<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 1999
Commission File Number 1-9627
ZENITH NATIONAL INSURANCE CORP.
[Exact name of registrant as specified in its charter]
Delaware 95-2702776
[State or other jurisdiction of [I.R.S. Employer
incorporation or organization] Identification No.]
21255 Califa Street, Woodland Hills, California 91367-5021
[Address of principal executive offices] [Zip Code]
(818) 713-1000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant [1] has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and [2] has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
At November 1, 1999, there were 17,201,000 shares of Zenith Common Stock
outstanding, net of 7,956,000 shares of treasury stock.
1
<PAGE>
PART l
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------------
September 30, December 31,
(Dollars in thousands, except per share data) 1999 1998
- ----------------------------------------------------------------------------------------------------------------------------------
(Unaudited)
<S> <C> <C>
ASSETS:
Investments:
Fixed maturities:
At amortized cost (fair value $28,759 in 1999 and $36,712 in 1998) $ 28,675 $ 35,143
At fair value (cost $692,109 in 1999 and $725,397 in 1998) 672,926 735,284
Floating rate preferred stocks, at fair value (cost $6,799 in 1999 and
$16,614 in 1998) 6,593 17,324
Convertible and non-redeemable preferred stocks, at fair value (cost
$4,300 in 1999 and $7,679 in 1998) 3,800 7,350
Common stocks, at fair value (cost $26,354 in 1999 and $22,402 in 1998) 25,408 26,935
Short-term investments (at cost, which approximates fair value) 142,191 187,123
Other investments 44,071 39,522
---------------- -----------------
TOTAL INVESTMENTS 923,664 1,048,681
Cash 12,559 1,998
Accrued investment income 12,610 13,646
Premiums receivable 85,510 133,631
Receivable from reinsurers and state trust funds and
prepaid reinsurance premiums 363,706 373,045
Deferred policy acquisition costs 8,746 23,941
Properties and equipment, less accumulated depreciation 56,186 79,908
Net deferred tax asset 40,593 22,611
Federal income taxes receivable 2,740
Intangible assets 22,709 25,744
Other assets 102,708 92,781
---------------- -----------------
TOTAL ASSETS $ 1,628,991 $ 1,818,726
================ =================
</TABLE>
(continued)
2
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (CONTINUED)
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------------
September 30, December 31,
(Dollars in thousands, except per share data) 1999 1998
- ----------------------------------------------------------------------------------------------------------------------------------
(Unaudited)
<S> <C> <C>
LIABILITIES:
Policy liabilities and accruals:
Unpaid loss and loss adjustment expenses $ 906,990 $ 997,647
Unearned premiums 57,850 157,965
Policyholders' dividends accrued 3,014 4,763
Reserves on loss portfolio transfers 7,731 9,689
Payable to banks and other notes payable 20,572 19,255
Senior notes payable, less unamortized issue costs of $313 in 1999
and $404 in 1998 74,687 74,596
Federal income taxes payable 33,210
Payable to RISCORP 52,952
Other liabilities 76,255 81,566
---------------- -----------------
TOTAL LIABILITIES 1,180,309 1,398,433
---------------- -----------------
REDEEMABLE SECURITIES:
Company-obligated, mandatorily redeemable capital securities of Zenith National
Insurance Capital Trust I, holding solely 8.55% Subordinated Deferrable
Interest Debentures due 2028, of Zenith National Insurance Corp., less
unamortized issue cost and discount of $1,617 in 1999 and $1,659 in 1998 73,383 73,341
---------------- -----------------
Commitments and contingent liabilities
STOCKHOLDERS' EQUITY:
Preferred stock, $1 par - shares authorized 1,000; issued and outstanding, none
in 1999 and 1998
Common stock, $1 par - shares authorized 50,000; issued 25,125,
outstanding 17,169 in 1999; issued 24,970, outstanding 17,148 in 1998 25,125 24,970
Additional paid-in capital 274,226 270,679
Retained earnings 239,124 188,243
Accumulated other comprehensive income - net unrealized (depreciation)
appreciation on investments, net of deferred tax (benefit) expense of
$(7,277) in 1999 and $5,167 in 1998 (13,514) 9,596
---------------- -----------------
524,961 493,488
Less treasury stock at cost (7,956 shares in 1999 and 7,822 shares in 1998) (149,662) (146,536)
---------------- -----------------
TOTAL STOCKHOLDERS' EQUITY 375,299 346,952
---------------- -----------------
TOTAL LIABILITIES, REDEEMABLE SECURITIES AND
STOCKHOLDERS' EQUITY $ 1,628,991 $ 1,818,726
================ =================
</TABLE>
The accompanying notes are an integral part of this financial statement.
3
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
(Dollars in thousands, except per share data) 1999 1998 1999 1998
- ----------------------------------------------------------------------------------------------------------------------------
(Restated) (Restated)
<S> <C> <C> <C> <C>
CONSOLIDATED REVENUES:
Premiums earned $ 87,110 $ 136,151 $ 298,664 $ 392,489
Net investment income 14,229 14,198 40,500 40,124
Realized gains on investments 2,322 2,164 6,387 8,338
Real estate sales 14,034 8,398 39,240 28,830
Service fee income 802 1,206 2,346 2,598
----------- ------------- ------------ -------------
Total revenues 118,497 162,117 387,137 472,379
EXPENSES:
Loss and loss adjustment expenses incurred 116,563 101,690 288,036 280,199
Policy acquisition costs 13,165 25,707 53,999 74,696
Other underwriting and operating expenses 31,813 19,432 64,828 58,474
Policyholders' dividends and participation (954) 441 (12) 378
Real estate construction and operating costs 13,446 8,210 36,835 28,248
Interest expense 2,141 1,908 6,277 3,416
----------- ------------- ------------ -------------
Total expenses 176,174 157,388 449,963 445,411
Gain on sale of CalFarm Insurance Company (see Note 3) 160,335
------------
(Loss) income before federal income tax expense (57,677) 4,729 97,509 26,968
Federal income tax (benefit) expense, including expense
of $56,000 related to the sale of CalFarm Insurance Company
in the nine months ended September 30, 1999 (20,377) 1,329 33,809 9,168
----------- ------------- ------------ -------------
NET (LOSS) INCOME $ (37,300)$ 3,400 $ 63,700 $ 17,800
=========== ============= ============ =============
EARNINGS PER SHARE:
Net (loss) income per common share -
Basic $ (2.17)$ 0.20 $ 3.71 $ 1.05
=========== ============= ============ =============
Diluted $ (2.17)$ 0.20 $ 3.71 $ 1.04
=========== ============= ============ =============
Additional Required Disclosure:
Net (loss) income $ (37,300)$ 3,400 $ 63,700 $ 17,800
Change in unrealized (depreciation) appreciation on investments (8,793) 925 (23,110) 1,727
----------- ------------- ------------ -------------
Comprehensive (Loss) Income $ (46,093)$ 4,325 $ 40,590 $ 19,527
=========== ============= ============ =============
</TABLE>
The accompanying notes are an integral part of this financial statement.
4
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------
Nine Months Ended
September 30,
(Dollars in thousands) 1999 1998
- -----------------------------------------------------------------------------------------------------------------------------
(Restated)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Premiums and service fee income collected $ 316,259 $ 431,867
Investment income received 38,084 40,379
Proceeds from sales of real estate 39,240 28,830
Loss and loss adjustment expenses paid (251,323) (299,178)
Underwriting and other operating expenses paid (104,286) (145,420)
Real estate construction costs paid (46,574) (35,665)
Reinsurance premiums paid (29,320) (24,451)
Interest paid (9,584) (3,706)
Income taxes paid (2,830) (5,352)
--------------- --------------
Net cash used in operating activities (50,334) (12,696)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments:
Investment securities available-for-sale (349,081) (252,200)
Other investments (8,306) (7,008)
Proceeds from maturities and redemptions of investments:
Fixed maturities held-to-maturity 6,371 8,379
Investment securities available-for-sale 87,276 55,073
Proceeds from sales of investments:
Investment securities available-for-sale 189,844 210,448
Other investments 6,285 6,182
Capital and other expenditures (11,021) (15,233)
Net change in short-term investments (5,047) (6,310)
Cash paid to RISCORP (54,308) (35,000)
RISCORP acquisition costs (7,660)
Cash acquired in RISCORP Acquisition 29,309
Net proceeds from sale of CalFarm 211,068
--------------- --------------
Net cash provided by (used in) investing activities 73,081 (14,020)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of note assumed from RISCORP (15,000)
Net cash received from Zenith National Insurance Capital Trust I 8.55%
Capital Securities 73,320
Cash advanced from bank construction loans 40,433 23,015
Cash repaid on bank construction loans (35,253) (25,941)
Cash advanced from bank lines of credit 7,400 2,000
Cash repaid on bank lines of credit (12,400) (2,000)
Cash dividends paid to common stockholders (12,865) (12,739)
Proceeds from exercise of stock options 3,625 4,161
Purchase of treasury shares (3,126) (24,023)
--------------- --------------
Net cash (used in) provided by financing activities (12,186) 22,793
--------------- --------------
Net increase (decrease) in cash 10,561 (3,923)
Cash at beginning of period 1,998 12,504
--------------- --------------
Cash at end of period $ 12,559 $ 8,581
=============== ==============
</TABLE>
(continued)
5
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------
Nine Months Ended
September 30,
(Dollars in thousands) 1999 1998
- -------------------------------------------------------------------------------------------------------
(Restated)
<S> <C> <C>
RECONCILIATION OF NET INCOME TO NET CASH FLOWS
FROM OPERATING ACTIVITIES:
Net Income $ 63,700 $ 17,800
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization 6,716 6,734
Realized gain on sale of CalFarm Insurance Company (160,335)
Realized gains on investments (6,387) (8,338)
Decrease (increase) in:
Accrued investment income (959) 650
Premiums receivable 11,604 21,971
Receivable from reinsurers and state trust funds and
prepaid reinsurance premiums (13,663) 29,132
Federal income taxes 30,992 (7,362)
Deferred policy acquisition costs (425) 3,643
Real estate construction in progress (14,422) (9,496)
Increase (decrease) in:
Unpaid loss and loss adjustment expenses 34,884 (59,970)
Unearned premiums (9,151) (3,252)
Policyholders' dividends accrued (1,749)
Other policyholder funds (6,407)
Other 8,861 2,199
----------- -------------
Net cash used in operating activities $ (50,334) $ (12,696)
=========== =============
</TABLE>
The accompanying notes are an integral part of this financial statement.
6
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1. BASIS OF PRESENTATION
The accompanying unaudited, consolidated financial statements of Zenith
National Insurance Corp. ("Zenith National") and subsidiaries (collectively,
"Zenith") have been prepared in accordance with generally accepted accounting
principles ("GAAP") for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities
Exchange Act of 1934, as amended. Accordingly, they do not include all of the
information and footnotes required by GAAP for complete financial statements.
In the opinion of management, all adjustments (consisting of normal,
recurring adjustments) necessary for a fair presentation of the financial
position and results of operations of Zenith for the periods presented have
been included. The results of operations for an interim period are not
necessarily indicative of the results for an entire year. For further
information, refer to the financial statements and footnotes included in the
Zenith Annual Report on Form 10-K for the year ended December 31, 1998.
Certain prior year balances have been reclassified to conform to the current
year presentation. Zenith has elected to round to the nearest thousand
dollars, except for per share data, in reporting amounts in this statement.
The comparability of the nine months ended September 30, 1999 compared to the
corresponding period in 1998 is affected by the purchase of substantially all
of the assets and certain liabilities of the former operations of RISCORP,
Inc. and certain of its subsidiaries (collectively, "RISCORP") effective
April 1, 1998 (see Note 4). The comparability of the three months and nine
months ended September 30, 1999 compared to the corresponding periods in 1998
is affected by net charges in the third quarter of 1999 of $50,000,000 before
tax ($32,500,000 after tax, or $1.89 per share) associated with an increase
in the net liabilities for unpaid losses and loss adjustment expenses in the
Southeast Operations, which principally consists of the operations acquired
from RISCORP (see Note 4). The comparability of the three months and nine
months ended September 30, 1999 compared to the corresponding periods in 1998
is also affected by the sale of CalFarm Insurance Company ("CalFarm"), a
wholly-owned subsidiary of Zenith Insurance Company ("Zenith Insurance"), a
wholly-owned subsidiary of Zenith National, to Nationwide Mutual Insurance
Company effective March 31, 1999 (see Note 3).
RESTATEMENT - As previously reported, the Consolidated Balance Sheet,
Consolidated Statement of Operations and Consolidated Statement of Cash Flows as
of and for the quarter ended September 30, 1998 have been restated to
incorporate the resolution of the purchase price determination for the RISCORP
Acquisition (see Note 4). The restatement impacted invested assets, accrued
investment income, receivable from reinsurers, deferred policy acquisition
costs, federal income taxes, intangible assets, unpaid losses, policyholder
dividends accrued, other liabilities, net investment income, other underwriting
and operating expenses and federal income tax expense.
7
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
NOTE 2. EARNINGS AND DIVIDENDS PER SHARE
<TABLE>
<CAPTION>
- ---------------------------------------------------------------- ---------------------------- ----------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
(In thousands, except per share data) 1999 1998 1999 1998
- ---------------------------------------------------------------- -------------- ------------- -------------- -------------
(Restated) (Restated)
- --------------- ------------------------------------------------ -------------- ------------- -------------- -------------
<S> <C> <C> <C> <C> <C>
(A) Net (loss) income $(37,300) $3,400 $63,700 $ 17,800
- --------------- ------------------------------------------------ -------------- ------------- -------------- -------------
(B) Weighted average outstanding
shares during the period 17,188 17,055 17,155 17,018
Additional common shares issuable
under employee stock option plans
using the treasury stock method 9 113 14 155
- --------------- ------------------------------------------------ -------------- ------------- -------------- -------------
(C) Weighted average number of common shares
outstanding assuming
exercise of stock options 17,197 17,168 17,169 17,173
- --------------- ------------------------------------------------ -------------- ------------- -------------- -------------
- --------------- ------------------------------------------------ -------------- ------------- -------------- -------------
Net (loss) income per common share -
(A)/(B) Basic $(2.17) $ 0.20 $3.71 $ 1.05
(A)/(C) Diluted (2.17) 0.20 3.71 1.04
- --------------- ------------------------------------------------ -------------- ------------- -------------- -------------
- --------------- ------------------------------------------------ -------------- ------------- -------------- -------------
Dividends per common share 0.25 0.25 0.75 0.75
- --------------- ------------------------------------------------ -------------- ------------- -------------- -------------
</TABLE>
NOTE 3. SALE OF CALFARM INSURANCE COMPANY
Effective March 31, 1999, Zenith Insurance completed the sale of all of the
issued and outstanding capital stock of CalFarm for approximately $273,000,000
in cash to Nationwide Mutual Insurance Company. CalFarm wrote Zenith's Other
Property-Casualty business, principally in California, through March 31, 1999.
The gain on the sale, net of tax, was approximately $104,000,000.
Approximately $59,000,000 of cash was transferred from Zenith Insurance to
CalFarm in connection with the cessation of CalFarm's participation in the
intercompany reinsurance pooling agreement to which Zenith Insurance and its
wholly-owned property-casualty insurance subsidiaries are parties. Zenith
Insurance and its wholly-owned property-casualty subsidiaries, other than
CalFarm, will continue to participate in an intercompany reinsurance pooling
agreement.
After accounting for applicable taxes and expenses, the net proceeds from the
sale that were available to Zenith Insurance for investment was approximately
$211,000,000, compared to cash and investments of approximately $226,000,000
that were excluded from Zenith's Consolidated Balance Sheet with the sale of
CalFarm.
8
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
NOTE 3. SALE OF CALFARM INSURANCE COMPANY (CONTINUED)
The following table summarizes the assets and liabilities of CalFarm at March
31, 1999:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------
(Dollars in thousands) March 31, 1999
- ------------------------------------------------------------------
<S> <C>
Assets:
Investments $ 170,050
Cash 1,904
Receivable from Zenith Insurance Company 59,256
Premiums receivable 36,517
Receivable from reinsurers 23,002
Deferred policy acquisition costs 15,620
Properties and equipment 20,505
Other assets 6,874
- ------------------------------------------------------------------
Total assets $ 333,728
- ------------------------------------------------------------------
Liabilities:
Unpaid loss and loss adjustment expense $ 125,589
Unearned premium reserve 90,964
Other liabilities 10,617
- ------------------------------------------------------------------
Total liabilities $ 227,170
- ------------------------------------------------------------------
</TABLE>
Pro forma total revenues for Zenith for the three months ended September 30,
1999 and 1998 (after giving effect to the sale of CalFarm as if it had been
consummated at the beginning of the respective periods) would have been
$118,497,000 and $103,187,000, respectively. Pro forma results of operations
after tax for such periods would have been a net loss of $37,300,000 and
$400,000, respectively. Pro forma earnings per share for such periods would have
been a net loss of $2.17 (basic and diluted) and $0.02 (basic and diluted),
respectively.
Pro forma total revenues for Zenith for the nine months ended September 30, 1999
and 1998 (after giving effect to the sale of CalFarm as if it had been
consummated at the beginning of the respective periods) would have been
$329,985,000 and $295,959,000, respectively. Pro forma results of operations
after tax for such periods would have been a net loss of $42,600,000 and net
income of $8,700,000, respectively. Pro forma earnings per share for such
periods would have been a net loss of $2.48 (basic and diluted) and net income
of $0.51 (basic and diluted), respectively.
9
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
NOTE 3. SALE OF CALFARM INSURANCE COMPANY (CONTINUED)
Since CalFarm was acquired by Zenith Insurance in 1985, CalFarm's cumulative
combined ratio was approximately 100% and its cumulative underwriting income was
approximately zero. In addition to the loss of any underwriting income provided
by CalFarm, Zenith's annual consolidated net income would be reduced by the
investment income associated with the net reduction of approximately $15,000,000
of consolidated investments caused by the sale of CalFarm. Estimated investment
income after tax on such decrease would have been $139,000 for the nine month
period ended September 30, 1999, $417,000 for the comparable period ended
September 30, 1998 and $139,000 for the three months ended September 30, 1998.
Using such change in investment income, the underwriting income previously
reported by CalFarm and the gain on the sale of CalFarm, pro forma net (loss)
income would be as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------- ------------------------------- ------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
(Dollars in thousands) 1999 1998 1999 1998
- --------------------------------------------------------------- --------------- --------------- -------------- ---------------
<S> <C> <C> <C> <C>
Net (loss) income as reported (1998 restated) $(37,300) $ 3,400 $63,700 $ 17,800
Less: underwriting income of CalFarm after tax (2,361) (26) (3,483)
Less: gain on sale of CalFarm after tax (104,335)
Less: change in investment income after tax (139) (139) (417)
- --------------------------------------------------------------- --------------- --------------- -------------- ---------------
Pro forma net (loss) income $(37,300) $ 900 $(40,800) $ 13,900
- --------------------------------------------------------------- --------------- --------------- -------------- ---------------
Pro forma net (loss) income per common share -
Basic $(2.17) $0.05 $(2.38) $0.82
Diluted (2.17) 0.05 (2.38) 0.81
- --------------------------------------------------------------- --------------- --------------- -------------- ---------------
</TABLE>
NOTE 4. COMMITMENTS AND CONTINGENT LIABILITIES
RESOLUTION OF CONTINGENCIES SURROUNDING FAIR VALUES OF RISCORP ASSETS ACQUIRED
AND LIABILITIES ASSUMED AND SETTLEMENT OF CERTAIN LITIGATION BETWEEN ZENITH
INSURANCE AND RISCORP
On April 1, 1998, pursuant to an Asset Purchase Agreement dated June 17, 1997
(as amended from time to time, the "Asset Purchase Agreement") between Zenith
Insurance and RISCORP, Zenith Insurance acquired substantially all of the assets
and certain liabilities of RISCORP related to RISCORP's workers' compensation
business (the "RISCORP Acquisition"). The total purchase price for such acquired
assets and liabilities was determined by a three-step process in which RISCORP
and its external accounting and actuarial consultants and Zenith Insurance and
its external accounting and actuarial consultants made and presented their
estimates of the GAAP values of the assets and liabilities acquired by Zenith
Insurance to an independent third-party, acting as a Neutral Auditor and Neutral
Actuary. Such estimates varied considerably, particularly with respect to the
value of premiums receivable and the liability for unpaid losses and loss
adjustment expenses.
On March 19, 1999, the Neutral Auditor and Neutral Actuary issued its report
determining the disputes between the parties. As previously reported, Zenith
Insurance recorded the assets and liabilities acquired from RISCORP at their
estimated fair values consistent with the values determined by the neutral
Auditor and Neutral Actuary. Previously reported consolidated financial
statements for June 30, 1998 and September 30, 1998 were restated to reflect
the resolution of the disputes
10
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
NOTE 4. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)
between the parties. Zenith Insurance indicated that any new information that
might become available with respect to certain assets and liabilities
acquired from RISCORP may change the estimates of the carrying values of such
amounts and such changes, if any, would be reflected in the results of
operations for the period in which they occur.
In October of 1999, Zenith Insurance completed a review of the liabilities
for unpaid losses and loss adjustment expenses in its Southwest Operations,
which principally consists of the operations acquired from RISCORP. The review
was conducted with assistance from independent actuarial consultants and took
account of recent developments, including data through the third quarter of
1999. As a result of the review, Zenith Insurance recorded in the third
quarter of 1999, an increase of $46,000,000 ($29,000,000 after tax) in the
estimated net liabilities for unpaid losses and loss adjustment expenses
acquired from RISCORP. The increase results primarily from the adjustments to
reserves for the years 1984 through 1997. Certain related receivables,
principally contingent commissions receivable under reinsurance contracts
assumed from RISCORP, were reduced by approximately $19,000,000 net
($12,400,000 after tax). Such adjustments to the values of the acquired
assets and liabilities and under GAAP must be reported currently in results
of operations.
As previously reported, Zenith Insurance purchased reinsurance protection
relating to development of the unpaid loss and loss adjustment expense
reserves acquired from RISCORP. Such reinsurance allows Zenith Insurance to
recover up to $50,000,000 in excess of $182,000,000 for net unpaid losses and
allocated loss adjustment expenses acquired from RISCORP. The provisions of
Statement of Financial Accounting Standards No. 113, ACCOUNTING AND REPORTING
FOR REINSURANCE OF SHORT-DURATION AND LONG-DURATION CONTRACTS ("SFAS No.
113"), relating to accounting for retroactive reinsurance transactions
require a substantial amount of the benefit associated with such reinsurance
protection to be deferred and recognized in future periods. In the third
quarter of 1999, Zenith Insurance recorded an increase in the amount
recoverable to $50,000,000 and a benefit of $9,000,000 ($5,900,000 after tax)
associated with such reinsurance. An additional benefit of $25,000,000
($16,500,000 after tax) associated with such reinsurance has been deferred
and will be recognized over approximately the next four years, the estimated
settlement period of the reinsurance recoverable.
As previously announced, Zenith Insurance and RISCORP entered into a
settlement agreement, dated July 7, 1999 (the "Settlement Agreement"),
providing for the resolution of certain claims arising out of the RISCORP
Acquisition. Pursuant to the Settlement Agreement, Zenith Insurance and
RISCORP (i) have dismissed litigation pending between them in the United
States District Courts for the Middle District of Florida, Tampa Division,
and the Southern District of New York; (ii) have agreed that RISCORP may
request that the Neutral Auditor and Neutral Actuary (a) review an alleged
error concerning the proper treatment of certain reinsurance treaties in its
determinations with respect to the purchase price for the RISCORP
Acquisition, without waiving whatever rights they may have to litigation of
such issue, (b) determine whether the issue was properly in dispute before
the Neutral Auditor and Neutral Actuary and (c), if so, determine the merits
of the issue and whether a correction is appropriate; (iii) have agreed that
any other disputes arising under the Asset Purchase Agreement or the
Settlement Agreement, including any future claims for indemnification by
either
11
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
NOTE 4. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)
Zenith Insurance or RISCORP, are to be resolved by binding
arbitration; (iv) have agreed that Zenith is to receive $6,000,000 from an
escrow account established pursuant to the Asset Purchase Agreement, with
RISCORP to receive the balance of the escrow account; and (v) have agreed to
an allocation between them of any recovery received as a result of refund
claims that RISCORP has made to the Florida Department of Labor and
Employment Security, Division of Workers' Compensation. In a submission made
to the Neutral Auditor and Neutral Actuary, RISCORP claimed that the purchase
price for the RISCORP Acquisition should be adjusted by either $5,872,000 or
$23,365,000 as a result of alleged errors in the original determination of
the Neutral Auditor and Neutral Actuary's with respect to the purchase price.
On October 7, 1999, the Neutral Auditor and Neutral Actuary advised Zenith
and RISCORP that they cannot now consider the additional issue raised by
RISCORP because the issue had not previously been raised as a dispute
pursuant to the procedures set forth in their engagement letter. RISCORP has
advised Zenith that RISCORP will pursue all judicial or other available
remedies to seek correction of the alleged errors in the determinations made
by the Neutral Auditor and Neutral Actuary. Under the Settlement Agreement,
Zenith Insurance received $6,000,000 from the escrow account. Zenith
Insurance recorded the benefit of such settlement in the third quarter of
1999 to offset certain unexpected expenses incurred by Zenith Insurance in
operating the business acquired from RISCORP.
The adjustments associated with the increase in the liabilities for unpaid
loss and loss adjustment expenses acquired from RISCORP and the effect of the
Settlement Agreement, in the aggregate, are expected to ultimately reduce
income by approximately $16,000,000 after tax, or $0.93 per share, over the
current and next approximately four years. However, because of the deferral
of the reinsurance benefit required by SFAS No. 113 described above, the
impact of these adjustments on net income for the third quarter of 1999 was a
decrease of $32,500,000 after tax, or $1.89 per share. When the deferred
reinsurance benefit is recognized over approximately the next four years, net
income is expected to increase by approximately $16,500,000 after tax.
Under statutory accounting principles, the benefit of retroactive reinsurance
is recognized immediately as a separate component of surplus as regards
policyholders. Accordingly, the foregoing RISCORP-related adjustments, after
the benefit of the reinsurance protection for adverse development of the
unpaid loss and loss adjustment expense reserves acquired from RISCORP,
decreased the surplus of Zenith Insurance by approximately $25,000,000 after
tax in the third quarter of 1999.
CONTINGENCIES SURROUNDING RECOVERABILITY OF STATE DISABILITY TRUST FUND
RECEIVABLES
In Florida, the Specialty Disability Trust Fund (the "Fund") assesses
workers' compensation insurers to pay for what are commonly referred to as
"Second Injuries". Historic assessments have been inadequate to completely
fund obligations of the Fund. In late 1997, the Florida statute was amended
so that the Fund will not be liable for and will not reimburse employers or
carriers for Second Injuries occurring on or after January 1, 1998. Zenith
has recorded its receivable from the Fund for Second Injuries based on
specific claims and historical experience prior to January 1, 1998. At
September 30, 1999 and December 31, 1998, the receivable from the Fund was
$39,680,000 and $39,077,000, respectively, related to the pre-January 1, 1998
claims, of which $2,397,000 was collected in 1999.
12
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
NOTE 4. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED)
OTHER LITIGATION
Zenith National and its subsidiaries are defendants in various other litigation
in the ordinary course of business. In the opinion of management, after
consultation with legal counsel, such litigation is either without merit or the
ultimate liability, if any, will not have a material adverse effect on the
consolidated financial condition or results of operations of Zenith.
NOTE 5. CODIFICATION OF STATUTORY ACCOUNTING PRINCIPLES
In 1998, the National Association of Insurance Commissioners ("NAIC") adopted
the Codification of Statutory Accounting Principles guidance (the
"Codification"), which will replace the current Accounting Practices and
Procedures manual as the NAIC's primary guidance on statutory accounting.
(Statutory accounting is a comprehensive basis of accounting based on prescribed
accounting practices, which include state laws, regulations and general
administrative rules, as well as a variety of publications of the NAIC.) The
Codification provides guidance for the areas where statutory accounting has been
silent and changes current statutory accounting in some areas. The NAIC is now
considering amendments to the Codification that would also be effective upon
implementation. The NAIC has established January 1, 2001 as the effective date
of the Codification.
Currently, the state of California Department of Insurance is planning to adopt
the Codification, but it is unknown whether the Department of Insurance will
make any changes to that guidance. Implementation of the Codification may affect
the surplus level and the capitalization requirements of Zenith National's
insurance subsidiaries on a statutory basis. Zenith has not determined the
impact of the Codification.
NOTE 6. SEGMENT INFORMATION
Zenith classifies its business into six segments: Workers' Compensation,
Other Property-Casualty, Reinsurance, Real Estate Operations, Investment and
Parent. Segments are designated based on the types of products and services
provided and based on the risks associated with the products and services.
Workers' Compensation represents insurance coverage for the statutorily
prescribed benefits that employers are required to pay to their employees
injured in the course of employment. The Workers' Compensation segment
information includes the former RISCORP operations acquired effective April
1, 1998. Other Property-Casualty (which includes the gain on the sale of
CalFarm) represents multiple product line direct insurance other than
workers' compensation, primarily in California through March 31, 1999, the
effective date of the sale of CalFarm. Reinsurance represents the book of
assumed reinsurance of accumulated losses from catastrophes and the
reinsurance of large property risks. Real Estate Operations develop land and
primarily construct private residences for sale in Las Vegas, Nevada.
Investment represents investment income and realized gains on investments,
primarily from debt securities. Parent represents the holding company
operations of Zenith National owning, directly or indirectly, all of the
capital stock of the property and casualty insurance and non-insurance
companies.
13
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
NOTE 6. SEGMENT INFORMATION (CONTINUED)
The accounting policies of the segments are consistent with GAAP. Zenith
evaluates insurance segment performance based on the combined ratios and
income or loss from operations before income tax, not including investment
income or realized gains or losses.
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
Other Real
Workers' Property- Estate
(Dollars in thousands) Compensation Casualty Reinsurance Operations Investments Parent Total
- -------------------------------------------------------------------------------------------------------------------------------
For the Nine Months Ended September 30, 1999
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenues:
Premiums earned $ 217,461 $ 54,108 $ 27,095 $ 298,664
Net investment income $ 40,500 40,500
Realized gains on
investments 6,387 6,387
Real estate sales $ 39,240 39,240
Service fee income 2,346 2,346
- -------------------------------------------------- ------------ ------------ ------------ ------------- ---------- -------------
Total revenues 219,807 54,108 27,095 39,240 46,887 387,137
- -------------------------------------------------- ------------ ------------ ------------ ------------- ---------- -------------
Segment (loss) income
before tax (100,374) (22) (2,447) 2,406 46,887 $ (9,276) (62,826)
Gain on sale of CalFarm before tax 160,335 160,335
Interest expense before tax (6,277) (6,277)
Income tax benefit (expense) 34,590 (55,993) 830 (842) (15,640) 3,246 (33,809)
Segment assets 555,826 30,137 81,663 948,833 9,532 1,625,991
Combined ratios 146.2% 100.0% 109.0% 134.4%
- -------------------------------------------------- ------------ ------------ ------------ ------------- ---------- -------------
</TABLE>
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
For the Nine Months Ended September 30, 1998
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenues:
Premiums earned $ 202,182 $ 167,318 $ 22,989 $ 392,489
Net investment income $ 40,124 40,124
Realized gains on
investments 8,338 8,338
Real estate sales $ 28,830 28,830
Service fee income 2,598 2,598
- ------------------------------------------------- ------------ ------------ ------------ ------------- ---------- -------------
Total revenues 204,780 167,318 22,989 28,830 48,462 472,379
- ------------------------------------------------- ------------ ------------ ------------ ------------- ---------- -------------
Segment (loss) income
before tax (29,728) 4,916 8,963 582 48,461 $(6,226) 26,968
Interest expense before tax (3,416) (3,416)
Income tax benefit (expense) 9,907 (1,638) (2,987) (204) (16,239) 1,993 (9,168)
Segment assets 564,682 99,190 28,656 60,343 1,090,658 11,410 1,854,939
Combined ratios 114.7% 97.1% 61.0% 104.0%
- ------------------------------------------------- ------------ ------------ ------------ ------------- ---------- -------------
</TABLE>
14
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The principal source of consolidated net income of Zenith National Insurance
Corp. ("Zenith National") and subsidiaries (collectively, "Zenith") is the
income, including investment income and realized gains, from the operations
of its property-casualty insurance operations and its investment portfolio.
The property-casualty insurance operations comprise Workers' Compensation,
Other Property-Casualty (through March 31, 1999) and Reinsurance. Zenith's
Real Estate Operations develop land and primarily construct private
residences for sale in Las Vegas, Nevada. Zenith National owns, directly or
indirectly, all of the capital stock of its subsidiaries. The comparative
results of such operations are set forth in the tables on pages 16, 17 and
18, followed by a discussion of significant changes.
Results of operations of Zenith's Workers' Compensation Operations are being
adversely impacted by severe competition and inadequate pricing. Industry
results are at historic unprofitable levels. Except in its Southeast
Operations, which principally consists of the former operations of RISCORP,
Inc. and certain of its subsidiaries (collectively, "RISCORP"), Zenith's
workers' compensation premium revenues are declining as the company endeavors
to maintain rate adequacy. However, as a result of the sale of CalFarm
Insurance Company ("CalFarm"), a wholly-owned subsidiary of Zenith Insurance
Company ("Zenith Insurance"), a wholly-owned subsidiary of Zenith National,
the capitalization of Zenith's insurance operations improved significantly
and an extraordinary dividend of $100,000,000 to Zenith National added
considerably to the assets of Zenith National. Zenith's investment portfolio
is conservative, consisting principally of investment-grade, fixed maturity
securities. Early in November of 1999, the California Insurance Commissioner
adopted an average 18.4% increase in the pure premium advisory rates
recommended by the Workers' Compensation Insurance Rating Bureau of
California - a preliminary indication of possible changes in the California
workers' compensation market. In any event, Zenith intends to raise its rates
by an appropriate amount, together with other actions, with a goal to improve
its profitability.
The comparability of the nine months ended September 30, 1999 compared to the
corresponding period in 1998 is affected by the purchase of substantially all
of the assets and certain liabilities of the RISCORP operations effective April
1, 1998. The comparability of the three months and nine months ended
September 30, 1999 compared to the corresponding periods in 1998 is affected
by net charges in the third quarter of 1999 of $50,000,000 before tax
($32,500,000 after tax, or $1.89 per share) associated with an increase in
the net liabilities for unpaid losses and loss adjustment expenses in the
Southeast Operations, which principally consists of the operations acquired
from RISCORP. The comparability of the three months and nine months ended
September 30, 1999 compared to the corresponding periods in 1998 is also
affected by the sale of CalFarm Insurance Company ("CalFarm"), a wholly-owned
subsidiary of Zenith Insurance Company ("Zenith Insurance"), a wholly-owned
subsidiary of Zenith National, to Nationwide Mutual Insurance Company
effective March 31, 1999. Results are shown with and without RISCORP-related
adjustments on pages 17 and 18, respectively.
15
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The comparative results of the property-casualty insurance operations are set
forth in the following tables, followed by a discussion of the significant
changes.
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
(Dollars in thousands) 1999 1998 1999 1998
- -------------------------------------------------------------------------------------------------------------------------------
(Restated) (Restated)
<S> <C> <C> <C> <C>
Net investment income after tax $ 9,546 $ 9,561 $ 27,095 $ 26,802
Realized gains on investments after tax 1,510 1,407 4,152 5,420
- ----------------------------------------------------------------- -------------- -------------- --------------- ---------------
Sub-total 11,056 10,968 31,247 32,222
- ----------------------------------------------------------------- -------------- -------------- --------------- ---------------
Property-casualty underwriting results after tax:
Loss excluding catastrophes and RISCORP-
related adjustments (11,018) (3,347) (27,831) (4,717)
Catastrophe losses (3,120) (2,600) (7,085) (5,850)
RISCORP-related adjustments (32,500) (32,500)
- ----------------------------------------------------------------- -------------- -------------- --------------- ---------------
Property-casualty underwriting loss after tax (46,638) (5,947) (67,416) (10,567)
- ----------------------------------------------------------------- -------------- -------------- --------------- ---------------
Income from Real Estate Operations after tax 383 122 1,564 378
Interest expense after tax (1,392) (1,240) (4,080) (2,220)
Parent expenses after tax (709) (503) (1,950) (2,013)
- ----------------------------------------------------------------- -------------- -------------- --------------- ---------------
Net (loss) income after tax before gain on sale of
CalFarm Insurance Company (37,300) 3,400 (40,635) 17,800
- ----------------------------------------------------------------- -------------- -------------- --------------- ---------------
Gain on sale of CalFarm Insurance Company after tax 104,335
- ----------------------------------------------------------------- -------------- -------------- --------------- ---------------
Net (loss) income $ (37,300) $ 3,400 $ 63,700 $ 17,800
- ----------------------------------------------------------------- -------------- -------------- --------------- ---------------
</TABLE>
16
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
Premiums earned, underwriting results and combined ratios, before tax, for the
three and nine months ended September 30, 1999 and 1998 were as follows:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
(Dollars in thousands) 1999 1998 1999 1998
- ------------------------------------------------------------------------------------------------------------------------
(Restated) (Restated)
<S> <C> <C> <C> <C>
Premiums earned:
Workers' Compensation
California $ 25,652 $ 31,157 $ 81,795 $ 91,601
Outside California 52,042 41,024 135,666 110,582
----------------------------------------------------------
Total Workers' Compensation 77,694 72,181 217,461 202,183
Other Property-Casualty 56,162 54,108 167,317
Reinsurance 9,416 7,808 27,095 22,989
----------------------------------------------------------
Total $ 87,110 $136,151 $298,664 $392,489
==========================================================
Underwriting income (loss) before tax:
Workers' Compensation $ (70,506) $ (13,352) $ (100,374) $ (29,728)
Other Property-Casualty 3,165 (22) 4,916
Reinsurance (1,081) 1,070 (2,447) 8,963
----------------------------------------------------------
Total $ (71,587) $ (9,117) $ (102,843) $ (15,849)
==========================================================
Combined loss and expense ratios:
Workers' Compensation
Loss and loss adjustment expenses 138.5% 83.6% 104.2% 78.9%
Underwriting expenses 52.2% 34.9% 42.0% 35.8%
----------------------------------------------------------
Combined ratio 190.7% 118.5% 146.2% 114.7%
Other Property-Casualty
Loss and loss adjustment expenses 64.3% 66.5% 66.2%
Underwriting expenses 30.1% 33.5% 30.9%
--------------------------------------------
Combined ratio 94.4% 100.0% 97.1%
Reinsurance
Loss and loss adjustment expenses 94.6% 67.5% 93.9% 42.4%
Underwriting expenses 16.9% 18.8% 15.1% 18.6%
----------------------------------------------------------
Combined ratio 111.5% 86.3% 109.0% 61.0%
Total
Loss and loss adjustment expenses 133.8% 74.7% 96.4% 71.3%
Underwriting expenses 48.4% 32.0% 38.0% 32.7%
----------------------------------------------------------
Combined ratio 182.2% 106.7% 134.4% 104.0%
==========================================================
</TABLE>
17
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
Premiums earned, underwriting results and combined ratios, before tax, and
excluding net charges of $50,000,000 before tax ($32,500,000 after tax, or
$1.89 per share) associated with an increase in the net liabilities for unpaid
losses and loss adjustment expenses in the Southeast Operations, which
principally consists of the operations acquired from RISCORP, recorded in the
third quarter of 1999, were as follows:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
(Dollars in thousands) 1999 1998 1999 1998
- ------------------------------------------------------------------------------------------------------------------------
(Restated) (Restated)
<S> <C> <C> <C> <C>
Premiums earned:
Workers' Compensation
California $ 25,652 $ 31,157 $ 81,795 $ 91,601
Outside California 45,442 41,024 129,066 110,582
----------------------------------------------------------
Total Workers' Compensation 71,094 72,181 210,861 202,183
Other Property-Casualty 56,162 54,108 167,317
Reinsurance 9,416 7,808 27,095 22,989
----------------------------------------------------------
Total $ 80,510 $136,151 $292,064 $392,489
==========================================================
Underwriting income (loss) before tax:
Workers' Compensation $ (20,506) $ (13,352) $ (50,374) $ (29,728)
Other Property-Casualty 3,165 (22) 4,916
Reinsurance (1,081) 1,070 (2,447) 8,963
----------------------------------------------------------
Total $ (21,587) $ (9,117) $ (52,843) $ (15,849)
==========================================================
Combined loss and expense ratios:
Workers' Compensation
Loss and loss adjustment expenses 90.9% 83.6% 87.1% 78.9%
Underwriting expenses 37.9% 34.9% 36.8% 35.8%
----------------------------------------------------------
Combined ratio 128.8% 118.5% 123.9% 114.7%
Other Property-Casualty
Loss and loss adjustment expenses 64.3% 66.5% 66.2%
Underwriting expenses 30.1% 33.5% 30.9%
--------------------------------------------
Combined ratio 94.4% 100.0% 97.1%
Reinsurance
Loss and loss adjustment expenses 94.6% 67.5% 93.9% 42.4%
Underwriting expenses 16.9% 18.8% 15.1% 18.6%
----------------------------------------------------------
Combined ratio 111.5% 86.3% 109.0% 61.0%
Total
Loss and loss adjustment expenses 91.4% 74.7% 83.9% 71.3%
Underwriting expenses 35.4% 32.0% 34.2% 32.7%
----------------------------------------------------------
Combined ratio 126.8% 106.7% 118.1% 104.0%
==========================================================
</TABLE>
18
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
The profitability of the property-casualty insurance operations is principally
dependent upon the adequacy of rates charged to the insured for insurance
protection; the frequency and severity of claims; the ability to accurately
estimate and accrue reported and unreported losses in the correct period; the
level of dividends paid to policyholders; the ability to manage claims costs and
keep operating expenses in line with premium volume; and the ability to service
claims, maintain policies and acquire business efficiently. Some of the factors
that continue to impact the business and economic environment in which Zenith
operates include: an uncertain political and regulatory environment, both state
and federal; the outlook for economic growth in geographic areas where Zenith
operates; the expansion of the Workers' Compensation Operations outside of
California; the use by others in the industry of creative reinsurance; a highly
competitive insurance industry; and the changing environment for controlling
medical, legal and rehabilitation costs, as well as fraud and abuse. Although
management is currently unable to predict the effect of any of the foregoing,
these factors and related trends and uncertainties could have a material effect
of Zenith's future operations and financial condition.
ACQUISITION OF ZENITH'S COMMON STOCK BY FAIRFAX FINANCIAL HOLDINGS LIMITED
Pursuant to a Stock Purchase Agreement, dated June 25, 1999 (the "Stock
Purchase Agreement"), between Fairfax Financial Holdings Limited, a Canada
corporation ("Fairfax"), and Reliance Insurance Company ("Reliance"), Fairfax
agreed to purchase the 6,574,445 shares of the common stock of Zenith
owned by Reliance and its affiliates for $28.00 per share (the
"Transaction"). In an amendment to its Statement on Schedule 13D, dated
October 25, 1999 and filed with the Securities and Exchange Commission,
Reliance Financial Services Corporation reported that the consummation of the
Transaction occurred on October 25, 1999. Effective upon consummation of the
Transaction, each of Messrs. Saul P. Steinberg, Robert M. Steinberg and
George E. Bello resigned from Zenith's Board of Directors.
SALE OF CALFARM INSURANCE COMPANY
Effective March 31, 1999, Zenith Insurance completed the sale of all of the
issued and outstanding capital stock of CalFarm for approximately $273,000,000
in cash to Nationwide Mutual Insurance Company. CalFarm wrote Zenith's Other
Property-Casualty business, principally in California, through March 31, 1999.
The gain on the sale, net of tax, was approximately $104,000,000.
Approximately $59,000,000 of cash was transferred from Zenith Insurance to
CalFarm in connection with the cessation of CalFarm's participation in the
intercompany reinsurance pooling agreement (the "De-pooling Transaction") to
which Zenith Insurance and its wholly-owned property-casualty insurance
subsidiaries are parties. Zenith Insurance and its wholly-owned
property-casualty subsidiaries, other than CalFarm, will continue to participate
in an intercompany reinsurance pooling agreement.
After accounting for applicable taxes and expenses, the net proceeds from the
sale that were available to Zenith Insurance for investment was approximately
$211,000,000, compared to cash and investments of approximately $226,000,000
that were excluded from Zenith's Consolidated Balance Sheet with the sale of
CalFarm.
19
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
RESOLUTION OF CONTINGENCIES SURROUNDING FAIR VALUES OF RISCORP ASSETS ACQUIRED
AND LIABILITIES ASSUMED AND SETTLEMENT OF CERTAIN LITIGATION BETWEEN ZENITH
INSURANCE AND RISCORP
On April 1, 1998, pursuant to an Asset Purchase Agreement dated June 17, 1997
(as amended from time to time, the "Asset Purchase Agreement") between Zenith
Insurance and RISCORP, Zenith Insurance acquired substantially all of the
assets and certain liabilities of RISCORP related to RISCORP's workers'
compensation business (the "RISCORP Acquisition"). See Note 4 to the
Consolidated Financial Statements on pages 10-12 ("Note 4") for a full
discussion of the Resolution of Contingencies Surrounding Fair Values of
RISCORP Assets Acquired and Liabilities Assumed and Settlement of Certain
Litigation between Zenith Insurance and RISCORP which note is herein
incorporated by reference.
In October of 1999, Zenith Insurance completed a review of the liabilities for
unpaid losses and loss adjustment expenses in its Southeast Operations, which
principally consists of the operations acquired from RISCORP. The review was
conducted with assistance from independent actuarial consultants and took
account of recent developments, including data through the third quarter of
1999. As a result of the review, Zenith Insurance recorded, in the third quarter
of 1999, an increase of $46,000,000 ($29,900,000 after tax) in the estimated net
liabilities for unpaid losses and loss adjustment expenses acquired from
RISCORP. The increase results primarily from the adjustments to reserves for the
years 1994 through 1997. Certain related receivables, principally contingent
commissions receivable under reinsurance contracts assumed from RISCORP, were
reduced by approximately $19,000,000 net ($12,400,000 after tax). Such
adjustments are adjustments to the values of the acquired assets and liabilities
and under generally accepted accounting principles must be reported currently in
results of operations.
As previously reported, Zenith Insurance purchased reinsurance protection
relating to development of the unpaid loss and loss adjustment expense
reserves acquired from RISCORP. Such reinsurance allows Zenith Insurance to
recover up to $50,000,000 in excess of $182,000,000 for net unpaid losses and
allocated loss adjustment expenses acquired from RISCORP. The provisions of
Statement of Financial Accounting Standards No. 113, ACCOUNTING AND REPORTING
FOR REINSURANCE OF SHORT-DURATION AND LONG-DURATION CONTRACTS ("SFAS No.
113") relating to accounting for retroactive reinsurance transactions require
a substantial amount of the benefit associated with such reinsurance
protection to be deferred and recognized in future periods. In the third
quarter of 1999, Zenith Insurance recorded an increase in the amount
recoverable to $50,000,000 and a benefit of $9,000,000 ($5,900,000 after tax)
associated with such reinsurance. An additional benefit of $25,000,000
($16,500,000 after tax) associated with such reinsurance has been deferred
and will be recognized over approximately the next four years, the settlement
period of the reinsurance recoverable.
As described in Note 4 Zenith Insurance and RISCORP entered into a
settlement agreement, dated July 7, 1999 (the "Settlement Agreement"),
providing for the resolution of certain claims arising out of the RISCORP
Acquisition. Under the Settlement Agreement, Zenith Insurance received
$6,000,000 from the escrow account. Zenith Insurance recorded the benefit of
such settlement in the third quarter of 1999 to offset certain unexpected
expenses incurred by Zenith Insurance in operating the business acquired from
RISCORP.
20
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
The adjustments associated with the increase in the liabilities for unpaid
loss and loss adjustment expenses acquired from RISCORP and the effect of the
Settlement Agreement, in the aggregate, are expected to ultimately reduce
income by approximately $16,000,000 after tax, or $0.93 per share, over the
current and next approximately four years. However, because of the deferral
of the reinsurance benefit required by SFAS No. 113 described above, the
impact of these adjustments on net income for the third quarter of 1999 was a
decrease of $32,500,000 after tax, or $1.89 per share. When the deferred
reinsurance benefit is recognized over approximately the next four years, net
income is expected to increase by approximately $16,500,000 after tax.
Under statutory accounting principles, the benefit of retroactive reinsurance is
recognized immediately as a separate component of surplus as regards
policyholders. Accordingly, the foregoing RISCORP-related adjustments, after the
benefit of the reinsurance protection for adverse development of the unpaid loss
and loss adjustment expense reserves acquired from RISCORP, decreased the
surplus of Zenith Insurance by approximately $25,000,000 after tax in the third
quarter of 1999.
WORKERS' COMPENSATION
Following is a discussion of results of the Workers' Compensation operation as
set forth on page 18 excluding the impact of the RISCORP-related adjustments.
Premiums earned in the Workers' Compensation operation increased in the nine
months ended September 30, 1999 compared to the corresponding period in 1998,
principally as a result of the RISCORP Acquisition, which contributed
$29,194,000 and $77,366,000 of workers' compensation premiums earned in the
three and nine months ended September 30, 1999, respectively, compared to
$22,653,000 and $47,423,000 in the corresponding periods in 1998,
respectively. Excluding the effect of the additional premiums from the
RISCORP Acquisition, premiums earned in the Workers' Compensation operation
decreased in the three and nine months ended September 30, 1999 compared to
the corresponding periods in 1998, principally as a result of Zenith's
endeavoring to maintain rate adequacy in the face of intense competition in
the national workers' compensation insurance industry.
Underwriting losses in the Workers' Compensation operation increased in the
three and nine months ended September 30, 1999 compared to the corresponding
periods in 1998. The increase in such underwriting losses was attributable,
principally, to an increase in the severity of claims and claims operating
expenses that have not been reduced commensurately with premium revenues. Zenith
has reduced expenses during 1999 and 1998, principally through reductions in the
number of employees, throughout its Workers' Compensation Operations. However,
such reductions have been offset by a reduction of premium income for the three
and nine months ended September 30, 1999 compared to the corresponding periods
in 1998. Zenith is unable to predict when its Workers' Compensation operation
will return to underwriting profitability that is consistent with Zenith's
historical experience. The underwriting results for the three and nine months
ended September 30, 1998 included $2,000,000 of losses before tax related to
catastrophic workers' compensation claims.
21
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
In Florida, the Special Disability Trust Fund (the "Fund") assesses workers'
compensation insurers to pay for what are commonly referred to as "Second
Injuries". Historic assessments have been inadequate to completely fund
obligations of the Fund. In late 1997, the Florida statute was amended so
that the Fund will not be liable for and will not reimburse employers or
carriers for Second Injuries occurring on or after January 1, 1998. Zenith
has recorded its receivable from the fund for Second Injuries based on
specific claims and historical experience prior to January 1, 1998. At
September 30, 1999 and December 31, 1998, the receivable from the Fund was
$39,680,000 and $39,077,000, respectively, related to the pre-January 1, 1998
claims, of which $2,397,000 was collected in 1999.
OTHER PROPERTY-CASUALTY
Zenith's Other Property-Casualty business was operated primarily by CalFarm,
which was sold effective March 31, 1999. In the first quarter of 1999, the Other
Property-Casualty underwriting results were adversely impacted by continuing
losses in the Health line of business, increased severity and frequency of
weather related property losses and increased expenses attributable to
improvements in information systems. The first nine months of 1998 were
adversely impacted by approximately $5,000,000 of losses before tax
attributable to California wind and storm damage.
REINSURANCE
Reinsurance premiums earned increased in the three and nine months ended
September 30, 1999, compared to the corresponding periods in 1998, due
principally to additional premiums in 1999 for reinstatement of treaties
impacted by catastrophes. The underwriting results for the three and nine
months ended September 30, 1999 were adversely impacted by $4,800,000 and
$10,900,000 of catastrophe losses before tax, respectively, compared to
$2,000,000 of catastrophe losses in the three and nine months ended September
30, 1998.
REAL ESTATE OPERATIONS
Zenith recognized total revenues from its Real Estate Operations of
$14,034,000 and $39,240,000 for the three and nine months ended September 30,
1999, respectively, and $8,398,000 and $28,830,000 for the three and nine
months ended September 30, 1998, respectively. The results of operations for
the three and nine months ended September 30, 1999 benefited from a higher
number of home sales compared to the corresponding periods in 1998 (number of
closings were 86 and 255 for the three and nine months ended September 30,
1999, respectively, compared to 61 and 210 for the comparable periods in
1998, respectively), in addition to a gain from a land sale of $472,000 in
the first quarter of 1999. Construction in progress, including undeveloped
land, was $82,215,000 and $69,387,000 at September 30, 1999 and December 31,
1998, respectively. In addition to continuing home construction, Zenith may
use some land presently owned for commercial and multi-family dwelling
construction. Changes in interest rates or other factors could affect future
home sales.
22
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
INVESTMENTS
The yields on invested assets, which vary with the general level of interest
rates, the average life of invested assets and the amount of funds available for
investment, were as follows:
<TABLE>
<CAPTION>
- --------------------------------------------- ----------------------------------- ----------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
- --------------------------------------------- ----------------- ----------------- ---------------- -----------------
(Restated) (Restated)
<S> <C> <C> <C> <C>
Investment yield before tax 6.0% 5.7% 5.6% 5.8%
Investment yield after tax 4.0% 3.8% 3.7% 3.9%
- --------------------------------------------- ----------------- ----------------- ---------------- -----------------
</TABLE>
Bonds with an investment grade rating represented 94% and 96% of the
consolidated carrying values of fixed maturities at September 30, 1999 and
December 31, 1998, respectively. The average maturity of the investment
portfolio was 6.0 years at September 30, 1999 and 5.2 years at December 31,
1998.
The total fair value of fixed maturity investments and the unrealized gain
(loss) on held-to-maturity and available-for-sale fixed maturity investments,
were as follows:
<TABLE>
<CAPTION>
- ---------------------------------- -------------------------- -----------------------------------------------------
Total Fair Unrealized Gain (Loss) on Fixed Maturities
Value of HELD-TO-MATURITY AVAILABLE-FOR-SALE
(Dollars in thousands) Fixed Maturities* Before Tax Before Tax After Tax
- ---------------------------------- -------------------------- --------------------- --------------- ---------------
<S> <C> <C> <C> <C>
At September 30, 1999 $ 843,876 $ 84 $(19,135) $(12,438)
At December 31, 1998 959,119 1,569 9,864 6,412
- ---------------------------------- -------------------------- --------------------- --------------- ---------------
</TABLE>
* Includes short-term investments
At September 30, 1999 and December 31, 1998, 96% of Zenith's consolidated
portfolio of fixed maturity investments was classified as available-for-sale
with the unrealized appreciation or depreciation recorded as a separate
component of stockholders' equity. The change in fair value of fixed maturity
investments available-for-sale resulted in a decrease in stockholders' equity of
$18,850,000 after deferred tax from December 31, 1998 to September 30, 1999.
Stockholders' equity will continue to be affected by volatility in the fixed
maturity securities market and fluctuations in interest rates through changes in
the values of fixed maturity securities, which are classified as
available-for-sale.
23
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
The change in the carrying value of Zenith's consolidated investment portfolio
during the nine months ended September 30, 1999 was as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------- -------------- --------------------
(Dollars in thousands)
- --------------------------------------------------------------------------------- -------------- --------------------
<S> <C>
Carrying value at the beginning of the year $1,048,681
Purchases at cost 357,387
Investments of CalFarm at date of sale (170,050)
Maturities and redemptions (93,647)
Proceeds from sales of investments:
Investments available-for-sale (189,844)
Other investments (6,285)
Total proceeds from sales of investments --------- (196,129)
Net realized gains:
Investments available-for-sale 3,867
Other investments 2,520
Total net realized gains --------- 6,387
Change in unrealized gains (35,554)
Increase in short-term investments 5,023
Net accretion of bonds and preferred stocks and other changes 1,566
- --------------------------------------------------------------------------------- -------------- --------------------
Carrying value at September 30, 1999 $ 923,664
- --------------------------------------------------------------------------------- -------------- --------------------
</TABLE>
LIQUIDITY AND CAPITAL RESOURCES
Zenith is principally dependent upon its portfolio of marketable securities and
the investment yields thereon; dividends from its insurance subsidiaries, whose
operations are supported by their own cash flows; and available lines of credit
to pay its expenses, service outstanding debt, pay any cash dividends which may
be declared to its stockholders and fund the land acquisitions by the Real
Estate Operations.
On March 26, 1999, Zenith Insurance paid the remaining balance of approximately
$53,700,000, including interest, due to RISCORP pursuant to the RISCORP
Acquisition. On April 1, 1999, Zenith Insurance received approximately
$273,000,000 from Nationwide Mutual Insurance Company in connection with the
sale of the capital stock of CalFarm and paid approximately $59,000,000 to
CalFarm in connection with the De-pooling Transaction.
Net cash used in operations in the nine months ended September 30, 1999 was
$50,334,000 compared to $12,696,000 for the corresponding period in 1998. Net
cash used in operations was principally used to pay loss and loss adjustment
expenses related to previous years with less cash from current, reduced premium
revenues. Net cash flows from operations will continue to be adversely affected
by reduced premium income.
Zenith National has three revolving, unsecured lines of credit in an aggregate
amount of $100,000,000, all of which was available at September 30, 1999. A
$30,000,000 line of credit will not be renewed when it expires November 30,
1999.
24
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
At September 30, 1999, Zenith National was authorized to repurchase up to
991,000 shares of Zenith common stock pursuant to a share purchase program
authorized by its Board of Directors. These purchases are discretionary and can
be adequately funded from Zenith National's existing sources of liquidity.
Zenith's Real Estate Operations maintain certain bank credit facilities to
provide financing for development and construction of private residences for
sale. At September 30, 1999, the maximum permitted under such credit facilities
was $38,873,000. The credit agreements provide that funding and repayment of
development and construction loans are made in tandem for each project. A
development loan will always precede a construction loan for a project and the
proceeds of the construction loan are required to first be used to pay off the
respective development loan. The balance outstanding under the borrowing was
$18,218,000 at September 30, 1999.
In June of 1999, Zenith Insurance declared a dividend of $100,000,000 payable to
Zenith National. The dividend was approved by the California Department of
Insurance on June 24, 1999 and was paid on July 6, 1999. Zenith National added
such funds to, and invested them as part of, its investment portfolio. Zenith
has been informed by A.M. Best Company ("Best") that the payment of the dividend
will result in a downgrade of Best's rating of Zenith`s insurance company
affiliates from A+ to A.
YEAR 2000
The Year 2000 Problem refers to the inability of information technology ("IT")
and non-information technology ("non-IT") systems to accurately process dates
during and after 1999. IT systems include computer hardware and software. Non-IT
systems include equipment that incorporates embedded micro controllers such as
elevators, security systems and HVAC systems. If not corrected, the processes of
IT and non-IT systems that are date sensitive could fail or miscalculate data
resulting in disruptions of operations such as a temporary inability to process
transactions, send and receive electronic data with third parties or otherwise
engage in normal business activities. There may also be a negative impact on the
economic and social infrastructure on which Zenith depends.
In early 1996, Zenith formed a Year 2000 team consisting of staff familiar with
Zenith's IT and non-IT systems to coordinate the elimination, to the extent
possible, of Zenith's exposure to the Year 2000 Problem. Reports of the Year
2000 team's efforts are presented to Zenith's Board of Directors periodically.
Since 1996, Zenith has been systematically replacing and modifying its internal
systems to function correctly with dates from 1999 forward, thereby rendering
them "Year 2000 Compliant." Internal systems ("Internal Systems") consist of (1)
core information technology systems supporting corporate level accounting and
financial reporting processes ("Core Corporate IT Systems"); (2) core
information technology systems supporting operational processes involving (a)
underwriting, premium collection and claims processes in Zenith's insurance
operations (including those systems acquired in the RISCORP Acquisition) and (b)
land acquisitions, development, construction, sales and escrow
tracking/monitoring in the Real Estate Operations ("Core Operational IT
Systems"); (3) computer
25
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
networks and communications infrastructure ("IT Infrastructure"); (4)
personal and laptop computers including applications ("Other IT Equipment");
and (5) owned facility systems which rely on non-computer equipment
incorporating embedded microprocessors, such as elevators, HVAC and security
as well as office equipment such as facsimile and copy machines and postage
meters ("Facilities and Other Non-IT Systems"). The majority of Zenith's Year
2000 compliance efforts have been staffed internally, although Zenith has
engaged and will continue to engage technical consultants to assist its
internal staff, as well as to assist Zenith in reviewing its progress.
The Internal Systems are being corrected through a process with five phases,
some of which are concurrent: (1) Inventory (listing IT and non-IT systems and
their components); (2) Assessment (identifying possible Year 2000-related
failures and developing strategies to repair, replace, or eliminate them); (3)
Remediation (creating or acquiring corrections to identified deficiencies); (4)
Validation (confirming whether corrections would be successful); and (5)
Implementation (installing corrections into the business operations for general
use).
The status and scheduled completion dates of efforts to make the Internal
Systems supporting Zenith's operations Year 2000 Compliant are as follows:
<TABLE>
<CAPTION>
- --------------------------------------------- --------------- --------------- --------------- --------------- --------------
Inventory Assessment Remediation Validation Implementation
--------------- --------------- --------------- --------------- --------------
<S> <C> <C> <C> <C> <C>
Core Corporate IT Systems Completed Completed Completed Completed Completed
Core Operational IT Systems:
- ---------------------------------------------
Workers' Compensation Completed Completed Completed Completed Completed
Reinsurance Completed Completed Completed Completed Completed
Real Estate Operations Completed Completed Completed Completed Completed
IT Infrastructure:
- ---------------------------------------------
Workers' Compensation Completed Completed Completed Completed Completed
Reinsurance Completed Completed Completed Completed Completed
Real Estate Operations Completed Completed Completed Completed Completed
Other IT Equipment:
- ---------------------------------------------
Workers' Compensation Completed Completed Completed Completed Completed
Reinsurance Completed Completed Completed Completed Completed
Real Estate Operations Completed Completed Completed Completed Completed
Facilities and Other Non-IT Systems:
- ---------------------------------------------
Woodland Hills, CA Completed Completed Completed Completed Completed
Sarasota, FL Completed Completed Completed Completed Completed
- --------------------------------------------- --------------- --------------- --------------- --------------- --------------
</TABLE>
The above table excludes the scheduled completion dates for the Other Property &
Casualty Operations which were disposed of through the sale of the capital stock
of CalFarm on March 31, 1999.
Zenith is currently further testing and refining the Internal Systems to assure
that they function in Zenith's operating environment on an interconnected basis.
This process will continue to the end of 1999. Also during this period, Zenith
is limiting software changes into its production operating environment to
minimize the risk of invalidating remediation efforts.
26
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
Zenith's Year 2000 efforts also include a systematic assessment of the Year 2000
Compliant status of third parties upon which Zenith relies in its business
operations, including major suppliers of services and products, owners of its
leased facilities and principal business partners (collectively, "Key External
Dependencies"). Zenith has used letters, questionnaires, surveys and interviews
to determine whether these Key External Dependencies will achieve Year 2000
Compliant status. Zenith has received both oral and written assurances from its
Key External Dependencies that they will be Year 2000 Compliant. However, such
assurances are usually qualified and, in most instances, given within the safe
harbor provision of the Federal Year 2000 Information and Readiness Disclosure
Act . None of Zenith's Key External Dependencies has informed Zenith that such
Key External Dependency has a Year 2000 issue that would have a material adverse
impact on Zenith and nothing has come to Zenith's attention leading it to
conclude that there will be failures in Key External Dependencies that will have
a material adverse impact on Zenith. Nevertheless, because of the general nature
of the Year 2000 Problem and how it may manifest itself, Zenith remains cautious
about the state of readiness of its Key External Dependencies. Zenith intends to
continue systematic assessment, including follow-ups of its Key External
Dependencies.
All companies are faced with certain unknown risks arising from Year 2000 issues
that may impact them negatively. Zenith's Year 2000 efforts have been designed
to mitigate to the extent possible its risks from Year 2000-related failures
faced by Zenith. Despite Zenith's Year 2000-related efforts, Zenith recognizes
the possibility of some negative impact on its operations resulting from Year
2000-related failures. Zenith believes that the most reasonably-likely,
worst-case, Year 2000 scenarios could include failures of Zenith's Internal
Systems, a failure of one or more of its critical Key External Dependencies,
such as financial institutions, agents/brokers or reinsurers, and/or the
contamination of Zenith's IT systems due to receipt of corrupted data. Such a
scenario could result in a disruption of Zenith's normal business activities and
could have a material adverse effect on its financial condition and results of
operations. In the quarter ended September 30, 1998, Zenith began developing
contingency plans to substantially reduce material business disruptions from
such risks. Such plans include measures, such as 1) acceleration into the last
quarter of 1999 the performance of obligations and duties otherwise owed in the
first quarter of 2000; 2) identification of alternatives to Key External
Dependencies that may not be Year 2000 Compliant and therefore unable to meet
Zenith's needs; and 3) certain activities in Zenith's pre-existing Business
Recovery/Resumption Plan designed for Zenith to operate during, and to recover
from, catastrophes. Contingency plans have been in place since September 30,
1999. In connection with such plans, actions to be taken by each business unit
through January 2000 were established along with scheduled completion dates. The
actions to be taken and scheduled completion dates are reviewed and updated
regularly. Testing of manual processes to be used in the event of computer
failure has been completed for critical business functions.
27
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
Zenith has been planning to upgrade its IT Infrastructure and its other IT
equipment for some time; however, because of the Year 2000 problem, certain
components of those plans were accelerated and completed by mid-1999. The table
below sets out the costs for either repairing Zenith's IT systems ("IT Repair
Costs") or for replacing them ("IT Replacement Costs").
<TABLE>
<CAPTION>
- ----------------------------------------- ------------------ ------------------- ------------------ ------------------
Percent
Expenditures Expended Estimate Total
as of as of to Estimated IT
(Dollars in thousands) Sept. 30, 1999 Sept. 30, 1999 Complete Expenditure
- ----------------------------------------- ------------------ ------------------- ------------------ ------------------
<S> <C> <C> <C> <C>
IT Repair Costs $ 7,036 99% $ 76 $ 7,112
IT Replacement Costs:
Software 881 100% 881
Hardware 2,234 100% 2,234
Related Expenditures 417 63% 246 663
- ----------------------------------------- ------------------ ------------------- ------------------ ------------------
Total $ 10,568 97% $ 322 $10,890
- ----------------------------------------- ------------------ ------------------- ------------------ ------------------
</TABLE>
The above table includes amounts incurred for the Other Property & Casualty
Operations through March 31, 1999 and does not include any estimates to complete
for the Other Property & Casualty Operations since they were disposed of through
the sale of the capital stock of CalFarm on March 31, 1999.
IT Repair Costs and IT Replacement Costs include external costs and the cost of
dedicated information technology personnel. IT Repair Costs are expensed as they
are incurred; IT Replacement Costs are capitalized in accordance with Statement
of Position 98-1. The internal cost of user participation in acceptance testing
has not been measured and is not included in the foregoing estimates. Although
not quantified at this time, costs associated with non-IT systems and
contingency planning are not expected to be significant. All Year 2000-related
costs have been, and will continue to be, funded from internal sources. No
planned information technology projects were deferred because of Year
2000-related efforts.
The reader is directed to the section of this Report entitled "Forward-Looking
Information" and cautioned that the foregoing discussion on the Year 2000
Problem must be read in conjunction with such section. The forward looking
information on the Year 2000 Problem, including its impact on Zenith, future
costs, scheduled completion dates and the success of Zenith's efforts in
preparing for it are based on management's best estimates of future events. Such
estimates, however, are subject to the inherent uncertainty of the ultimate
effect and the extent of the Year 2000 Problem and the availability of technical
resources and hardware.
CODIFICATION OF STATUTORY ACCOUNTING PRINCIPLES
In 1998, the National Association of Insurance Commissioners ("NAIC") adopted
the Codification of Statutory Accounting Principles guidance (the
"Codification"), which will replace the current Accounting Practices and
Procedures manual as the NAIC's primary guidance on statutory accounting.
(Statutory accounting is a comprehensive basis of accounting based on prescribed
accounting practices, which include state laws, regulations and general
administrative rules, as well as a variety of publications of the NAIC.) The
Codification provides guidance for the areas where statutory accounting has been
silent and changes current statutory accounting in some areas. The NAIC is now
considering amendments to the Codification that would also be effective upon
implementation. The NAIC has established January 1, 2001 as the effective date
of the Codification.
28
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
Currently, the state of California Department of Insurance is planning to adopt
the Codification, but it is unknown whether the Department of Insurance will
make any changes to that guidance. Implementation of the Codification may affect
the surplus level and the capitalization requirements of Zenith National's
insurance subsidiaries on a statutory basis. Zenith has not determined the
impact of the Codification.
FORWARD-LOOKING INFORMATION
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for
forward-looking statements if accompanied by meaningful cautionary statements
identifying important factors that could cause actual results to differ
materially from those discussed. Forward-looking statements include those
related to the plans and objectives of management for future operations, future
economic performance, or projections of revenues, income, earnings per share,
capital expenditures, dividends, capital structure, or other financial items.
Statements containing words such as EXPECT, ANTICIPATE, BELIEVE, or similar
words that are used in Management's Discussion and Analysis of Financial
Condition and Results of Operations, in other parts of this report or in other
written or oral information conveyed by or on behalf of Zenith are intended to
identify forward-looking statements. Zenith undertakes no obligation to update
such forward-looking statements, which are subject to a number of risks and
uncertainties that could cause actual results to differ materially from those
projected. These risks and uncertainties include but are not limited to the
following: (1) heightened competition, particularly intense price competition;
(2) adverse state and federal legislation and regulation; (3) changes in
interest rates causing a reduction of investment income; (4) general economic
and business conditions which are less favorable than expected; (5)
unanticipated changes in industry trends; (6) adequacy of loss reserves; (7)
catastrophic events; (8) ability to timely and accurately complete the Year 2000
conversion process; (9) impact of any failure of third parties with whom Zenith
does business to be Year 2000 compliant; (10) uncertainties related to the
RISCORP Acquisition, including (a) the ability of Zenith to integrate on a
profitable basis the business acquired from RISCORP, (b) the value of
transferred assets and transferred liabilities, and (c) the resolution of
RISCORP's claim set forth in the Settlement Agreement that the Neutral Auditor
and Neutral Actuary allegedly made an error in its determinations with respect
to the purchase price for the RISCORP Acquisition; (11) changing environment for
controlling medical, legal and rehabilitation costs, as well as fraud and abuse;
and (12) other risks detailed herein and from time to time in Zenith's other
reports and filings with the Securities and Exchange Commission.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As of September 30, 1999, approximately 96% of the carrying value of fixed
maturity investments are categorized as available-for-sale, for which category
changes in fair value are reflected in stockholders' equity. The fair value of
the fixed income investment portfolio is exposed to interest rate risk - the
risk of loss in fair value resulting from adverse changes in prevailing market
rates of interest for similar financial instruments. In addition, certain
mortgage-backed securities are exposed to accelerated prepayment risk in that a
decline in interest rates could prompt mortgage holders to refinance existing
mortgages at lower rates. However, Zenith has the ability to hold fixed income
investments to maturity.
29
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (CONTINUED)
Zenith relies on the experience and judgment of senior management to monitor and
mitigate the effects of market risk. Zenith does not utilize financial
instrument hedges or derivative financial instruments to manage risks, nor does
it enter into any swap, forward or options contracts, but will attempt to
mitigate its exposure through active portfolio management. The allocation among
various types of securities is adjusted from time to time based on market
conditions, credit conditions, tax policy, fluctuations in interest rates and
other factors. In addition, Zenith places the majority of its investments in
high quality, marketable securities and limits the amount of credit exposure
with respect to any single issuer.
The table below provides information about Zenith's financial instruments as of
September 30, 1999 for which fair values are subject to changes in interest
rates. For fixed maturity investments, the table presents fair value and
weighted average interest rates by expected maturity dates. Such investments
include preferred stocks that are redeemable or have sinking fund provisions,
corporate bonds, municipal bonds, government bonds and mortgage backed
securities. For debt obligations, the table presents principal cash flows by
expected maturity dates (including interest).
<TABLE>
<CAPTION>
- ------------------------------------- -----------------------------------------------------------------------------------------
Expected Maturity Date
-----------------------------------------------------------------------------------------
(Dollars in thousands) 1999 2000 2001 2002 2003 Thereafter Total
- ------------------------------------- ------------ ------------ ------------ ------------ ------------ ----------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Fixed maturities:
Held-to-maturity and
available-for-sale securities:
Fixed rate $7,127 $80,292 $155,803 $44,629 $51,887 $359,012 $698,750
Weighted average interest
rate 4.9% 5.6% 5.7% 6.5% 7.5% 8.2%
Trading Securities:
Fixed rate $2,935 2,935
Weighted average interest
rate 6.8%
Short-term investments $142,191 142,191
Debt obligations:
Payable to banks and other
notes payable 1,920 $16,551 $2,299 $1,357 $ 34 $ 407 22,568
9% senior notes payable 3,375 6,750 6,750 78,375 95,250
8.55% redeemable securities 6,413 6,413 6,413 6,413 235,325 260,977
- ------------------------------------- ------------ ------------ ------------ ------------ ------------ ----------- ------------
</TABLE>
30
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
PART II, OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Zenith Insurance Company ("Zenith Insurance") and RISCORP, Inc. and certain
of its subsidiaries (collectively, "RISCORP") entered into a settlement
agreement, dated July 7, 1999 (the "Settlement Agreement"), providing for the
resolution of certain claims arising out the RISCORP Acquisition. Pursuant to
the Settlement Agreement, Zenith Insurance and RISCORP (i) have dismissed
litigation pending between between them in the United States District Courts
for the Middle District of Florida, Tampa Division, and the Southern District
of New York; (ii) have agreed that RISCORP may request that the Neutral
Auditor and Neutral Actuary (a) review an alleged error concerning the proper
treatment of certain reinsurance treaties in its determinations with respect
to the purchase price for the RISCORP Acquisition, without waiving whatever
rights they may have to litigation of such issue, (b) determine whether the
issue was property in dispute before the Neutral Auditor and Neutral Actuary
and (c), if so, determine the merits of the issue and whether a correction is
appropriate; (iii) have agreed that any other disputes arising under the
Asset Purchase Agreement or the Settlement Agreement, including any future
claims for indemnification by either Zenith Insurance or RISCORP, are to be
resolved by binding arbitration; (iv) have agreed that Zenith is to receive
$6,000,000 from an escrow account established pursuant to the Asset Purchase
Agreement with RISCORP to receive the balance of the escrow account; and (v)
have agreed to an allocation between them of any recovery received as a result
of refund claims that RISCORP has made to the Florida Department of Labor and
Employment Security, Division of Workers' Compensation. In a submission made
to the Neutral Auditor and Neutral Actuary, RISCORP claimed that the purchase
price for the RISCORP Acquisition should be adjusted by either $5,872,000 or
$23,365,000 as a result of alleged errors in the original determination of
the Neutral Auditor and Neutral Actuary's with respect to the purchase price.
On October 7, 1999, the Neutral Auditor and Neutral Actuary advised Zenith
and RISCORP that they cannot now consider the additional issue raised by
RISCORP because the issue had not previously been raised as a dispute
pursuant to the procedures set forth in their engagement letter. RISCORP has
advised Zenith that RISCORP will pursue all judicial or other available
remedies to seek correction of the alleged errors in the determinations made
by the Neutral Auditor and Neutral Actuary.
31
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
PART II, OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
3.1 Certificate of Incorporation of Zenith as in effect immediately prior
to November 22, 1985. (Incorporated herein by reference to Exhibit 3 to
Zenith's amendment on Form 8, date of amendment October 10, 1985, to
Zenith's Current Report on Form 8-K, date of report July 26, 1985.)
Certificate of Amendment to Certificate of Incorporation of Zenith,
effective November 22, 1985. (Incorporated herein by reference to
Zenith's Current Report on Form 8-K, date of report November 22, 1985.)
3.2 By-laws of Zenith, as currently in effect. (Incorporated herein by
reference to Exhibit 3.2 to Zenith's Annual Report on Form 10-K for the
year ended December 31, 1988)
10.1 Fourth Amendment to Credit Agreement, dated July 22, 1999, between
Zenith National Insurance Corp. and Bank of America National Trust and
Savings Association.
10.2 Fifth Amendment to Credit Agreement, dated August 9, 1999, between
Zenith National Insurance Corp. and Bank of America National Trust and
Savings Association.
10.3 Restated Tranche A Note, dated July 22, 1999, between Zenith National
Insurance Corp. and Bank of America National Trust and Savings
Association.
11 Statement re computation of per share earnings. (Note 2 of the
Consolidated Financial Statements (unaudited) included in Item 1 of
Part I of this Quarterly Report on Form 10-Q is incorporated herein by
reference.)
27 Financial data schedule
(b) Reports on Form 8-K
Zenith filed a Current Report on Form 8-K, dated October 22, 1999, in
connection with the review of the liabilities for unpaid losses and
loss adjustment expenses in its Southeast Operations.
Zenith filed a Current Report on Form 8-K, dated October 25, 1999, on
November 8, 1999 in connection with the Stock Purchase Agreement, dated
June 25, 1999, between Fairfax Financial Holdings Limited and Reliance
Insurance Company in which Fairfax agreed to purchase the 6,574,445
shares of the common stock of the Zenith owned by Reliance and its
affiliates.
32
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
ZENITH NATIONAL INSURANCE CORP.
Registrant
Date: November 12, 1999 /s/ Stanley R. Zax
------------------------------------
Stanley R. Zax
Chairman of the Board and President
(Principal Executive Officer)
Date: November 12, 1999 /s/ Fredricka Taubitz
------------------------------------
Fredricka Taubitz
Executive Vice President
& Chief Financial Officer
(Principal Accounting Officer)
32
<PAGE>
FOURTH AMENDMENT TO
CREDIT AGREEMENT
THIS FOURTH AMENDMENT TO CREDIT AGREEMENT (this "Amendment") dated as of
July 22, 1999 is entered into between ZENITH NATIONAL INSURANCE CORP. (the
"Company"), and BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION (the
"Bank").
W I T N E S S E T H:
WHEREAS, the Company and the Bank are parties to that certain Credit
Agreement dated as of July 24, 1997 (as amended, herein called the "Credit
Agreement"; terms used but not otherwise defined herein are used herein as
defined in the Credit Agreement); and
WHEREAS, the Company and the Bank desire to make certain amendments to
the Credit Agreement on the terms and conditions set forth herein;
NOW, THEREFORE, in consideration of the premises, and intending to be
legally bound hereby, the Company and the Bank hereby agree as follows:
SECTION 1. AMENDMENTS.
Subject to and upon the terms and conditions hereof and in reliance on
the Company's warranties set forth in SECTION 2 below, as of the date hereof
the Credit Agreement is amended by amending clause (a) of the definition of
"Tranche A Termination Date" set forth in Section 1.1 of the Credit Agreement
to delete the reference to July 22, 1999 contained therein and replacing it
with August 20, 1999.
SECTION 2. WARRANTIES.
To induce the Bank to enter into this Amendment, the Company warrants to
the Bank as of the date hereof that:
(a) After giving effect to this Amendment, all representations and
warranties contained in the Credit Agreement and the Loan Documents are true
and correct in all material respects on and as of the date hereof (except to
the extent such representations and warranties expressly refer to an earlier
date).
(b) After giving effect to this Amendment, no Default or Event of
Default has occurred and is continuing.
(c) The execution, delivery and performance by the Company of this
Amendment have been duly authorized by all necessary corporate and other
action and do not and will not require any registration with, consent or
approval of, notice to or action by, any
<PAGE>
Person (including any governmental authority) in order to be effective and
enforceable. The Credit Agreement as modified by this Amendment constitutes
the legal, valid and binding obligation of the Company, enforceable against
it in accordance with the Credit Agreement's terms, without defense,
counterclaim or offset.
SECTION 3. GENERAL.
(a) As hereby modified, the Credit Agreement shall remain in full force
and effect and is hereby ratified, approved and confirmed in all respects.
(b) The Company acknowledges and agrees that the execution and delivery
by the Bank of this Amendment shall not be deemed to create a course of
dealing or otherwise obligate the Bank to execute similar modifications under
the same or similar circumstances in the future.
(c) This Amendment may be executed in any number of counterparts and by
the different parties on separate counterparts, and each such counterpart
shall be deemed to be an original, but all such counterparts shall together
constitute but one and the same Amendment.
Delivered at Chicago, Illinois, as of the date and year first above written.
BANK OF AMERICA NATIONAL TRUST AND
SAVINGS ASSOCIATION
By: /s/ Jim V. Miller
-------------------------------------
Name: Jim V. Miller
-----------------------------------
Title: Managing Director
----------------------------------
ZENITH NATIONAL INSURANCE CORP.
By: /s/ Stanley R. Zax
-------------------------------------
Name: Stanley R. Zax
-----------------------------------
Title: Chairman & President
----------------------------------
-2-
<PAGE>
FIFTH AMENDMENT TO
CREDIT AGREEMENT
THIS FIFTH AMENDMENT TO CREDIT AGREEMENT (this "Amendment") dated as of
August 9, 1999 is entered into between ZENITH NATIONAL INSURANCE CORP. (the
"Company"), and BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION (the
"Bank").
W I T N E S S E T H:
WHEREAS, the Company and the Bank are parties to that certain Credit
Agreement dated as of July 24, 1997 (as amended, herein called the "Credit
Agreement"; terms used but not otherwise defined herein are used herein as
defined in the Credit Agreement); and
WHEREAS, the Company and the Bank desire to make certain amendments to
the Credit Agreement on the terms and conditions set forth herein;
NOW, THEREFORE, in consideration of the premises, and intending to be
legally bound hereby, the Company and the Bank hereby agree as follows:
SECTION 1. AMENDMENTS.
Subject to and upon the terms and conditions hereof and in reliance on
the Company's warranties set forth in SECTION 2 below, as of the date hereof
the Credit Agreement is amended as follows:
(a) Clause (b) of the definition of "Applicable Margin" set forth in
Section 1.1 of the Credit Agreement shall be amended by deleting the
reference to .375% contained therein and replacing it with .475%; and
(b) Clause (a) of the definition of "Tranche A Termination Date" set
forth in Section 1.1 of the Credit Agreement shall be amended by deleting the
reference to August 20, 1999 contained therein and replacing it with July 21,
2000.
SECTION 2. WARRANTIES.
To induce the Bank to enter into this Amendment, the Company warrants to
the Bank as of the date hereof that:
(a) After giving effect to this Amendment, all representations and
warranties contained in the Credit Agreement and the Loan Documents are true
and correct in all material respects on and as of the date hereof (except to
the extent such representations and warranties expressly refer to an earlier
date).
<PAGE>
(b) After giving effect to this Amendment, no Default or Event of
Default has occurred and is continuing.
(c) The execution, delivery and performance by the Company of this
Amendment have been duly authorized by all necessary corporate and other
action and do not and will not require any registration with, consent or
approval of, notice to or action by, any Person (including any governmental
authority) in order to be effective and enforceable. The Credit Agreement as
modified by this Amendment constitutes the legal, valid and binding
obligation of the Company, enforceable against it in accordance with the
Credit Agreement's terms, without defense, counterclaim or offset.
SECTION 3. GENERAL.
(a) As hereby modified, the Credit Agreement shall remain in full force
and effect and is hereby ratified, approved and confirmed in all respects.
(b) The Company acknowledges and agrees that the execution and delivery
by the Bank of this Amendment shall not be deemed to create a course of
dealing or otherwise obligate the Bank to execute similar modifications under
the same or similar circumstances in the future.
(c) This Amendment may be executed in any number of counterparts and by
the different parties on separate counterparts, and each such counterpart
shall be deemed to be an original, but all such counterparts shall together
constitute but one and the same Amendment.
Delivered at Chicago, Illinois, as of the date and year first above written.
BANK OF AMERICA, N.A.
By: /s/ Gary R. Peet
-------------------------------------
Name: Gary R. Peet
-----------------------------------
Title: Managing Director
----------------------------------
ZENITH NATIONAL INSURANCE CORP.
By: /s/ Stanley R. Zax
-------------------------------------
Name: Stanley R. Zax
-----------------------------------
Title: Chairman & President
----------------------------------
-2-
<PAGE>
RESTATED TRANCHE A NOTE
$20,000,000 July 22, 1999
On or before the Tranche A Termination Date the undersigned, FOR VALUE
RECEIVED, promises to pay to the order of Bank of America, N.A. (as successor
by merger to Bank of America National Trust And Savings Association) (the
"Lender") at its principal office at 231 South LaSalle Street in Chicago,
Illinois, TWENTY MILLION DOLLARS ($20,000,000) or, if less, the aggregate
unpaid principal amount of all Tranche A Loans (as defined in the Credit
Agreement hereinafter referred to) made by the Lender to the undersigned
pursuant to the Credit Agreement, as shown in the schedule attached hereto
(and any continuation thereof).
The undersigned also promises to pay interest on the unpaid principal
amount hereof from time to time outstanding from the date hereof until
maturity (whether by acceleration or otherwise) and, after maturity, until
paid, at the rates PER ANNUM and on the dates specified in the Credit
Agreement.
Payments of both principal and interest are to be made in lawful money
of the United States of America in same day or immediately available funds.
This Restated Note is the Tranche A Note described in, and is subject to
the terms and provisions of, a Credit Agreement, dated as of July 24, 1997
(as the same may at any time be amended or modified and in effect, the
"Credit Agreement"), between the undersigned and the Lender. Reference is
hereby made to the Credit Agreement for a statement of the prepayment rights
and obligations of the undersigned and for a statement of the terms and
conditions under which the due date of this Restated Note may be accelerated.
Upon the occurrence of any Event of Default as specified in the Credit
Agreement, the principal balance hereof and the interest accrued hereon may
be declared to be forthwith due and payable, and any indebtedness of the
holder hereof to the undersigned may be appropriated and applied hereon.
THIS RESTATED TRANCHE A NOTE CONSTITUTES A RENEWAL AND RESTATEMENT OF,
AND A REPLACEMENT AND SUBSTITUTE FOR, THE EXISTING TRANCHE A NOTE. THE
INDEBTEDNESS EVIDENCED BY THE EXISTING TRANCHE A NOTE IS CONTINUING
INDEBTEDNESS, AND NOTHING HEREIN SHALL BE DEEMED TO CONSTITUTE A PAYMENT,
SETTLEMENT OR NOVATION OF THE EXISTING FACILITY A NOTE OR TO ADVERSELY AFFECT
ANY RIGHTS OF THE LENDER IN CONNECTION WITH THIS NOTE, THE CREDIT AGREEMENT
OR THE LOAN DOCUMENTS.
In addition to and not in limitation of the foregoing and the provisions
of the Credit Agreement, the undersigned further agrees, subject only to any
limitation imposed by applicable law, to pay all expenses, including
reasonable attorneys' fees and legal expenses, incurred by the holder of this
Restated Note in endeavoring to collect any amounts payable hereunder which
are not paid when due, whether by acceleration or otherwise.
All parties hereto, whether as makers, endorsers, or otherwise,
severally waive presentment for payment, demand, protest and notice of
dishonor.
<PAGE>
THIS RESTATED NOTE SHALL BE DEEMED TO BE A CONTRACT MADE UNDER AND
GOVERNED BY THE INTERNAL LAWS OF THE STATE OF CALIFORNIA.
ZENITH NATIONAL INSURANCE CORP.
By: /s/ Stanley R. Zax
-------------------------------------
Name: Stanley R. Zax
-----------------------------------
Title: Chairman & President
----------------------------------
-2-
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<PAGE>
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