operations, the realization of
financial assets, or its results of operations. The Company will continue to
monitor its operations for non-compliant components. The Company is also
monitoring its open transactions with customers and vendors to ensure that
there are no undetected Year 2000 problems that could have a material adverse
effect on the Company or its operations.
Forward Looking Information
The statements included in this 1999 Annual Report regarding future
financial performance and results and other statements that are not historical
facts are forward-looking statements. The words "expect," "project,"
"estimate," "predict," "anticipate," "believes" and similar expressions are
also intended to identify forward-looking statements. Such statements are
subject to numerous risks, uncertainties and assumptions, including but not
limited to, the uncertainties relating to industry and market conditions,
natural disasters and other catastrophes, and other risks and uncertainties
described in this 1999 Annual Report and in the Company's other filings with
the Securities and Exchange Commission. Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual outcomes may vary materially from those indicated.
ITEM 7A: Quantitative and Qualitative Disclosures about Market Risk.
Market Risk
Market risk is the risk of lower securities and portfolio values resulting
from adverse changes in interest rates, foreign currency exchange rates and
other relevant market rate or price changes. The Company's investment strategy
is to maximize income and total return by investing in a diverse portfolio of
high-quality
26
<PAGE>
investment grade securities. The carrying value of the Company's investment
portfolio as of December 31, 1999 and 1998 was $792.2 million and $1,025.4
million, respectively. The primary market risk to the investment portfolio is
interest rate risk associated with investments in fixed maturity securities.
The Company's exposure to equity price risk and foreign exchange risk is not
material. The Company has no direct commodity risk.
The Company has exposure to market price declines resulting from increases
in interest rates. The Company attempts to mitigate its exposure to interest
rate risk through active portfolio management including limiting average
portfolio duration to approximately four and one-half years. Market prices for
all securities held are updated and reviewed monthly including estimates of
cash flows as well as the impact of interest rate fluctuations relating to the
Company's investment portfolio. For the Company's investment portfolio, there
were no significant changes in the Company's primary market risk exposures or
in how those exposures are managed for 1999 compared to 1998. The Company does
not currently anticipate significant changes in its primary market risk
exposures or in how those exposures are managed in future reporting periods
based upon what is known or expected to be in effect in future reporting
periods.
Sensitivity Analysis. Sensitivity analysis is defined as the measurement of
potential loss in future earnings, fair values or cash flows of market
sensitive instruments resulting from one or more selected hypothetical changes
in interest rates and other market rates or prices over a selected time. In
the Company's sensitivity analysis model, a hypothetical change in market
rates is selected that is expected to reflect reasonably possible changes in
those rates over a one-year period. Actual results may differ from the
hypothetical change in market rates assumed in this disclosure, especially
since this sensitivity analysis does not reflect the results of any actions
that would be taken by the Company to mitigate such hypothetical losses in
fair value. In this sensitivity analysis model, the Company uses fair values
to measure its potential loss. The sensitivity analysis model uses a 100 basis
point change in interest rates to measure the hypothetical change in fair
value of financial instruments included in the model. For this analysis, the
Company assumes an instantaneous shift in interest rates and that the
composition of its investment portfolio remains relatively constant. Also, the
Company assumes a change in interest rates is reflected uniformly across all
financial instruments even though interest rates on certain types of
instruments may fluctuate or lag behind other instruments.
The rates should not be considered a prediction by the Company of future
events. This analysis is not intended to provide a precise forecast of the
effect of changes in interest rates on the Company's income, cash flow and
stockholders' equity.
The sensitivity analysis model used by the Company produces a loss in fair
value of market sensitive instruments of $37.4 million and $62.4 million based
on a 100 basis point increase in interest rates as of December 31, 1999 and
1998, respectively. This loss value only reflects the impact of an interest
rate increase on the fair value of the Company's financial instruments, which
constitute approximately 40.4% of total assets and approximately 46.8% of
total liabilities as of December 31, 1999 and approximately 45.3% of total
assets and approximately 52.7% of total liabilities as of December 31, 1998.
As a result, the loss value excludes a significant portion of the Company's
consolidated balance sheet which would materially mitigate the impact of the
loss in fair value.
In addition to the above, the Company's Credit Agreement is also subject to
interest rate fluctuations. An increase in interest rates of 100 basis points
(1%) would result in additional annual interest expense of $650,000.
ITEM 8: Financial Statements and Supplemental Data.
The Consolidated Financial Statements are set forth herein beginning on
page F-1 of this Report.
ITEM 9: Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
None.
27
<PAGE>
PART III
ITEM 10: Directors and Executive Officers of the Registrant.
This item is omitted because a definitive proxy statement which involves
the election of directors and which contains the information required by this
item will be filed with the Securities and Exchange Commission not later than
120 days after the close of the fiscal year, and is incorporated herein by
reference.
ITEM 11: Executive Compensation.
This item is omitted because a definitive proxy statement which involves
the election of directors and which contains the information required by this
item will be filed with the Securities and Exchange Commission not later than
120 days after the close of the fiscal year, and is incorporated herein by
reference.
ITEM 12: Security Ownership of Certain Beneficial Owners and Management.
This item is omitted because a definitive proxy statement which involves
the election of directors and which contains the information required by this
item will be filed with the Securities and Exchange Commission not later than
120 days after the close of the fiscal year, and is incorporated herein by
reference.
ITEM 13: Certain Relationships and Related Transactions.
This item is omitted because a definitive proxy statement which involves
the election of directors and which contains the information required by this
item will be filed with the Securities and Exchange Commission not later than
120 days after the close of the fiscal year, and is incorporated herein by
reference.
28
<PAGE>
PART IV
ITEM 14: Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) (1) and (2) Financial Statements. The Consolidated Financial Statements
and Schedules are listed in the Index to Financial Statements on page F-1 and
are filed as part of this Report.
(a) (3) Exhibits.
<TABLE>
<C> <S>
*2.1 Amended and Restated Agreement and Plan of Merger among Highlands
Insurance Group, Inc., Highlands Acquisition Corp. and Vik Brothers
Insurance, Inc. dated as of February 13, 1997
*2.2 Amendment No. 1 to the Amended and Restated Plan of Merger dated March
10, 1997
+3.1 Amended and Restated Certificate of Incorporation of the Registrant
+3.2 Form of Amended and Restated Bylaws of the Registrant
+4.1 Form of Stock Certificate of Common Stock (See also Exhibits 3.1 and
3.2)
+4.2 Form of 10% Convertible Subordinated Debentures Due December 31, 2005
+4.3 Form of Common Stock Subscription Warrant, Series A
+4.4 Form of Common Stock Subscription Warrant, Series B
+4.5 Form of 10% Convertible Subordinated Debentures Due December 31, 2005,
Series 2
+4.6 Form of Common Stock Subscription Warrant, Series A-2
+4.7 Form of Common Stock Subscription Warrant, Series B-2
*4.8 Stockholders Agreement among Highlands Insurance Group, Inc., Insurance
Partners, L.P., Insurance Partners Offshore (Bermuda) L.P., The
Scandinavia Company, Erik M. Vik and Manoeuvre Ltd.
*4.9 Form of Amendment Number 1 to 10% Convertible Subordinated Debenture,
Due December 31, 2005 of Highlands Insurance Group, Inc.
*4.10 Form of Amendment Number 1 to 10% Convertible Subordinated Debenture,
Series 2, Due December 31, 2005 of Highlands Insurance Group, Inc.
*4.11 Form of Amendment Number 1 to Common Stock Subscription Warrant, Series
A
*4.12 Form of Amendment Number 1 to Common Stock Subscription Warrant, Series
B
*4.13 Form of Amendment Number 1 to Common Stock Subscription Warrant, Series
A-2
*4.14 Form of Amendment Number 1 to Common Stock Subscription Warrant, Series
B-2
*10.1 Credit Agreement among Highlands Insurance Group, Inc., Various Lending
Institutions and The Chase Manhattan Bank, as Administrative Agent,
dated April 30, 1997
+10.2 Form of Registration Rights Agreement among Insurance Partners, L.P.,
Insurance Partners Offshore (Bermuda), L.P. and the Registrant
+10.3 Form of 1995 Stock Option Plan
10.4 Restricted Stock Plan
+10.5 Form of Employment Agreement between the Registrant and Richard M.
Haverland
10.6 Retirement and Release Agreement between the Registrant and Richard M.
Haverland
+10.7 Form of Indemnification Agreement between the Registrant and each of
its directors
+10.8 Form of 1995 Directors' Stock Plan
+10.9 Amendatory Agreement dated as of November 9, 1995 among the Company,
Halliburton, the Investors, Robert A. Spass and Bradley E. Cooper
(amending the Investment Agreement)
</TABLE>
29
<PAGE>
<TABLE>
<C> <S>
+10.10 Form of note issued in consideration for the issuance by the
Registrant of 10% Convertible Subordinated Debentures Due December
31, 2005, Series 2, Common Stock Subscription Warrants, Series A-2,
and Common Stock Subscription Warrants, Series B-2
+10.11 Form of pledge agreement to secure the note filed as Exhibit 10.10
+10.12 Form of Purchase, Redemption and Bonus Agreement entered into between
the Company and the Management Investors with respect to the
Management Securities
***10.13 Agency Stock Purchase Plan
++10.14 Employee Stock Purchase Plan
++10.15 Employees' Retirement And Savings Plan
10.16 Amendment No. 1 to Employees' Retirement and Savings Plan
10.17 Amendment No. 2 to Employees' Retirement and Savings Plan
10.18 Employment Agreement between the Registrant and Willis T. King, Jr.
21 List of Subsidiaries
23 Consent of Independent Auditors
27 Financial Data Schedule (included only in the electronic data filing
of this document)
</TABLE>
- --------
+ Incorporated by reference to the Company's registration statement on Form
10 as filed with the Commission on January 4, 1996.
* Incorporated by reference to the Company's Report on Form 8-K, as amended,
dated April 30, 1997 as filed with the Commission.
** Incorporated by reference to the Company's Report on Form 10-K, for the
fiscal year ended December 31, 1998 as filed with the Commission.
*** Incorporated by reference to the Company's registration statement on Form
S-3 as filed with the Commission on May 1, 1998.
++ Incorporated by reference to the Company's registration statement on Form
S-8 as filed with the Commission on June 1, 1998
(b) Reports on Form 8-K during the quarter ended December 31, 1999.
None.
30
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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 on the 30th day of
March, 2000.
Highlands Insurance Group, Inc.
/s/ Willis T. King, Jr.
By: _________________________________
Willis T. King, Jr.
Chairman, President and Chief
Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ Willis T. King, Jr. Chairman, President and March 30, 2000
______________________________________ Chief Executive Officer
Willis T. King, Jr.
/s/ Charles J. Bachand Vice President, Treasurer March 30, 2000
______________________________________ and Principal Financial
Charles J. Bachand and Accounting Officer
/s/ Robert A. Spass Director March 30, 2000
______________________________________
Robert A. Spass
/s/ Bradley E. Cooper Director March 30, 2000
______________________________________
Bradley E. Cooper
/s/ W. Bernard Pieper Director March 30, 2000
______________________________________
W. Bernard Pieper
/s/ Kenneth S. Crews Director March 30, 2000
______________________________________
Kenneth S. Crews
/s/ Philip J. Hawk Director March 30, 2000
______________________________________
Philip J. Hawk
/s/ Robert W. Shower Director March 30, 2000
______________________________________
Robert W. Shower
/s/ Richard M. Haverland Director March 30, 2000
______________________________________
Richard M. Haverland
</TABLE>
31
<PAGE>
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
<TABLE>
<CAPTION>
Page
----
<S> <C>
Audited Financial Statements
Report of Independent Public Accountants................................. F-2
Consolidated Balance Sheets as of December 31, 1999 and 1998............. F-3
Consolidated Statements of Operations for the Years Ended December 31,
1999, 1998 and 1997..................................................... F-4
Consolidated Statements of Stockholders' Equity for the Years Ended
December 31, 1999, 1998 and 1997........................................ F-5
Consolidated Statements of Comprehensive Income for the Years Ended
December 31, 1999, 1998 and 1997........................................ F-6
Consolidated Statements of Cash Flows for the Years Ended December 31,
1999, 1998 and 1997..................................................... F-7
Notes to the Consolidated Financial Statements........................... F-8
Financial Statement Schedules
Schedule I--Summary of Investments Other Than Investments in Related
Parties--
December 31, 1999....................................................... F-27
Schedule II--Condensed Financial Information of Registrant (Parent
Company only):
Balance Sheets--As of December 31, 1999 and 1998....................... F-28
Statements of Operations--For the Years Ended December 31, 1999, 1998
and 1997.............................................................. F-29
Statements of Cash Flows--For the Years Ended December 31, 1999, 1998
and 1997.............................................................. F-30
Schedule III--Supplementary Insurance Information--As of and For the
Years Ended December 31, 1999, 1998 and 1997............................ F-31
Schedule IV--Reinsurance--For the Years Ended December 31, 1999, 1998 and
1997.................................................................... F-32
Schedule V--Valuation and Qualifying Accounts--For the Years Ended
December 31, 1999, 1998 and 1997........................................ F-33
Schedule VI--Supplemental Information Concerning Consolidated
Property/Casualty Insurance
Operations--As of and For the Years Ended December 31, 1999, 1998 and
1997.................................................................... F-34
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors
Highlands Insurance Group, Inc.:
We have audited the consolidated financial statements of Highlands
Insurance Group, Inc. and subsidiaries (the Company) as listed in the
accompanying index. In connection with our audits of the consolidated
financial statements, we also audited the financial statement schedules as
listed in the accompanying index. These consolidated financial statements and
financial statement schedules are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Highlands
Insurance Group, Inc. and subsidiaries as of December 31, 1999 and 1998 and
the results of their operations and their cash flows for each of the years in
the three-year period ended December 31, 1999 in conformity with generally
accepted accounting principles. Also in our opinion, the related financial
statement schedules, when considered in relation to the basic consolidated
financial statements taken as a whole, present fairly, in all material
respects, the information set forth therein.
KPMG LLP
Houston, Texas
March 9, 2000, except as to note 4, which is as of March 20, 2000
F-2
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1999 AND 1998
(in thousands)
<TABLE>
<CAPTION>
ASSETS 1999 1998
------ ---------- ---------
<S> <C> <C>
Investments:
Fixed maturity securities available-for-sale, at fair
value (amortized cost of $802,594 in 1999 and
$975,858 in 1998).................................... $ 762,478 1,001,236
Equity securities, at fair value (cost of $31,376 in
1999 and $20,585 in 1998)............................ 26,594 21,057
Other investments, at cost............................ 3,100 3,107
---------- ---------
Total investments................................... 792,172 1,025,400
Cash and cash equivalents............................... 78,283 70,747
Premiums in course of collection, net................... 56,574 51,138
Premiums due under retrospective policies............... 142,849 144,613
Receivable from reinsurers.............................. 684,525 787,344
Prepaid reinsurance premiums............................ 3,777 2,523
Funds on deposit with reinsurers........................ 17,534 17,873
Net deferred tax asset.................................. 82,536 70,433
Accrued investment income............................... 11,396 13,916
Deferred policy acquisition costs....................... 33,556 31,537
Other assets............................................ 58,085 49,519
---------- ---------
Total assets........................................ $1,961,287 2,265,043
========== =========
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
<S> <C> <C>
Loss and loss adjustment expense reserves............... $1,353,524 1,603,548
Unearned premiums....................................... 146,832 137,353
Senior bank debt........................................ 59,004 65,000
Convertible subordinated debentures..................... 57,816 57,017
Accounts payable and accrued liabilities................ 75,069 83,571
---------- ---------
Total liabilities................................... 1,692,245 1,946,489
---------- ---------
Mandatorily redeemable preferred stock.................. 4,641 --
---------- ---------
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares
authorized, 13,957,303 shares issued and outstanding
in 1999, 13,235,316 shares issued and outstanding in
1998................................................. 140 132
Additional paid-in capital............................ 231,515 223,976
Accumulated other comprehensive (loss) income......... (29,184) 16,803
Treasury stock, at cost (739,400 shares in 1999 and
724,400 shares in1998)............................... (9,459) (9,268)
Deferred compensation on restricted stock............. (3,147) (1,074)
Retained earnings..................................... 74,536 87,985
---------- ---------
Total stockholders' equity.......................... 264,401 318,554
---------- ---------
Total liabilities, mandatorily redeemable preferred
securities and stockholders' equity................ $1,961,287 2,265,043
========== =========
</TABLE>
The accompanying notes to the consolidated financial statements are an integral
part of these statements.
F-3
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
(in thousands, except per common share data)
<TABLE>
<CAPTION>
1999 1998 1997
-------- ------- -------
<S> <C> <C> <C>
Revenues:
Net premiums earned.............................. $325,305 388,813 311,993
Net investment income............................ 67,684 77,969 74,383
Net realized investment gains.................... 22 16,874 5,585
-------- ------- -------
Total revenues................................. 393,011 483,656 391,961
-------- ------- -------
Expenses:
Loss and loss adjustment expense incurred........ 238,940 328,400 246,479
Underwriting expenses............................ 130,121 141,788 115,564
Debt interest and amortization expense........... 11,753 12,258 10,542
Loss on write-off of subsidiary.................. 10,452 -- --
Other expenses (income), net..................... 2,210 2,000 857
-------- ------- -------
Total expenses................................. 393,476 484,446 373,442
-------- ------- -------
Income (loss) before income taxes.................. (465) (790) 18,519
Income tax expense (benefit)....................... 12,984 (3,887) 1,683
-------- ------- -------
Net income (loss).............................. $(13,449) 3,097 16,836
======== ======= =======
Earnings (loss) per common share:
Basic............................................ $ (1.04) .24 1.34
Diluted.......................................... $ (1.04) .20 1.09
Weighted average number of common shares
outstanding:
Basic............................................ 12,956 13,095 12,600
Diluted.......................................... 12,956 15,811 15,388
</TABLE>
The accompanying notes to the consolidated financial statements are an integral
part of these statements.
F-4
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
(in thousands)
<TABLE>
<CAPTION>
1999 1998 1997
-------- ------- -------
<S> <C> <C> <C>
Common Stock:
Balance, beginning of year......................... $ 132 132 114
Issuance of common stock, par value............... 8 -- 18
-------- ------- -------
Balance, end of year............................... 140 132 132
-------- ------- -------
Additional paid-in capital:
Balance, beginning of year......................... 223,976 223,460 192,273
Issuance of common stock, paid in capital......... 7,539 516 31,187
-------- ------- -------
Balance, end of year............................... 231,515 223,976 223,460
-------- ------- -------
Accumulated other comprehensive (loss) income:
Balance, beginning of year......................... 16,803 22,278 3,036
Changes in net unrealized investment gains
(losses), net of tax............................. (46,138) (5,475) 19,242
Net unrealized investment losses of written-off
subsidiary, net of tax.......................... 151 -- --
-------- ------- -------
Balance, end of year............................... (29,184) 16,803 22,278
-------- ------- -------
Treasury stock, at cost:
Balance, beginning of year......................... (9,268) -- --
Acquisition of treasury stock..................... (191) (9,268) --
-------- ------- -------
Balance, end of year............................... (9,459) (9,268) --
-------- ------- -------
Deferred compensation on restricted stock:
Balance, beginning of year......................... (1,074) (1,465) --
Net forfeitures (issuance) of restricted stock.... (2,073) 391 (1,465)
-------- ------- -------
Balance, end of year............................... (3,147) (1,074) (1,465)
-------- ------- -------
Retaining earnings:
Balance, beginning of year......................... 87,985 84,888 68,052
Net income (loss)................................. (13,449) 3,097 16,836
-------- ------- -------
Balance, end of year............................... 74,536 87,985 84,888
-------- ------- -------
Total stockholders' equity.......................... $264,401 318,554 329,293
======== ======= =======
</TABLE>
The accompanying notes to the consolidated financial statements are an
integral part of these statements.
F-5
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
(in thousands)
<TABLE>
<CAPTION>
1999 1998 1997
-------- ------- ------
<S> <C> <C> <C>
Net income (loss).................................... $(13,449) 3,097 16,836
-------- ------- ------
Other comprehensive (loss) income, net of taxes:
Increase (decrease) in unrealized gains (losses) on
investments net of taxes of $(24,836); $2,958; and
$12,316........................................... (46,124) 5,493 22,872
Reclassification adjustments for gains in net
income net of taxes of $(8); $(5,906); and
$(1,955).......................................... (14) (10,968) (3,630)
Net unrealized investment losses of written-off
subsidiary, net of taxes of $81; $0; and $0....... 151 -- --
-------- ------- ------
Other comprehensive income (loss), net of taxes.... (45,987) (5,475) 19,242
-------- ------- ------
Comprehensive income (loss).......................... $(59,436) (2,378) 36,078
======== ======= ======
</TABLE>
The accompanying notes to the consolidated financial statements are an integral
part of these statements.
F-6
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
(in thousands)
<TABLE>
<CAPTION>
1999 1998 1997
--------- -------- --------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss).............................. $ (13,449) 3,097 16,836
--------- -------- --------
Adjustments to reconcile net income (loss) to
net cash used in operating activities:
Depreciation and amortization................. 3,768 3,453 2,054
Net realized investment gains................. (22) (16,874) (5,585)
Write-off of subsidiary....................... 10,452 -- --
Deferred tax expense (benefit)................ 12,659 (3,443) 1,516
Change in:
Premiums in course of collection.............. (2,771) 33,839 19,972
Premiums due under retrospective policies..... 1,764 (14,463) (8,874)
Receivable from reinsurers.................... 60,407 (64,230) (303)
Prepaid reinsurance premiums.................. (1,254) 21,928 19,634
Funds on deposit with reinsurers.............. 339 2,299 (5,716)
Deferred policy acquisition costs............. (2,019) 776 3,623
Loss and loss adjustment expense reserves..... (189,740) (1,826) (72,170)
Unearned premiums............................. 9,554 (36,058) (36,019)
Funds held.................................... (4,983) (9,974) 7,548
Other operating assets and liabilities........ 2,304 (49,705) 2,513
--------- -------- --------
Total adjustments............................ (99,542) (134,278) (71,807)
--------- -------- --------
Net cash used in operating activities........ (112,991) (131,181) (54,971)
--------- -------- --------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale.. 184,817 409,954 140,985
Equity securities............................. 8,311 986 26,767
Other investments............................. -- 842 1,559
Maturities or calls:
Fixed maturity securities available-for-sale.. 149,610 155,698 163,907
Fixed maturity securities held-to-maturity.... -- -- 5,972
Investment purchases:
Fixed maturity securities available-for-sale.. (180,269) (392,686) (306,180)
Equity securities............................. (18,940) (18,337) --
Net purchases of property and equipment........ (10,313) (6,134) (6,793)
Cash and cash equivalents of written-off
subsidiary.................................... (12,843) -- --
Acquisition of subsidiary, net of cash
acquired...................................... -- -- 5,124
Payment of acquisition expenses................ -- -- (3,730)
Other proceeds................................. 867 -- 92
Proceeds from disposal of subsidiary, net...... -- -- 10,000
--------- -------- --------
Net cash provided by investing activities..... 121,240 150,323 37,703
--------- -------- --------
Cash flows from financing activities:
Proceeds from senior bank debt................ -- -- 65,000
Repayment of senior bank debt................. (5,996) -- --
Repayment of acquired bank debt............... -- -- (35,638)
Payment for debt issuance expense............. -- (675) (1,017)
Issuance of common stock...................... 5,474 831 156
Acquisition of treasury stock................. (191) (9,268) --
--------- -------- --------
Net cash (used in) provided by financing
activities................................... (713) (9,112) 28,501
--------- -------- --------
Net increase in cash and cash equivalents....... 7,536 10,030 11,233
Cash and cash equivalents at beginning of year.. 70,747 60,717 49,484
--------- -------- --------
Cash and cash equivalents at end of year........ $ 78,283 70,747 60,717
========= ======== ========
Supplemental disclosure of cash flow
information:
Interest paid................................. $ 10,163 10,603 8,803
========= ======== ========
Reclassification of fixed income securities
from held-to-maturity to available-for sale
available for sale........................... $ -- -- 348,130
========= ======== ========
</TABLE>
The accompanying notes to the consolidated financial statements are an integral
part of these statements.
F-7
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies:
Basis of Reporting and Operations
The accompanying consolidated financial statements include the accounts of
Highlands Insurance Group, Inc., (Highlands Group) and its subsidiaries (the
Company). Highlands Group is an insurance holding company for Highlands
Insurance Company and its subsidiaries (Highlands), American Reliance, Inc.
and its subsidiaries (American Reliance) beginning April 30, 1997, and
Highlands Holdings (U.K.) Limited and its subsidiary (Highlands UK) (a foreign
reinsurance company located in the United Kingdom) and certain other
immaterial companies (collectively, the Insurance Subsidiaries). For reporting
purposes, the Company considers all of its property/casualty insurance
operations as one segment. All material intercompany accounts and transactions
have been eliminated.
As discussed in Note 4, the Company has written-off its remaining
investment in and deferred taxes associated with LMI Insurance Company (LMI).
The assets and liabilities of LMI have not been included in the accompanying
balance sheet as of December 31, 1999. The 1998 consolidated financial
statements have not been restated.
The accompanying consolidated financial statements are presented in
accordance with generally accepted accounting principles. Certain items in the
December 31, 1998 and 1997 consolidated financial statements have been
reclassified to conform to the current year's presentation. Such
reclassifications had no impact on stockholders' equity or net income (loss)
as previously reported.
Net Premiums Earned
Insurance premiums on property/casualty insurance contracts are earned
ratably over the terms of the policies after estimated adjustments for
retrospectively rated policies and a deduction for ceded insurance.
Loss and Loss Adjustment Expense Reserves
Loss and loss adjustment expense reserves are based on (a) case basis
estimates for claims reported on direct business, adjusted in the aggregate
for ultimate loss expectations, (b) estimates of incurred but not reported
(IBNR) claims based upon past experience, (c) estimates of assumed insurance
losses, (d) estimates of future expenses to be incurred in settlement of
claims and (e) estimates of claim recoveries. In establishing these estimates,
consideration is given to current conditions and trends as well as past
Company and industry experience.
Loss and loss adjustment expense reserves are based on estimates, and the
ultimate liability may vary significantly from such estimates (see note 11).
Any adjustments that are made to the reserves are reflected in the
consolidated statements of operations in the year such adjustments are known.
Deferred Acquisition Costs
Costs of acquiring insurance business which vary with and are primarily
related to the production of such business are deferred. Such costs include
commissions, premium taxes and certain underwriting and policy issuance costs.
Deferred acquisition costs are amortized ratably over the period the related
premiums are earned. Anticipated investment income and business line
profitability are considered in the determination of the recoverability of
deferred acquisition costs. Amortization of deferred acquisition costs were
$65.3 million, $71.5 million and $61.7 million for the years ended December
31, 1999, 1998 and 1997, respectively.
Investments
Investments classified as available-for-sale are carried at fair value.
Unrealized gains and losses on available-for-sale investments are reported
within accumulated other comprehensive income as a separate
F-8
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
component of stockholders' equity, net of applicable deferred taxes. Fixed
income securities may be sold to take advantage of investment opportunities
generated by changing interest rates, prepayments and tax and credit
considerations, as part of the Company's asset/liability strategy, or for
similar factors. As a result, the Company considers all of its fixed income
securities (bonds and redeemable preferred stocks) and all equity securities
as available-for-sale. The amortized cost of debt securities is adjusted for
amortization of premiums and accretion of discounts to expected maturity. Such
amortization and accretion are included in net investment income.
The cost of each security sold was specifically identified in computing the
related gain or loss. The Company continually monitors the difference between
the cost and estimated fair value of the investments. When impairment of the
value of an investment is considered other than temporary, the decrease in
value is reported in earnings as a realized investment loss and a new cost
basis is established.
Cash and Cash Equivalents
The Company defines cash equivalents as short-term, highly liquid
investments that are readily convertible to known amounts of cash. In general,
only investments with original maturities of three months or less qualify as
cash equivalents.
Debt Issuance Costs
Deferred financing and related costs consist of capitalized fees associated
with the $65 million senior revolving credit facility and the issuance of
$62.85 million in principal amount of 10% convertible subordinated debentures
(Debentures). These costs include underwriting, legal and accounting fees.
Debt issuance costs of $5.6 million were capitalized in connection with the
issuance of the Debentures and are being amortized on the straight line basis
and charged to income over the remaining life of each instrument.
Certain Risks and Uncertainties
The preparation of these financial statements requires management to make
estimates and assumptions as of the date of the financial statements that
affect the reported amounts of assets and liabilities as well as disclosures
of contingent assets and liabilities. Management must make estimates and
assumptions that affect amounts of revenues and expenses for the reporting
period, primarily for loss and loss adjustment expense incurred. Management
must also make estimates and assumptions in determining reinsurance and
retrospective premium collectibility, deferred tax asset utilization and in
determining litigation accruals. Actual results could differ from these
estimates. Future events, which could impact the estimates used in these
financial statements, include inflationary pressures that may tend to affect
the amount of loss; judicial, legislative and regulatory decisions affecting
insurers' liabilities; and fluctuations in interest rates.
Accounting Standards
In June, 1997, FASB issued Statement of Financial Accounting Standards No.
130, "Comprehensive Income" (SFAS 130). SFAS 130 establishes standards for the
reporting and disclosure of comprehensive income and its components (revenues,
expenses, gains and losses). SFAS 130 requires that all items that are
required to be recognized under accounting standards as components of
comprehensive income be reported in the statement of operations or in a
separate statement. SFAS 130 requires that an enterprise (a) classify items of
other comprehensive income by their nature and (b) display the accumulated
balance of other comprehensive income separately from retained earnings and
additional paid-in capital in the equity section of the balance sheet.
Unrealized available-for-sale investment gains and losses is the Company's
most significant item of other comprehensive income. SFAS 130 is effective for
fiscal years beginning after December 15, 1997. The Company has presented a
consolidated statement of comprehensive income.
F-9
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In June, 1997, FASB issued Statement of Financial Accounting Standards No.
131, "Disclosure about Segments of an Enterprise and Related Information"
(SFAS 131). SFAS 131 establishes standards for public business enterprises to
report 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 has 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 or financial condition.
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. 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.
In June, 1999, FASB issued Statement of Financial Accounting Standards No.
137, "Accounting for Derivative Instruments and Hedging Activities--Deferral
of the Effective Date of FASB Statement No. 133, an Amendment of FASB
Statement No. 133" (SFAS 137). SFAS 137 defers the effective date of FASB
Statement 133, "Accounting for Derivative Instruments and Hedging Activities"
(SFAS 133) for one year. SFAS 133, as amended, is now effective for all fiscal
quarters of all fiscal years beginning after June 15, 2000. SFAS 133
establishes new accounting and reporting standards requiring that all
derivative instruments (including certain derivative instruments embedded in
other contracts) be recorded in the balance sheet as either an asset or
liability measured at its fair value. The statement requires that changes in
the derivative's fair value be recognized currently in earnings unless
specific hedge accounting criteria are met. Special accounting for qualifying
hedges allows a derivative's gains and losses to offset related results on the
hedged item in the income statement and requires that a company must formally
document, designate, and assess the effectiveness of transactions that receive
hedge accounting. The Company anticipates that the adoption of the provisions
of SFAS 133 and SFAS 137 will not have a material impact on the results of
operations, financial condition or cash flows.
2. Business Acquisition
On April 30, 1997, Highlands Group acquired Vik Brothers Insurance, Inc.
and its subsidiaries (VBI). Immediately after the consummation of the
acquisition, VBI was renamed American Reliance, Inc. The acquisition was
accounted for as a purchase and, accordingly, the financial results of
American Reliance, Inc. and subsidiaries (American Reliance) are included in
these consolidated financial statements effective April 30, 1997.
F-10
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The acquisition was financed with a combination of common stock, bank debt,
preferred stock and cash. In connection with the acquisition, Highlands Group
paid approximately $55.4 million in cash (including $35.6 million to repay
American Reliance's outstanding bank debt) and issued 1,656,700 shares of its
common stock (representing approximately 12.6% of Highlands Group's then
outstanding common stock) and 21,366 shares of newly issued series one
preferred stock to the holders of the common stock warrants, preferred
stockholders and creditors of American Reliance. The closing price of
Highlands Group's common stock was $17.625 on April 30, 1997. Simultaneously
with the closing, Highlands Group contributed approximately $41.5 million to
the capital of the insurance companies within the American Reliance
organization.
In connection with the acquisition, Highlands Group obtained a $65 million
senior revolving credit facility from a consortium of banks led by The Chase
Manhattan Bank (Credit Agreement). Highlands Group funded the cash portion of
the acquisition and capital contribution by utilizing the credit facility and
available working capital.
American Reliance is an insurance holding company for the following
property and casualty insurance companies: Northwestern National Casualty
Company (NNCC); Pacific National Insurance Company (PNIC); Pacific Automobile
Insurance Company (PAIC); State Capital Insurance Company (SCIC); American
Professionals Insurance Company (APIC); NN Insurance Company (NNIC); and
Statesman Insurance Company (SIC).
The following unaudited pro forma information presents the results of
operations of the Company and American Reliance for the year ended December
31, 1997, with pro forma adjustments as if the acquisition and transactions
related to the funding of the acquisition had been consummated as of January
1, 1997. This pro forma information is not necessarily indicative of what
would have occurred had the acquisition and related transactions been made on
the date indicated, or of future results of the Company.
<TABLE>
<CAPTION>
Year Ended
December 31, 1997
-----------------
(In thousands,
except
per share data)
<S> <C>
Revenues................................................ $507,038
Net income.............................................. $ 18,372
Basic earnings per share................................ $ 1.46
Diluted earnings per share.............................. $ 1.19
</TABLE>
3. Disposal of Assets
In December 1997, the Company sold to an independent purchaser a management
contract which was acquired as part of the American Reliance acquisition. The
management contract established control over Northwestern National Casualty
Mutual (NNCM). NNCM, a Texas county mutual insurance company, wrote non-
standard personal automobile insurance business in Texas and was 100%
reinsured by NNCC. In a separate transaction, all of the existing in force
business of NNCM, including the outstanding unearned premium reserves and
outstanding loss reserves, the renewal rights and broker agreements, were
transferred to an independent purchaser. Highlands Group has provided a
partial guarantee (up to $1.3 million) of the adequacy of the loss reserves.
Total proceeds to the Company from both transactions were $13.5 million.
NNCC's historical cost basis for the assets being sold did not exceed $2.5
million. These transactions were part of the fair value allocation of the
purchase price of American Reliance.
F-11
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
4. Write-off of Subsidiary
The Company wrote-off its remaining investment in and deferred tax assets
associated with LMI, which has been in run-off since April 1997 when it was
acquired in the purchase of American Reliance. The charge, totaling $22.1
million, consists of $10.5 million for the Company's remaining investment in
LMI and $11.6 million of associated deferred tax assets. In March 2000, the
Court of Common Pleas in Franklin County, Ohio, entered an order appointing
the Superintendent of Insurance of the State of Ohio as the Rehabilitator of
LMI. As Rehabilitator, the Superintendent is by operation of law vested with
control of LMI, including title to all LMI assets. Since 1997, the Company
supported LMI; however, based upon a year-end assessment of the value of LMI,
the Company concluded that continued support of LMI was no longer in the best
interest of the Company and its shareholders. Management believes that the
regulatory matters concerning LMI will not have a material impact on the
Company's ongoing operations.
Following is a summary of net assets and results of operations of LMI as of
December 31, 1999 (the date of disposal) and 1998 and for the periods then
ended (in thousands):
<TABLE>
<CAPTION>
1999 1998
------- ------
<S> <C> <C>
Fixed maturity securities, at fair value................. $18,686 22,221
Highlands Group preferred stock.......................... 4,641 21,366
------- ------
Total investments...................................... 23,327 43,587
Cash and cash equivalents................................ 12,843 16,346
Receivable from reinsurers............................... 42,412 29,952
Other assets............................................. 2,247 6,640
------- ------
Total Assets........................................... $80,829 96,525
======= ======
Loss and loss adjustment expense reserves................ 60,284 82,839
Other liabilities........................................ 10,093 1,090
------- ------
Total liabilities...................................... $70,377 83,929
======= ======
Net Assets............................................... $10,452 12,596
======= ======
<CAPTION>
Years Ended
December 31,
---------------
1999 1998
------- ------
<S> <C> <C>
Total revenues........................................... $ 3,396 3,882
Total expenses........................................... 3,099 9,913
------- ------
Net income (loss) before taxes......................... 297 (6,031)
Income tax expense (benefit)............................. 2,604 (2,531)
------- ------
Net loss............................................... $(2,307) (3,500)
======= ======
</TABLE>
The 1998 consolidated financial statements have not been restated to
reflect the write-off of LMI. LMI stand alone financial statements were not
prepared and issued in accordance with generally accepted accounting
principles for the current or prior years. The 1998 LMI stand alone financial
statements prepared in accordance with statutory accounting practices received
an adverse audit opinion due to a deficiency in loss reserves with an
explanatory paragraph regarding LMI's ability to continue as a going concern.
F-12
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
5. Investments and Investment Income
Net investment income for the years ended December 31, 1999, 1998 and 1997
is comprised of the following (in thousands):
<TABLE>
<CAPTION>
1999 1998 1997
------- ------ ------
<S> <C> <C> <C>
Gross investment income:
Fixed maturity securities........................... $62,981 74,075 68,074
Equity securities................................... 1,973 517 2,073
Cash equivalents and other investments.............. 3,456 4,050 5,369
------- ------ ------
Gross investment income........................... 68,410 78,642 75,516
Investment expenses................................. 726 673 1,133
------- ------ ------
Net investment income............................. $67,684 77,969 74,383
======= ====== ======
</TABLE>
The following is a summary of available-for-sale securities as of December
31, 1999 and 1998 (in thousands):
<TABLE>
<CAPTION>
Gross
Unrealized
Amortized --------------
Cost Gains Losses Fair Value
--------- ------ ------- ----------
<S> <C> <C> <C> <C>
December 31, 1999--
Fixed maturities available-for-sale:
United States Government and
government agencies.................. $119,510 63 (3,615) 115,958
States, municipalities and political
subdivisions......................... 41,735 1,064 (1,460) 41,339
Asset-backed and collateralized
securities........................... 351,297 436 (15,137) 336,596
Corporate securities.................. 290,052 328 (21,795) 268,585
-------- ------ ------- ---------
802,594 1,891 (42,007) 762,478
Equity securities....................... 31,376 375 (5,157) 26,594
-------- ------ ------- ---------
$833,970 2,266 (47,164) 789,072
======== ====== ======= =========
December 31, 1998--
Fixed maturities available-for-sale:
United States Government and
government agencies.................. $202,499 3,076 (63) 205,512
States, municipalities and political
subdivisions......................... 57,227 4,035 (73) 61,189
Asset-backed and collateralized
securities........................... 407,565 8,688 (1,242) 415,011
Corporate securities.................. 307,479 11,665 (734) 318,410
Other................................. 1,088 26 -- 1,114
-------- ------ ------- ---------
975,858 27,490 (2,112) 1,001,236
Equity securities....................... 20,585 487 (15) 21,057
-------- ------ ------- ---------
$996,443 27,977 (2,127) 1,022,293
======== ====== ======= =========
</TABLE>
The fair value of investments is based on quoted market prices, where
available, or quotes from external pricing sources such as brokers for similar
investments and issues. With the exception of the securities of United States
Government and government agencies, the Company has no investment in any one
individual security issuer exceeding 10 percent of total assets.
F-13
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The amortized cost and estimated fair value of fixed maturity securities as
of December 31, 1999, by contractual maturity, are presented below (in
thousands). Actual maturities may differ from contractual maturities as
securities may be restructured, called or prepaid. Securities with multiple
maturity dates are disclosed separately rather than allocated over several
maturity groupings.
<TABLE>
<CAPTION>
Amortized Fair
Cost Value
--------- -------
<S> <C> <C>
Available-for-sale:
Within one year....................................... $ 7,955 7,949
After one year through five years..................... 132,099 129,318
After five years through ten years.................... 118,773 112,279
After ten years....................................... 192,470 176,336
Asset-backed and collateralized securities............ 351,297 336,596
-------- -------
$802,594 762,478
======== =======
</TABLE>
The change in net unrealized gains and losses on investments available-for-
sale follows (in thousands):
<TABLE>
<CAPTION>
Years Ended December
31,
-------------------------
1999 1998 1997
-------- ------ -------
<S> <C> <C> <C>
Fixed maturity securities.................... $(65,889) (8,751) 30,291
Equity securities............................ (5,092) 328 (687)
Write-off of subsidiary net unrealized loss.. 232 -- --
-------- ------ -------
(70,749) (8,423) 29,604
Deferred income taxes........................ 24,762 2,948 (10,362)
-------- ------ -------
Change in net unrealized gains and losses,
net of tax................................ $(45,987) (5,475) 19,242
======== ====== =======
</TABLE>
Sales of Securities
Gross realized investment gains and losses and proceeds from the sale of
investments for the years ended December 31, 1999, 1998 and 1997 are as
follows (in thousands):
<TABLE>
<CAPTION>
1999 1998 1997
-------- ------- -------
<S> <C> <C> <C>
Fixed maturities:
Gross realized gains...................... $ 3,967 18,975 2,597
Gross realized losses..................... (4,866) (3,050) (238)
-------- ------- -------
$ (899) 15,925 2,359
======== ======= =======
Equity securities:
Gross realized gains...................... $ -- 387 1,987
Gross realized losses..................... -- 385 --
-------- ------- -------
$ -- 2 1,987
======== ======= =======
Other investments:
Gross realized gains...................... $ 921 999 1,239
Gross realized losses..................... -- (52) --
-------- ------- -------
$ 921 947 1,239
-------- ------- -------
Proceeds from sale of fixed maturity
securities (calls and maturities
excluded).................................. $185,684 409,954 140,985
======== ======= =======
</TABLE>
F-14
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
6. Dividends from Subsidiaries and Statutory Information
The Company's insurance subsidiaries are restricted by law as to the amount
of dividends they may pay without the approval of regulatory authorities.
During 2000, the total maximum amount of dividends which can be paid without
such approval is approximately $30.9 million.
Combined net income and policyholders' surplus of the Company's combined
insurance subsidiaries, as determined in accordance with statutory accounting
practices, follows (in millions):
<TABLE>
<CAPTION>
1999 1998 1997
------ ----- -----
<S> <C> <C> <C>
Net income............................................ $ 6.5 13.4 18.5
====== ===== =====
Policyholders' surplus................................ $270.8 313.5 333.1
====== ===== =====
</TABLE>
The above combined statutory financial information of the Company's
insurance subsidiaries was prepared in accordance with accounting practices
prescribed or permitted by the various insurance departments of the insurance
subsidiaries' states of domicile. "Prescribed" statutory accounting practices
include state laws, regulations and general administrative rules, as well as a
variety of publications of the National Association of Insurance Commissioners
(NAIC). "Permitted" statutory accounting practices encompass all accounting
practices that are not prescribed; such practices may differ from state to
state, may differ from company to company within a state, and may change in
the future. In 1999, the Company's insurance subsidiaries obtained permission
from certain insurance departments to write-off directly to policyholder
surplus certain computer software amounts that were previously non-admitted
under prescribed statutory accounting practices. There was no impact on
surplus at December 31, 1999 due to this permitted accounting. The Company's
insurance subsidiaries did not have any other material permitted statutory
accounting practices in 1999, 1998 and 1997.
In March 1998, the NAIC adopted the Codification of Statutory Accounting
Principles (the Codification). The implementation of the Codification and the
date thereof will be ultimately dependent on an insurer's state of domicile.
Until the Company is notified of the implementation plans by the various
insurance departments, the Company cannot reasonably determine the impact of
the Codification on its statutory financial information.
The NAIC adopted risk based capital (RBC) requirements that require
insurance companies to calculate and report information under a risk-based
formula which measures statutory capital and surplus needs based on a
regulatory definition of risk for a company's mix of products and its balance
sheet. The insurance subsidiaries of the Company have an RBC amount above the
company action level, as defined by the NAIC at December 31, 1999.
The NAIC Insurance Regulatory Information System ("IRIS") was developed to
assist state Insurance Commissioners to oversee the financial condition of
insurance companies operating in their respective states. If the review
confirms that the insurer's situation should be accorded the highest
surveillance priority, the insurer receives a "first priority" designation.
The "second priority" and "third priority" designations signify
recommendations for lower levels of increased regulatory attention. The NAIC's
review of each company's financial ratio results and statutory annual
statements for 1999 has not been completed.
F-15
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
7. Federal and Foreign Income Taxes
The Company provides for income taxes on its statements of operations
pursuant to Statement of Financial Accounting Standards 109, "Accounting for
Income Taxes" (SFAS 109).
The primary components of the Company's deferred tax assets and liabilities
and the related valuation allowance as of December 31, 1999 and 1998,
respectively, follow (in thousands):
<TABLE>
<CAPTION>
1999 1998
-------- --------
<S> <C> <C>
Deferred tax assets--
Loss and loss adjustment expense reserves........... $ 45,281 51,301
Net operating loss carryforward..................... 43,304 50,222
Unearned premiums................................... 10,014 9,475
Deferred credits for processing fees................ 2,726 3,642
Unrealized loss on investments...................... 15,714 --
Other............................................... 6,607 7,592
-------- --------
Gross deferred tax assets......................... 123,646 122,232
Valuation allowance................................. (12,791) (18,994)
-------- --------
Net deferred tax assets........................... 110,855 103,238
-------- --------
Deferred tax liabilities--
Deferred acquisition costs.......................... 11,745 11,038
Accrued retrospective premiums...................... 9,999 8,629
Unrealized gain on investments...................... -- 9,048
Other............................................... 6,575 4,090
-------- --------
Gross deferred tax liabilities.................... 28,319 32,805
-------- --------
Net deferred tax asset.......................... $ 82,536 70,433
======== ========
</TABLE>
The realization of the net deferred tax asset is dependent upon the
Company's ability to generate sufficient taxable income in future periods. The
net deferred tax asset is net of valuation allowances of $12.8 and $19.0
million as of December 31, 1999 and 1998, respectively. The reduction in the
valuation allowance includes $5.6 million related to the valuation allowance
associated with the acquired net operating loss carryforwards of LMI. The
valuation allowances are based upon management's assessment that it is more
likely than not that the portion of the deferred tax asset related to American
Reliance's purchased net operating loss carryforwards (reduced in 1999 for
those associated with LMI) and Highlands (UK)'s net operating loss
carryforwards will not be realized. For tax return purposes, the Company had
net operating loss carryforwards that expire net of valuation allowances, if
unused, in 2011-2019. Based upon Highlands Group's anticipated future
earnings, projected reversal of the temporary differences, tax planning
strategies available if required and all other available evidence, both
positive and negative, management has concluded it is more likely than not
that the net deferred tax asset will be realized. Adjustments to the valuation
allowance will be made if there is a change in management's assessment of the
amount of the deferred tax asset that is realizable.
F-16
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The income tax expense (benefit) was different from the amount computed by
applying the federal income tax rate to income (loss) before income taxes for
the following reasons (in thousands):
<TABLE>
<CAPTION>
1999 1998 1997
------- ------ ------
<S> <C> <C> <C>
Income (loss) before income
taxes...................... $ (465) (790) 18,519
Tax rate.................... 35% 35% 35%
------- ------ ------
Application of the tax
rate..................... (163) (277) 6,482
Tax effect of:
Tax-exempt interest....... (1,102) (2,547) (4,731)
Write-off of subsidiary... 3,657 -- --
Net deferred taxes of
written-off subsidiary... 11,618 -- --
Other..................... (1,026) (1,063) (68)
------- ------ ------
Income tax (benefit)
expense................ $12,984 (3,887) 1,683
======= ====== ======
</TABLE>
The income tax expense (benefit) consisted of the following (in thousands):
<TABLE>
<CAPTION>
1999 1998 1997
------ ------ -----
<S> <C> <C> <C>
Current expense (benefit)............................ 325 (444) 167
Deferred expense (benefit)........................... 12,659 (3,443) 1,516
------ ------ -----
Income tax expense (benefit)....................... 12,984 (3,887) 1,683
====== ====== =====
</TABLE>
8. Debt and Preferred Stock Outstanding
On April 30, 1997, the Company entered into a $65 million Credit Agreement,
with a consortium of banks. The Credit Agreement, which contains customary
terms and restrictions, currently provides for an interest rate of LIBOR plus
150 to 225 basis points based upon a performance grid with the full principal
amount thereunder due on April 30, 2002. The Credit Agreement was used to
finance the purchase of American Reliance. During 1999, the Company repaid
$6.0 million of the loan. This payment permanently reduced the senior
revolving credit facility from $65.0 million to $59.0 million. The average
interest rate for the year ended December 31, 1999 was 6.59%. The Company and
its lenders have amended the Credit Agreement to amend certain financial
covenants and to provide for the payment of $10.0 million in principal during
2000. The Company is in compliance with the amended covenants in the Credit
Agreement.
On January 23, 1996, Highlands Group issued $62.85 million in principal
amount of 10% convertible subordinated debentures (Debentures) due December
31, 2005, together with Series A and A-2 (collectively the "Series A
Warrants") and B and B-2 (collectively the "Series B Warrants") common stock
purchase warrants, to Insurance Partners, L.P., and Insurance Partners
Offshore (Bermuda), L.P. (collectively "IP") and certain members of the
Company's management team (Management Investors). The Company received $60
million in cash from IP and the Management Investors and individual promissory
notes (each, a "Note" and, collectively, the "Notes") in the aggregate
principal amount of $2.85 million made by the individual Management Investors
without personal liability and secured by a pledge of Debentures. The
Debentures issued in exchange for the Management Investors Notes were issued
pursuant to a Purchase, Redemption and Bonus Agreement (the "Purchase
Agreement").
The carrying values of the Debentures, Series A Warrants and Series B
Warrants at the Distribution date were determined by allocating the $62.85
million purchase price based upon the estimated relative fair value of such
securities. The estimated fair value of the Series A Warrants and Series B
Warrants amounting to $8.2 million was recorded in paid-in capital, net of $.8
million of Debentures' acquisition costs. The debt discount related to the
value allocated to the Series A Warrants and Series B Warrants is being
amortized over the ten-year life of the Debentures and amounted to $.8 million
for the year ended December 31, 1999.
The Debentures are convertible, at the option of the holders, into Common
Stock of Highlands Group. If all of the Debentures are converted into
Highlands Group Common Stock at the conversion price of $16.16 per
F-17
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
share, the holders would receive approximately 3.9 million shares of Highlands
Group Common Stock and have an ownership interest in Highlands Group of
approximately 23%. Interest on the Debentures is payable semi-annually in cash
at 10% per annum. Highlands Group can redeem the Debentures at any time after
December 31, 2002. Total interest expense incurred and paid on the Debentures
was $6.0 million in 1999, 1998 and 1997. The total amortization of debt
discount and acquisition costs incurred related to the Debentures was $1.3
million in 1999, 1998 and 1997.
The detachable Series A Warrants enable the holders to purchase Highlands
Group Common Stock at an exercise price of $9.77 per share, equal to an
additional ownership interest in Highlands Group of approximately 19% after
giving effect to the assumed conversion of the Debentures and the exercise of
the Series A Warrants. If all of the Series A Warrants were exercised, the
holders would receive approximately 4.0 million shares of Common Stock of
Highlands Group. The exercise price of Highlands Group Common Stock into which
the Series A Warrants are exercisable is subject to adjustment related to
adverse loss reserve and uncollectible reinsurance development. Such
adjustment increased the exercise price by $0.94 per share in 1999 and reduced
the exercise price by $2.04 and $2.02 per share in 1998 and 1997,
respectively. The detachable Series A Warrants expire on December 31, 2005.
The detachable Series B Warrants enable the holders to purchase Highlands
Group Common Stock at an exercise price of $9.77 per share, equal to an
additional ownership interest of 5% after giving effect to the assumed
conversion of the Debentures and the exercise of the Series A and B Warrants.
The Series B Warrants become exercisable by the holders in the event that the
average closing market price of Highlands Group Common Stock exceeds 1.61
times the exercise price for any 30 consecutive trading days between January
1, 1999 and December 31, 2000. If all of the Series B Warrants were exercised,
the holders would receive approximately 1.0 million additional shares of
Highlands Group Common Stock. The Series B Warrants exercise price is subject
to the same adjustment as the Series A Warrants. The detachable Series B
Warrants expire on December 31, 2005.
The Purchase Agreement further provides for a bonus to be paid to each
Management Investor on the fifth anniversary of the Purchase Agreement if the
average closing price of the Company Common Stock is equal to or greater than
prices expressed as a percentage of the exercise price of the Series A
Warrants (as adjusted from time to time) and specified in the Purchase
Agreement (the "Bonus Trigger Stock Price"). The amount of the bonus is stated
as a percentage of a maximum bonus amount separately determined for each
Management Investor and equal to the aggregate principal amount of each
Management Investor's Note. If the Bonus Trigger Stock Price is at least 1.40
times but less than 1.50 times the Series A Warrant exercise price, the bonus
is 25% of the maximum bonus amount, 50% if the Bonus Trigger Stock Price is at
least 1.50 but less than 1.61 times the Series A Warrant exercise price and
100% if the Bonus Trigger Stock Price is 1.61 times the Series A Warrant
exercise price or higher.
If the Debentures are converted into Common Stock of Highlands Group and
the Series A and B Warrants are utilized by the holders to purchase Common
Stock of Highlands Group, the holders will have an ownership interest in
Highlands Group of approximately 40%.
On April 30, 1997, the Company authorized the designation of a series of
Preferred Stock (the "Series One Preferred Stock") for use in transactions
related to the acquisition of American Reliance. The Company is authorized to
issue up to 50,000 shares of non-voting shares of the Series One Preferred
Stock. At the time of the stock issuance 100% of the outstanding shares were
held by the subsidiaries of Highlands Group and eliminated in consolidation.
At December 31, 1999, there were 15,004.32 shares issued and outstanding of
which 4,660.66 shares were held by LMI. As a result of the Company's write-off
of LMI the shares held by LMI are reflected as outstanding in the consolidated
balance sheet of the Company as of December 31, 1999. The Series One Preferred
Stock have cumulative dividends payable quarterly at 6% and can be in the form
of cash or paid-
F-18
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
in-kind ("PIK") dividends with PIK dividends being elected to date. The Series
One Preferred Stock is mandatorily redeemable at January 1, 2004. The
liquidation preference amount is $1,000 per share plus cumulative unpaid
dividends.
9. Earnings Per Share
The following table sets forth the computation of basic and diluted
earnings per share (in thousands, except per share data):
<TABLE>
<CAPTION>
1999 1998 1997
-------- ------ ------
<S> <C> <C> <C>
NUMERATOR:
Net income (loss), as reported and for basic earnings
(loss) per share.................................... $(13,449) 3,097 16,836
Effect of dilutive securities--after tax debt expense
applicable to convertible subordinated debentures... -- -- --
-------- ------ ------
Numerator for diluted earnings (loss) per common
share--income available to common stockholders after
assumed conversions................................. $(13,449) 3,097 16,836
DENOMINATOR:
Denominator for basic earnings (loss) per share--
weighted average shares............................. 12,956 13,095 12,600
Effect of dilutive securities:
Common stock warrants and outstanding stock options
(based on treasury stock method).................. -- 2,716 2,788
Convertible subordinated debentures................ -- -- --
-------- ------ ------
Denominator for diluted earnings per share--adjusted
weighted average shares and assumed conversions..... $ 12,956 15,811 15,388
======== ====== ======
Basic earnings (loss) per share...................... $ (1.04) .24 1.34
Diluted earnings (loss) per share.................... $ (1.04) .20 1.09
</TABLE>
The Debentures, which are convertible into approximately 3.9 million
shares, were outstanding during 1999, 1998 and 1997, but were not included in
the computation of diluted earnings per share because the assumed conversion
would be antidilutive.
Stock options for 978,309 and 400,048 shares for 1999 and 1998,
respectively, were not included in earnings per share calculations as they
were antidilutive.
10. Reinsurance
The Company assumes and cedes insurance with other insurers and reinsurers
and members of various reinsurance pools and associations and syndicates. The
Company utilizes reinsurance arrangements to limit its maximum loss, to
provide greater diversification of risks and to minimize exposures on larger
risks. Generally, reinsurance coverage is on an excess of loss basis. In
addition, the Company has catastrophe coverage for certain types of losses
over stipulated aggregate amounts arising from any one occurrence or event.
The ceding of reinsurance does not discharge the primary liability of the
original insurer. The Company currently places reinsurance with other carriers
only after careful review of the nature of the contract and a thorough
assessment of the reinsurer's current credit quality and claim settlement
performance.
Based upon its evaluations of reinsurers, the Company has established an
allowance for uncollectible reinsurance ($2.2 million and $1.7 million as of
December 31, 1999 and 1998, respectively) or does not record certain contracts
as ceded business but retains these amounts ($22.9 million and $22.3 million
as of December 31, 1999 and 1998, respectively) as loss reserves for
potentially uncollectible reinsurance at such time as an uncollectible amount
is probable and the amount may be reasonably estimated. Because of the
difficulty of acquiring accurate information for certain reinsurers, including
Lloyds' syndicates and members, the Company
F-19
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
believes that no meaningful range of potentially uncollectible reinsurance can
be established beyond recorded reserves. With respect to certain carriers and
reinsurers that are not authorized reinsurers as determined by the appropriate
Department of Insurance, the Company often receives collateral primarily in
the form of bank letters of credit generally securing the reinsurance
recoverable regarding reported losses and in some instances IBNR. As of
December 31, 1999, such collateral totaled approximately $41.2 million.
The Company's three largest recoverables as of December 31, 1999, were
approximately $137.9 million with Underwriters at Lloyds of London, $90.9
million with American Reinsurance Company and $64.0 million with General
Reinsurance Company. American Reinsurance Company and General Reinsurance
Company are rated by A. M. Best A+ and A++ rating, respectively.
The effects of assumed and ceded reinsurance on net premiums and losses
follows (in thousands):
<TABLE>
<CAPTION>
Direct Assumed Ceded Net
-------- ------- -------- -------
<S> <C> <C> <C> <C>
Year ended December 31,
1999--
Written premiums........ $355,313 8,816 (30,524) 333,605
Earned premiums......... $345,885 9,181 (29,761) 325,305
Loss and loss adjustment
expense incurred....... $257,024 21,973 (40,057) 238,940
======== ====== ======== =======
Year ended December 31,
1998--
Written premiums........ $370,210 7,874 (3,268) 374,816
Earned premiums......... $406,028 8,464 (25,679) 388,813
Loss and loss adjustment
expense incurred....... $321,033 27,573 (20,206) 328,400
======== ====== ======== =======
Year ended December 31,
1997--
Written premiums........ $342,414 3,631 (68,308) 277,737
Earned premiums......... $367,630 (8,879) (46,758) 311,993
Loss and loss adjustment
expense incurred....... $273,114 79,269 (105,904) 246,479
======== ====== ======== =======
</TABLE>
11. Loss and Loss Adjustment Expense Reserves
The Company establishes loss reserves which are estimates of future
payments of reported and unreported claims for losses and the related expenses
with respect to insured events that have occurred. The process of establishing
loss reserves is subject to uncertainties that are normal, recurring and
inherent in the property and casualty business. The process requires reliance
upon estimates based on available data that reflects past experience, current
trends and other information and the exercise of informed judgment. As
information develops that varies from experience, provides additional data or,
in some cases, augments data that previously was not considered sufficient for
use in determining reserves, changes in the Company's estimate of ultimate
liabilities may be required. The effect of these changes, net of reinsurance,
is charged or credited to income for the periods in which they are determined.
Reserving for asbestos, environmental-related and certain other long-term
exposure claims is subject to significant additional uncertainties that are
not generally present for other types of claims. Developed case law and
adequate claim history do not exist for such claims. Highlands and the
insurance industry dispute coverage for certain environmental, pollution and
asbestos liabilities of their policyholders. These claims differ from almost
all others in that it is not often clear that an insurable event has occurred
and which, if any, multiple policy years and insurers will be liable. These
uncertainties prevent identification of applicable policy and policy limits
until after a claim is reported and substantial time is spent (many years in
some cases) resolving contract issues and determining facts necessary to
evaluate the claim. If the courts continue in the future to expand the intent
of the policies and the scope of the coverage as they have in the past,
additional liabilities could emerge for amounts in excess of the current
reserves held.
F-20
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company uses methods and assumptions that are consistent with
prevailing actuarial practice and are modified periodically based on changes
in circumstances. However, estimation of loss reserves for asbestos,
environmental related and other long-term exposure claims is one of the most
difficult aspects of establishing reserves, especially given the above
uncertainties. The Company has recorded its best estimate of loss and loss
adjustment expense reserves; however because of the significant uncertainties
involved and the likelihood that these uncertainties will not be resolved in
the near future, the ultimate amounts paid upon settlement of these matters
may be more or less than the current estimate.
In management's judgment, information currently available has been
appropriately considered in estimating the Company's loss reserves. However,
future changes in estimates of the Company's liability for insured events may
adversely affect results in future periods although such effects cannot be
reasonably estimated.
The following table represents a reconciliation of beginning and ending
consolidated loss and loss adjustment expense reserves for each of the last
three years (in thousands).
<TABLE>
<CAPTION>
1999 1998 1997
---------- --------- ---------
<S> <C> <C> <C>
Balance at January 1........................... $1,603,548 1,605,374 1,156,824
Acquisition of American Reliance............. -- -- 520,719
Less--Reinsurance recoverables............... 732,567 692,668 652,449
---------- --------- ---------
Net balance at January 1....................... 870,981 912,706 1,025,094
---------- --------- ---------
Incurred related to--
Current year................................. 247,027 256,528 230,033
Commutation of Aggregate Excess of Loss
Reinsurance Agreement....................... -- 50,000 --
Prior year--
Asbestos and environmental................. 1,795 19,119 5,433
All other.................................. (9,882) 2,753 11,013
---------- --------- ---------
Total prior year............................. (8,087) 21,872 16,446
---------- --------- ---------
Total incurred............................. 238,940 328,400 246,479
---------- --------- ---------
Paid related to--
Current year................................. 101,294 90,635 120,705
Prior year...................................
Asbestos and environmental................. 15,038 9,712 6,812
All other.................................. 230,240 269,778 231,350
---------- --------- ---------
Total prior year............................. 245,278 279,490 238,162
---------- --------- ---------
Total paid................................. 346,572 370,125 358,867
---------- --------- ---------
Elimination of reserves of written-off
subsidiary.................................... 24,033 -- --
---------- --------- ---------
Net balance at December 31..................... 739,316 870,981 912,706
Add--Reinsurance recoverables................ 614,208 732,567 692,668
---------- --------- ---------
Balance at December 31......................... $1,353,524 1,603,548 1,605,374
========== ========= =========
</TABLE>
As a result of changes in estimates of insured events in prior years,
primarily environmental and pollution claims, construction defect claims and
catastrophe claims, and the effects of the termination of the Stop Loss
Agreement in 1998, the provision for losses and loss adjustment expenses (net
of reinsurance recoveries of $20.6 million, $69.3 million, and $112.5 million
for 1999, 1998 and 1997, respectively) decreased by $8.1 million in 1999 and
increased $71.9 million in 1998, $16.4 million in 1997.
F-21
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
12. Employee Benefits
The Company has a retirement and savings plan (defined contribution plan)
for which all employees are eligible to participate. The Company's
contributions are restricted to amounts authorized annually by the board of
directors. Employees, at their option, may contribute a portion of their
eligible earnings to the plan. Retirement benefits are based on the balance in
each employee's account, including the amount vested in employer
contributions. The plan may be canceled at any time at the option of the
Company. The Company's net contributions to the plan for 1999, 1998 and 1997
were approximately $1.2 million, $1.1 million, and $1.3 million, respectively.
13. Stock Compensation Plans
At December 31, 1999, the Company had two types of stock-based compensation
plans, a stock option plan and a restricted stock plan. The Company applies
APB Opinion No. 25 and related Interpretations in accounting for its plans.
Accordingly, compensation cost is being recognized for the grant of options to
acquire Company Common Stock prior to a market price (January 23, 1996) for
Company Common Stock. The compensation cost that has been charged against
income for its stock-based plans was $321,000, $472,000 and $500,000 for 1999,
1998 and 1997, respectively. However, no compensation cost has been recognized
for shares issued with an exercise price equal to the market value at date of
grant. Had all compensation cost for the Company's stock-based compensation
plans been determined consistent with Statement of Financial Accounting
Standards No. 123, the Company's net income (loss) and income (loss) per share
would have been the pro forma amounts indicated below (in thousands, except
per share data):
<TABLE>
<CAPTION>
1999 1998 1997
-------- ----- ------
<S> <C> <C> <C> <C>
Net income (loss)..................... As reported $(13,449) 3,097 16,836
Pro forma $(13,974) 1,915 15,568
Basic earnings (loss) per share....... As reported $ (1.04) .24 1.34
Pro forma $ (1.08) .15 1.24
Diluted earnings (loss) per share..... As reported $ (1.04) .20 1.09
Pro forma $ (1.08) .12 1.01
</TABLE>
During 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.
Stock Option Plan
Pursuant to the Company's 1995 Stock Option Plan, Highlands Group may grant
either incentive stock options (ISO) or non-qualified stock options (NQSO).
The exercise price for each share subject to an option will be an amount that
the Compensation Committee of the Board of Directors determines, in its good
faith judgment. In the case of ISOs, however, the exercise price per share may
not be less than the amount the Committee determines, in its good faith
judgment, to be not less than 100% of the fair value of the Company's common
stock on the date the option is granted. Options are typically exercisable
over a period not in excess of ten years. The options generally vest over
three to four years, or in full upon a change of control of the Company. The
maximum number of shares that were reserved for issuance under all option
plans was 1,350,000 at December 31, 1999.
F-22
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
A summary of the status of the Company's stock option plans at December 31,
1999 and changes during the three years then ended is presented below:
<TABLE>
<CAPTION>
1999 1998 1997
------------------- ------------------- ------------------
Weighted- Weighted- Weighted-
Average Average Average
Shares Exercise Shares Exercise Shares Exercise
Fixed Options (000) Price (000) Price (000) Price
- ------------- -------- --------- -------- --------- ------- ---------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning
of year................ 841,920 $18.35 751,983 $17.22 486,000 $15.03
Granted................. 448,201 $11.91 233,150 $23.78 333,000 $20.31
Exercised............... -- $ -- (8,375) $17.31 (10,599) $14.69
Forfeited............... (311,812) $21.31 (134,838) $21.47 (56,418) $17.06
-------- ------ -------- ------ ------- ------
Outstanding at end of
year................... 978,309 $14.48 841,920 $18.35 751,983 $17.22
======== ======== ======= ======
Options exercisable at
year-end............... 389,679 299,757 125,589
======== ======== =======
</TABLE>
The following table summarizes information about stock options outstanding
at December 31, 1999:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
-------------------------------- --------------------
Weighted
Average Weighted Weighted
Number Remaining Average Number Average
Outstanding Contractual Exercise Exercisable Exercise
Range of Exercise Prices at 12/31/99 Life Price at 12/31/99 Price
- ------------------------ ----------- ----------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$9.50-13.25.............. 442,813 9.29 $11.76 7,164 $10.38
$14.69-14.69............. 397,033 6.01 $14.69 322,033 $14.69
$14.88-28.38............. 138,463 7.94 $22.59 60,482 $21.96
------- -------
$9.50-28.38.............. 978,309 7.77 $14.48 389,679 $15.74
======= =======
</TABLE>
The fair value of stock options granted during the years ended December 31,
1999, 1998 and 1997 was $3.4 million, $3.1 million and $2.3 million,
respectively. The weighted average estimated per share fair value of options
granted during the years ended December 31, 1999, 1998 and 1997 was $7.61,
$13.25 and $6.80, respectively. The fair value of each option is estimated on
the date of the grant using the Black-Scholes option-pricing model. The
following weighted average assumptions were used in the Black-Scholes option
pricing model for grants in 1999, 1998 and 1997, respectively: dividend yields
of -0- percent, expected volatilities of 46 percent, 48 percent and 15 percent,
risk-free interest rates of 6.5 percent, 5.9 percent and 5.8 percent, and
expected terms of 6.5 years.
Employee Stock Purchase Plan
In May 1998, the Company adopted a tax-qualified employee stock purchase
plan (the Purchase Plan). An aggregate of 300,000 shares of the Common Stock
has been reserved for issuance under the Purchase Plan. All employees of the
Company with at least three months of service can purchase Common Stock on the
annual offering date at a price equal to 85% of its fair market value at the
time of purchase. Employees can authorize payroll deductions in order to
accumulate funds for any offering during the year prior to any offering. At
December 31, 1999, 29,105 shares were issued under the Purchase Plan.
Restricted Stock Plans
In May 1997, the Company adopted a restricted stock plan ("Restricted Stock
Plan") pursuant to which participants are granted an award of shares of the
Company's Common Stock (Restricted Stock) subject to restrictions. The number
of shares of Restricted Stock granted to each participant is equal to the
number of shares
F-23
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
of Common Stock of the Company, if any, that the participant purchases under
the Restricted Stock Plan. There are restrictions as to the transferability of
the Restricted Stock, which restrictions lapse on the fifth anniversary from
the date of issuance if the closing price of the Company's Common Stock is
equal to or greater than the prices expressed as a percentage of the price on
the date of issuance (the "Restricted Stock Trigger Price"). If the Restricted
Stock Trigger Price is at least 1.40 times but less than 1.50 times the price
on the date of issuance, 75% of the Restricted Stock shall be forfeited and
transferred to the Company, 50% if the Restricted Stock Trigger Price is at
least 1.50 times but less than 1.61 times the price on the date of issuance
and 0% if the Restricted Stock Trigger Price is 1.61 times the price on date
of issuance or higher. Termination of employment with the Company during the
restricted period will also cause the Restricted Stock to be forfeited and
transferred to the Company.
As of December 31, 1999, the number of shares of stock reserved under the
Restricted Stock Plan was 350,000. The Company granted 276,158, 10,695 and
63,525 shares of Restricted Stock at weighted average fair values of $11.21,
$18.20 and $23.20 per share during 1999, 1998 and 1997, respectively.
Restricted Stock is considered issued and outstanding when awarded. As of
December 31, 1999, 69,761 restricted shares have been forfeited to the Company
and 280,617 shares are outstanding under the plan. The fair market value of
Restricted Stock on the date of issuance has been recorded as a deferred
expense and included as a component of stockholder's equity. No amortization
of the deferred expense was recorded in 1999, 1998 or 1997. The deferred
expense will be amortized over the remaining vesting period once certain
closing prices of the Company's Common Stock are achieved.
15. Fair Value of Financial Instruments
The Company has identified certain assets as financial instruments that
require fair value disclosure. The estimated fair value of financial
instruments has been determined by the Company using available market
information and appropriate valuation methodologies. However, considerable
judgment is necessarily required in interpreting market data to develop the
estimates of fair value. Accordingly, the Company's estimates of fair value
are not necessarily indicative of the amounts that the Company could realize
in a current market exchange. Potential taxes and other transaction costs have
not been considered in estimating fair value. As a number of the Company's
significant assets (including deferred policy acquisition costs, property and
equipment, and deferred taxes) and liabilities (loss and loss adjustment
expense reserves) are not considered financial instruments, the disclosures
that follow do not reflect the fair value of the Company as a whole.
The carrying values and estimated fair values of financial instruments at
December 31, 1999 and 1998, were as follows (in thousands):
<TABLE>
<CAPTION>
1999 1998
---------------- -------------------
Carrying Fair Carrying Fair
-------- ------- --------- ---------
<S> <C> <C> <C> <C>
Assets:
Fixed maturity securities................ $762,478 762,478 1,001,236 1,001,236
Equity securities........................ $ 26,594 26,594 21,057 21,057
Other investments........................ $ 3,100 3,100 3,107 3,107
Cash and cash equivalents................ $ 78,283 78,283 70,747 70,747
Premium installment receivables.......... $ 1,388 1,388 1,114 1,114
Accrued investment income................ $ 11,396 11,396 13,916 13,916
Liabilities:
Convertible subordinated debentures...... $ 57,816 60,000 57,017 60,000
Senior bank debt......................... $ 59,004 59,004 65,000 65,000
</TABLE>
F-24
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Fair values for fixed maturity securities are based on quoted market
prices, where available. If quoted market prices were not available, fair
values were determined by dealers specializing in those securities. Equity
securities are valued based on quoted market prices. Cash and cash
equivalents, premium installment receivables, accrued investment income and
other investments are valued at their carrying value as they are highly liquid
financial assets with maturities of less than one year. The fair value for
convertible subordinated debentures was estimated using discounted cash flow
calculations based upon Highlands Group's current incremental borrowing for
similar types of borrowing arrangements. The senior bank debt is carried at
fair value.
16. Contingent Liabilities
Legal Action
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.
Leases
At December 31, 1999, the Company was obligated under noncancelable
operating leases, expiring on various dates through 2003, principally for
office space and computer software. Future aggregate minimum rentals on
noncancelable operating leases are as follows: $3.7 million in 2000, $2.0
million in 2001, $.9 million in 2002, $.8 million in 2003 and $.3 million
thereafter.
The Company's gross rental expense was approximately $3.1 million, $4.3
million, and $6.6 million for 1999, 1998 and 1997, respectively.
Halliburton--Environmental
From 1958 until 1986, the Company issued fixed premium (non-retrospectively
rated) insurance policies to a subsidiary of Halliburton. From 1987 on, the
Company's insurance policies with the Halliburton companies have been written
on a retrospectively rated or high-deductible basis. Since the mid-1990's, the
subsidiary which had been issued fixed premium policies has received a
substantial number of asbestos claims. Through December 31, 1999, the Company
paid Halliburton $.8 million under the fixed premium policies on account of
the asbestos claims, and billed Halliburton $5.2 million under the
retrospectively rated and high-deductible policies on account of asbestos
claims. Halliburton has not paid this billed amount and has questioned the
proper allocation of the asbestos claims between the fixed premium and the
retrospectively rated and high-deductible policies. The Company has examined
this question, and believes that it is not responsible for a material amount
of additional asbestos liability under the fixed premium policies.
17. Business Concentration and Foreign Operations
In the normal course of business, the Company underwrites risks of its
former parent, Halliburton, and various subsidiaries and affiliates of
Halliburton. During 1999, 1998 and 1997, net premiums earned from Halliburton
aggregated approximately $22.9 million, $53.9 million, and $44.7 million,
respectively.
A portion of this business is retrospectively rated, meaning that ultimate
premiums will approximate ultimate losses plus certain expenses. Future
premiums due from Halliburton under these retrospective arrangements
approximate $108.6 million and $109.5 million at December 31, 1999 and 1998,
respectively. The agreement between Halliburton and the Company under which
the Company underwrote Halliburton business expired in January 2000.
F-25
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company's United Kingdom operations as a percentage of the Company's
consolidated revenues, loss before income taxes and identifiable assets as of
and for the year ended December 31, 1999, 1998 and 1997 are not significant.
18. Quarterly Financial Data (Unaudited)
The following quarterly financial information for each of the three months
ended March 31, June 30, September 30 and December 31, 1999 and 1998 is
unaudited. However, in the opinion of management, all adjustments (consisting
of normal recurring adjustments) necessary to present fairly the results of
operations for such periods, have been made for a fair presentation of the
results shown.
<TABLE>
<CAPTION>
Quarter Ended March 31 June 30 Sept 30 Dec 31
- ------------- -------- ------- ------- -------
(dollars in thousands, except
per share data)
<S> <C> <C> <C> <C>
1999
Net premiums earned....................... $ 81,705 78,158 78,091 87,351
Total revenues............................ $ 99,964 96,634 95,942 100,471
Total expenses............................ $ 96,377 93,034 101,333 102,732
Net income (loss)......................... $ 2,752 2,799 (3,323) (15,677)
Earnings (loss) per common share:
Basic................................... $ .22 .22 (.25) (1.19)
Diluted................................. $ .20 .20 (.25) (1.19)
1998
Net premiums earned....................... $ 83,230 85,652 85,027 134,904
Total revenues............................ $107,053 107,962 111,013 157,628
Total expenses............................ $ 98,562 121,211 100,847 163,826
Net income (loss)......................... $ 6,386 (7,732) 6,725 (2,282)
Earnings (loss) per common share:
Basic................................... $ .48 (.59) .51 (.18)
Diluted................................. $ .37 (.59) .43 (.18)
</TABLE>
F-26
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
SCHEDULE I
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
DECEMBER 31,1999
(in thousands)
<TABLE>
<CAPTION>
Amount at
which Shown
Amortized Fair in the
Type of investment Cost Value Balance Sheet
- ------------------ --------- ------- -------------
<S> <C> <C> <C>
At December 31, 1999
Fixed maturity securities available-for-sale:
United States Government and government
agencies.................................... $119,510 115,958 115,958
States, municipalities and political
subdivisions................................ 41,735 41,339 41,339
Asset-backed and collateralized securities... 351,297 336,596 336,596
Corporate securities......................... 290,052 268,585 268,585
-------- ------- -------
802,594 762,478 762,478
Equity securities............................. 31,376 26,594 26,594
-------- ------- -------
Total securities, available-for-sale....... 833,970 789,072 789,072
-------- ------- -------
Other investments............................. 3,100 3,100 3,100
-------- ------- -------
Total investments.......................... $837,070 792,172 792,172
======== ======= =======
</TABLE>
See accompanying report of independent public accountants.
F-27
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
December 31,
-----------------
ASSETS 1999 1998
------ -------- -------
<S> <C> <C>
Investments in subsidiaries................................. $350,085 427,963
Fixed maturity securities available-for-sale, at fair
value...................................................... -- 5,092
Cash and cash equivalents................................... 12,731 4,175
Accrued investment income................................... 60 2,086
Net deferred tax asset...................................... 29,318 2,809
Taxes receivable from subsidiaries.......................... 3,022 3,539
Deferred debt expense....................................... 3,475 4,161
Other assets................................................ 3,045 3,594
-------- -------
Total assets............................................ $401,736 453,419
======== =======
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
<S> <C> <C>
Senior bank debt............................................ $ 59,004 65,000
Convertible subordinated debentures......................... 57,816 57,017
Payable to subsidiaries..................................... 94 275
Accounts payable and accrued liabilities.................... 15,780 12,573
-------- -------
Total liabilities....................................... 132,694 134,865
-------- -------
Mandatorily redeemable preferred stock...................... 4,641 --
-------- -------
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares
authorized; 13,957,303 shares issued and outstanding in
1999, 13,235,316 shares issues and outstanding in 1998... 140 132
Additional paid-in capital................................ 231,515 223,976
Accumulated other comprehensive income.................... (29,184) 16,803
Treasury stock, at cost (739,400 shares in 1999 and
724,400 shares in 1998).................................. (9,459) (9,268)
Deferred compensation on restricted stock................. (3,147) (1,074)
Retained earnings......................................... 74,536 87,985
-------- -------
Total stockholders' equity.............................. 264,401 318,554
-------- -------
Total liabilities, mandatorialy redeemable preferred
securities and stockholders' equity.................... $401,736 453,419
======== =======
</TABLE>
See accompanying report of independent public accountants.
F-28
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF OPERATIONS
(in thousands, except per common share data)
<TABLE>
<CAPTION>
For the Years ended
December 31,
------------------------
1999 1998 1997
-------- ------ ------
<S> <C> <C> <C>
Revenues:
Net investment income............................... $ 594 595 1,507
Net realized investment gains....................... 28 -- --
-------- ------ ------
Total revenues.................................... 622 595 1,507
-------- ------ ------
Equity in net income (loss) of subsidiaries(1)........ (4,257) 11,890 24,854
-------- ------ ------
Expenses:
Interest expense.................................... 11,952 12,291 10,210
Debt amortization................................... 1,297 1,286 1,411
Other expenses...................................... 1,151 3,041 2,222
-------- ------ ------
Total expenses.................................... 14,400 16,618 13,843
-------- ------ ------
Income (loss) before income tax benefit............. (18,035) (4,133) 12,518
Income tax benefit.................................. 4,586 7,230 4,318
-------- ------ ------
Net income (loss)................................. $(13,449) 3,097 16,836
======== ====== ======
Earnings (loss) per common share:
Basic............................................... $ (1.04) $ .24 1.34
Diluted............................................. $ (1.04) $ .20 1.09
Weighted average number of common shares outstanding:
Basic............................................... 12,956 13,095 12,600
Diluted............................................. 12,956 15,811 15,388
</TABLE>
- --------
(1) 1999 includes a $22.1 million charge to write-off the Company's $10.5
million investment in LMI and $11.6 million of associated deferred tax
assets.
See accompanying report of independent public accountants.
F-29
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
For the Years ended December 31,
-----------------------------------
1999 1998 1997
----------- ---------- ----------
<S> <C> <C> <C>
Cash flow from operating activities:
Net income (loss)....................... $ (13,449) 3,097 16,836
Adjustments to reconcile net income
(loss) to net cash provided by (used
in) operating activities:
Equity in net (income) loss of
subsidiaries......................... 4,257 (11,890) (24,854)
Deferred tax (benefit) expense........ (1,747) (5,765) 1,634
Debt amortization..................... 1,297 1,286 1,411
Dividends received from subsidiaries.. 17,000 17,500 5,000
Decrease/(increase) in taxes
receivable from subsidiaries......... 517 284 (3,823)
Changes in other operating assets and
liabilities.......................... 1,394 2,222 6,371
----------- ---------- ----------
Total adjustments................... 22,718 3,637 (14,261)
----------- ---------- ----------
Net cash provided by operating
activities........................... 9,269 6,734 2,575
----------- ---------- ----------
Cash flows from investing activities:
Maturities or calls of fixed maturity
securities available-for-sale.......... -- -- 34,520
Investment purchases of fixed maturity
securities available-for-sale.......... -- -- (14,978)
Acquisition of subsidiary, net.......... -- -- (15,000)
Capital contributions to subsidiaries... -- -- (53,244)
Payment of acquisition expenses......... -- -- (3,730)
Other proceeds.......................... -- -- 92
----------- ---------- ----------
Net cash used in investing
activities......................... $ -- -- (52,340)
----------- ---------- ----------
Cash flows from financing activities:
Proceeds from senior bank debt.......... -- -- 65,000
Payment for debt issuance expense....... -- (675) (1,017)
Repayment of acquired bank debt......... -- -- (35,638)
Repayment of senior bank debt........... (5,996) -- --
Issuance of Common Stock................ 5,474 831 156
Acquisition of treasury stock........... (191) (4,000) --
----------- ---------- ----------
Net cash provided by financing
activities......................... (713) (3,844) 28,501
----------- ---------- ----------
Net increase (decrease) in cash and cash
equivalents.............................. 8,556 2,890 (21,264)
Cash and cash equivalents at beginning of
year..................................... 4,175 1,285 22,549
----------- ---------- ----------
Cash and cash equivalents at end of year.. $ 12,731 4,175 1,285
=========== ========== ==========
Supplemental disclosure of cash flow
information:
Interest paid........................... $ 10,163 10,603 8,803
=========== ========== ==========
Noncash financing activities:
Parent company stock acquired by
subsidiaries and held in treasury...... $ -- 5,268 --
=========== ========== ==========
</TABLE>
See accompanying report of independent public accountants.
F-30
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
(in thousands)
<TABLE>
<CAPTION>
As of December 31,
------------------------------
Deferred Losses,
Policy Claims
Acquisition and Loss Unearned
Property/Casualty Operations Costs Expenses Premiums
- ---------------------------- ----------- --------- --------
<S> <C> <C> <C>
1999............................................. $33,556 1,353,524 146,832
======= ========= =======
1998............................................. $31,537 1,603,548 137,353
======= ========= =======
1997............................................. $32,313 1,605,374 173,411
======= ========= =======
</TABLE>
<TABLE>
<CAPTION>
For the Years Ended December 31,
--------------------------------------------------------------
Amortization
Loss and of Deferred
Net Loss Policy Other Net
Property/Casualty Premium Investment Adjustment Acquisition Operating Premiums
Operations Revenue Income Expense Costs Expenses Written
- ----------------- -------- ---------- ---------- ------------ --------- --------
<S> <C> <C> <C> <C> <C> <C>
1999.................... $325,305 67,684 238,940 65,308 64,813 333,605
======== ====== ======= ====== ====== =======
1998.................... $388,813 77,969 328,400 71,538 70,250 374,816
======== ====== ======= ====== ====== =======
1997.................... $311,993 74,383 246,479 61,745 53,819 277,737
======== ====== ======= ====== ====== =======
</TABLE>
See accompanying report of independent public accountants.
F-31
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
SCHEDULE IV--REINSURANCE
(in thousands)
<TABLE>
<CAPTION>
Assumed Percent Of
Ceded to From Amount
Direct Other Other Net Assumed to
Amount Companies Companies Amount Net
-------- --------- --------- ------- ----------
<S> <C> <C> <C> <C> <C>
Premiums Earned:
Year ended December 31,
1999
Property-liability
insurance.............. $345,885 (29,761) 9,181 325,305 2.8 %
======== ======= ====== ======= ====
Year ended December 31,
1998
Property-liability
insurance.............. $406,028 (25,679) 8,464 388,813 2.2 %
======== ======= ====== ======= ====
Year ended December 31,
1997
Property-liability
insurance.............. $367,630 (46,758) (8,879) 311,993 (2.8)%
======== ======= ====== ======= ====
</TABLE>
See accompanying report of independent public accountants.
F-32
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
<TABLE>
<CAPTION>
Additions
-------------------------------
Balance at Charges to Balance at
Beginning Cost and Other End of
of Period Expenses Additions Deductions Period
---------- ---------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C>
Year ended December 31,
1999
Allowance for
uncollectible
reinsurance(1)........ $ 1,702 -- 455 -- 2,157
======= ===== ====== ===== ======
Allowance for bad
debts(2).............. $ 7,269 -- -- 2,448 4,821
------- ----- ------ ----- ------
Deferred tax asset
valuation
allowance(3).......... $18,994 -- -- 6,203 12,791
======= ===== ====== ===== ======
Year ended December 31,
1998
Allowance for
uncollectible
reinsurance(1)........ $ 2,157 -- -- 455 1,702
======= ===== ====== ===== ======
Allowance for bad
debts................. $ 5,803 1,466 -- -- 7,269
------- ----- ------ ----- ------
Deferred tax asset
valuation allowance... $19,567 -- -- 573 18,994
======= ===== ====== ===== ======
Year ended December 31,
1997
Allowance for
uncollectible
reinsurance(1)........ $ 2,410 -- -- 253 2,157
======= ===== ====== ===== ======
Allowance for bad
debts(4).............. $ 2,345 149 3,309 -- 5,803
------- ----- ------ ----- ------
Deferred tax asset
valuation
allowance(4).......... $ 5,204 -- 14,363 -- 19,567
======= ===== ====== ===== ======
</TABLE>
- --------
(1) Deductions in the allowance for uncollectible reinsurance represent write-
offs, net of recoveries, of amounts determined to be uncollectible.
(2) $1.2 million of the deduction relates to the write-off of LMI.
(3) $5.6 million of the deduction relates to the write-off of LMI.
(4) Other addition relates to the acquisition of American Reliance.
See accompanying report of independent public accountants.
F-33
<PAGE>
HIGHLANDS INSURANCE GROUP, INC.
SCHEDULE VI
SUPPLEMENTAL INFORMATION CONCERNING CONSOLIDATED
PROPERTY/CASUALTY INSURANCE OPERATIONS
(in thousands)
<TABLE>
<CAPTION>
As of December 31,
-------------------------------
1999 1998 1997
---------- --------- ---------
<S> <C> <C> <C>
Deferred policy acquisition costs.............. $ 33,556 31,537 32,313
Loss and loss adjustment expense reserves...... $1,353,524 1,603,548 1,605,374
Unearned premiums.............................. $ 146,832 137,353 173,411
<CAPTION>
For the Years Ended December
31,
-------------------------------
1999 1998 1997
---------- --------- ---------
<S> <C> <C> <C>
Net premiums earned............................ $ 325,305 388,813 311,993
Net investment income.......................... $ 67,684 77,969 74,383
Net loss and loss adjustment expense incurred
Current year................................. 247,027 256,528 230,033
Commutation of Aggregate Excess of Loss
Reinsurance................................. -- 50,000 --
Prior year................................... (8,087) 21,872 16,446
---------- --------- ---------
$ 238,940 328,400 246,479
========== ========= =========
Amortization of deferred policy acquisition
costs......................................... $ 65,308 71,538 61,745
Net paid loss and loss adjustment expense...... $ 346,572 370,125 358,867
Net premiums written........................... $ 333,605 374,816 277,737
</TABLE>
See accompanying report of independent public accountants.
F-34
<PAGE>
Exhibit 10.4
HIGHLANDS INSURANCE GROUP
1997 RESTRICTED STOCK PLAN
(as amended through May 10, 1999)
1. Purpose
This Plan's purpose is to align the interests of management more closely
with those of stockholders, by providing an incentive to invest in Highlands
Insurance Group, Inc. common stock, and by rewarding long service with the
Company and its Subsidiaries.
2. Definitions
For purposes of this Plan, the following terms shall have the definitions
set forth below:
(a) "Board." The Company's Board of Directors.
(b) "Committee." The Compensation Committee of the Board. No member of
the Committee shall participate in the administration of the Plan unless he is a
nonemployee director described in Rule 16b-3(e)(3) promulgated by the Securities
and Exchange Commission or any successor definition thereto.
(c) "Company." Highlands Insurance Group, Inc., a Delaware corporation.
(d) "Date of Issuance." The date Restricted Shares are issued to a
Participant.
(e) "Escrow Agent." The bank or other institution appointed by the Company
from time to time to hold Restricted Shares during the Restricted Period.
(f) "Participant." An employee of the Company or a Subsidiary selected for
participation in the Plan pursuant to Section 4.
(g) "Plan." The Highlands Insurance Group 1997 Restricted Stock Plan.
(h) "Restricted Period." The period described in Section 6(c).
(i) "Restricted Shares." The shares of common stock of the Company
reserved pursuant to Section 3 hereof and any such shares issued to a
Participant pursuant to this Plan.
(j) "Subsidiary" or "Subsidiaries." A corporation or corporations of which
the Company owns, directly or indirectly, shares having a majority of the
ordinary voting power for the election of directors.
<PAGE>
3. Restricted Share Reserve
(a) Establishment. The Company shall establish a Restricted Share reserve
to which shall be credited 350,000 shares of the common stock of the Company,
par value $.01 per share. Should the shares of the Company's common stock be
increased or decreased, or changed into or exchanged for, a different number or
kind of shares of stock or other securities of the Company or of another
corporation, due to a stock split or stock dividend or combination of shares or
any other change, or exchange for other securities, by reclassification,
reorganization, merger, consolidation, recapitalization or otherwise, the number
of shares then remaining in the Restricted Share reserve shall be adjusted
appropriately to reflect such action. If any such adjustment results in a
fractional share, the fraction shall be disregarded.
(b) Adjustments to Reserve. Upon the grant of shares hereunder, the
reserve shall be reduced by the number of shares so granted. Upon the
forfeiture of any Restricted Shares, the reserve shall be increased by such
number of shares, and such shares may again be the subject of grants hereunder.
(c) Source of Restricted Shares. As the Board shall in its sole discretion
determine, Restricted Shares may be authorized but unissued shares or treasury
shares. All authorized and unissued shares issued as Restricted Shares in
accordance with the Plan shall be fully paid and non-assessable shares and free
from preemptive rights.
4. Eligibility
(a) Eligible Employees. Any management employee of the Company or any
Subsidiary (including officers and directors, except for persons serving as
directors only) shall be eligible to receive a grant of Restricted Shares
pursuant to the Plan.
(b) Selection by the Committee. From the employees eligible to receive
grants pursuant to the Plan, the Committee may from time to time select
employees to receive grants. The Committee shall base its selections on the
positions and responsibilities of the eligible employees, the value of their
services to the Company and its Subsidiaries and such other factors as the
Committee deems pertinent.
(c) Participation in Other Stock Plans. A person who has received options
or other rights to purchase stock of the Company or a Subsidiary may exercise
the same in accordance with their terms, and shall not by reason thereof be
ineligible to receive Restricted Shares under this Plan. A person who has
received Restricted Shares hereunder shall not be ineligible for that reason to
be granted any option or other rights to purchase stock.
5. Amounts of Grants
(a) Participant Election. The number of Restricted Shares granted to each
Participant shall be equal to the number of shares of common stock of the
Company, if any, that the Participant purchases under the Plan. Each
Participant shall elect in writing, within
-2-
<PAGE>
the time permitted by the Committee, how many shares of common stock of the
Company to purchase pursuant to the Plan. Such an election shall be made by
delivering to the Secretary of the Company a written election on the form
provided by the Company. Any such election shall be accompanied by a stock power
endorsed in blank in order to permit the Escrow Agent to transfer Restricted
Shares to the Company in the event they are forfeited.
(b) Purchase of Shares. The Secretary of the Company shall arrange for
purchase in the market of the number of shares elected by Participants. The
Secretary shall inform each Participant promptly of the amount needed to
purchase the shares elected by the Participant, and of the date by which payment
must be received. The election of any Participant who fails to make timely
payment in full to the Secretary shall be null and void.
(c) Disposition of Purchased Shares. The Secretary of the Company shall
cause all shares purchased at the election of Participants to be delivered to
the respective Participants or their designees by the broker executing the
transaction.
(d) Listing on Stock Exchange. The Company shall take such action as shall
be necessary to cause any Restricted Shares issued pursuant to this Plan and not
previously listed to be listed on the New York Stock Exchange and/or such other
exchange(s) on which shares of the same class as the Restricted Shares are then
listed.
(e) Delivery of Written Notice. All elections and notices in writing
required pursuant to this Plan shall be sufficient only if actually delivered or
if sent via registered or certified mail, postage prepaid, to the Company,
attention Secretary, and/or the Escrow Agent at its principal office, and shall
be conclusively deemed given on the third business day following the date of
such mailing, if mailed.
5A. Exchange Offer
(a) Offer. Each Participant shall be entitled to exchange his Restricted
Shares granted under Section 5 for new Restricted Shares in accordance with this
Section 5A. The number of new Restricted Shares granted shall be 75% of the
number of Restricted Shares that the Participant elects to exchange.
(b) Participant Election. Each Participant shall elect in writing, within
the time specified on the Exchange Offer Election form, whether he wishes to
accept the exchange offer described in (a) above. Such an election shall apply
to all of a Participant's Restricted Shares. The election shall be made by
delivering to the Secretary of the Company a written election on the form
provided by the Company. An election to accept the exchange offer shall be
accompanied by a stock power endorsed in blank in order to permit the Escrow
Agent to transfer the new Restricted Shares to the Company in the event they are
forfeited.
(c) Date of Issuance. The Date of Issuance of new Restricted Shares issued
under this Section 5A shall be March 10, 1999 for all purposes under this Plan.
6. Restrictions
-3-
<PAGE>
(a) Transfer/Issuance. Restricted Shares shall be issued or transferred to
Participants promptly after completion of the purchases pursuant to Section
5(b), and certificates for such shares shall be issued in the respective
Participants' names. Each Participant shall thereupon be the record owner of
all the shares represented by the certificate or certificates. As such, the
Participant shall have all the rights of a shareholder with respect to such
shares, including the right to vote them and to receive all dividends and other
distributions (subject to (b), below) paid with respect to them, provided,
however, that the shares shall be subject to the restrictions in (d), below.
The shares represented thereby may not be sold, exchanged, transferred, pledged,
hypothecated, or otherwise disposed of during the Restricted Period, and each
transfer agent for the common stock shall be instructed to that effect. In aid
of such restrictions, all certificates for Restricted Shares shall be deposited
by the Company with the Escrow Agent.
(b) Adjustments to Restricted Shares. If, due to a stock split, stock
dividend, combination of shares, or any other change or exchange for other
securities by reclassification, reorganization, merger, consolidation,
recapitalization or otherwise, the Participant, as the owner of Restricted
Shares subject to restrictions hereunder, shall be entitled during the
Restricted Period to new, additional, or different shares of stock or other
securities, the certificate or certificates for, or other evidences of, such
new, additional, or different shares or securities also shall be deposited by
the issuer with the Escrow Agent. If any of the event(s) described in the
preceding sentence occur, all Plan provisions relating to restrictions and lapse
of restrictions shall apply to such new, additional, or different shares or
securities, provided, however, that if the Participant shall receive rights,
warrants or fractional interests in respect of any of such Restricted Shares,
such rights or warrants may be held, exercised, sold or otherwise disposed of,
and such fractional interests may be settled, by the Participant free and clear
of the restrictions hereinafter set forth.
(c) Restricted Period. The restrictions set forth in (d), below, shall
apply to Restricted Shares during a period starting on the Date of Issuance of
such shares and ending on the fifth anniversary of such date.
(d) Restrictions. The restrictions to which Restricted Shares shall be
subject are the following:
(i) During the Restricted Period applicable to Restricted Shares,
none of such shares shall be sold, exchanged, transferred, pledged,
hypothecated, or otherwise disposed of; provided, that Restricted Shares may be
transferred to the Company if the Committee offers an exchange for new
Restricted Shares.
(ii) If a Participant's employment with the Company and its
Subsidiaries terminates for any reason, including such Participant's death or
disability, at any time before the third anniversary of the Date of Issuance of
Restricted Shares, the Restricted Shares shall be forfeited and transferred to
the Company.
-4-
<PAGE>
(iii) If a Participant resigns, or is terminated for cause, from
employment with the Company and its Subsidiaries at any time before the
Restricted Period ends, the Participant's Restricted Shares shall be forfeited
and transferred to the Company.
(iv) If the price on the date the Restricted Period ends is less than
161% of the price at the Date of Issuance, all or a portion of the Restricted
Shares shall be forfeited, and transferred to the Company, as determined by the
following table.
Price at End Compared with
Beginning of Restricted Period Forfeited Percentage
------------------------------ --------------------
Less than 140% 100%
140% but less than 150% 75%
150% but less than 161% 50%
(e) Special Definitions. For purposes of this Section 6, the following
terms shall have the definitions set forth below.
(i) Cause means fraud, dishonesty or similar willful misconduct on
the part of a Participant; a material breach by a Participant of any of his
obligations under any employment agreement with the Company or any of its
Subsidiaries or otherwise in connection with any position that such Participant
holds, or in the future may hold, at the Company or any Subsidiary (provided
that the Participant shall first be notified of and be given a reasonable
opportunity to cure such breach); gross negligence by a Participant in the
performance of the services contemplated by such Participant's employment
agreement (if any) or performed in connection with the Participant's position as
an employee of the Company or its Subsidiary; or conviction of a Participant (or
the entering of a plea of guilty, nolo contendere, or request for deferred
adjudication) for fraud, misappropriation, embezzlement, financial misconduct,
any felony, or any lesser criminal offense which carries a potential penalty of
imprisonment for a term of one year or more and/or a fine of $5,000 or more
(other than such a lesser criminal offense that relates solely to the action or
omission of one or more persons other than the Participant), whether or not a
lesser penalty or fine is assessed.
(ii) Price on a given date means the average closing price of the
common stock of the Company on the preceding five trading days, as reported on
the principal national securities exchange on which the common stock is then
listed, or if there were no sales on any of such days, on the most recent five
days on which there were sales.
7. Delivery of Vested Shares
(a) Lapse of Restricted Period. After the end of the Restricted Period,
the Escrow Agent shall transfer to the Company any Restricted Shares that are
forfeited pursuant to Section 6(d), above. Subject to (b), below, the Escrow
Agent shall release to the respective Participants, free of such restrictions,
the remaining Restricted Shares.
-5-
<PAGE>
(b) The Escrow Agent shall not release shares from escrow to a Participant
or executor or administrator until the Participant or executor or administrator
has remitted to the Company or its Subsidiary all federal, state and local taxes
that the Company or its Subsidiary determines it is required to withhold.
8. Death of a Participant
In the event of the death of a Participant prior to the third anniversary
of the Date of Issuance, the Restricted Shares shall be forfeited and the Escrow
Agent shall transfer them to the Company. If a Participant dies after the third
anniversary of the Date of Issuance, but before the end of the Restricted
Period, the Restricted Shares that are not forfeited pursuant to Section 6(d),
if any, shall be released as provided in Section 7 to the Participant's executor
or administrator.
9. Finality of Determination
The Committee shall administer this Plan and construe its provisions. Any
determination by the Committee in carrying out, administering, or construing
this Plan shall be final and binding for all purposes and upon all interested
persons and their heirs, successors, and personal representatives.
10. No Right to Continued Employment
Neither the Company's action in establishing the Plan, nor any action taken
by it or by the Board or the Committee under the Plan, nor any provision of the
Plan, shall be construed as giving to any person the right to be retained in the
employ of the Company or any Subsidiary.
11. Amendment, Suspension or Termination of Plan
(a) The Plan shall be submitted for approval by the stockholders of the
Company at the 1998 annual meeting of stockholders. If the Plan is not approved
by a majority of shares present in person or by proxy, it shall be void and of
no effect, and all Restricted Shares shall be transferred to the Company.
(b) The Board may amend, suspend or terminate the Plan in whole or in part
at any time; provided that such amendment shall not affect adversely rights or
obligations with respect to grants previously made.
12. Governing Law
The Plan shall be governed by the laws of the State of New Jersey.
-6-
<PAGE>
13. Expenses of Administration
All costs and expenses incurred in the operation and administration of this
Plan shall be borne by the Company.
14. Registration of Restricted Shares
The Company, at its expense, shall register the Plan under the Securities
Act of 1933.
-7-
<PAGE>
Exhibit 10.6
RETIREMENT AND RELEASE AGREEMENT
--------------------------------
This Retirement and Release Agreement (the "Agreement") is made and
entered into as of the 1st day of June 1999, by and between Highlands Insurance
Group, Inc., a Delaware corporation, 1000 Lenox Drive, Lawrenceville, New Jersey
("Highlands") and Richard M. Haverland, a citizen of New Jersey employed by
Highlands and its subsidiaries in Lawrenceville, New Jersey (hereinafter
"Haverland").
WITNESSETH:
WHEREAS, Haverland has been employed by Highlands and its subsidiaries
as President and Chief Executive Officer and has been a member of the boards of
directors of Highlands and certain of its subsidiaries;
WHEREAS, Haverland wishes to retire and resign from all his positions
with Highlands and its subsidiaries, effective June 1, 1999 (except that
Haverland shall continue as a member of the Board of Directors of Highlands);
NOW, THEREFORE, for and in consideration of the agreements, covenants
and conditions of this Agreement, the adequacy and sufficiency of which are
hereby acknowledged by each of the parties hereto, the parties agree as follows:
1. Resignation of Offices and Directorships. Haverland hereby
----------------------------------------
resigns and relinquishes any rights to reinstatement to any and all his offices
and directorships with Highlands and each of its subsidiaries, effective June 1,
1999, and shall have no further active duties or responsibilities as of that
date (except that Haverland shall continue as a member of the Board of Directors
of Highlands).
2. Consideration. Highlands agrees that Haverland shall continue to
-------------
be paid an amount equal to his salary ($43,750 per month) in semi-monthly
payments until December 31, 1999. During this period, Haverland agrees to
provide consulting services to Highlands and to assist in the transition of his
duties as requested by Highlands. Highlands also agrees to pay Haverland a
bonus equal to $231,000.
3. Other Benefits.
--------------
a. Haverland may continue to participate in Highlands' standard
health insurance plans until the earlier of May 31, 2001 or his obtaining
employment with another company. Highlands agrees to pay the portion of the cost
of such standard health insurance to the extent of and consistent with
Highlands' then current normal payment practices.
<PAGE>
b. Haverland shall be paid his earned and unused vacation through
June 1, 1999 and shall be entitled to receive his amounts in the Highlands
Insurance Group Employees' Retirement and Savings Plan which are vested as of
June 1, 1999.
c. If Haverland's membership on the Board of Directors of
Highlands terminates, such termination shall be treated as a retirement at
normal retirement age in connection with the 1995 Directors' Stock Plan
Nonstatutory Stock Option Agreement dated January 4, 1996 between Highlands
Insurance Group, Inc. and Haverland.
d. Haverland shall be treated as an employee of Highlands in
connection with the Purchase, Redemption and Bonus Agreement dated January 23,
1996 between Highlands and Haverland on the fifth anniversary of such agreement.
4. Method of Payment. The semi-monthly payments shall be sent to
-----------------
Haverland via direct deposit into his bank account in accordance with Highlands'
normal payroll practices. The bonus payment shall be paid to Haverland in the
payroll following the Effective Date (defined in Section 17).
5. No Other Benefits. Except as specifically stated in this
-----------------
Agreement, Haverland shall not be entitled to any other compensation or benefits
of any kind from Highlands and its subsidiaries.
6. Attorneys Fees and Costs. Highlands shall reimburse Haverland for
------------------------
his reasonable attorneys fees and costs incurred in connection with the
enforcement of the terms of this Agreement in the event Highlands breaches any
terms of this Agreement, including, but not limited to, the fees and expenses
incurred in any suit to recover the severance payments and/or benefits due under
this Agreement. In the event that Haverland commences such a lawsuit and does
not prevail, then Haverland agrees to reimburse Highlands for the reasonable
attorneys fees and costs incurred by it in defending such a lawsuit.
7. General Releases and Covenants Not to Sue.
-----------------------------------------
a. Effective upon the signing of this Agreement, Haverland, for
himself and his agents, trustees, attorneys, assigns, estate, heirs,
- ---
administrators, executors, personal representatives and affiliates (the
"Releasing Parties"), hereby remises, releases and forever discharges Highlands
and its employees, agents, officers, directors, trustees, attorneys, assigns,
subsidiaries and affiliates (the "Released Parties"), of and from all claims,
demands, actions, liabilities and other claims for relief of any kind, whether
known or unknown, arising at any time out of or relating to the conduct of any
of the Released Parties, and any tort or contract claims, whether known or
unknown, choate or inchoate, past, present or future concerning or emanating
from the conduct or operations of the Released Parties. Haverland acknowledges
and understands that the claims being released in this paragraph include, but
are not limited to, (i) any claim based on contract or in tort or common law;
(ii) any claim based on or arising under any employment laws, such as the
federal Age Discrimination in Employment Act (29 U.S.C. (S) 621 et seq.), Title
-- ---
VII of the Civil Rights Act of 1964 (42 U.S.C. (S) 2000e et seq.), the Americans
-- ---
with Disabilities Act (42 U.S.C. (S) 12101 et seq.), the Rehabilitation Act (29
-- ---
U.S.C. (S) 791 et
--
-2-
<PAGE>
seq.), the Employee Retirement Income Security Act (29 U.S.C. (S) 1001 et seq.),
- --- -- ---
the Equal Pay Act (29 U.S.C. (S) 206 (d)(1)), the Civil Rights Act of 1991, and
any state laws; (iii) any claim based on or arising out of Haverland's
employment by Highlands and/or the termination thereof; and (iv) any claims for
compensatory, liquidated or punitive damages, damages for emotional distress,
back pay, front pay, benefits, counsel fees, costs and expenses. Haverland
understands that, by signing this Agreement, he waives all claims he ever had or
now has against any of the Released Parties that arose or may have arisen before
he signs this Agreement. This release also applies to any claims brought by any
person or agency or any class action under which Haverland may have any right or
benefit. Further, Haverland promises never to file a lawsuit asserting any
claims that are released by Haverland and promises not to accept any recoveries
or benefits which may be obtained on Haverland's behalf by any other person or
agency or any class action. Notwithstanding the foregoing, Haverland shall not
be deemed to have released the Released Parties from any breach of this
Agreement or for any claims for defense, contribution and indemnification as a
former employee, officer or director pursuant to Highlands' and its
subsidiaries' Articles of Incorporation, Bylaws, insurance contracts, or the
corporation law governing them.
b. Effective upon the signing of this Agreement, Highlands, for
itself and its agents, officers, directors, employees, trustees, attorneys,
assigns, subsidiaries and affiliates (the "Releasing Parties"), hereby remises,
releases and forever discharges Haverland and his agents, trustees, attorneys,
assigns, estate, heirs, administrators, executors, personal representatives and
affiliates (the "Released Parties"), of and from all claims, demands, actions,
liabilities and other claims for relief of any kind, whether known or unknown,
including, but not limited to, claims arising at any time out of or relating to
the conduct of the Released Parties, any tort, contract or defamation claims,
whether known or unknown, choate or inchoate, past, present or future, and any
claims concerning or emanating from the conduct or operations of the Released
Parties. Notwithstanding the foregoing, Highlands shall not be deemed to have
released Haverland from any breach of this Agreement.
c. Haverland and Highlands further covenant and agree not to sue
or otherwise assert a claim against any of the Released Parties for any claims
released hereunder. If Haverland or Highlands brings a legal action or asserts a
claim against any Released Party in violation of this provision, he or it will
be liable to such Released Party for all of its or his expenses and legal fees
for opposing such claim, plus any other relief the court may award.
8. Confidentiality Provisions.
--------------------------
a. In connection with Haverland's employment, Highlands, its
subsidiaries, advisors and agents made available to Haverland information which
is non-public, confidential or proprietary in nature ("Confidential Material").
b. By execution of this Agreement, Haverland agrees to treat such
Confidential Material confidentially and to observe the terms and conditions set
forth herein. For purposes of this Agreement, Confidential Material shall
include all non-public information, regardless of the form in which it is
communicated or maintained (whether prepared by
-3-
<PAGE>
Highlands or otherwise), that contains or otherwise reflects non-public
information concerning Highlands or its subsidiaries obtained in the course of
Haverland's employment with Highlands and its subsidiaries, including, but not
limited to, non-public information about Highlands and its subsidiaries' (i)
existing business and business techniques, (ii) current financial condition,
(iii) agreements, (iv) current agents and employees, (v) current policyholders,
(vi) technology and software and (vii) present or future business plans and
strategies.
c. Except as specifically permitted by this Agreement or as
otherwise authorized by Highlands, Haverland will not disclose Confidential
Material to any person or entity whatsoever.
d. In the event that Haverland is requested or required (by
deposition, interrogatories, requests for information or documents in legal
proceedings, subpoenas, civil investigative demand or similar process), in
connection with any proceeding, to disclose any Confidential Material, Haverland
will give Highlands prompt notice of such request or requirement so that
Highlands may, at its own expense, have the opportunity to seek an appropriate
protective order or other remedy and/or waive compliance with the provisions of
this Agreement. In the event that such protective order or other remedy is not
obtained or Highlands waives compliance with the relevant provisions of this
Agreement, Haverland will furnish only that portion of the Confidential Material
which, in the written opinion of his counsel, is legally required to be
disclosed.
e. Haverland agrees that money damages would not be a sufficient
remedy for any breach of this paragraph 8 of this Agreement by him and that in
addition to all other remedies, Highlands shall be entitled to specific
performance and injunctive or other equitable relief as a remedy for any such
breach.
f. In the event that Haverland materially breaches the provisions
of this paragraph 8 of this Agreement, then Haverland agrees to pay Highlands
for its reasonable attorneys fees and costs incurred in connection with the
enforcement of these provisions; provided that Highlands prevails in such a
lawsuit to enforce the Agreement. In the event that Highlands commences such a
lawsuit and does not prevail, then Highlands agrees to reimburse Haverland for
the reasonable attorneys fees and costs incurred by his in defending such a
lawsuit.
9. Entire Agreement; Amendment. This Agreement contains the entire
---------------------------
agreement between the parties hereto with respect to the subject matter hereof,
and supersedes and cancels all previous agreements, commitments and writings
between the parties, except to the extent such agreements are expressly retained
hereunder. This Agreement may not be modified in any manner except by an
instrument in writing signed by the parties hereto.
10. Binding on Successors and Assigns. This Agreement shall be
---------------------------------
binding upon and inure to the benefit of each of the parties hereto, and their
respective parents, subsidiaries, affiliates, legal representatives, estates,
purchasers, successors, assigns, heirs, administrators, personal
representatives, executors and trustees.
-4-
<PAGE>
11. Governing Law. This Agreement shall be construed and enforced in
-------------
accordance with the laws of the State of New Jersey.
12. Notices. All notices, requests, demands and other communications
-------
hereunder shall be in writing, and shall be deemed to have been duly given if
made by hand delivery, by telex, by facsimile transmission or by registered or
certified mail (postage prepaid and return receipt requested) or by overnight
express delivery service to the parties at the following address (or at such
other address for a party as shall be specified by it by like notice):
If to Highlands:
Highlands Insurance Group, Inc.
1000 Lenox Drive
Lawrenceville, New Jersey 08648-0426
Attn: Stephen L. Kibblehouse, Esquire
Facsimile: (609) 219-1774
If to Haverland:
821 Pretty Brook Road
Princeton, New Jersey 08540
Telephone: (609) 430-9352
Facsimile: (609) 430-9354
All such notices, requests, demands or other communications shall be deemed to
have been duly given: when delivered by hand, if personally delivered; five (5)
business days after being deposited in the mail, postage prepaid, if delivered
by mail; two (2) business days after being sent by overnight express delivery
service; when answered back, if telexed; and within one (1) day of confirmed
transmission, if sent by facsimile transmission.
13. Counterparts. This Agreement may be executed by each of the
------------
parties hereto in separate counterparts and has the same force and effect as if
the parties had executed it as a single document.
14. Acknowledgment. Haverland acknowledges that he has been advised
--------------
of his right to consult with an attorney before signing this Agreement and that
he has been given a period of twenty-one (21) days to consider the Agreement
before signing it.
15. Representations. Haverland represents that he has read the
---------------
Agreement and understands it, and that he is signing this Agreement voluntarily
and of his own free will, without any coercion or duress. Haverland further
warrants and represents that in deciding whether to enter into this Agreement,
he is not relying on any promises, statements or representations other than
those expressly set forth herein.
-5-
<PAGE>
16. No Admission. By offering or entering into this Agreement,
------------
Highlands does not admit that it or any of its employees violated any law or any
legal right of Haverland and, in fact, Highlands expressly denies liability.
Highlands is entering into this Agreement solely for the purpose of effectuating
a mutually satisfactory severance of Haverland's employment.
17. Effective Date. This Agreement will not become effective or
--------------
enforceable until seven (7) days after Haverland executes it. Haverland may
revoke this Agreement at any time within that seven (7) day period, by sending a
written notice to Stephen L. Kibblehouse, Esquire, at the address indicated
above. Such written notice may be sent by mail, overnight express delivery
service, fax or hand delivery. If a revocation is sent within that seven (7) day
period, this Agreement shall be null and void for all purposes. If revocation is
not sent within that seven (7) day period, this Agreement will go into effect on
the first day immediately following the expiration of said seven (7) day period
("Effective Date").
IN WITNESS WHEREOF, the parties have caused this Agreement to be
properly executed as of the date first written above.
HIGHLANDS INSURANCE GROUP, INC.
By:_____________________________
Stephen J. Greenberg
Vice President
________________________________ _______________________________
RICHARD M. HAVERLAND Witness
________________________________
Date of Signing
-6-
<PAGE>
Exhibit 10.16
AMENDMENT NO. 1
to
HIGHLANDS INSURANCE GROUP
EMPLOYEES' RETIREMENT AND SAVINGS PLAN
Highlands Insurance Group, Inc., a Delaware corporation, hereby amends
the Highlands Insurance Group Employees' Retirement and Savings Plan, pursuant
to Article XVI thereof, in the following respect.
The following new sentence is added to Section 10.2(b), effective July
1, 1998:
Notwithstanding the foregoing, (a) above shall apply to
any Participant who terminates employment with the
Employer after (i) the sum of his age and his years of
Vesting Service equals or exceeds 70, or (ii) attaining
the age of 55 if he was a Participant on January 1,
1987.
IN WITNESS WHEREOF, Highlands Insurance Group, Inc. has caused this
instrument of amendment to be executed its officer hereunto duly authorized this
_____ day of _____________________, 1999.
HIGHLANDS INSURANCE GROUP, INC.
By:_________________________________
Its:_________________________________
<PAGE>
Exhibit 10.17
AMENDMENT NO. 2
to
HIGHLANDS INSURANCE GROUP
EMPLOYEES' RETIREMENT AND SAVINGS PLAN
Highlands Insurance Group, Inc., a Delaware corporation, hereby amends
the Highlands Insurance Group Employees' Retirement and Savings Plan, pursuant
to Article XVI thereof, in the following respects.
1. The following new subsections are added to Section 11.1, effective
March 1, 2000:
(e) A Participant who has attained age 592 may, in
addition to withdrawals under (a) and (f),
withdraw any or all amounts held in his Tax
Deferred Savings Account. No withdrawal may be
made under this subsection (e) in a Plan Year in
which a withdrawal has been made under any other
subsection of this Section 11.1 at an earlier
date.
(f) A Participant may withdraw not less than all of
his Rollover Account at any time. No portion of a
Rollover Account that is withdrawn pursuant to
this subsection (f) may be recontributed to the
Plan.
2. The Appendix B annexed hereto is added to the Plan, effective
July 1, 2000.
IN WITNESS WHEREOF, Highlands Insurance Group, Inc. has caused this
instrument of amendment to be executed by its officer hereunto duly authorized
this ____ day of _____________________, 2000.
HIGHLANDS INSURANCE GROUP, INC.
By:_________________________________
Its:_________________________________
<PAGE>
Exhibit 10.18
Employment Agreement
THIS EMPLOYMENT AGREEMENT (this "Agreement") is entered into as of the
10/th/ day of May, 1999, between Highlands Insurance Group, Inc., a Delaware
corporation (the "Company") and Willis T. King, Jr. ("Employee").
WHEREAS, it is the mutual desire of the Company and Employee that the
Company employ Employee on the terms and conditions described in this Agreement.
Now, THEREFORE, in consideration of the premises and the mutual covenants
hereinafter set forth and for other good and valuable consideration, the receipt
and adequacy of which are hereby acknowledged, the parties hereto agree as
follows:
1. Employment. The Company hereby employs Employee for the Employment
----------
Period specified in Section 2 below as Chairman, President and Chief Executive
Officer of the Company. Employee hereby accepts such employment and agrees to
diligently and to the best of Employee's abilities perform the duties and
services appropriate to such positions and to devote his full business time and
efforts to the performance of the duties of such position or positions, which
shall include, but not be limited to, managing the operations of the Company.
Employee further agrees to at all times comply with and be subject to the
policies and procedures the Company may establish from time to time, so long as
such policies and procedures do not violate any applicable laws or regulations.
2. Employment Period. The period of Employee's employment under this
-----------------
Agreement (the "Employment Period") shall commence on June 1, 1999 and shall end
upon the earlier of (i) the date three months following receipt by Employee of
written notice of termination of the Employment Period from the Company (but in
no event earlier than the third anniversary of this Agreement) or (ii) the
termination of the Employment Period pursuant to Section 6 below.
3. Compensation.
------------
(a) As compensation for all services rendered and to be rendered by
Employee pursuant to this Agreement, the Company agree to pay Employee:
(i) during the Employment Period, an annual salary (the "Base
Annual Salary") of $420,000 and
(ii) an annual incentive of up to 150% of Employee's Base Annual
Salary based on the performance of the Company as measured by the
achievement of specified performance objectives. The objectives
will be determined by the board of directors of the Company (the
"Board of Directors") in its sole discretion. Employee shall
receive a minimum bonus for 1999 and 2000 of
<PAGE>
$210,000 per year, payable in a lump sum on or prior to April 15
of the next year. Any additional bonus amounts for 1999 and 2000
and any other bonuses shall be payable in accordance with the
Company's current practice for all key executives under its
Management Incentive Plan ("MIP"). Exhibit A is a summary of the
MIP.
(b) The Base Annual Salary shall be reviewed no less frequently than
annually by the Compensation Committee of the Board of Directors and may be
increased upon the approval of the Board of Directors in its sole discretion.
The Base Annual Salary shall accrue and be payable in accordance with the
payroll practices of the Company as in effect from time to time.
4. Other Employment Benefits.
-------------------------
(a) During the Employment Period, Employee shall be entitled to such
other benefits as are customarily accorded the executives of the Company,
including, without limitation, the right to participate in employee benefit
programs maintained by the Company, including a health and life insurance
program and disability and retirement plans, provided, that nothing contained
herein shall be construed to require the Company to establish or maintain any
policy or program. The Employee will be entitled to five weeks vacation
annually.
(b) The Company shall grant Employee an option under the Company's
1995 Director's Stock Plan exercisable for 150,000 shares of common stock, par
value of $0.01 per share, of the Company's Common Stock ("Common Stock"). Such
option shall (i) have an exercise price per share equal to the closing price of
the Common Stock on the New York Stock Exchange on May 10, 1999, (ii) vest in
three equal annual installments commencing on the first anniversary of this
Agreement, (iii) fully vest on a change of control of the Company, or the death
or termination by reason of disability of Employee, the termination of Employee
without Cause, or the voluntary termination by Employee for Good Reason, and
(iv) expire on the tenth anniversary of this Agreement. The Company agrees to
use reasonable efforts to register the sale by Employee of the shares of Common
Stock issuable upon exercise of such options under the Securities Act of 1933,
as amended.
(c) Employee will purchase $5 million of Common Stock from the Company
at a price per share equal to the closing price of the Common Stock on the New
York Stock Exchange on May 10, 1999. Employee will be issued 250,000 shares of
Restricted Stock under the Company's Restricted Stock Plan, with a base price
equal to the price of the Common Stock purchased from the Company. If Employee
retires, is terminated by reason of death or disability, is terminated without
Cause or voluntarily terminates for Good Reason after the three-year period
specified in paragraph 6(d) of the Plan, his Restricted Shares will not be
forfeited on account of such retirement or termination.
-2-
<PAGE>
(d) In the case of a conflict in terms between this Agreement and the
Directors' Stock Plan or the Restricted Stock Plan, as the case may be, the
terms of this Agreement shall govern.
5. Expenses. Upon submission of expense vouchers and corresponding
--------
receipts and related documentation in accordance with Company policies then in
effect, the Company shall promptly reimburse Employee for all reasonable
expenses incurred by Employee on behalf of the Company or in accordance with
Employee's performance of Employee's duties hereunder including, without
limitation, all reasonable travel, entertainment and lodging expenses incurred
by Employee in connection with the performance of his duties hereunder.
6. Termination. The Employment Period may be terminated pursuant to any
-----------
one or more of the following provisions:
(a) The Employment Period may be terminated at any time by the Company
by written notice to Employee or by Employee by written notice to the Company.
Upon such termination, all of Employee's rights under Sections 3, 4, and 5 above
---------- - -
shall immediately terminate, except that the Company will pay to Employee all
amounts accrued in respect of periods prior to such termination. If such
termination (i) is by the Company without Cause (as hereinafter defined) or by
the Employee with Good Reason (as hereinafter defined) and (ii) is other than
the result of Employee's death or Disability (as hereinafter defined), the
Company shall pay to Employee severance pay during the Severance Period (as
hereinafter defined) in an amount equal to the amount of salary and pro rated
portion of any bonus that would otherwise be payable to Employee under this
Agreement (assuming that the Base Term (as hereinafter defined) were extended,
if necessary, so as to end concurrently with the end of the Severance Period),
based upon the Base Annual Salary and the bonus terms in effect on the date of
such termination ("Severance Payments"). Such Severance Payments shall be
payable in installments during the Severance Period on the same basis as salary
and bonus would be otherwise be payable to Employee during the Base Term. In
addition, Employee shall be entitled to all benefits accorded by Section 4(a) so
------------
along as Employee is eligible to receive Severance Payments.
(b) The term "Cause" shall mean (i) fraud, dishonesty, or similar
willful misconduct on the part of Employee, (ii) a material breach by Employee
of any of his representations or obligations under this Agreement (provided that
Employee shall first be notified of an be given a reasonable opportunity to cure
such breach), (iii) gross negligence by Employee in the performance of the
services contemplated by this Agreement, or (iv) conviction of Employee (or the
entering of a plea of guilty, nolo contendere, or request for deferred
adjudication) for fraud, misappropriation, embezzlement, financial misconduct,
any felony, or any lesser criminal offense which carries a potential penalty of
imprisonment for a term of one year or more and/or a fine of $25,000 or more,
whether or not a lesser penalty or fine is assessed. The term "Good Reason"
shall mean, without Employee's written consent, (i) any reduction in the amount
of Employee's Base Annual Salary, (ii) any material reduction in Employee's
title, duties,
-3-
<PAGE>
or responsibilities with the Company, (iii) the failure of the Board of
Directors to discharge an employee of the Company, at the request of Employee,
for an act that would constitute "Cause" under clause (i), (iii) or (iv) of the
immediately prior sentence, or (iv) a material breach by the Company of its
obligations under this Agreement. Notwithstanding the foregoing sentence, the
occurrence of any of the events described in the foregoing sentence will not
constitute Good Reason unless Employee gives the Company written notice that
such event constitutes Good Reasons, and the Company thereafter fails to cure
the event within 30 days after receipt of such notice. The term "Severance
Period" shall mean a period of time equal to the greater of (i) two years or
(ii) the period commencing on the date of Employee's termination of employment
with the Company and ending on the last day of the Base Term. The term "Base
Term" shall mean the period from the date hereof to and including the third
anniversary of this Agreement.
(c) If employee shall terminate his employment with the Company
without Good Reason or shall die during the Employment Period, the Employment
Period shall terminate as of the date of such termination, all of Employee's
rights under Sections 3, 4 (other than subsections 4(b) and 4(c)), and 5 above
---------- - -
shall immediately terminate, and the Company shall pay to Employee or Employee's
estate or legal representative only the amount of salary and pro rated portion
of any bonus accrued to Employee under this Agreement through the date of such
termination without Good Reason or death.
(d) If Employee is unable to discharge his duties hereunder for a
period of four consecutive months, or for a total of six months in any 12-month
period, by reason of physical or mental illness, injury, or incapacity
("Disability"), the Company may, by written notice to Employee, terminate the
Employment Period. In such case, all of Employee's rights under Sections 3, 4,
---------- -
and 5 above shall immediately terminate, and the Company shall pay to Employee
-
only the amount of salary and pro rated portion of any bonus accrued to Employee
under this Agreement through the date of such termination. During any such
period in which Employee is unable to discharge his duties hereunder, Employee's
Base Annual Salary shall be reduced by the amount of any Company sponsored
disability benefits paid to Employee during such period.
(e) The Severance Payments paid to Employee shall be in consideration
of Employee's continuing obligations hereunder after such termination
(including, without limitation, or Employee's obligations under Section 10
----------
hereof). Employee shall not be under any duty or obligation to seek or accept
other employment following a termination of employment pursuant to which
Severance Payments are owing, and Severance Payments shall not be reduced by any
amounts earned by Employee from subsequent employment or as a self-employed
individual during the Severance Period. Employee's rights under this Section
-------
6(e) are Employee's sole and exclusive rights against the Company or its
- ----
affiliates under this Agreement and the Company's sole and exclusive liability
to Employee under this Agreement, for the termination of his Employment
relationship with the Company. Employee covenants not to sue or lodge any
claim, demand or cause of action against the Company based upon
-4-
<PAGE>
Employee's termination of employment under this Agreement for any moneys other
than those specified in Section 6(a). If Employee breaches this covenant, the
------------
Company shall be entitled to recover from Employee all sums expended by the
Company (including costs and attorneys' fees) in connection with such suit claim
demand or cause of action. Nothing contained in Section 6 shall be construed to
---------
be a waiver by Employee of any benefits accrued for or due Employee through the
date of termination of Employee's employment under any employee benefit plan (as
such term is defined in the Employees' Retirement Income Security Act of 1974,
as amended) maintained by the Company.
7. Representations by Employee. Employee hereby represents and warrants
---------------------------
to the Company that (a) Employee's execution and delivery of this Agreement and
his performance of his duties and obligations hereunder will not conflict with,
or cause a default under, or give any party a right to damages under, or to
terminate, any other agreement to which Employee is a party or by which he is
bound, and (b) there are no restrictions, agreements, or understandings that
would make unlawful Employee's execution or delivery of this Agreement or his
employment hereunder.
8. Arbitration.
-----------
(a) Any controversy or claim arising out or relating to this
Agreement, or the breach thereof, shall be settled by arbitration in accordance
with the Commercial Arbitration Rules of the American Arbitration Association
("AAA"), and judgment on the award rendered by the arbitrator(s) may be entered
in any court having jurisdiction thereof. Any arbitration brought under the
terms of this Agreement shall be conducted in the manner set forth in this
Section 8.
- ---------
(b) In accordance with the rules of the AAA, each of the parties
hereto shall appoint one person as an arbitrator. The two arbitrators so chosen
shall select a third impartial arbitrator within ten (10) days of the date on
which the second arbitrator is selected. The three arbitrators shall determine
all questions presented to them by majority vote. The decision of a majority of
the arbitrators shall be final and conclusive on the parties hereto.
(c) The arbitration hearing shall be held at a location to be
determined by the parties hereto in good faith in Mercer County, New Jersey.
(d) The parties agree that, subject to the rulings and scheduling of
the arbitrators, the following time limitations shall govern the arbitration
proceedings conducted under the terms of this Agreement.
(i) Any demand for arbitration must be filed within a
reasonable time following the date on which the dispute arises or the
alleged breach occurs.
(ii) Each party must select an arbitrator within thirty
(30) days of receipt of notice that an arbitration proceeding has
commenced. In the event that no such selection is made, the arbitrator
selected by the other party may conduct the arbitration proceeding without
selecting any other arbitrator.
-5-
<PAGE>
(iii) The hearing must be held thirty (30) days of the date
on which the third arbitrator is selected.
(e) Costs of arbitration hereunder shall be borne by the Company.
Unless the arbitrators determine that Employee did not have a reasonable basis
for asserting his position with respect to the dispute in questions, the Company
shall also reimburse Employee for his reasonable attorneys' fees incurred with
respect to any arbitration. Pending the resolution of any arbitration or court
proceeding, the Company shall continue payment of all amounts due Employee under
this Agreement and all benefits to which Employee is entitled at the time such
dispute arises (other than the amounts which are the subject of such dispute).
9. Taxes and Other Deductions. The Company shall have the right to
--------------------------
deduct from any compensation paid to Employee or his estate or legal
representative under this Agreement all taxes and other amounts which may be
required to be deducted or withheld by law (including, without limitation,
income tax withholding and social security payments), whether such laws are now
in effect or become effective after the date of this Agreement.
10. Noncompetition; Confidentiality
-------------------------------
(a) During Employee's employment with the Company and for an
additional period of two years immediately following Employee's employment with
the Company (the "Restriction Period"), Employee shall not, directly or
indirectly, (i) solicit any employee of the Company to terminate his or her
employment with the Company or (ii) call upon or solicit, with the intent to
divert or take away, or attempt to call upon or solicit, with the intent to
divert or take away, or divert or take away, any clients, policyholders, agents,
customers, or accounts of the Company.
(b) During and after Employee's employment with the Company, Employee
shall not use for his personal benefit, or disclose, communicate, or divulge to,
or use for the direct or indirect benefit of any person, firm, association, or
company other than the Company, any Confidential Information. "Confidential
Information" means information relating to the processes, products, services,
customers, agents, or operations of the Company or any subsidiary thereof that
is not generally known, is proprietary to the Company or such subsidiary and is
made known to Employee or learned or acquired by Employee while in the employ of
the Company. However, Confidential Information shall not include under any
circumstances any information with respect to the foregoing matters that becomes
publicly available through no fault of Employee. All materials or articles of
information of any kind furnished to Employee by the Company or developed by
Employee in the course of his employment hereunder are and shall remain the sole
property of the Company; and if the Company requests the return of such
information at
-6-
<PAGE>
any time during, upon, or after the termination of Employee's employment,
Employee shall immediately deliver the same to the Company.
(c) Employee acknowledges that, in view of the nature of the business
in which the Company is engaged, the restrictions contained in Section 10(a) and
-------------
10(b) above (the "Restrictions") are reasonable and necessary in order to
- -----
protect the legitimate interests of the Company, and that any violation thereof
would result in irreparable injuries to the Company, and Employee therefore
further acknowledges that, in the event Employee violates, or threatens to
violate, any of such Restrictions, the Company shall be entitled to obtain from
any court of competent jurisdiction, without the posting of any bond or other
security, preliminary and permanent injunctive relief as well as damages and an
equitable accounting of all earnings, profits, and other benefits arising from
such violation, which rights shall be cumulative and in addition to any other
rights or remedies in law or equity to which the Company may be entitled.
(d) If any Restriction, or any part thereof, shall be determined in
any judicial or administrative proceeding to be invalid or unenforceable, the
remainder of the Restrictions shall not thereby be affected and shall be given
full effect, without regard to the invalid provisions. If the period of time or
the area specified in the Restrictions shall be determined in any judicial or
administrative proceeding to be unreasonable, then the court or administrative
body shall have the power to reduce the period of time or the area covered and,
in its reduced form, such provisions shall then be enforceable and shall be
enforced.
(e) If Employee violates any of the Restrictions, the applicable
restrictive period shall be tolled from the time of the Commencement of any such
violation until such time as such violation shall be cured by Employee to the
reasonable satisfaction of the Company.
(f) Employee may not engage, directly or indirectly, in any other
business, investment, or activity which (i) substantially interferes with
Employee's performance of his duties hereunder (ii) is contrary to the best
interests of the Company, or (iii) requires such portion of Employee's business
time as to render compliance with Section 1 impracticable. In that regard,
---------
subject toSection 10(g), Employee may serve on the board of directors (or
-------------
comparable controlling body) of corporations or other legal entities of
Employee's choice so long as service on any such board or controlling body does
not constitute a violation of federal or state statutory provisions, or related
rules and regulations pertaining to interlocking directorships, and the meeting
times of such boards or controlling bodies do not materially conflict with the
meeting times of the Board of Directors. Employee acknowledges and agrees that
Employee owes certain duties to the Company under applicable law and agrees to
do not act which would intentionally injure the Company's business, interests,
or reputation. In keeping with Employee's fiduciary duties to the Company,
Employee agrees that Employee shall not knowingly become involved in a conflict
of interest with the Company, or upon discovery thereof, allow such a conflict
to continue. Moreover, Employee agrees that Employee shall disclose to
-7-
<PAGE>
the Audit Committee of the Board of Directors any facts which might reasonably
be expected to involve a conflict of interest with the Company.
(g) Employee may not serve on the Board of Directors of any entity
other than the Company during the term of this Agreement without the approval of
the Audit Committee of the Board of Directors in accordance with the Company's
policies and procedures regarding such service, which approval will not be
unreasonably withheld. The Board of Directors of the Company consents to
Employee's service on the following boards of directors on which he is currently
serving: SCPIE Holdings, Inc.; BCSI Holdings, Inc.; and Homeowners' Holdings,
Inc.
11. Notices. Any notice or communication given pursuant to this Agreement
-------
must be in writing and (a) delivered personally, (b) sent by telefacsimile or
other similar facsimile transmission, (c) delivered by overnight express, or (d)
sent by registered or certified mail, postage prepaid, as follows:
(i) If to Employee:
Willis T. King, Jr.
122 Prospect Street
Summit, New Jersey 07901
Facsimile Number: (908) 277-0329
with a copy to:
Russell L. Hewit, Esq.
Dughi & Hewit
340 North Avenue
Cranford, New Jersey 07016
Facsimile Number: (908) 272-0909
(ii) If to the Company:
Highlands Insurance Group, Inc.
1000 Lenox Drive
Lawrenceville, NJ 08648
Attention: General Counsel
Facsimile Number: (609) 219-1774
All notices and other communications required or permitted under this Agreement
that are addressed as provided in this Section will (A) if delivered personally
or by overnight express, be deemed given upon delivery; (B) if delivered by
telefacsimile or similar facsimile transmission, be deemed given when
electronically confirmed; and (C) if sent by registered or certified mail, be
deemed given when received. Any party from time to time may change its address
for the purpose of notices to that party by giving a similar
-8-
<PAGE>
notice specifying a new address, but no such notice will be deemed to have been
given until it is actually received by the party sought to be charged with the
contents thereof.
12. Entire Agreement. This Agreement, and the plans referenced in this
----------------
Agreement, constitute the entire agreement between the parties hereto with
respect to the subject matter hereof and (other than as to the employee benefit
plans and practices of the Company) supersedes all prior communications,
agreements, understandings, representations, and warranties, whether oral or
written, between the parties hereto with respect to the subject matter hereof.
Other than the employee benefit plans and practices of the Company, there are no
oral or written agreements, understandings, representations, or warranties
between the parties hereto with respect to the subject matter hereof other than
those set forth in this Agreement.
13. Assignment and Amendment of Agreement. This Agreement will be binding
-------------------------------------
upon the parties hereto and their respective successors and permitted assignees.
Because Employee's duties and services hereunder are special, personal and
unique in nature, Employee may not transfer, sell or otherwise assign his
rights, obligations or benefits under this Agreement. This Agreement may be
modified or amended only by a writing duly executed on behalf of each party
hereto.
14. Governing Law. This Agreement will be governed by and construed and
-------------
enforced in accordance with the Laws of the State of New Jersey (without regard
to the principles of conflicts of law) applicable to a contract executed and to
be performed in such state.
15. No Third Party Rights. Except as specifically provided in this
---------------------
Agreement, this Agreement is not intended and may not be construed to create any
rights (including third party beneficiary rights) in any parties other than
Employee and the Company, and their respective successors and permitted
assignees.
16. Headings, Gender, etc. The headings used in this Agreement have been
----------------------
inserted for convenience and do not constitute manner to be construed or
interested in connection with this Agreement. Unless the context of this
Agreement otherwise requires, (a) words of any gender will be deemed to include
each other gender, (b) words using the singular or plural number also will
include the plural or singular number, respectively, (c) the terms "hereof,"
"herein", "hereby," hereunder," "hereto," and derivative or similar words will
refer to this entire Agreement, (d) the terms "Article" or "Section" will refer
to the specified Article or Section of this Agreement, and (e) the conjunction
"or" will denote any one or more, or any combination or all, of the specified
items or matters involved in the applicable list.
17. Waiver and Remedies. Any term or condition of this Agreement may be
-------------------
waived at any time by the party that is entitled to the benefit thereof. Any
such waiver will be in writing and will be executed by such party. A waiver on
one occasion will not be deemed to be a waiver of the same or any other breach
on a future occasion. All
-9-
<PAGE>
remedies, either under this Agreement, or by law or otherwise afforded, will be
cumulative and not alternative.
18. Invalid Provisions. Subject to the provisions of Section 10(d) above,
------------------ -------------
if any provision of this Agreement is held to be illegal, invalid, or
unenforceable under any present or future law, and if the rights or obligations
of any party hereto under this Agreement will not be materially and adversely
affective thereby, (a) such provision will be fully severable, (b) this
Agreement will be construed and enforced as if such illegal, invalid, or
unenforceable provision had never comprised a part hereof, (c) the remaining
provisions of the Agreement will remain in full force and effect and will not be
affected by the illegal, invalid, or unenforceable provision or by its severance
herefrom, and (d) in lieu of such illegal, invalid, or unenforceable provision,
there will be added automatically as a part of this Agreement a legal, valid,
and enforceable provision as similar in terms to such illegal, invalid, or
unenforceable provision as may be possible.
19. Counterparts. This Agreement may be executed simultaneously in one or
------------
more counterparts, each of which will be deemed an original, but all of which
together will constitute one and the same instrument.
IN WITNESS WHEREOF, the Company and Employee have executed this
Agreement as of the day and year first above written.
COMPANY: HIGHLANDS INSURANCE GROUP, INC.
By: __________________________________________
Stephen J. Greenberg
Vice President
EMPLOYEE: __________________________________________
Willis T. King, Jr.
-10-
<PAGE>
EXHIBIT 21
HIGHLANDS INSURANCE GROUP, INC.
LIST OF SUBSIDIARIES
Jurisdiction
of
Incorporation
or
Name Organization
- ---- --------------
Aberdeen Insurance Company Texas
American Professionals Insurance Company Indiana
American Reliance, Inc. Indiana
American Reliance Realty, Inc. Delaware
Certified Finance Corporation Texas
Highlands Limited Bermuda
Highlands Insurance Company (U.K.) Limited United Kingdom
Highlands Claims and Safety Services, Inc. Texas
Highlands Underwriters Insurance Company Texas
Highlands Holdings (UK), Ltd. United Kingdom
Highlands Underwriting Agents, Limited United Kingdom
Highlands Insurance Company Texas
Highlands Casualty Company Texas
Highlands Overseas Limited Bermuda
Highlands Lloyds Texas
Highlands Services Corporation Delaware
Highlands Underwriters Insurance Agency, Inc. Texas
Insurance Management Corporation Texas
NN Insurance Company Wisconsin
Northwestern National Casualty Company Wisconsin
Northwestern National Holding Company, Inc. Delaware
Pacific Automobile Insurance Company California
Pacific National Insurance Company California
SICO, Inc. Indiana
State Capital Insurance Company North Carolina
Statesman Insurance Company Indiana
Timeco, Inc. Indiana
Underwriters Special Risks, Inc. Texas
Underwriters Special Risks of La., Inc. Louisiana
<PAGE>
EXHIBIT 23
Consent of Independent Auditors
-------------------------------
The Board of Directors
Highlands Insurance Group, Inc.:
We consent to incorporation by reference in the registration statements on Form
S-3 (No. 333-51693 and No. 333-82135) and Form S-8 (No. 333-34701, No. 333-55699
and No. 333-82141) of Highlands Insurance Group, Inc. of our report dated
March 9, 2000, except as to note 4, which is as of March 20, 2000, relating to
the consolidated financial statements of Highlands Insurance Group, Inc. and
subsidiaries as of December 31, 1999 and 1998, and for each of the years in the
three-year period then ended, and all related schedules, which report appears in
the December 31, 1999 annual report on Form 10-K of Highlands Insurance Group,
Inc.
KPMG LLP
Houston, Texas
March 29, 2000
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> DEC-31-1999
<DEBT-HELD-FOR-SALE> 0
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 762,478
<EQUITIES> 26,594
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 792,172
<CASH> 78,243
<RECOVER-REINSURE> 684,525
<DEFERRED-ACQUISITION> 33,556
<TOTAL-ASSETS> 1,961,287
<POLICY-LOSSES> 1,353,524
<UNEARNED-PREMIUMS> 146,832
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 116,820
0
0
<COMMON> 140
<OTHER-SE> 264,261
<TOTAL-LIABILITY-AND-EQUITY> 1,961,287
325,305
<INVESTMENT-INCOME> 67,684
<INVESTMENT-GAINS> 22
<OTHER-INCOME> (24,415)
<BENEFITS> 238,940
<UNDERWRITING-AMORTIZATION> 65,308
<UNDERWRITING-OTHER> 64,813
<INCOME-PRETAX> (465)
<INCOME-TAX> (12,984)
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (13,449)
<EPS-BASIC> (1.04)
<EPS-DILUTED> (1.04)
<RESERVE-OPEN> 1,603,548
<PROVISION-CURRENT> 247,027
<PROVISION-PRIOR> (8,087)
<PAYMENTS-CURRENT> 101,294
<PAYMENTS-PRIOR> 245,278
<RESERVE-CLOSE> 1,353,524
<CUMULATIVE-DEFICIENCY> 8,087
</TABLE>
