<PAGE> 1
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
----------------
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
----------- ------------
COMMISSION FILE NUMBER 0-25984
----------------
SUPERIOR NATIONAL INSURANCE GROUP, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-4610936
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
26601 AGOURA ROAD
CALABASAS, CA 91302
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(818) 880-1600
(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 [ ]
Number of shares of Common Stock, $0.01 par value per share,
outstanding as of close of business on August 12, 1998: 5,877,567 shares.
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<PAGE> 2
SUPERIOR NATIONAL INSURANCE GROUP, INC.
INDEX TO FORM 10-Q
PART I. FINANCIAL INFORMATION
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
Item 1. Financial Statements................................................................................... 3
Condensed consolidated balance sheets as of June 30, 1998 (unaudited) and December 31, 1997........... 3
Condensed consolidated statements of income for the three and six months ended June 30, 1998
(unaudited) and June 30, 1997 (unaudited)....................................................... 4
Condensed consolidated statement of changes in stockholders' equity for the six months ended
June 30, 1998 (unaudited) and for the twelve months ended December 31, 1997..................... 5
Condensed consolidated statements of cash flows for the six months ended June 30, 1998 (unaudited)
and June 30, 1997 (unaudited)..................................................................... 6
Notes to condensed consolidated financial statements (unaudited)...................................... 7
Item 2. Management's Discussion and Analysis of Consolidated Financial Condition and Results of
Operations............................................................................................ 10
PART II. OTHER INFORMATION
Item 5. Other Information...................................................................................... 17
Item 6. Exhibits and Reports on Form 8-K....................................................................... 18
SIGNATURE........................................................................................................ 19
EXHIBIT INDEX.................................................................................................... 20
</TABLE>
<PAGE> 3
PART I -- FINANCIAL INFORMATION
ITEM 1 -- FINANCIAL STATEMENTS
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
--------- ---------
(UNAUDITED) (*)
<S> <C> <C>
ASSETS
INVESTMENTS
Bonds and notes:
Available-for-sale, at market (cost: 1998, $179,057; 1997, $203,373) .............. $ 180,830 $ 205,214
Equity securities, at market (cost: 1998, $5,179; 1997, $1,356) ...................... 5,263 1,526
Funds withheld from reinsurers, at amortized cost (market: $2,192) ................... 2,185 --
Cash and short-term instruments
(Restricted cash: 1998, $49; 1997, $651) .......................................... 5,071 35,376
--------- ---------
TOTAL INVESTMENTS .............................................................. 193,349 242,116
Reinsurance recoverable .............................................................. 55,474 53,082
Premiums receivable (less allowance for doubtful accounts:
1998 & 1997, $800) ................................................................ 34,518 36,888
Deferred income taxes (less valuation allowance of $8,129, 1998 & 1997) .............. 11,731 12,200
Prepaid reinsurance premiums ......................................................... 25,822 1,598
Goodwill ............................................................................. 35,248 35,887
Prepaid and other .................................................................... 29,033 34,798
--------- ---------
TOTAL ASSETS ................................................................... $ 385,175 $ 416,569
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Claims and claim adjustment expenses ................................................. $ 154,843 $ 201,255
Unearned premiums .................................................................... 16,198 12,913
Reinsurance payable .................................................................. 17,964 3,412
Accounts payable and other liabilities ............................................... 36,424 37,894
--------- ---------
TOTAL LIABILITIES .............................................................. 225,429 255,474
COMPANY-OBLIGATED TRUST PREFERRED SECURITIES OF SUBSIDIARY
TRUST HOLDING SOLELY SENIOR SUBORDINATED NOTES OF SNIG;
$1,000 face per share; issued and outstanding 105,000 shares in 1997 and 1998 . 101,051 101,277
STOCKHOLDERS' EQUITY
Common stock, $0.01 par value; authorized 25,000,000 shares:
issued 5,876,399 shares in 1998 and 5,871,279 shares in 1997 ...................... 59 59
Paid-in capital excess of par ..................................................... 34,274 34,242
Paid-in capital - warrants ........................................................... 2,206 2,206
Accumulated other comprehensive income;
Unrealized gain on investments, net of taxes ...................................... 1,225 1,327
Retained earnings .................................................................... 26,076 21,984
Less: 245,000 shares of treasury stock at cost ....................................... (5,145) --
--------- ---------
TOTAL STOCKHOLDERS' EQUITY ..................................................... 58,695 59,818
========= =========
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ..................................... $ 385,175 $ 416,569
========= =========
</TABLE>
*Derived from audited financial statements.
See Notes to Condensed Consolidated Financial Statements.
3
<PAGE> 4
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
THREE AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ---------------------------
1998 1997 1998 1997
-------- -------- -------- --------
(UNAUDITED) (UNAUDITED) (UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
REVENUES:
Premiums written, net of reinsurance ceded ................ $ 19,164 $ 43,703 $ 47,665 $ 63,706
Net change in unearned premiums ........................... 6,040 1,707 8,126 682
-------- -------- -------- --------
Net premiums earned ....................................... 25,204 45,410 55,791 64,388
Net investment income ..................................... 3,761 3,435 8,014 5,521
-------- -------- -------- --------
TOTAL REVENUES .......................................... 28,965 48,845 63,805 69,909
EXPENSES:
Claims and claim adjustment expenses, net of
reinsurance recoveries ................................. 15,399 34,724 33,687 44,995
Commissions, net of reinsurance ceding commissions ........ (1,497) 4,687 1,467 6,888
Interest expense .......................................... -- 2,417 -- 4,144
General and administrative expenses
Underwriting ........................................... 8,129 6,158 15,156 10,961
Other .................................................. 196 340 375 521
Goodwill ............................................... 335 137 639 137
-------- -------- -------- --------
TOTAL EXPENSES .......................................... 22,562 48,463 51,324 67,646
-------- -------- -------- --------
INCOME BEFORE INCOME TAXES, PREFERRED SECURITIES DIVIDENDS
AND ACCRETION .......................................... 6,403 382 12,481 2,263
Income tax expense ........................................ 2,354 98 4,665 769
-------- -------- -------- --------
INCOME BEFORE PREFERRED SECURITIES DIVIDENDS AND ACCRETION 4,049 284 7,816 1,494
Preferred Securities dividends and accretion, net of
income tax ............................................. -- (453) -- (907)
Trust Preferred Securities dividends and accretion, net of
income tax ............................................. (1,852) -- (3,724) --
Extraordinary loss on retirement of long-term debt, net of
income tax ............................................. -- (10,361) -- (10,361)
-------- -------- -------- --------
NET INCOME ................................................ $ 2,197 $(10,530) $ 4,092 $ (9,774)
======== ======== ======== ========
BASIC EARNINGS PER SHARE:
INCOME BEFORE PREFERRED SECURITIES DIVIDENDS AND ACCRETION $ 0.69 $ 0.05 $ 1.34 $ 0.32
Preferred securities dividends and accretion .............. (0.32) (0.08) (0.64) (0.20)
Extraordinary items ....................................... -- (1.77) -- (2.23)
-------- -------- -------- --------
NET INCOME ................................................ $ 0.37 $ (1.80) $ 0.70 $ (2.11)
======== ======== ======== ========
DILUTED EARNINGS PER SHARE:
INCOME BEFORE PREFERRED SECURITIES DIVIDENDS AND ACCRETION $ 0.50 $ 0.04 $ 0.99 $ 0.23
Preferred securities dividends and accretion .............. (0.23) (0.06) (0.47) (0.14)
Extraordinary items ....................................... -- (1.37) -- (1.61)
-------- -------- -------- --------
NET INCOME ................................................ $ 0.27 $ (1.39) $ 0.52 $ (1.52)
======== ======== ======== ========
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
4
<PAGE> 5
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
ACCUMULATED
OTHER
COMPREHENSIVE
INCOME
-------------
UNREALIZED
NUMBER OF GAIN (LOSS) PAID IN TOTAL
SHARES COMMON TREASURY ON CAPITAL- COMPREHENSIVE RETAINED STOCKHOLDERS'
OUTSTANDING STOCK STOCK INVESTMENTS WARRANTS INCOME EARNINGS EQUITY
----------- -------- -------- ----------- ------------- ------------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at
December 31, 1996 .... 3,446,492 $16,022 $ -- $ (162) $2,206 $ 27,125 $ 45,191
Comprehensive income
Net income .......... -- -- -- -- -- (5,141) (5,141) (5,141)
-------
Other comprehensive
income, net of tax
change in unrealized
gain (loss) on
investments......... -- -- -- 1,489 -- 1,489 -- 1,489
-------
Other comprehensive
income ............. 1,489
-------
Comprehensive income .... $(3,652)
=======
Common stock issued ..... 2,390,438 18,000 -- -- -- -- 18,000
Stock issued under
stock option plan ..... 22,127 105 -- -- -- -- 105
Common stock issued
under stock
incentive plan ........ 12,222 174 -- -- -- -- 174
--------- ------- ------- -------- ------ -------- --------
Balance at
December 31, 1997 ..... 5,871,279 34,301 -- 1,327 2,206 21,984 59,818
--------- ------- ------- -------- ------ -------- --------
Comprehensive income
Net income ........... -- -- -- -- -- 4,092 4,092 4,092
--------
Other comprehensive
income, net of tax
Change in
unrealized
gain (loss) ....... -- -- -- (102) -- (102) -- (102)
--------
Other comprehensive
income ............. (102)
--------
Comprehensive income..... $ 3,990
========
Common stock issued ..... -- -- -- -- -- -- --
Stock issued under
stock option plan ..... 5,120 32 -- -- -- -- 32
Common stock issued
under stock
incentive plan ....... -- -- -- -- -- -- --
Treasury stock .......... (245,000) -- (5,145) -- -- -- (5,145)
========= ======= ======= ======== ====== ======== =======
Balance at
June 30, 1998 ......... 5,631,399 $34,333 $(5,145) $ 1,225 $2,206 $ 26,076 $58,695
========= ======= ======= ======== ====== ======== =======
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
5
<PAGE> 6
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30,
-------------------------
1998 1997
--------- ---------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income .................................................... $ 4,092 $ (9,774)
--------- ---------
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Amortization of bonds and preferred stock ......................... 30 (803)
Amortization of capital lease obligation .......................... (666) --
(Gain) loss on sale of investments ................................ (1,028) 123
Amortization of goodwill .......................................... 639 136
Extraordinary loss - retirement of long-term debt ................. -- 10,362
Interest expense on long-term debt ................................ -- 3,146
Preferred securities dividends and accretion ...................... 3,724 907
Increase in reinsurance receivables ............................... (2,392) (4,216)
Decrease in premiums receivable ................................... 2,370 2,004
Increase in other assets .......................................... (2,235) (3,149)
Decrease in deferred income taxes ................................. 4,485 769
(Decrease) increase in claims and claim adjustment expense reserves (46,413) 2,714
Increase (decrease) in unearned premium reserves .................. 3,286 (909)
Decrease in accounts payable and other liabilities ................ (3,692) (13,239)
--------- ---------
Total adjustments ............................................... (41,892) (2,155)
--------- ---------
Net cash used in operating activities ........................... (37,800) (11,929)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Paid-in-capital - restricted stock ................................ 31 3
Proceeds from issuance of common stock ............................ -- 18,000
Long-term debt - Chase Manhattan Bank ............................. -- 44,000
Retirement of long-term debt - Imperial Bank ...................... -- (7,250)
Funding of discontinued operations ................................ (2,043) (17,125)
Reinsurance deposit ............................................... (12,654) --
Purchase of treasury stock ........................................ (5,145) --
--------- ---------
Net cash (used in) provided by financing activities ............. (19,811) 37,628
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of bonds and notes:
Investments available-for-sale .................................. (108,103) (90,283)
Investments funds withheld from reinsurer ....................... (2,185) --
Purchase of equity security ....................................... (64,536) (145)
Purchase of Pac Rim Holding Corporation ........................... -- (41,170)
Sale of property, plant and equipment ............................. 8,000 --
Sales of bonds and notes: Investments available-for-sale .......... 114,120 13,540
Maturities of bonds and notes: Investments available-for-sale ..... 19,121 6,968
Sale of equity securities ......................................... 60,745 517
Net decrease in invested cash ..................................... 144 55,364
--------- ---------
Net cash provided by (used in) investing activities ............. 27,306 (55,209)
--------- ---------
Net decrease in cash ............................................ (30,305) (29,510)
Cash and invested cash at beginning of period ........................ 35,376 101,937
--------- ---------
Cash and invested cash at end of period .............................. $ 5,071 $ 72,427
========= =========
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes ........................... $ 181 $ 4
========= =========
Cash paid during the year for interest ............................... $ 5,614 $ 191
========= =========
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
6
<PAGE> 7
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 1998
(UNAUDITED)
NOTE A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A.1 Basis of Presentation
Superior National Insurance Group, Inc. ("SNIG") is a holding company that
through its wholly-owned subsidiaries, Superior National Insurance Company
("SNIC") and Superior Pacific Casualty Company ("SPCC"), is engaged in writing
workers' compensation insurance principally in the States of California and
Arizona, and until September 30, 1993, was engaged in writing commercial
property and casualty insurance. SNIC and SPCC conduct business under the
"Superior Pacific" trade name. Unless the context indicates otherwise, "Superior
Pacific," as used herein, refers to SNIC and SPCC and their combined operations
from April 1997 to the present, and refers only to SNIC and its operations for
all prior periods. The "Company" refers to SNIG and its subsidiaries.
The accompanying unaudited condensed consolidated financial statements of
the Company have been prepared in accordance with generally accepted accounting
principles for interim financial information and with the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management, all
adjustments, including normally occurring accruals, considered necessary for a
fair presentation have been included. Certain reclassifications of prior year
amounts have been made to conform with the 1998 presentation. Operating results
for the six months ended June 30, 1998 are not necessarily indicative of the
results to be expected for the year ending December 31, 1998. These consolidated
financial statements should be read in conjunction with the consolidated
financial statements and footnotes thereto contained in the Company's Annual
Report on Form 10-K for the year ended December 31, 1997.
A.2 Acquisition of Pac Rim Holding Corporation
On April 11, 1997, the Company completed its acquisition of Pac Rim Holding
Corporation ("Pac Rim") and its wholly-owned subsidiary, The Pacific Rim
Assurance Company, for total consideration of approximately $42.0 million in
cash. This consideration resulted in payments of approximately $20.0 million to
Pac Rim stockholders; $20.0 million to Pac Rim's convertible debenture holders;
and $2.0 million to Pac Rim's warrant and option holders. In addition, the
Company incurred $2.0 million in transaction fees and related expenses. The
Pacific Rim Assurance Company was renamed Superior Pacific Casualty Company upon
its acquisition by the Company. The Company financed the acquisition of Pac Rim
through a $44.0 million term loan and the sale of $18.0 million in newly issued
shares of common stock in a private transaction. Approximately $6.6 million of
the loan proceeds was used to prepay SNIG's previously outstanding long-term
debt, and approximately $10.0 million was contributed by SNIG to the capital of
SPCC. The $44.0 million term loan was subsequently retired from funds raised
from the sale of $105.0 million of 10 3/4% Trust Preferred Securities by a
subsidiary of SNIG. See Note A.5.
The purchase of Pac Rim resulted in $36.9 million of goodwill that is being
amortized on a straight line basis over 27.5 years. The transaction was
accounted for using the purchase method and the results of operations since the
date of acquisition have been included in operations. The designated accounting
date of the purchase of Pac Rim is April 1, 1997.
The balance sheet of Pac Rim at the acquisition date included the following
assets: investments of $105.9 million, cash of $2.6 million, receivables of
$17.3 million, and other assets of $22.3 million. Liabilities assumed in the
acquisition included unearned premiums of $6.9 million, claim and claim
adjustment expense reserves of $107.7 million and other liabilities of $32.3
million.
A.3 Earnings Per Share ("EPS"); Comprehensive Income
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard No. 128 ("FAS No. 128"), "Earnings Per Share,"
which requires presentation of basic and diluted earnings per share for all
publicly traded companies effective for fiscal years ending after December 15,
1997.
7
<PAGE> 8
The following is an illustration of the reconciliation of the numerators
and denominators of the basic and diluted earnings per share (EPS) computations
for the six months ended June 30, 1998 and June 30, 1997:
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30, 1998 SIX MONTHS ENDED JUNE 30, 1997
------------------------------------------ ---------------------------------------------
INCOME SHARES PER SHARE INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ------ ----------- ------------- ------
(IN THOUSANDS) (IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
BASIC EPS
Income before items
below $ 7,816 5,853,713 $ 1.34 $ 1,494 4,641,954 $ 0.32
Preferred Securities (3,724) (0.64) (907) (0.20)
Extraordinary items - - (10,361) (2.23)
-------- ------ -------- ------
Net Income $ 4,092 $ 0.70 $ (9,774) $(2.11)
======== ====== ======== ======
EFFECT OF DILUTIVE
SECURITIES
Options 386,280 336,603
Warrants 1,672,234 1,432,309
DILUTED EPS
Income before items
below $ 7,816 7,912,227 $ 0.99 $ 1,494 6,410,866 $ 0.23
Preferred Securities (3,724) (0.47) (907) (0.14)
Extraordinary items - - (10,361) (1.61)
-------- ------ -------- ------
Net Income $ 4,092 $ 0.52 $ (9,774) $(1.52)
======== ====== ========= ======
</TABLE>
The following is an illustration of the reconciliation of the numerators
and denominators of the basic and diluted earnings per share (EPS) computations
for the three months ended June 30, 1998 and June 30, 1997:
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, 1998 THREE MONTHS ENDED JUNE 30, 1997
-------------------------------------------- ---------------------------------------------
INCOME SHARES PER SHARE INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ------ ----------- ------------- ---------
(IN THOUSANDS) (IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
BASIC EPS
Income before items
below $ 4,049 5,834,347 $ 0.69 $ 284 5,837,173 $ 0.05
Preferred Securities (1,852) (0.32) (453) (0.08)
Extraordinary items - - (10,361) (1.77)
-------- ------ --------- ------
Net Income $ 2,197 $ 0.37 $ (10,530) $(1.80)
======== ====== ========== ======
EFFECT OF DILUTIVE
SECURITIES
Options 417,582 321,992
Warrants 1,732,524 1,387,215
DILUTED EPS
Income before items
below $ 4,049 7,984,453 $ 0.50 $ 284 7,546,380 $ 0.04
Preferred Securities (1,852) (0.23) (453) (0.06)
Extraordinary items - - (10,361) (1.37)
-------- ------ --------- ------
Net Income $ 2,197 $ 0.27 $ (10,530) $(1.39)
======== ====== ========== ======
</TABLE>
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS
No. 130"). SFAS 130 is effective for periods ending after December 15, 1997,
including interim periods. SFAS No. 130 requires companies to report
comprehensive income and its components in a financial statement and display the
accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in-capital. Comprehensive income includes all
changes in equity during a period except those resulting from investments by
stockholders and distributions to stockholders. The Company has included the
required disclosure of SFAS No. 130 in this filing.
8
<PAGE> 9
A.4 Claim and Claim Adjustment Expense Reserves
The liability for unpaid claim and claim adjustment expenses is based on an
evaluation of reported losses and on estimates of incurred but unreported
losses. The reserve liabilities are determined using adjusters' individual case
estimates and statistical projections, which can be affected by many external
factors that are difficult to predict, including changes in the economy, trends
in medical treatments and litigation, changes in regulatory environment, medical
services, and employment rights. The liability is reported net of estimated
salvage and subrogation recoverables. Adjustments to the liability resulting
from subsequent developments or revisions to the estimate are reflected in
results of operations in the period in which such adjustments become known.
While there can be no assurance that reserves at any given date are adequate to
meet the Company's obligations, the amounts reported on the balance sheet are
management's best estimate of that amount.
A.5 Trust Preferred Securities
In December 1997, SNIG formed Superior National Capital Trust I, a
statutory business trust (the "Trust"), whose sole purpose was to issue 10 3/4%
Trust Preferred Securities (the "Trust Preferred Securities"), having an
aggregate liquidation amount of $105 million, and to invest the proceeds thereof
in an equivalent amount of 10 3/4% Senior Subordinated Notes due 2017 of the
Company (the "Senior Subordinated Notes"). The Company owns directly all of the
common securities issued by the Trust, which it purchased for an aggregate
consideration of $3.25 million. The proceeds from the sale of the Trust
Preferred Securities were used solely to purchase SNIG's Senior Subordinated
Notes in the aggregate principal amount of $108.25 million, which are the sole
assets of the Trust. In addition, the Company entered into several contractual
undertakings which, the Company believes, when taken together, guarantee to the
holders of the Trust Preferred Securities an unconditional right to enforce the
payment of the distributions with respect to such securities.
A.6 Large Account Quota-Share Arrangement
Effective February 1, 1998, Superior Pacific entered into a Quota-Share
Arrangement with United States Life Insurance Company, rated "A+" by A.M. Best
Company, Inc., under which Superior Pacific ceded 100% of premiums and claim and
claim adjustment expenses associated with policies having $100,000 or more of
estimated annual premium. Superior Pacific received a 35.0% ceding commission on
premiums ceded under this contract. Effective May 1, 1998, the Quota-Share
Arrangement was amended so that the ceding level was reduced to $25,000 in
estimated annual premium at inception, and the ceding commission was adjusted to
33.5%. The term of the amended agreement is three years, with two one-year
extensions.
NOTE B. DISCONTINUED OPERATIONS
Outstanding discontinued operations claim and claim adjustment expense
reserves were $11.3 million at June 30, 1998, which was consistent with
management's expectations. Offsetting these liabilities are $10.9 million of
deferred tax assets and $0.5 million of reinsurance recoverable on paid claim
and claim adjustment expenses.
9
<PAGE> 10
ITEM 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
References to "SNIG" and "the Company" in this quarterly report include the
results of operations of the recently acquired subsidiary Superior Pacific
Casualty Company ("SPCC"), formerly known as The Pacific Rim Assurance Company,
for the period beginning April 1, 1997. References to "SNIC" in this quarterly
report refer to Superior National Insurance Company, the primary operating
subsidiary of SNIG.
This discussion and analysis contains statements that constitute
"forward-looking" statements within the meaning of the Private Securities
Litigation Reform Act of 1995. Such forward-looking statements relate to future
events or the future financial performance of the Company and involve known and
unknown risks, uncertainties and other factors that may cause the actual
results, performance or achievements of the Company to be materially different
from any future results, performance or achievements expressed or implied by
such forward-looking statements. Such factors include, among other things,
inherent uncertainties related to the effect of the acquisitions, the Company's
leverage, and general conditions in the economy and in the workers' compensation
insurance market in particular, and such factors could cause actual results to
differ materially from those indicated by such forward-looking statements.
OVERVIEW
The Company recorded an underwriting profit from continuing operations of
$5.5 million in the six month period ended June 30, 1998, versus an underwriting
profit of $1.5 million in the corresponding period in the prior year. The
increase in underwriting profit from continuing operations was primarily the
result of an increase in premiums as a result of the SPCC acquisition. During
the six months ended June 30, 1998, the Company realized net income of $4.1
million or $0.52 per share on a diluted basis as compared to a loss of $9.8
million or $1.52 per share on a diluted basis for the six months ended June 30,
1997. In addition to improved underwriting profit, net income increased due to a
$2.5 million increase in investment income, which resulted from the increase in
invested assets. Invested assets increased due to the SPCC acquisition and the
net proceeds of the issuance of the Trust Preferred Securities discussed below.
The increase in underwriting profit and investment income was offset in part by
dividends and accretion on the Trust Preferred Securities and amortization of
goodwill. The loss in the prior year relates to a $10.4 million net-of-tax
extraordinary charge related to the retirement of long-term debt.
GENERAL FINANCIAL CONDITION
Total assets decreased by $31.4 million or 7.5% to $385.2 million for the
six months ended June 30, 1998. The decrease is due to a $48.8 million reduction
of investments used primarily to fund operations, which is partially offset by a
$24.2 million increase to prepaid reinsurance premiums.
Total liabilities decreased by $30.3 million or 8.5% to $326.5 million for
the six months ended June 30, 1998. The decrease is principally due to a $46.4
million reduction in claim and claim adjustment expense reserves, which is
partially offset by a $14.6 million increase in reinsurance payables associated
with the Large Account Quota-Share as discussed below in "Results of
Operations."
Total equity decreased by $1.1 million or 1.9% to $58.7 million for the six
months ended June 30, 1998. This decrease primarily consists of $5.1 million
paid by SNIC to purchase 245,000 shares of SNIG's common stock ("Common Stock"),
which are held by SNIC as treasury stock on a GAAP basis, offset by $4.1 million
in net income.
RESULTS OF OPERATIONS
Effective February 1, 1998, the Company entered into a Quota-Share
Arrangement (the "Large Account Quota-Share") with United States Life Insurance
Company, rated "A+" by A.M. Best Company, Inc. ("A.M. Best"), an independent
insurance rating agency, under which the Company ceded 100% of premiums and
claim and claim adjustment expenses associated with policies having $100,000 or
more of estimated annual premium. The Company received a 35.0% ceding commission
on premiums ceded under this contract. Effective May 1, 1998, the Quota-Share
Arrangement was amended so that the ceding level was reduced to $25,000 in
estimated annual premium at inception, and the ceding commission was adjusted to
33.5%. The term of the amended agreement is three years, with two one-year
extensions.
10
<PAGE> 11
Effective June 30, 1998, the Company and Zurich Reinsurance (North America),
Inc. ("ZRNA") entered an agreement to settle and commute (the "ZRNA
Commutation") all obligations and liabilities known and unknown associated with
the ZRNA Quota-Share contract and its related Assumption of Liability
Endorsement facility for the contract years incepting January 1, 1994, 1995,
1996, and 1997. The commutation was negotiated in accordance with the
commutation provision from the original ZRNA Quota-Share contract, which
resulted in a $1.8 million loss to the Company.
The following selected financial data and analysis provide an assessment of
the Company's financial results for the three months ended June 30, 1998, as
compared to the three months ended June 30, 1997. Certain prior period amounts
have been reclassified to conform to the current period presentation.
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30,
---------------------------
1998 1997
-------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Gross written premium ................... $ 40,898 $ 48,310
Net written premium ..................... $ 19,164 $ 43,703
Net premium earned ...................... $ 25,204 $ 45,410
Net claim and claim adjustment expenses . 15,399 34,724
Net underwriting and general and
administrative expenses ............... 6,632 10,845
-------- --------
Underwriting profit (loss) .............. $ 3,173 $ (159)
Net investment income ................... 3,761 3,435
Underwriting ratios (GAAP Basis)
Claims and claim adjustment expense ratio 61.1% 76.5%
Underwriting expense ratio .............. 26.3% 23.9%
Policyholder dividends ratio ............ 0.0% 0.0%
-------- --------
Combined ratio .......................... 87.4% 100.4%
======== ========
</TABLE>
Gross written premium decreased $7.4 million or 15.3% to $40.9 million in
the second quarter of 1998 as compared to the same period in 1997. This decrease
can be attributed to non-renewal of policies written by SPCC prior to the
acquisition and which expired in March 1998. Net written premium decreased $24.5
million or 56.1% to $19.2 million in the second quarter of 1998 as compared to
the same period in 1997. Along with the decrease in gross written premium,
essentially all of the decrease in net written premium is due to $23.7 million
of reinsurance premiums ceded under the Large Account Quota-Share, which is
partially offset by a $5.5 million reduction to reinsurance premiums ceded
related to the ZRNA Commutation. Net premium earned decreased $20.2 million or
44.5% to $25.2 million in the second quarter of 1998 as compared to the same
period in 1997, reflecting the decrease in net written premium.
Net claim and claim adjustment expenses decreased $19.3 million or 55.7% to
$15.4 million in the second quarter of 1998 as compared to the same period in
1997. This decrease consists of a $10.5 million decrease in net claim and claim
adjustment expense, a $16.9 million increase in ceded claim and claim adjustment
expense related to the Large Account Quota-Share and a $8.1 million increase in
net claim and claim adjustment expense reserves associated with the ZRNA
Commutation. The $10.5 million reduction in net claim and claim adjustment
expense is primarily due to a $9.8 million decrease in net premium earned,
excluding the decreases reflected in net premium written associated with the
Large Account Quota-Share and the ZRNA commutation as discussed above. The
reduction is also partially due to the re-underwriting of the policies that
expired related to the SPCC acquisition, which resulted in a decrease in net
claim and claim adjustment expense for the three months ended June 30, 1998 as
compared to the same period in 1997. The net claim and claim adjustment expense
ratio decreased to 61.1% in the second quarter of 1998 from 76.5% in the same
period of 1997. This decrease in the net claim and claim adjustment expense
ratio is due to an increase, during the second quarter of 1997, in claim and
claim adjustment expenses relative to the related premium level from activity
related to the SPCC acquisition.
Underwriting and general and administrative expenses increased $2.0 million
or 32.0% to $8.1 million in the second quarter of 1998, as compared to the same
period in 1997. This increase was due primarily to the acquisition of SPCC. Net
commission expense decreased $6.2 million or 131.9% to $(1.5) million in the
second quarter of 1998, as compared to the same period in 1997. The decrease in
net commission expense is mainly due to $4.6 million in ceded commission related
to the Large Account Quota-Share and partially due to a decrease in gross
commission expense related to the decrease in gross premium written. Net
underwriting and general and administrative expenses decreased 38.8% to $6.6
million in the second quarter of 1998 from $10.8 million in the same period of
1997, primarily due to the decrease in net commission expense as discussed
above. The Company's underwriting expense ratio
11
<PAGE> 12
increased 2.4 percentage points to 26.3% for the second quarter of 1998 from
23.9% for the same period in 1997, due primarily to a reduction in the related
net premium level from premiums ceded under the Large Account Quota-Share.
The Company recorded an underwriting profit from continuing operations of
$3.2 million in the second quarter of 1998, versus an underwriting loss of $0.2
million for the same period in 1997. The increase in underwriting profit from
continuing operations was primarily the result of the decrease in claim and
claim adjustment expense discussed above, along with a decrease in underwriting
and general and administrative expenses.
Net investment income, excluding realized investment gains/losses,
decreased $0.3 million or 8.6% to $3.1 million in the second quarter of 1998
compared to the same period in 1997. This 8.6% decrease was due to a decrease in
average investable assets of $33.5 million as compared to the same period in
1997.
No interest expense was incurred in the second quarter of 1998 as compared
to $2.4 million for the same period in 1997, due to the repayment in the fourth
quarter of 1997 of all long term debt with funds obtained through the sale of
the Trust Preferred Securities.
Distributions and accretion on preferred securities increased by $2.1
million to $2.8 million in the second quarter of 1998, as compared to the same
period in 1997, as a result of the issuance of the Trust Preferred Securities
and by the redemption of preferred securities issued by an affiliate in December
1997.
The following selected financial data and analysis provide an assessment of
the Company's financial results for the six months ended June 30, 1998, as
compared to the six months ended June 30, 1997. Certain prior period amounts
have been reclassified to conform to the current period presentation.
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30,
-------------------------
1998 1997
------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Gross written premium ................... $81,951 $71,090
Net written premium .................... $47,665 $63,706
Net premium earned ...................... $55,791 $64,388
Net claim and claim adjustment expenses . 33,687 44,995
Net underwriting and general and
administrative expenses ............... 16,623 17,849
------- -------
Underwriting profit (loss) .............. $ 5,481 $ 1,544
Net investment income ................... 8,014 5,521
Underwriting ratios (GAAP Basis)
Claims and claim adjustment expense ratio 60.4% 69.9%
Underwriting expense ratio .............. 29.8% 27.7%
Policyholder dividends ratio ............ 0.0% 0.0%
------- -------
Combined ratio .......................... 90.2% 97.6%
======= =======
</TABLE>
Gross written premium increased $10.9 million or 15.3% to $82.0 million in
the first six months of 1998 as compared to the same period in 1997.
Substantially all of this increase can be attributed to the addition of business
written by SPCC. Net written premium decreased $16.0 million or 25.2% to $47.7
million in the first six months of 1998 as compared to the same period in 1997.
This decrease is primarily due to $31.6 million in premiums ceded under the
Large Account Quota-Share, which is partially offset by a $10.9 increase to
gross written premium and a $5.5 million reduction to ceded premium related to
the ZRNA Commutation. Net premium earned decreased $8.6 million or 13.4% to
$55.8 million in the first six months of 1998 as compared to the same period in
1997, reflecting the decrease in net written premium.
Net claim and claim adjustment expenses decreased $11.3 million or 25.1% to
$33.7 million in the first six months of 1998 as compared to the same period in
1997. This decrease primarily reflects a $17.7 million increase in ceded claim
and claim adjustment expense related to the Large Account Quota-Share and a $8.4
million increase in net claim and claim adjustment expense reserves associated
with the ZRNA Commutation. The net claim and claim adjustment expense ratio
decreased to 60.4% in the first six months of 1998 from 69.9% in the same period
of 1997. This decrease in the net claim and claim adjustment expense ratio is
due to an increase, during the second quarter of 1997, in claim and claim
adjustment expenses relative to the related premium level from activity related
to the SPCC acquisition.
12
<PAGE> 13
Underwriting and general and administrative expenses increased $4.2 million
or 38.3% to $15.2 million in the first six months of 1998, as compared to the
same period in 1997. This increase is primarily due to the acquisition of SPCC.
Net commission expense decreased $5.4 million or 78.7% to $1.5 million in the
first six months of 1998, as compared to the same period in 1997. The decrease
in net commission expense is mainly due to $6.6 million in ceded commission
related to the Large Account Quota-Share, which is partially offset by an
increase in gross commission expense related to the increase in gross premium
written. Net underwriting and general and administrative expenses decreased 6.9%
to $16.6 million in the first six months of 1998 from $17.8 million in the same
period of 1997, primarily due to the decrease in net commission expense as
discussed above. The Company's underwriting expense ratio increased 2.1
percentage points to 29.8% for the first six months of 1998 from 27.7% for the
same period in 1997, due primarily to a reduction in the related net premium
level from premiums ceded under the Large Account Quota-Share.
The Company recorded an underwriting profit from continuing operations of
$5.5 million in the first six months of 1998, versus $1.5 million for the same
period in 1997. The increase in underwriting profit from continuing operations
was primarily the result of the decrease in claim and claim adjustment expense
discussed above, along with a decrease in underwriting and general and
administrative expenses.
Net investment income, excluding realized investment gains/losses,
increased $1.5 million or 27.0% to $7.0 million in the first six months of 1998
compared to the same period in 1997. The improvement was due to the increase in
assets available for investment resulting from the SPCC acquisition and the
availability of $30.0 million in invested assets as a result of the issuance of
the Trust Preferred Securities. Excluding the assets acquired in the SPCC
acquisition and the increase in invested assets due to the issuance of the Trust
Preferred Securities, net investment income decreased $2.6 million or 46.4% to
$2.9 million in the first six months of 1998 as compared to the same period in
1997. This 46.4% decrease was due to a decrease in the average investable asset
of $10.9 million as compared to the same period in 1997.
No interest expense was incurred in the first six months of 1998 as
compared to $4.1 million for the same period in 1997, due to the repayment in
the fourth quarter of 1997 of all long term debt with funds obtained through the
sale of the Trust Preferred Securities.
Distributions and accretion on preferred securities increased by $4.3
million to $5.6 million in the first six months of 1998 as compared to the same
period in 1997, as a result of the issuance of the Trust Preferred Securities
and by the redemption of preferred securities issued by an affiliate in December
1997.
A summary of net investment income, excluding capital gains (losses), for
the three and six months ended June 30, 1998 and 1997 is as follows (in
thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ----------------
1998 1997 1998 1997
------ ------ ------ ------
<S> <C> <C> <C> <C>
Interest on bonds and notes $3,042 $1,940 $6,685 $2,798
Interest on invested cash . 200 1,706 518 3,052
Other ..................... 67 -- 143 --
------ ------ ------ ------
Total investment income ... 3,309 3,646 7,346 5,850
Capital gains ............. 629 10 1,029 19
Investment expense ........ 177 221 361 348
------ ------ ------ ------
Net investment income ..... $3,761 $3,435 $8,014 $5,521
====== ====== ====== ======
</TABLE>
The Company's management monitors the matching of assets and liabilities
and attempts to maintain the Company's portfolio's investment duration at the
mid-point of the length of its net claim and claim adjustment expenses payout
pattern. Investment duration is the weighted average measurement of the current
maturity of a fixed income security, in terms of time, of the present value of
the future payments to be received from that security. However, in selecting
assets to purchase for its investment portfolio, the Company considers each
security's modified duration and the effect of that security's modified duration
on the portfolio's overall modified duration. Modified duration is a measurement
that estimates the percentage change in market value of an investment for a
small change in interest rates. The modified duration of fixed maturities at
June 30, 1998 was 2.94 years compared to 2.90 years at December 31, 1997. At
June 30, 1998, 99.5% of the carrying values of investments in the fixed
maturities portfolio were rated as investment grade by the Securities Valuation
Office of the National Association of Insurance Commissioners.
13
<PAGE> 14
DISCONTINUED OPERATIONS
Discontinued operations had claim and claim adjustment expense reserves of
$11.3 million as of June 30, 1998, which was consistent with management's
expectations. The Company has significant exposure to construction defect
liabilities on property and casualty insurance policies underwritten from 1986
to 1993. Management continues to closely monitor the Company's potential
exposure to construction defect claims and has not changed its estimates of
ultimate claim and claim adjustment expenses on discontinued operations since
1995. Management believes its current reserves are adequate to cover the
Company's claims activity. There can be no assurance, however, that further
upward development of ultimate claim and claim adjustment expense reserves
associated with construction defect claims will not occur. The Company will
continue to closely monitor the adequacy of its claim and claim adjustment
expense reserves in the discontinued operations. Offsetting these liabilities
are $10.9 million of deferred tax assets and $0.5 million in reinsurance
recoverable on paid claim and claim adjustment expenses.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is a measure of an entity's ability to secure sufficient cash to
meet its contractual obligations and operating needs. The Company's cash inflows
are generated from cash collected for policies sold, investment income on the
existing portfolio and sales and maturities of investments. The Company's cash
outflows consist primarily of payments for policyholders' claims, operating
expenses, and debt service. For their insurance operations, the Company's
subsidiaries must have available cash and liquid assets to meet their
obligations to policyholders and claimants in accordance with contractual
obligations in addition to meeting their ordinary operating costs. Absent
adverse material changes in the workers' compensation insurance market,
management believes that the Company's present cash resources are sufficient to
meet the needs of the Company for the foreseeable future.
During the first six months of 1998, the Company used $37.8 million of cash
in its operations versus $11.9 million during the same period in 1997. This
$25.9 million increase in cash used in operations is primarily due to the
addition of SPCC's operations beginning April 1, 1997. The Company's continued
negative cash flow is the result of the Company's historical inforce premium
base being significantly higher than its current level and higher than expected
payments of claim and claim adjustment expenses in the 1995 and 1996 accident
years. The Company anticipates it will continue to experience negative cash flow
from operations until the claims related to the historically higher premium base
have been paid out. In addition, the reduction in net written premium arising
out of the Large Account Quota-Share will increase negative cash flow
substantially. The Company believes its Claim Severity Management Program will
mitigate cash outflows related to the 1995 and 1996 accident years at acceptable
levels, but there can be no assurance that it will be successful. In any event,
the Company believes that it has adequate short-term investments and readily
marketable investment grade securities to cover both claim payments and
expenses. As of June 30, 1998, the Company had total cash, cash equivalents and
investments of $193.3 million and had 97.3% of its investment portfolio invested
in cash, cash equivalents, and fixed maturities. In addition, 97.1% of the
Company's fixed-income portfolio had ratings of "AA" or equivalent or better and
99.5% had ratings of "BBB" or equivalent or better.
The Company used $19.8 million in cash from financing activities for the
six months ended June 30, 1998, and generated $37.6 million for the
corresponding period in 1997. The cash generated by financing activities in the
six months of 1997 were primarily associated with the Company's acquisition on
April 11, 1997, of Pac Rim Holding Corporation ("Pac Rim") and its wholly-owned
subsidiary, The Pacific Rim Assurance Company, for total consideration of
approximately $42.0 million in cash. This consideration resulted in payments of
approximately $20.0 million to Pac Rim stockholders; $20.0 million to Pac Rim's
convertible debenture holders; and $2.0 million to Pac Rim's warrant and option
holders. In addition, the Company incurred $2.0 million in transaction fees and
related expenses. The Pacific Rim Assurance Company was renamed Superior Pacific
Casualty Company upon its acquisition by the Company. The Company financed the
acquisition of Pac Rim through a $44.0 million term loan and the sale of $18.0
million in newly issued shares of common stock in a private transaction.
Approximately $6.6 million of the loan proceeds was used to prepay SNIG's
previously outstanding long-term debt. During the six months ended June 30,
1998, funds used for financing activities consisted of $12.7 million in
reinsurance deposits to ZRNA associated with a 1998 reinsurance contract, $5.1
million to purchase 245,000 shares of Common Stock, which are held by SNIC as
treasury stock on a GAAP basis, and $2.0 million to fund discontinued
operations.
On December 3, 1997, Superior National Capital Trust I (the "Trust"), a
wholly owned subsidiary of SNIG, issued its 10 3/4% Trust Preferred Securities
(the "Trust Preferred Securities"), having an aggregate liquidation amount of
$105 million, in a private placement and also issued to SNIG, for an aggregate
consideration of approximately $3.25 million, all of the Trust's common
securities. The proceeds from the sale of these securities were used to purchase
SNIG's 10 3/4% Senior Subordinated Notes due 2017 (the "Senior Subordinated
Notes"), all of which were issued in connection with such transaction. In
addition, the Company entered into
14
<PAGE> 15
several contractual undertakings which, the Company believes, when taken
together, guarantee (the "Company Guarantee") to the holders of the Trust
Preferred Securities a full and unconditional right to enforce the payment of
the distributions with respect to such securities. On January 16, 1998, SNIG and
the Trust completed the registration with the Securities and Exchange Commission
of an exchange offer for the outstanding Trust Preferred Securities, Senior
Subordinated Notes and Company Guarantee, pursuant to which substantially all of
such securities were exchanged for substantially similar securities. SNIG used
the proceeds it received from the issuance of the Senior Subordinated Notes to
repay the $40.3 million outstanding balance on the term loan used to acquire
SPCC, to redeem approximately $27.7 million in preferred stock issued by a SNIG
affiliate to Centre Reinsurance (Bermuda) Ltd., to pay approximately $4.0
million in related transaction costs, and for general corporate purposes,
including a $15.0 million contribution to the surplus of SNIC.
Distributions on the Trust Preferred Securities (and interest on the
related Senior Subordinated Notes) are payable semi-annually, in arrears, on
June 1 and December 1 of each year, and commenced June 1, 1998. Subject to
certain conditions, on or after December 1, 2005, SNIG has the right to redeem
the Senior Subordinated Notes at any time, in whole or in part, at call prices
(expressed as a percentage of principal amount) ranging from 105.375% at
December 1, 2005 to 101.792% at December 1, 2007, and 100% thereafter. The
proceeds from any such redemption will be immediately applied by the Trust to
redeem Trust Preferred Securities and the Trust's common securities at such
redemption prices. In addition, SNIG has the right, at any time, subject to
certain conditions, to defer payments of interest on the Senior Subordinated
Notes for Extension Periods (as defined in the related Indenture), each not
exceeding 10 consecutive semi-annual periods; provided that no Extension Period
may extend beyond the maturity date of the Senior Subordinated Notes. As a
consequence of any such extension by SNIG of the interest payment period,
distributions on the Trust Preferred Securities would be deferred (though such
distributions would continue to accrue interest at a rate of 10.75% per annum
compounded semi-annually). Upon the termination of any Extension Period and the
payment of all amounts then due, SNIG may commence a new Extension Period,
subject to certain requirements.
In November 1996, the Company entered into a financing transaction
involving Centre Reinsurance Limited ("Centre Re") and The Chase Manhattan Bank
("Chase") pursuant to which Chase extended a $93.1 million term loan, net of
transaction costs. The Company used the proceeds from the transaction to
purchase from SNIC reinsurance receivables due from Centre Re. On June 30, 1997,
the Company and Chase reached an agreement under which the Company agreed to
transfer such reinsurance receivables to Chase in exchange for the cancellation
of the Company's debt to Chase. As a result of these actions, the Company's
investable assets increased $93.1 million. The additional investments
contributed to the increase in investment income in 1997.
The Company has a reverse repurchase facility with a national securities
brokerage firm that allows it to engage in up to $20 million in reverse
repurchase transactions secured either by U.S. Treasury instruments, U.S. Agency
debt, or corporate debt. This arrangement provides the Company with additional
short-term liquidity. Reverse repurchase transactions may be rolled over from
one period to the next, at which time the transaction is repriced. This type of
financing provides the Company a great deal of flexibility to manage short-term
investments, avoiding the unnecessary realization of losses to satisfy
short-term cash needs. Further, this method of financing is less expensive than
bank debt. As of June 30, 1998, the Company had no obligation outstanding under
this facility.
Because SNIG is a holding company, it depends on dividends and tax
allocation payments from its insurance subsidiaries, SNIC and SPCC, for its net
cash flow requirements, which consist primarily of periodic payments on its
outstanding debt obligations, principally the Senior Subordinated Notes
underlying the Trust Preferred Securities. Absent other sources of cash flow,
SNIG cannot expend funds materially in excess of the amount of dividends or tax
allocation payments that could be paid to it by SNIC and SPCC. Further,
insurance companies are subject to restrictions affecting the amount of
shareholder dividends and advances that may be paid within any year without the
prior approval of the California Department of Insurance (the "DOI"). The
California Insurance Code provides that amounts may be paid as dividends on an
annual noncumulative basis (generally based up to the greater of (i) net income
for the preceding year or (ii) 10% of statutory surplus as regards policyholders
as of the preceding December 31) without prior notice to, or approval by, the
DOI. No dividends were paid during the six months ended June 30, 1998. Insurance
holding company regulations, in ordinary circumstances, place a two-year
moratorium on payments of dividends by a subsidiary that has undergone a change
of control. The Company has requested of the DOI, and expects to receive, a
waiver from the moratorium in connection with the Company's proposed acquisition
of Business Insurance Group, Inc. ("BIG"). If dividends are available for
payment as expected, the Company believes it will have adequate cash to service
its debt.
The Company is a party to various leases principally associated with the
Company's home and branch office space, as well as its fixed assets. Such leases
contain provisions for scheduled lease charges and escalations in base rent over
the lease term. The Company's minimum commitment with respect to these leases in
1998, is approximately $7.6 million. These leases expire from 2000 to 2003.
15
<PAGE> 16
With the exception of the approximately $285 million necessary to complete
the Company's proposed acquisition of BIG, the Company does not foresee any
expenditures during the next twelve months other than those arising in the
normal course of business. See Part II - Item 5 - Other Information.
The effect of inflation on the Company's revenues and net income during the
six months ended June 30, 1998 was not significant.
TAXES
As of June 30, 1998, the Company had available approximately $128.0 million
in net operating loss carryforwards ("NOLs") to offset taxable income recognized
by the Company in periods after June 30, 1998. For federal income tax purposes,
these NOLs will expire in material amounts beginning in the year 2006. Any 5%
shift in the current ownership of the Company may result in a "change of
ownership" under Section 382 of the Internal Revenue Code of 1986, as amended,
and limit and defer the Company's ability to utilize NOLs. In an effort to
protect these NOLs, the Company's charter documents contain provisions
prohibiting 5% owners of the Common Stock (including holders of options and
warrants) from acquiring additional stock and prohibiting any additional person
or entity from becoming a 5% holder of Common Stock. The prohibition against
changes of ownership by the 5% holders of Common Stock expires in April 2000.
The Company believes that it is very likely that the equity financings it will
conduct to help fund the Company's proposed acquisition of BIG will result in a
"change of ownership," but has concluded that the cost of the limitation of use
of the NOLs in relation to the benefits derived from the acquisition of BIG is
acceptable. See Part II - Item 5 - Other Information. The Company is seeking
stockholder approval of a proposal to eliminate these restrictive charter
provisions at the Company's 1998 Annual Meeting of Stockholders.
YEAR 2000 STRATEGY
A significant percentage of the software that runs most of the computers in
the United States and the rest of the world relies on two-digit date codes to
perform computations and decision making functions. Commencing January 1, 2000,
these computer programs may fail from an inability to interpret date codes
properly, misinterpreting "00" as the year 1900 rather than 2000. The Company is
in the process of identifying all necessary software changes to ensure that it
does not experience any loss of critical business functionality due to the Year
2000 issue. The Company has appointed an internal Year 2000 project manager and
adopted a three phase approach of assessment, correction, and testing. The scope
of the project includes all internal software, hardware, and operating systems,
and assessment of risk to the business from producers, vendors, and other
partners in Year 2000 issues. The Company believes that this formal assessment
of risk (including the prioritization of business risk), correction (including
conversions to new software), and testing of necessary changes will minimize the
business risk of Year 2000 from internal systems. The Company plans to complete
its Year 2000 conversion not later than December 31, 1998. Although the Company
has not completed its Year 2000 project, the Company does not believe the Year
2000 issue will cause any system problems that could have a material adverse
effect on the operations of the Company. The Company does not expect the cost
associated with its Year 2000 project to be material.
16
<PAGE> 17
PART II -- OTHER INFORMATION
ITEM 5 -- OTHER INFORMATION
On May 5, 1998, the Company and Foundation Health Corporation ("FHC"), a
wholly owned subsidiary of Foundation Health Systems, Inc., entered into a
Purchase Agreement under which the Company agreed to purchase for approximately
$285 million in cash (the "Acquisition") all outstanding shares of the capital
stock of BIG, an insurance holding company that, through its wholly owned
insurance subsidiaries, California Compensation Insurance Company, Business
Insurance Company, Combined Benefits Insurance Company, and Commercial
Compensation Insurance Company, writes workers' compensation and group health
insurance, principally in California, with branch operations throughout the
continental United States.
In connection with the Acquisition, FHC will provide, through the purchase
of reinsurance, $175 million of adverse development protection on BIG's claim
and claim adjustment expense reserves. In addition, the Company has entered into
a three-year quota share reinsurance agreement with a reinsurer rated "A+" by
A.M. Best, under which the Company and BIG will reinsure accounts with premiums
in excess of $25,000. See Part I - Item 2 - Management's Discussion and Analysis
of Consolidated Financial Condition and Results of Operations - Results of
Operations. The Company has also agreed to enter into long-term contracts with
affiliates of FHC under which such affiliates will continue to provide bill
review and other claims control services to BIG and following the Acquisition,
to the Company.
The Acquisition will be financed by the Company with a combination of
equity and debt. The debt portion of the financing will be provided by the
proceeds from the issuance and sale in a public offering of approximately $110
million in aggregate principal amount of the Company's senior notes (the "Senior
Notes Offering"). The equity portion consists of the issuance and sale of
approximately $109.7 million of Common Stock (the "Stock Offering"), which
consists of the offering of rights to purchase Common Stock to existing
stockholders (other than IP Delaware and IP Bermuda) and warrant holders
(excluding certain warrant holders exercising preemptive rights) and the
offering of rights to holders of options and grants of restricted stock.
Additionally, Insurance Partners, L.P. ("IP Delaware"), Insurance Partners
Offshore (Bermuda), L.P. ("IP Bermuda"), and Insurance Partners II, L.P. and/or
Insurance Partners II Private Fund, L.P. (collectively with IP Delaware and IP
Bermuda, "IP") will purchase $94 million in Common Stock in a private
transaction (the "IP Stock Issuance"). IP has also agreed to provide a standby
commitment of up to $106 million to purchase an amount of shares of Common Stock
not subscribed for in the Stock Offering (the "Standby Commitment") sufficient
to assure the Company of $200 million in total equity financing. In addition, in
connection with its investment, IP has agreed to certain restrictions protecting
minority stockholders. The amounts obtained from all of these financings in
excess of $285 million will be used for transaction costs in connection with the
Acquisition and the related financing transactions, for capital for the
Company's insurance subsidiaries, and for general corporate purposes. The Stock
Offering, the Standby Commitment, the IP Stock Issuance, and the Senior Notes
Offering are each conditioned on the completion of the other and the completion
of the Acquisition.
All of the Common Stock to be issued in connection with these financing
transactions will be sold at a purchase price of $16.75 per share. The $16.75
price and other terms of the Stock Offering were determined on behalf of the
Company by two independent directors of the Company, in consultation with the
Company's financial advisors and in negotiations with IP, and will be materially
the same as the terms of the IP Stock Issuance and Standby Commitment, subject
to adjustments determined by the Company's board of directors to be reasonable
and appropriate. This description does not constitute an offer of any
securities. Any offering of securities in the transactions described above,
other than pursuant to the IP Stock Issuance, will be made only by means of a
prospectus. Stockholders are cautioned, however, that the mere decision to
undertake a transaction does not change the contingencies that apply to these
prospective transactions, or the likelihood that an offering will, in fact,
occur. Registration statements have been filed with the Securities and Exchange
Commission relating to the Stock Offering and the Senior Notes Offering, and
none of these securities may be sold before the registration statements are
declared effective.
The Acquisition is subject to the now-expired waiting period under the
Hart-Scott-Rodino Anti-Trust Improvements Act of 1976, as amended, and approval
by several state insurance regulatory authorities. In addition, the Stock
Offering and the IP Stock Issuance are each subject to stockholder approval,
which the Company intends to solicit at its 1998 Annual Meeting of Stockholders,
presently scheduled to occur in late September 1998. Furthermore, the holders of
the Trust Preferred Securities are being requested to consent to the Senior
Notes Offering. Assuming the preceding approvals are obtained and that no
unforeseen impediments arise, the Company anticipates that the Acquisition will
be consummated in late October to early November of 1998.
17
<PAGE> 18
ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
<S> <C>
10.64 Commutation and Settlement Agreement, effective as of June 30, 1998, by
and between the Company and ZRNA.
11 Summary of the calculation of EPS.
27 Financial Data Schedule.
</TABLE>
(b) REPORTS ON FORM 8-K: No reports were filed on Form 8-K during the second
quarter of 1998.
18
<PAGE> 19
SIGNATURE
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.
Dated: August 14, 1998 SUPERIOR NATIONAL INSURANCE
GROUP, INC.
By /s/ J. CHRIS SEAMAN
-----------------------------------
Name: J. Chris Seaman
Title: Executive Vice President and
Chief Financial Officer
19
<PAGE> 20
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
<S> <C>
10.64 Commutation and Settlement Agreement, effective as of June 30, 1998, by
and between the Company and ZRNA.
11 Summary of the calculation of EPS.
27 Financial Data Schedule.
</TABLE>
20
<PAGE> 1
EXHIBIT 10.64
COMMUTATION AND SETTLEMENT AGREEMENT
(hereinafter referred to as the "Agreement")
THIS Agreement is entered into by and between Zurich Reinsurance (North
America), Inc., (formerly known as Zurich Reinsurance Centre, Inc.), Stamford,
Connecticut (hereinafter referred to as the "REINSURER") and Superior National
Insurance Company, Calabasas, California (hereinafter referred to as the
"COMPANY"), and made effective June 30, 1998.
WHEREAS, the REINSURER and the COMPANY entered into that certain Workers
Compensation and Employers' Liability Quota Share reinsurance contract,
identified by Reinsurer's Reference Number WC30006A, effective January 1, 1994
(the "Contract);
WHEREAS, the REINSURER and the COMPANY entered into that certain Retrocession
agreement, effective January 1, 1994 (the "Retrocession Agreement");
WHEREAS, effective June 30, 1998, the REINSURER and the COMPANY desire fully
and finally to settle and commute all obligations and liabilities known and
unknown of the REINSURER and the COMPANY under or related to the following
agreement years under the Contract:
(i) Agreement year incepting January 1, 1994
(ii) Agreement year incepting January 1, 1995
(iii) Agreement year incepting January 1, 1996
(iv) Agreement year incepting January 1, 1997,
and the corresponding agreement years under the Retrocession Agreement
(together, the "Commuted Liabilities"); and
WHEREAS, pursuant to that certain Agreement effective June 9, 1998 between the
REINSURER and the COMPANY, the REINSURER has already paid to the COMPANY and
the COMPANY has received from the REINSURER $5,500,000 (the "Partial Payment")
in partial payment of the Commutation Payment (hereinafter defined) and now
desires to make payment of the remainder of the Commutation Payment as more
fully set forth below.
NOW, THEREFORE, for good and valuable consideration the receipt of which is
hereby acknowledged, IT IS HEREBY AGREED BY AND BETWEEN THE REINSURER AND THE
COMPANY THAT:
1. The REINSURER shall pay the COMPANY the sum of $84,870 (together with the
Partial Payment, the "Commutation Payment"). This Agreement shall be of no
force and effect unless and until such payment is received by the COMPANY and
shall be void if no such payment is made.
2. Subject to the receipt of the sum of the Commutation Payment described in
Paragraph 1, above herein by the COMPANY, the COMPANY hereby releases and fully
discharges the REINSURER, its predecessors, successors, parents, affiliates,
agents, officers, directors and shareholders and assigns from any and all past,
present and future payment obligations,
1
<PAGE> 2
adjustments, executions, offsets, actions, causes of action, suits, debts, sums
of money, accounts, reckonings, bonds, bills, covenants, contracts,
controversies, agreements, promises, damages, judgments, claims, demands,
liabilities and/or losses whatsoever, all whether known or unknown, which the
COMPANY, and their successors and assigns ever had, now have, or hereinafter
may have, whether grounded in law or equity, in contract or in tort, against
the REINSURER or any of them by reason of any matter whatsoever arising out of
or under or relating, directly or indirectly, to the Commuted Liabilities, it
being the intention of the parties that this release operate as a full and
final settlement of the REINSURER's past, present and future liabilities to the
COMPANY under or related to the Commuted Liabilities.
3. Subject to the release by the COMPANY of the REINSURER as provided for in
Paragraph 2 herein above, the REINSURER hereby releases and fully discharges
the COMPANY, its predecessors, successors, parents, affiliates agents,
officers, directors and shareholders and assigns from any and all past, present
and future payment obligations, adjustments, executions, offsets, actions,
causes of action, suits, debts, sums of money, accounts, reckonings, bonds,
bills, covenants, contracts, controversies, agreements, promises, damages,
judgments, claims, demands, liabilities and/or losses whatsoever, all whether
known or unknown, which the REINSURER, and their successors and assigns ever
had, now have, or hereinafter may have, whether grounded in law or equity, in
contract or in tort, against the COMPANY or any of them by reason of any matter
whatsoever arising out of or under or relating, directly or indirectly, to the
Commuted Liabilities, it being the intention of the parties that this release
operate as a full and final settlement of the Company's past, present and
future liabilities to the REINSURER under or related to the Commuted
Liabilities.
4. The rights, duties and obligations set forth herein shall inure to the
benefit of and be binding upon any and all predecessors, successors,
affiliates, officers, directors, employees, parents, subsidiaries,
stockholders, liquidators, receivers and assigns of the parties hereto.
5. The parties hereto expressly warrant and represent that they are entities
in good standings in their respective places of domicile; that the execution of
this Agreement is fully authorized by each of them, that the person or persons
executing this Agreement have the necessary and appropriate authority to do so;
that there are no pending agreements, transactions, or negotiations to which
any of them are a party that would render this Agreement or any part thereof
void, voidable, or unenforceable; and that no authorization, consent or
approval of any government entity is required to make this Agreement valid and
binding upon them.
6. This Agreement contains the entire agreement between the parties as
respects its subject matter. All discussions and agreements previously
entertained between the parties concerning the subject matter of the
commutation are merged into this Agreement. This Agreement may not be modified
or amended, nor any of its provisions waived, except by an instrument in
writing, signed by the parties hereunder.
7. The parties hereto and each of them do hereby covenant and agree to do
such things and execute such further documents, agreements and assurances as
may be necessary or advisable from time to time in order to carry out the terms
and conditions of this Agreement in accordance with their true intent.
2
<PAGE> 3
8. This Agreement shall be governed by and construed in accordance with the
laws of the State of New York and the parties hereto hereby irrevocably submit
to the non-exclusive jurisdiction of the Courts of New York and to the extent
permitted by law expressly waive all rights to challenge or otherwise limit
such jurisdiction.
9. This Agreement shall be read and be considered as an integral part of the
Contract and the Retrocession Agreement and in the case of any conflict with
any part of said Contract or the Retrocession Agreement the provisions of this
Agreement shall prevail.
10. This Agreement may be executed and delivered in one or more counterparts,
each of which shall together constitute one and the same instrument.
IN WITNESS WHEREOF, this Agreement has been executed this 30th day of June,
1998 by
For and on behalf of
ZURICH REINSURANCE (NORTH AMERICA), INC.
/s/ PAUL R. LIVINGSTONE
- ---------------------------------------
Name: Paul R. Livingstone
Title: Vice President
Date: 7/7/98
For and on Behalf of
SUPERIOR NATIONAL INSURANCE COMPANY
/s/ J. CHRIS SEAMAN
- ---------------------------------------
Name: J. Chris Seaman
Title: CFO
Date: 7/8/98
3
<PAGE> 1
EXHIBIT 11
Summary of the calculation of EPS.
The following is an illustration of the reconciliation of the numerators
and denominators of the basic and diluted earnings per share (EPS) computations
for the six months ended June 30, 1998 and June 30, 1997:
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30, 1998 SIX MONTHS ENDED JUNE 30, 1997
------------------------------------------ ---------------------------------------------
INCOME SHARES PER SHARE INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ------ ----------- ------------- ------
(IN THOUSANDS) (IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
BASIC EPS
Income before items
below $ 7,816 5,853,713 $ 1.34 $ 1,494 4,641,954 $ 0.32
Preferred Securities (3,724) (0.64) (907) (0.20)
Extraordinary items - - (10,361) (2.23)
-------- ------ -------- ------
Net Income $ 4,092 $ 0.70 $ (9,774) $(2.11)
======== ====== ======== ======
EFFECT OF DILUTIVE
SECURITIES
Options 386,280 336,603
Warrants 1,672,234 1,432,309
DILUTED EPS
Income before items
below $ 7,816 7,912,227 $ 0.99 $ 1,494 6,410,866 $ 0.23
Preferred Securities (3,724) (0.47) (907) (0.14)
Extraordinary items - - (10,361) (1.61)
-------- ------ -------- ------
Net Income $ 4,092 $ 0.52 $ (9,774) $(1.52)
======== ====== ======== ======
</TABLE>
The following is an illustration of the reconciliation of the numerators
and denominators of the basic and diluted earnings per share (EPS) computations
for the three months ended June 30, 1998 and June 30, 1997:
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, 1998 THREE MONTHS ENDED JUNE 30, 1997
-------------------------------------------- ---------------------------------------------
INCOME SHARES PER SHARE INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ------ ----------- ------------- ---------
(IN THOUSANDS) (IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
BASIC EPS
Income before items
below $ 4,049 5,834,347 $ 0.69 $ 284 5,837,173 $ 0.05
Preferred Securities (1,852) (0.32) (453) (0.08)
Extraordinary items - - (10,361) (1.77)
-------- ------ --------- ------
Net Income $ 2,197 $ 0.37 $ (10,530) $(1.80)
======== ====== ========== ======
EFFECT OF DILUTIVE
SECURITIES
Options 417,582 321,992
Warrants 1,732,524 1,387,215
DILUTED EPS
Income before items
below $ 4,049 7,984,453 $ 0.50 $ 284 7,546,380 $ 0.04
Preferred Securities (1,852) (0.23) (453) (0.06)
Extraordinary items - - (10,361) (1.37)
-------- ------ --------- ------
Net Income $ 2,197 $ 0.27 $ (10,530) $(1.39)
======== ====== ========== =======
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<DEBT-HELD-FOR-SALE> 180,830
<DEBT-CARRYING-VALUE> 2,185
<DEBT-MARKET-VALUE> 2,192
<EQUITIES> 5,263
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 193,349
<CASH> 5,071
<RECOVER-REINSURE> 2,541
<DEFERRED-ACQUISITION> 5,422
<TOTAL-ASSETS> 385,175
<POLICY-LOSSES> 154,843
<UNEARNED-PREMIUMS> 16,198
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 1,370
<NOTES-PAYABLE> 30
101,051
0
<COMMON> 34,333
<OTHER-SE> 24,362
<TOTAL-LIABILITY-AND-EQUITY> 385,175
55,791
<INVESTMENT-INCOME> 8,014
<INVESTMENT-GAINS> 1,029
<OTHER-INCOME> 0
<BENEFITS> 33,687
<UNDERWRITING-AMORTIZATION> 5,879
<UNDERWRITING-OTHER> 10,744
<INCOME-PRETAX> 12,481
<INCOME-TAX> 4,665
<INCOME-CONTINUING> 7,816
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,092
<EPS-PRIMARY> 0
<EPS-DILUTED> 0.52
<RESERVE-OPEN> 152,100
<PROVISION-CURRENT> 20,321
<PROVISION-PRIOR> 13,366
<PAYMENTS-CURRENT> 3,349
<PAYMENTS-PRIOR> 80,528
<RESERVE-CLOSE> 101,910<F1>
<CUMULATIVE-DEFICIENCY> 13,366
<FN>
<F1>RESERVES FOR UNPAID CLAIMS, PROVISION FOR INSURED EVENTS, AND PAYMENTS OF
CLAIMS ARE STATED NET OF REINSURANCE.
</FN>
</TABLE>
