<PAGE> 1
- --------------------------------------------------------------------------------
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
------------------------
FORM 10-Q/A
(AMENDMENT NO. 2)
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1997
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)
<TABLE>
<S> <C>
DELAWARE 95-4610936
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
</TABLE>
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 [ ] No [X]
Number of shares of Common Stock, $.01 par value per share, outstanding as
of close of business on November 7, 1997: 5,859,269 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>
Item 1. Financial Statements
Condensed consolidated balance sheets as of September
30, 1997 (unaudited) and December 31, 1996............ 1
Condensed consolidated statements of operations for the
three and nine months ended September 30, 1997
(unaudited) (restated) and September 30, 1996
(unaudited)........................................... 2
Condensed consolidated statement of changes in
stockholders' equity for the nine months
ended September 30, 1997 (unaudited)................. 3
Condensed consolidated statements of cash flows
(restated) for the nine months ended September 30,
1997 (unaudited) and September 30, 1996 (unaudited)... 4
Notes to condensed consolidated financial statements
(unaudited)........................................... 5
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
</TABLE>
i
<PAGE> 3
PART I -- FINANCIAL INFORMATION
ITEM 1 -- FINANCIAL STATEMENTS
SUPERIOR NATIONAL INSURANCE GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
ASSETS
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1997 1996
------------- ------------
(UNAUDITED) (*)
<S> <C> <C>
Investments:
Bonds and notes:
Available-for-sale, at market (cost: 1997, $203,354;
1996, $46,549)......................................... $204,732 $ 46,330
Equity securities, at market (cost: 1997, $686; 1996,
$1,199)................................................ 849 1,173
Short-term investments, at cost......................... 7,613 67,514
-------- --------
Total Investments.................................. 213,194 115,017
Cash and cash equivalents (restricted cash: 1997, $476;
1996, $297)............................................ 25,610 34,423
Reinsurance receivable.................................. 54,887 25,274
Premiums receivable (less allowance for doubtful
accounts: 1997, $3,604; 1996, $300).................... 23,232 9,390
Earned but unbilled premiums receivable................. 9,123 5,251
Deferred policy acquisition costs....................... 5,834 3,042
Deferred income taxes................................... 27,133 9,520
Funds held by reinsurer................................. 3,815 1,948
Receivable from reinsurer............................... -- 110,527
Goodwill................................................ 25,766 --
Prepaid and other....................................... 22,634 9,438
-------- --------
Total Assets....................................... $411,228 $323,830
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Claims and claim adjustment expenses.................... 222,625 115,529
Unearned premiums....................................... 14,988 9,702
Reinsurance Payable..................................... 9,833 874
Long-term debt.......................................... 42,366 98,961
Discontinued operations liability....................... 14,036 17,261
Accounts payable and other liabilities.................. 24,904 12,741
-------- --------
Total Liabilities.................................. 328,752 255,068
Preferred securities issued by affiliate; authorized
1,100,000 shares; issued and outstanding 1,062,920
shares in 1997, and 1,013,753 shares in 1996........... 25,672 23,571
Stockholders' Equity:
Common stock, $0.01 par value; authorized 25,000,000 shares;
issued and outstanding 5,837,173 shares in 1997 and
3,446,492 shares in 1996.................................. 58 --
Paid-in capital excess of par............................. 34,070 16,022
Paid in capital -- warrants................................. 2,206 2,206
Unrealized gain on equity securities, net of taxes.......... 108 (17)
Unrealized gain (loss) on available-for-sale investments,
net of income taxes....................................... 879 (145)
Retained earnings........................................... 19,483 27,125
-------- --------
Total Stockholders' Equity......................... 56,804 45,191
-------- --------
Total Liabilities and Stockholders' Equity......... $411,228 $323,830
======== ========
</TABLE>
- ---------------
* Derived from audited financial statements
See Notes to Condensed Consolidated Financial Statements.
1
<PAGE> 4
SUPERIOR NATIONAL INSURANCE GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- --------------------
1997 1996 1997 1996
-------- -------- ---------- -------
(RESTATED)
<S> <C> <C> <C> <C>
Revenues:
Premiums written, net of reinsurance ceded............. $32,890 $23,337 $ 96,596 $66,133
Net change in unearned premiums........................ 1,870 (330) 2,552 (93)
------- ------- -------- -------
Net premiums earned.................................... 34,760 23,007 99,148 66,040
Net investment income.................................. 3,723 2,129 9,244 6,394
------- ------- -------- -------
Total Revenues................................. 38,483 25,136 108,392 72,434
Expenses:
Claims and claim adjustment expenses, net of
reinsurance recoveries.............................. 21,316 14,201 66,311 36,801
Commissions, net of reinsurance commissions............ 2,773 2,607 9,661 7,865
Policyholder dividends................................. -- (715) -- (2,121)
Interest expense....................................... 1,158 2,126 5,302 6,922
General and administrative expenses
Underwriting........................................ 7,140 5,304 18,101 18,681
Loss on termination of financing transaction with a
related party reinsurer........................... -- -- 15,699 --
Other............................................... 296 173 817 (216)
Goodwill............................................ 340 -- 477 --
------- ------- -------- -------
Total Expenses................................. 33,023 23,696 116,368 67,932
------- ------- -------- -------
Income before income taxes and preferred securities
dividends and accretion, and extraordinary items....... 5,460 1,440 (7,976) 4,502
Income tax expense....................................... 2,052 300 (2,517) 1,348
------- ------- -------- -------
Income before preferred securities dividends and
accretion, and extraordinary items..................... 3,408 1,140 (5,459) 3,154
Preferred securities dividends and accretion, net of
income taxes........................................ (480) (428) (1,387) (1,238)
Extraordinary loss on redemption of Pac Rim's
debentures, net of income tax benefit of $327....... (635) -- (635) --
Extraordinary loss on early retirement of Imperial Bank
loan, net of income tax benefit of $83.............. (161) -- (161) --
------- ------- -------- -------
Net (loss) Income.............................. $ 2,132 $ 712 $ (7,642) $ 1,916
======= ======= ======== =======
Earnings per common and dilutive common equivalent
shares:
Income before preferred securities dividends accretion,
and extraordinary items................................ $ 0.44 $ 0.23 $ (1.09) $ 0.64
Preferred securities dividends and accretion........... (0.06) (0.08) (0.28) (0.23)
Extraordinary loss on redemption of Pac Rim's
debentures, net of income tax benefit............... (0.08) -- (0.12) --
Extraordinary loss on early retirement of Imperial Bank
loan, net of income tax benefit..................... (0.02) -- (0.03) --
------- ------- -------- -------
Net (loss) Income.............................. $ 0.28 $ 0.15 $ (1.52) $ 0.41
======= ======= ======== =======
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
2
<PAGE> 5
SUPERIOR NATIONAL INSURANCE GROUP, INC.
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
COMMON STOCK
------------------------------ UNREALIZED NET UNREALIZED
PAID-IN GAIN GAIN (LOSS)
CAPITAL (LOSS) ON AVAILABLE- PAID IN TOTAL
SHARES $.01 PAR EXCESS ON EQUITY FOR-SALE CAPITAL- RETAINED SHAREHOLDERS'
ISSUED VALUE OF PAR SECURITIES INVESTMENTS WARRANTS EARNINGS EQUITY
--------- -------- ------- ---------- -------------- -------- -------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31,
1996....................... 3,446,492 -- $16,022 $(17) $ (145) $2,206 $27,125 $45,191
Net loss..................... -- -- -- -- -- -- (7,642) (7,642)
Change in unrealized gain on
equity Securities.......... -- -- -- 125 -- -- -- 125
Change in unrealized gain
(loss) on investments, net
of taxes................... -- -- -- -- 1,024 -- -- 1,024
Common stock issued.......... 2,390,681 58 18,048 -- -- -- -- 18,106
--------- --- ------- ---- ------ ------ ------- -------
Balance at September 30,
1997....................... 5,837,173 $58 $34,070 $108 $ 879 $2,206 $19,483 $56,804
========= === ======= ==== ====== ====== ======= =======
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
3
<PAGE> 6
SUPERIOR NATIONAL INSURANCE GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS AS RESTATED
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------
1997 1996
--------- --------
<S> <C> <C>
Cash flows from operating activities:
Net (loss) income......................................... $ (7,642) $ 1,916
--------- --------
Adjustments to reconcile net (loss) income to net cash
provided by (used in) operating activities:
Amortization of bonds and preferred stock............... (1,004) (705)
Loss (gain) on sale of investments...................... 95 (33)
Gain on sale of Centre Re Investments................... -- (2,261)
Amortization of Goodwill................................ 477 --
Loss on termination of financing transaction with a
related party reinsurer................................ 15,699 --
Extraordinary Loss...................................... 796 --
Interest expense on long-term debt...................... 4,225 --
Preferred securities dividends and accretion............ 1,387 1,876
Increase in reinsurance receivable...................... (25,593) (1,292)
(Increase) decrease in premiums receivables............. (716) 1,009
Decrease (increase) in earned but unbilled premiums
receivable............................................. 270 (1,656)
(Increase) decrease in accrued investment income........ (637) 339
Increase in deferred policy acquisition costs........... (2,792) (340)
Decrease in deferred income taxes....................... (2,517) 706
Increase in funds held by reinsurer..................... (1,867) (413)
Decrease in investments withheld from a related party
reinsurer.............................................. -- 38,586
(Increase) decrease in prepaid reinsurance premiums..... (5,278) 498
Increase in other assets................................ (1,411) (855)
Decrease in claims and claim adjustment expense
reserves............................................... (979) (25,268)
Decrease in unearned premium reserves................... (1,573) (404)
Increase in reinsurance payable......................... 8,959 122
Decrease in policyholder dividends payable.............. -- (3,577)
(Decrease) increase in accounts payable and other
liabilities............................................ (6,354) 8,659
--------- --------
Total adjustments................................... (18,813) 14,991
--------- --------
Net cash used in operating activities............... (26,455) 16,907
--------- --------
Cash flows from financing activities:
Paid-in-capital -- restricted stock....................... 106 13
Proceeds from issuance of common stock.................... 18,000 --
Long-term debt -- Chase Manhattan Bank.................... 41,257 --
Retirement of long-term debt -- Imperial Bank............. (7,250) (900)
Prepayment penalty on early retirement of long-term
debt.................................................... (244) --
Proceeds from repurchase transaction...................... -- 3,596
--------- --------
Net cash provided by financing activities........... 51,869 2,709
--------- --------
Cash flows from investing activities:
Purchases of bonds and notes:
Investments available-for-sale.......................... (93,936) (29,119)
Purchase of equity security............................... (145) --
Acquisition of Pac Rim.................................... (44,016) --
Investments and cash for discontinued operations.......... (3,225) --
Sales of bonds and notes; Investments
available-for-sale...................................... 37,906 22,414
Maturities of bonds and notes: Investments
available-for-sale...................................... 8,771 12,286
Sale of equity security................................... 517 --
Net decrease in short term investment..................... 59,901 1,549
--------- --------
Net cash (used in) provided by investing activities..... (34,227) 7,130
--------- --------
Net (decrease) increase in cash......................... (8,813) 26,746
--------- --------
Cash and invested cash at beginning of period............... 34,423 6,188
--------- --------
Cash and invested cash at end of period..................... $ 25,610 $ 32,934
========= ========
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes.................. $ 4 $ 4
========= ========
Cash paid during the year for interest...................... $ 1,124 $ 488
========= ========
</TABLE>
See Notes to Condensed Consolidated Financial Statements
4
<PAGE> 7
SUPERIOR NATIONAL INSURANCE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1997
(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. 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 1997 presentation. Operating results
for the nine months ended September 30, 1997 are not necessarily indicative of
the results to be expected for the year ended December 31, 1997. 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, 1996.
A.2 Acquisition of Pac Rim Holding Corporation
On April 11, 1997, the Company completed its acquisition of Pac Rim Holding
Corporation ("PRHC") and its wholly-owned subsidiary, The Pacific Rim Assurance
Company, for total consideration of approximately $42 million in cash. The
consideration paid by SNIG resulted in payment of approximately $20 million
($2.105 per share) to PRHC's common stockholders; $20 million to PRHC's
debenture holders; and the remainder to PRHC's warrant and option holders. The
Pacific Rim Assurance Company was renamed Superior Pacific Casualty Company upon
its acquisition by the Company. SNIG financed the acquisition with the issuance
and sale in a private transaction, of approximately $18.0 million in common
stock, (2,390,438 shares) to a group of investors including Insurance Partners,
L.P., TJS Partners, L.P., and SNIG management and the incurrence of a $44
million term loan by a bank syndicate led by The Chase Manhattan Bank ("Chase").
Approximately $6.6 million of the loan proceeds was used to prepay SNIG's
previously outstanding long-term debt, and approximately $10 million was
contributed by SNIG to the capital of SPCC.
The Company accounted for the acquisition of PRHC as a purchase, and
accordingly, assets and liabilities of PRHC were adjusted to their fair value at
the time of the purchase. As of September 30, 1997, the Company had recorded
$25.8 million in goodwill, the excess of purchase price over amounts assigned to
identifiable assets acquired less liabilities assumed.
In connection with the Company's SEC reporting obligations the Company has
prepared pro forma financial information. The following is a comparison, between
the actual and pro forma information presented. The following pro forma amounts
are presented as if the acquisition of PRHC by SNIG had occurred as of the
beginning of each period presented.
<TABLE>
<CAPTION>
PRO FORMA
---------------------------------------------
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, DECEMBER 31,
1997(1) 1997(2) 1997(3) 1996(4)
------------- ------------- ------------- ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
Total Revenues........................... $ 108,392 $ 128,609 $ 129,348 $ 187,732
Net income (loss) from continuing
operations............................. $ (5,459) $ (1,985) $ (23,543) $ (20,417)
Net loss................................. $ (7,642) $ (9,666) $ (25,726) $ (22,880)
Earnings (loss) per common share from
continuing operations.................. $ (1.09) $ (0.34) $ (4.03) $ (2.65)
Loss per common share.................... $ (1.52) $ (1.66) $ (4.41) $ (2.97)
Weighted average shares outstanding...... 5,040,360 5,837,173 5,837,173 7,706,108
</TABLE>
5
<PAGE> 8
SUPERIOR NATIONAL INSURANCE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1997
(UNAUDITED)
- ---------------
(1) Represents the results of operations of the Company for the nine months
ended September 30, 1997. The acquired Company's results are incorporated in
the Company's results for periods after April 1, 1997. Balances reflect all
purchase accounting adjustments known to date.
(2) Represents the pro forma combined balances of SNIG and PRHC at September 30,
1997 adjusted for purchase accounting; the restatement of PRHC's December
31, 1996 audited financial statements; and the expected savings from
management's implementation of its integration plan for PRHC.
(3) Represents the pro forma combined balances of SNIG and PRHC as if the
transaction had occurred on January 1, 1997. The balances have been adjusted
for the results of PRHC's first quarter results; purchase accounting and the
restatement of PRHC's December 31, 1996 audited financial statements as
filed in Form 8-K/A dated September 5, 1997.
(4) Represents the pro forma combined balances of SNIG and PRHC as if the
transaction had occurred on January 1, 1996. The balances have been adjusted
for purchase accounting adjustments and the restatement of PRHC's December
31, 1996 audited financial statements as filed in Form 8-K/A dated September
5, 1997.
A.3 Earnings Per Share ("EPS")
Earnings per common and dilutive common equivalent shares for the three and
nine months ended September 30, 1997, and 1996, are based on the average number
of common shares outstanding during each period and the number of common shares
that would be outstanding if all outstanding stock options and warrants were
exercised. While the assumed conversion of common stock equivalents, such as
stock options and warrants, generally has a dilutive effect on EPS, if the
assumed conversion of all common stock equivalents is antidilutive to the EPS
calculation, then such common stock equivalents are excluded from EPS amounts.
The number of shares used in the EPS calculations are 7,692,289 and 5,040,360
shares for the three and nine months ended September 30, 1997, respectively, and
5,316,873 shares for the three and nine months ended September 30, 1996.
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard presentation No. 128, and "Earnings per Share"
("SFAS 128"), which establishes the computation, presentation, and disclosure
requirements for earnings per share. SFAS 128 is effective for fiscal periods
ending after December 15, 1997. The effects of SFAS 128 on the Company's
earnings per share calculation is not expected to be materially different from
that historically presented.
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 not determined
the impact of SFAS No. 130.
Also, in June 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards, No. 131, "Disclosures about
Segments of an Enterprise and Related Information" ("SFAS No. 131"). This
statement specifies revised guidelines for determination of an entity's
operating segments and the type and level of financial information to be
disclosed. SFAS No. 131 is effective for periods ending after
6
<PAGE> 9
SUPERIOR NATIONAL INSURANCE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1997
(UNAUDITED)
December 15, 1997, including interim periods. The Company has not determined the
impact of SFAS No. 131.
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 SNIG's obligations, the amounts reported on the balance sheet are
management's best estimate of that amount.
NOTE B. FINANCING AGREEMENT
During 1996, the Company entered into a financing transaction involving
Centre Re and Chase. Chase extended a $93.1 million term loan (net of
transaction costs). The Company used the proceeds from the financing to purchase
from SNIC reinsurance receivables due from Centre Re. The principal balance of
the loan was collateralized by receivables due from the reinsurer and amortized
based upon the payout pattern of the underlying claims of the reinsurance
receivables. In June 1997, the $93.1 million term loan was retired, $110.5
million of receivables from a related party reinsurer, in connection with a
financing transaction, was transferred to Chase in exchange for the cancellation
of the Company's $94.9 million debt due to Chase under the loan. The retirement
of this collateralized financing resulted in the Company's recognizing a $15.7
million charge.
NOTE C. DEBT AGREEMENT
Upon the close of the PRHC acquisition on April 11, 1997, the Company
obtained a term loan in the amount of $44 million. The loan is collateralized by
the stock of the Company's intermediate holding company Superior Pacific
Insurance Group, Inc. ("SPIG") and certain of SPIG's subsidiaries. The Company
used the proceeds of the term loan for the acquisition and related expenses, a
capital contribution to SPCC, and to prepay existing indebtedness. The loan is
due six years from April 11, 1997. Principal payments are due semi-annually in
eleven consecutive installments of $3.65 million commencing October 11, 1997,
with a final installment of $3.85 million. The interest rate on the debt is a
LIBOR-based variable rate that will not exceed Chase's prime commercial lending
rate unless default interest becomes due.
NOTE D. DISCONTINUED OPERATIONS
Outstanding discontinued operations claim and claim adjustment expense
reserves were $21.2 million at September 30, 1997, which was consistent with
management's expectations. Offsetting these liabilities are $7.4 million of
reinsurance recoverables on paid and unpaid claim and claim adjustment expenses.
7
<PAGE> 10
SUPERIOR NATIONAL INSURANCE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1997
(UNAUDITED)
NOTE E. RECONCILIATION WITH PREVIOUSLY REPORTED AMOUNTS
The amounts shown in the Condensed Consolidated Statement of Cash Flows
differ from those previously reported as a result of reclassifications made to
the Condensed Consolidated Balance Sheet. A reconciliation of amounts restated
are as follows:
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------
1997 1996
-------- --------
<S> <C> <C>
Net cash (used in) provided by operating activities
As previously reported.................................... $(26,455) $(21,679)
Reclass of investments withheld from reinsurer............ -- $ 38,586
-------- --------
As restated............................................. $(26,455) $ 16,907
======== ========
Net cash (used in) provided by financing activities
As previously reported.................................... $ 48,644 $ 2,709
Reclass of investments and cash for discontinued
operations.............................................. 3,225 --
-------- --------
As restated............................................. $ 51,869 $ 2,709
======== ========
Net cash (used in) provided by investing activities
As previously reported.................................... $(90,903) $ 52,098
Reclass of investment funds withheld from reinsurer....... -- 71,061
Reclass of funds withheld from reinsurers................. -- (110,098)
Reclass of investments held for sale...................... 55,339 --
Reclass of investments and cash for discontinued
operations.............................................. (3,225) --
Reclass of invested cash from cash and cash equivalents to
short term investments.................................. 4,562 (5,931)
-------- --------
As restated............................................. $(34,227) $ 7,130
======== ========
Cash and cash equivalents at the end of the period
As previously reported.................................... $ 33,223 $ 36,080
Reclass of invested cash from cash and cash equivalents to
short term investments.................................. (7,613) (3,146)
-------- --------
As restated............................................. $ 25,610 $ 32,934
======== ========
</TABLE>
8
<PAGE> 11
SUPERIOR NATIONAL INSURANCE GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1997
(UNAUDITED)
Additionally, in 1997 the Company previously reported a $10.4 million
extraordinary loss on retirement of long-term debt, net of income tax benefit.
Subsequently, this amount was reclassified to an operating expense separately
disclosed as loss on termination of financing transaction with related party
reinsurer. This reclass resulted in no change to net income or stockholders'
equity. A reconciliation of amounts restated are as follows:
[CAPTION]
<TABLE>
<CAPTION>
<S> <C>
NINE MONTHS
ENDED
SEPTEMBER 30, 1997
--------
<S> <C>
Total Expenses
As previously reported.................................... $100,669
Reclass of loss on termination of financing transaction
with related party reinsurer........................... 15,699
--------
As restated............................................ $116,368
========
Income tax expense (benefit)
As previously reported.................................... $ 2,821
Reclass on tax effect of loss on termination of financing
transaction with related party reinsurer............... (5,338)
--------
As restated............................................ $ (2,517)
========
Income before preferred securities dividends and accretion,
discontinued operations, and extraordinary items
As previously reported.................................... $ 4,902
Reclass of extraordinary loss on retirement on long-term
debt, net of tax....................................... (10,361)
--------
As restated............................................ $ (5,459)
========
</TABLE>
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30, 1997
-------------------------------
AS
PREVIOUSLY AS
REPORTED RECLASS RESTATED
---------- ------- --------
<S> <C> <C> <C>
Earnings per common and dilutive common equivalent shares:
Income before preferred securities dividends accretion,
and extraordinary items................................ $ 0.97 $(2.06) $(1.09)
Preferred securities dividends and accretion.............. (0.28) -- (0.28)
Extraordinary loss on redemption of Pac Rim's debentures,
net of income tax benefit.............................. (0.12) -- (0.12)
Extraordinary loss on early retirement of Imperial Bank
loan, net of income tax benefit........................ (0.03) -- (0.03)
Extraordinary loss on retirement of long-term debt, net of
income tax benefit..................................... (2.06) 2.06 --
------ ------ ------
Net loss.................................................. $(1.52) $ -- $(1.52)
====== ====== ======
</TABLE>
9
<PAGE> 12
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 newly acquired subsidiary Superior Pacific Casualty
Company ("SPCC"), formerly known as The Pacific Rim Assurance Company for the
period beginning April 1, 1997.
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 acquisition of Pac Rim
Holding Corporation ("PRHC") and its subsidiary SPCC, 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
$3.5 million in the three month period ended September 30, 1997, versus an
underwriting profit of $1.6 million in the corresponding period in the prior
year, and an underwriting profit of $5.1 million for the nine month period ended
September 30, 1997, versus an underwriting profit of $4.8 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 three months ended September 30, 1997
the Company realized net income of $2.1 million or $0.28 per share as compared
to $0.7 million or $0.15 per share for the three months ended September 30,
1996. The primary reason for the increase in net income was the increase in
investment income, resulting from the increase in invested assets. The Company
incurred a net loss of $7.6 million or $1.52 per share for the nine month period
ended September 30, 1997, versus income of $1.9 million or $0.41 per share in
the corresponding period of the prior year. The loss in the current year relates
to a $15.7 million charge due to the termination of a financing transaction with
a related party reinsurer, (namely, Centre Reinsurance Limited "Centre Re").
The Company acquired PRHC for approximately $42 million on April 11, 1997,
and thereupon SPCC became a subsidiary of the Company. The acquisition was
accounted for as a purchase. Total assets, including goodwill, increased to
$411.2 million at September 30, 1997, from $323.8 million at December 31, 1996,
primarily as a result of the acquisition. As of September 30, 1997, the Company
had recorded $25.8 million in goodwill, the excess of purchase price over
amounts assigned to identifiable assets acquired less liabilities assumed.
The previously announced audit by the Company's independent auditors of the
financial statements of PRHC for the fiscal years ended December 31, 1996, 1995,
and 1994 was completed August 28, 1997. See "Item 6(b) -- Reports on Form 8K."
GENERAL FINANCIAL CONDITION
Total assets increased $183.1 million or 80.3% to $411.2 million at
September 30, 1997, as compared to the same period in 1996. The increase was due
to approximately $189.3 million in assets recorded related to the acquisition of
PRHC, which was partially offset by a reduction of approximately $91.6 million
in receivables due from a related party reinsurer that were transferred to Chase
in exchange for cancellation of debt.
Total liabilities increased $168.6 million or 105.2% to $328.8 million at
September 30, 1997, as compared to the same period in 1996. The increase was due
to approximately $171.2 million in liabilities recorded
10
<PAGE> 13
related to the acquisition of PRHC, which was partially offset by the
cancellation of the $94.9 million debt to Chase and $6.6 million Imperial Bank
debt.
Total equity increased $11.7 million or 25.9% to $56.8 million at September
30, 1997, as compared to the same period in 1996. Approximately $18 million in
additional capital was related to the April 11, 1997, private stock issuance and
sale. This increase was partially offset by expenditures and increases in claims
reserves associated with the acquisition of PRHC and the $15.7 million charge
due to the termination of a financing transaction with a related party
reinsurer.
RESULTS OF OPERATIONS
The following selected financial data and analysis provide an assessment of
SNIG's financial results for the three months ended September 30, 1997, as
compared to the three months ended September 30, 1996. Certain prior period
amounts have been reclassified to conform to the current period presentation.
Selected financial data as reported for the three months ended September
30, 1997 and 1996 are presented below.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
SEPTEMBER 30,
----------------------
1997 1996
--------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Gross premiums written.................................... $ 43,121 $ 26,033
Net premiums written...................................... $ 32,890 $ 23,337
Net premiums earned....................................... $ 34,760 $ 23,007
Less:
Claim and claim adjustment expenses, net of
reinsurance.......................................... (21,316) (14,201)
Underwriting and general and administrative expenses.... (9,913) (7,911)
Policyholder dividends.................................. -- 715
--------- ---------
Underwriting profit....................................... 3,531 1,610
Net investment income (excluding capital gains and
losses)................................................. 3,696 2,117
Net investment gains...................................... 27 12
Interest expense.......................................... (1,158) (2,126)
Other income (expense), net............................... (296) (173)
Goodwill amortization..................................... (340) --
--------- ---------
Income from continuing operations -- pre-tax.............. 5,460 1,440
Income tax expense........................................ 2,052 300
--------- ---------
Income before preferred securities dividends, accretion
and extraordinary items................................. 3,408 1,140
Preferred securities dividends and accretion, net of
taxes................................................... (480) (428)
Extraordinary loss on retirement of long-term debt, net of
taxes................................................... (796) --
--------- ---------
Net Income...................................... $ 2,132 $ 712
========= =========
UNDERWRITING RATIOS (GAAP BASIS):
Net claims and claim adjustment expense ratio............. 61.3% 61.7%
Underwriting expense ratio................................ 28.5% 34.4%
Policyholder dividends ratio.............................. -- (3.1%)
--------- ---------
Combined ratio............................................ 89.8% 93.0%
========= =========
</TABLE>
Gross premiums written increased $17.1 million or 65.6% to $43.1 million in
the third quarter of 1997 as compared to the same period in 1996. Substantially
all of this increase can be attributed to the addition of business written by
SPCC. Net premiums written increased $9.6 million or 40.9% to $32.9 million in
the third quarter of 1997 as compared to the same period in 1996, reflecting the
increase in gross premiums written. Net
11
<PAGE> 14
premiums earned increased $11.8 million or 51.1% to $34.8 million in the third
quarter of 1997 as compared to the same period in 1996, reflecting the increase
in net premiums written.
Net claim and claim adjustment expenses increased $7.1 million or 50.1% to
$21.3 million in the third quarter of 1997 as compared to the same period in
1996, $1.4 million of which resulted from the addition of business written by
SPCC. The remaining $5.7 million increase was due to the return of results in
1997 to historical averages and to unfavorable development in the 1995 accident
year. The net claim and claim adjustment expense ratio slightly decreased to
61.3% in the third quarter of 1997 from 61.7% in the same period of 1996.
Although the Company has been experiencing a reduction in the frequency of
claims, at the same time there may be an increase in claims severity for
injuries sustained in 1995 and thereafter. Management currently intends to
address this potential trend with the planned severity management program, which
is intended to reduce the Company's average ultimate claim and claim adjustment
expense per claim for 1995 and subsequent dates of injury. See "Item 5 -- Other
Information."
Underwriting and general and administrative expenses, excluding
policyholder dividends, increased $2.0 million or 25.3% to $9.9 million in the
third quarter of 1997, as compared to the same period in 1996. Net commission
expense increased $0.2 million or 6.4% to $2.8 million in the third quarter of
1997, as compared to the same period in 1996. The increase in net commission
expense is due to an increase in premiums. Net underwriting and general and
administrative expenses increased 35% to $7.1 million in the third quarter of
1997 from $5.3 million in the same period of 1996. The Company's underwriting
expense ratio decreased 5.9% to 28.5% for the third quarter of 1997 from 34.4%
for the same period in 1996, due primarily to a reduction in commission expense
relative to the related premium level. Commission expense decreased relative to
premium levels due to an increase in ceding commissions received.
No policyholder dividends were paid during the third quarter of 1997, as
compared to the payment of $0.8 million of such dividends during the same period
in 1996. Prior to the elimination of required minimum rates in California ("open
rating"), policyholder dividends served both as an economic incentive to
employers for safe operations and as a means of price differentiation. Estimated
amounts to be returned to policyholders were accrued when the related premium
was earned by the Company, and dividends were paid to the extent that a surplus
was accumulated from premiums on workers' compensation policies. As a result of
consumers' preference for the lowest net price at the policy's inception under
open rating, dividends are no longer a significant factor in the marketing of
workers' compensation insurance in California. In 1995, as a result of the
diminishing value of policyholder dividends, SNIC's management declared a
moratorium on the payment of policyholder dividends for California policies. In
December 1996, the Company discontinued policyholder dividend payments.
The Company recorded an underwriting profit from continuing operations of
$3.5 million in the third quarter of 1997, versus $1.6 million for the same
period in 1996. The increase in underwriting profit from continuing operations
was primarily the result of an increase in premiums as a result of the SPCC
acquisition, coupled with a decrease in related expenses relative to the premium
level.
Net investment income, excluding realized investment gains/losses,
increased $1.6 million or 74.6% to $3.7 million in the third quarter of 1997
compared to the same period in 1996. The improvement is due to the increase in
assets available for investment resulting from the SPCC acquisition. Excluding
SPCC, net investment income decreased $0.3 million or 13% to $1.8 million in the
third quarter of 1997 as compared to the same period in 1996. This 13% decrease
was due to a decline in the average amount of invested assets by $21.9 million
or 14.4% to $130.3 million in the third quarter of 1997 as compared to the same
period in 1996. Essentially no realized investment gains or losses were recorded
in the quarters ended September 30, 1997 and 1996.
Interest expense decreased $1.0 million or 45.5% to $1.2 million in the
third quarter of 1997 as compared to the same period in 1996, due primarily to
the termination of interest payments on the funds withheld balance connected
with a 1993 contract with a related party reinsurer and the retirement of
approximately $6.6 million in outstanding debt, offset by the Company's
incurrence of a $44.0 million term loan in connection with its acquisition of
Pac Rim.
12
<PAGE> 15
Selected financial data as reported for the nine months ended September 30,
1997 and 1996 are presented below.
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
1997 1996
---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Gross premiums written.................................... $ 114,211 $ 74,192
Net premiums written...................................... $ 96,596 $ 66,133
Net premiums earned....................................... $ 99,148 $ 66,040
Less:
Claim and claim adjustment expenses, net of
reinsurance.......................................... (66,311) (36,801)
Underwriting and general and administrative expenses.... (27,762) (26,546)
Policyholder dividends.................................. -- 2,121
---------- ----------
Underwriting profit....................................... 5,075 4,814
Net investment income (excluding capital gains and
losses)................................................. 9,198 6,361
Net investment gains (losses)............................. 46 33
Interest expense.......................................... (5,302) (6,922)
Loss on termination of financing transaction with a
related party reinsurer................................. (15,699) --
Other income (expense), net............................... (817) 216
Goodwill amortization..................................... (477) --
---------- ----------
Income from continuing operations -- pre-tax.............. (7,976) 4,502
Income tax expense........................................ (2,517) 1,348
---------- ----------
Income before preferred securities dividends and accretion
and extraordinary items................................. (5,459) 3,154
Preferred securities dividends and accretion, net of
taxes................................................... (1,387) (1,238)
Extraordinary loss on retirement of long-term debt, net of
taxes................................................... (796) --
---------- ----------
Net (Loss) Income......................................... $ (7,642) $ 1,916
========== ==========
UNDERWRITING RATIOS (GAAP BASIS):
Net claims and claim adjustment expense ratio............. 66.9% 55.7%
Underwriting expense ratio................................ 28.0% 40.2%
Policyholder dividends ratio.............................. -- (3.2%)
---------- ----------
Combined ratio............................................ 94.9% 92.7%
========== ==========
</TABLE>
Gross premiums written increased $40.0 million or 53.9% to $114.2 million
in the first nine months of 1997 as compared to the same period in 1996.
Substantially all of this increase can be attributed to the addition of business
written by SPCC. Net premiums written increased $30.5 million or 46.1% to $96.6
million in the first nine months of 1997 as compared to the same period in 1996,
reflecting the increase in gross premiums written. Net premiums earned increased
$33.1 million or 50.1% to $99.1 million in the first nine months of 1997 as
compared to the same period in 1996, reflecting the increase in net premiums
written.
Net claims and claim adjustment expenses increased $29.5 million or 80.2%
to $66.3 million in the first nine months of 1997 as compared to the same period
in 1996, $19.9 million or 67.5% of which resulted from business written by SPCC.
The net claims and claim adjustment expense ratio increased to 66.9% in the
first nine months of 1997 from 55.7% in the same period of 1996, due primarily
to business written by SPCC. Excluding SPCC, SNIC's net claim and claim
adjustment expense ratio increased to 68.3% in the first nine months of 1997
from 55.7% in the same period of 1996, due to the return of results in 1997 to
historical averages and to unfavorable development in the 1995 accident year.
Although the Company has been experiencing a reduction in the frequency of
claims, at the same time there may be an increase in claims severity for
injuries sustained in 1995 and thereafter. Management currently intends to
address this potential trend with the planned severity management program, which
is intended to reduce the Company's average
13
<PAGE> 16
ultimate claim and claim adjustment expense per claim for 1995 and subsequent
dates of injury. See "Item 5 -- Other Information."
Underwriting expenses, excluding policyholder dividends and a loss on the
termination of a financing transaction with a related party reinsurer, increased
$1.2 million or 4.6% to $27.8 million in the first nine months of 1997 as
compared to the same period in 1996. Net commission expense increased $1.8
million or 22.8% to $9.7 million in the first nine months of 1997 from the same
period in 1996. Excluding the one-time expense of $5.3 million for the
cancellation of a reinsurance contract recorded during the second quarter of
1996, underwriting expenses increased $6.5 million or 31.0% to $27.8 million in
the first nine months of 1997 as compared to the same period in 1996 as a result
of the SPCC acquisition. The Company's expense ratio decreased to 28.0% for the
nine months ended September 30, 1997 from 37.0% for the same period in 1996, due
primarily to the 1996 expense of $5.3 million in connection with a negotiated
settlement of a reinsurance contract with Centre Re. Excluding SPCC, the
Company's expense ratio decreased to 37.3% for the first nine months of 1997
from 37.0% for the same period during 1996.
No policyholder dividends were paid during the first nine months of 1997 as
compared to the payment of $1.3 million of such dividends during the same period
in 1996. Prior to open rating, policyholder dividends served both as an economic
incentive to employers for safe operations and as a means of price
differentiation. Estimated amounts to be returned to policyholders were accrued
when the related premium was earned by the Company. Dividends were paid to the
extent that a surplus was accumulated from premiums on workers' compensation
policies. As a result of consumers' preference for the lowest net price at the
policy's inception under open rating, dividends are no longer a significant
factor in the marketing of workers' compensation insurance in California. In
1995, as a result of the diminishing value of policyholder dividends, SNIC's
management declared a moratorium in the payment of policyholder dividends for
California policies. In December 1996, the Company discontinued policyholder
dividend payments.
The Company recorded an underwriting profit, excluding the loss on the
termination of a financing transaction with a related party reinsurer, from
continuing operations of $5.1 million for the nine months ended September 30,
1997, versus $4.8 million for the same period in 1996. The increase in
underwriting profit from continuing operations was primarily the result of a
decrease in underwriting expenses relative to the related premiums. The Company
incurred a net loss of $7.6 million or $1.52 per share for the nine month-
period ended September 30, 1997, versus income of $1.9 million or $0.41 per
share in the corresponding period of the prior year. The loss in the current
year relates to a $15.7 million pretax charge due to the termination of a
financing transaction with a related party reinsurer.
Net investment income, excluding investment gains/losses, increased $2.8
million or 44.6% to $9.2 million in the first nine months of 1997 as compared to
the same period in 1996 as a result of the acquisition of SPCC. Excluding SPCC,
net investment income decreased 8.5% or $0.5 million in the first nine months of
1997 as compared to the same period in 1996. This 8.5% decrease was due to a
decline in the average amount of invested assets by $19.8 million or 12.6% to
$137.7 million in the nine months of 1997 as compared to the same period in
1996. Essentially no realized investment gains or losses were recorded for the
nine months ended September 30, 1997 and 1996.
Interest expense decreased $1.6 million or 23.4% to $5.3 million for the
first nine months of 1997 as compared to the same period in 1996, due primarily
to the elimination of funds withheld balance and the retirement of approximately
$6.6 million in outstanding debt, partially offset by the Company's incurrence
of a $44.0 million term loan in connection with its acquisition of Pac Rim.
In June 1997, the Company recorded a $15.7 million charge related to the
termination of a financing transaction with a related party reinsurer. The
termination of the financing transaction transferred $110.5 million in
receivables from a related party reinsurer in exchange for the cancellation of
$94.9 million in indebtedness to Chase. No such charges were incurred in the
1996 period.
14
<PAGE> 17
A summary of net investment income, excluding capital gains (losses), for
the three and nine months ended September 30, 1997 and 1996 are as follows:
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------- ---------------
1997 1996 1997 1996
------ ------ ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Interest on bonds and notes................. $3,234 $1,909 $6,032 $6,060
Interest on invested cash................... 662 324 3,714 656
------ ------ ------ ------
Total investment income..................... 3,896 2,233 9,746 6,716
Capital gains............................... 27 12 46 33
Investment expense.......................... 200 116 548 355
------ ------ ------ ------
Net investment income....................... $3,723 $2,129 $9,244 $6,394
====== ====== ====== ======
</TABLE>
The distribution of SNIG's consolidated investment portfolio is as follows
(in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, 1997 DECEMBER 31, 1996
------------------- ------------------
CARRYING MARKET CARRYING MARKET
AVAILABLE FOR SALE: VALUE VALUE VALUE VALUE
------------------- -------- -------- -------- -------
<S> <C> <C> <C> <C>
U.S. Government Agencies and
Authorities......................... $ 49,823 $ 49,823 $22,484 $22,484
Collateralized Mortgage Obligations... 48,189 48,189 12,855 12,855
Corporate Instruments................. 43,383 43,383 9,867 9,867
Special Revenue and Special
Assessment.......................... 63,337 63,337 -- --
State and Political Subdivisions...... -- -- 1,124 1,124
-------- -------- ------- -------
Total Available for Sale.............. $204,732 $204,732 $46,330 $46,330
======== ======== ======= =======
</TABLE>
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1997 1996
------------- ---------------
MARKET MARKET
EQUITY SECURITIES COST VALUE COST VALUE
----------------- ---- ------ ------ ------
DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Corporate..................................... $686 $849 $1,199 $1,173
---- ---- ------ ------
Total......................................... $686 $849 $1,199 $1,173
==== ==== ====== ======
</TABLE>
The Company's management monitors the matching of assets and liabilities
and attempts to maintain its 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 September 30, 1997,
was 2.91 years compared to 4.69 years at December 31, 1996. At September 30,
1997, 98.0% 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.
DISCONTINUED OPERATIONS
Outstanding discontinued operations claims counts and losses were 216 and
$21.2 million, respectively, as of September 30, 1997, 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 its 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 its claims activity. There
can be no assurance, however, that further upward development of ultimate loss
costs associated with construction defect
15
<PAGE> 18
claims will not occur. Offsetting these liabilities are $7.4 million of
reinsurance recoverables on paid and unpaid claim and claim adjustment expenses.
The Company will continue to closely monitor the adequacy of its loss reserves
in the discontinued operations.
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, SNIC and SPCC 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 nine months of 1997, the Company used $26.5 million of
cash in its operations versus cash generated of $16.9 million during the same
period in 1996. 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. 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. The $43.4 million increase in cash used in
operations during the first nine months of 1997 is partially due to $4.8 million
from the addition of SPCC operations for the second and third quarters of 1997
and a $38.6 million decrease in 1996 from investments withheld from related
party reinsurer. 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 September 30, 1997, the Company had total
cash, cash equivalents and investments of $238.8 million and had 99.7% of its
investment portfolio invested in cash, cash equivalents, and fixed maturities.
In addition, 85.8% of the Company's fixed-income portfolio had ratings of "AA"
or equivalent or better and 98.0% had ratings of "BBB" or equivalent or better.
The Company generated $51.9 million in cash from financing activities for
the nine months ended September 30, 1997, as compared to $2.7 million for the
corresponding period in 1996. The Company substantially increased its financing
activities in the first nine months of 1997 compared to the same period in 1996
because of its need to fund its acquisition in April 1997 of Pac Rim and to
repay outstanding bank debt. The Company generated the necessary cash with the
proceeds from a $44.0 million term loan and the issuance and sale by the Company
of approximately $18.0 million in Common Stock. Of the approximately $62.0
million raised in such financing transactions, approximately $6.6 million was
used to prepay the Company's then outstanding bank debt, $10 million was
contributed as capital to SPCC, and the remainder was used for general corporate
purposes, including the payment of related transaction costs.
During the first nine months of 1997, the Company's working cash flow
increased approximately $44.0 million as a result of the California Department
of Insurance's (the "DOI") release of excess assets pledged by SNIC to secure
future workers' compensation claims. In addition, the Company has been informed
by the DOI that it will release in the fourth quarter of 1997, an additional $20
million of excess assets currently pledged by SPCC to secure future workers'
compensation claims.
In November 1996, the Company entered into a financing transaction
involving Centre Re and 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. 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.
In June 1997, the term loan was retired when $110.5 million of receivables
from Centre Re were transferred to Chase in exchange for cancellation of the
Company's $94.9 million debt due to Chase under the term loan. The retirement of
the term loan resulted in the Company recognizing a $15.7 million charge.
16
<PAGE> 19
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 allows 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 September 30, 1997, the Company had no obligation outstanding
under this facility.
The Company, as a holding company, depends on dividends and intercompany
tax allocation payments from its operating Subsidiaries for its net cash flow
requirements, which consist primarily of periodic payments on its outstanding
debt obligations. Absent other sources of cash flow, the Company 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 DOI.
The California Insurance Code provides that amounts may be paid as dividends on
an annual noncumulative basis (generally up to the greater of (i) net income for
the preceding year and (ii) 10% of statutory surplus as regards policyholders as
of the preceding December 31) without prior notice to, or approval by, the DOI.
Dividends may only be paid out of "earned surplus" as defined in the California
Insurance Code. No dividends were paid during the nine months ended September
30, 1997.
The Company is a party to various leases principally associated with the
Company's home and branch office space. 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 1997, is
approximately $4.1 million. These leases expire from 1997 to 2002.
The Company does not foresee any expenditures during the next twelve months
other than those arising in the normal course of business. The Company is
required to make principal payments on the Chase term loan of $3.65 million
twice per annum commencing October 11, 1997.
The Company made a $10 million capital contribution to SPCC upon
consummation of the acquisition, and management believes SPCC is adequately
capitalized for the foreseeable future. In connection with its acquisition of
SPCC, the Company agreed with the DOI that SPCC would operate in a "run-off"
situation and that all new and renewed business would be written only by SNIC.
As a result, the Company has been integrating SPCC's pre-acquisition operations
into SNIC's operations and has substantially completed the process.
The effect of inflation on the revenues and net income during the three and
nine months ended September 30, 1997 was not significant.
PART II -- OTHER INFORMATION
ITEM 5 -- OTHER INFORMATION
In November 1997, the Company entered into a non-binding letter of intent
with Risk Enterprise Management Limited ("REM"), an affiliate of Zurich
Reinsurance Centre Holdings, Inc. ("Zurich"), that contemplates an agreement
under which certain of the Company's claims management functions would be
performed by REM. In connection with the Company's plan to enter into the claim
management program, the Company and Zurich Reinsurance (North America), Inc.
("ZRNA"), another Zurich affiliate, have signed a non-binding letter of intent
whereby ZRNA would provide average claims severity protection through accident
year 2000 (together, with the claims management program, the "Severity
Management Program"). The total cost of the Severity Management Program to the
Company is expected to be approximately $35.0 million through December 31, 1998,
with amounts thereafter to be determined. While the Company expects that
definitive documents will be completed in the near future, the letters of intent
are not binding on the parties; as a result, there can be no assurance that the
Severity Management Program, if consummated, will take the form outlined in the
letters of intent.
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<PAGE> 20
The letter of intent with REM contemplates that REM would provide certain
claims management services, while the Company would provide claims facilities
and data processing systems. REM would be bound by operational restrictions and
performance standards designed to assure quality claims administration. The
Company believes that combining REM's claims management techniques with its
claims processing systems should produce material improvements in the Company's
claims severity, more than offsetting the cost of such services. The Company
believes that the Severity Management Program will reduce the Company's ultimate
severity with favorable cost-benefit trade-offs.
Under the proposed agreement with ZRNA, ZRNA would credit the Company
direct claims costs by up to $3,500 per claim (up to an aggregate of $30
million) to the extent that the Company's open claims severity through 1997
exceeds $38,700, and for claims incurred after 1997, ZRNA will credit the
Company direct claims costs by as yet undetermined per claim amounts to the
extent that the Company's ultimate claims severity subsequent to 1997 exceeds
expected severity targets. The Company would pay ZRNA $10 million in 1997, an
estimated $10 million in 1998, and as yet unspecified amounts in 1999 and 2000.
ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.1 Employment Agreement, dated June 1, 1997, by and between Mr.
William L. Gentz, President and Chief Executive Officer of
the Company, and the Company+
10.3 Employment Agreement, dated June 1, 1997, by and between J.
Chris Seaman, Executive Vice President and Chief Financial
Officer of the Company, and the Company+
10.40 State of California Department of Insurance Amended
Certificate of Authority+
10.65 Amendment No. 1 to 1997 Credit Agreement, dated as of
September 25, 1997+
11 Computation of Earnings per Share+
27 Financial Data Schedule*
</TABLE>
- ---------------
+ Previously filed as an exhibit to the Company's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1997, as filed with the SEC on November
13, 1997 and incorporated herein by reference.
* Previously filed as an exhibit to the Company's Quarterly Report on Form
10-Q/A (Amendment No. 1) for the quarter ended September 30, 1997, as filed
with the SEC on October 16, 1998 and incorporated herein by reference.
(b) REPORTS ON FORM 8-K:
On July 10, 1997, the Company filed a Current Report on Form 8-K reporting
under Item 5 the prepayment of approximately $88.6 million of long-term debt
outstanding to The Chase Manhattan Bank.
On April 25, 1997, the Company filed a Current Report on Form 8-K with
respect to its April 11, 1997 acquisition of PRHC. Such Form 8-K was filed
without the financial statements and pro forma financial information required by
Item 7 of Form 8-K, as it was impractical to do so at that time. On July 25,
1997, the Company announced that it was investigating the possibility that
errors contained in the historical financial statements of PRHC might have to be
corrected in a filing with the Securities and Exchange Commission. SNIG had
engaged its auditors, KPMG Peat Marwick LLP, to re-audit the financial
statements of PRHC for the years ending December 31, 1996, 1995, and 1994. In
SNIG's view, the financial statements provided to SNIG by PRHC's management and
auditors prior to SNIG's April 11, 1997, acquisition of PRHC used methods and
assumptions that may not have been consistent with generally accepted accounting
principles. On September 5, 1997, the Company filed a Form 8-K/A in order to
amend the Form 8-K filed on April 25, 1997, which included the re-audited
financial statements of PRHC and the other financial statements and pro forma
financial information required by Item 7 of Form 8-K with respect to the
Company's acquisition of PRHC. The net effect of the audit was an overall
adjustment to the December 31, 1996 financial statements of
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<PAGE> 21
PRHC that resulted in an increase in net loss of $7 million and a net decrease
in stockholders' equity of $7 million.
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: November 3, 1998 SUPERIOR NATIONAL INSURANCE
GROUP, INC.
By /s/ J. CHRIS SEAMAN
----------------------------------
Name: J. Chris Seaman
Title: Executive Vice President and
Chief Financial Officer
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