<PAGE> 1
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
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 SEPTEMBER 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)
<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 [X] No [ ]
Number of shares of Common Stock, $0.01 par value per share, outstanding as
of close of business on November 3, 1998: 5,961,497 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 September 30,
1998 (unaudited) and December 31, 1997.................... 3
Condensed consolidated statements of income for the three
and nine months ended September 30, 1998 (unaudited) and
September 30, 1997 (unaudited) (restated)................. 4
Condensed consolidated statement of changes in stockholders'
equity for the nine months ended September 30, 1998
(unaudited) and for the twelve months ended December 31,
1997...................................................... 5
Condensed consolidated statements of cash flows for the nine
months ended September 30, 1998 (unaudited) and September
30, 1997 (unaudited) (restated)........................... 6
Notes to condensed consolidated financial statements
(unaudited)............................................... 7
Item 2. Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations............. 11
PART II. OTHER INFORMATION
Item 5. Other Information........................................... 20
Item 6. Exhibits and Reports on Form 8-K............................ 36
SIGNATURE............................................................ 37
EXHIBIT INDEX
</TABLE>
2
<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)
ASSETS
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
(UNAUDITED) *
<S> <C> <C>
INVESTMENTS
Bonds and notes:
Available-for-sale, at market (cost: 1998, $140,143; 1997,
$203,373)............................................... $143,190 $205,214
Equity securities, at market (cost: 1998, $4,892; 1997,
$1,356)................................................... 4,753 1,526
Short-term investments, at cost............................. 2,330 6,634
Other investments........................................... 50 --
-------- --------
TOTAL INVESTMENTS.................................. 150,323 213,374
Cash and cash equivalents (Restricted cash: 1998, $263;
1997, $651)............................................... 16,882 28,742
Reinsurance recoverable..................................... 82,978 53,082
Premiums receivable (less allowance for doubtful accounts:
1998 and 1997, $800)...................................... 38,119 36,888
Deferred income taxes (less valuation allowance: 1998 and
1997, $8,129)............................................. 20,952 25,104
Prepaid reinsurance premiums................................ 13,377 1,598
Receivable from a related party reinsurer................... 14,070 --
Goodwill.................................................... 34,912 35,887
Prepaid and other........................................... 33,232 34,798
-------- --------
TOTAL ASSETS....................................... $404,845 $429,473
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Claims and claim adjustment expenses........................ $156,206 $201,255
Unearned premiums........................................... 16,939 12,913
Reinsurance payable......................................... 21,607 3,412
Discontinued operations liability........................... 9,480 12,904
Accounts payable and other liabilities...................... 38,051 37,894
-------- --------
TOTAL LIABILITIES.................................. 242,283 268,378
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........... 101,068 101,277
STOCKHOLDERS' EQUITY
Common stock, $0.01 par value; authorized 25,000,000 shares:
issued 5,961,529 shares in 1998 and 5,871,279 shares in
1997...................................................... 60 59
Paid-in capital excess of par............................... 35,622 34,242
Paid-in capital -- warrants................................. 2,206 2,206
Accumulated other comprehensive income;
Unrealized gain on investments, net of taxes.............. 1,919 1,327
Retained earnings........................................... 28,171 21,984
Less: Unearned compensation................................. (1,339) --
Less: 245,000 shares of treasury stock at cost.............. (5,145) --
-------- --------
TOTAL STOCKHOLDERS' EQUITY......................... 61,494 59,818
======== ========
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY......... $404,845 $429,473
======== ========
</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 NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
1998 1997 1998 1997
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
(UNAUDITED) (UNAUDITED) (UNAUDITED) (UNAUDITED)
<CAPTION>
(RESTATED)
<S> <C> <C> <C> <C>
REVENUES:
Premiums written, net of reinsurance ceded................ $11,415 $32,890 $53,495 $ 96,596
Net change in unearned premiums........................... (669) 1,870 7,457 2,552
------- ------- ------- --------
Net premiums earned....................................... 10,746 34,760 60,952 99,148
Net investment income..................................... 3,421 3,723 11,435 9,244
------- ------- ------- --------
TOTAL REVENUES.................................... 14,167 38,483 72,387 108,392
EXPENSES:
Claims and claim adjustment expenses, net of reinsurance
recoveries.............................................. 1,319 21,316 27,638 66,311
Commissions, net of reinsurance ceding commissions........ (6,223) 2,773 (4,756) 9,661
Policyholder dividend expense............................. 96 -- 96 --
Interest expense.......................................... -- 1,158 -- 5,302
General and administrative expenses
Underwriting............................................ 12,146 7,140 29,085 18,101
Loss on termination of financing transaction with a
related party reinsurer............................... -- -- -- 15,699
Other................................................... 254 296 629 817
Goodwill................................................ 336 340 975 477
------- ------- ------- --------
TOTAL EXPENSES.................................... 7,928 33,023 53,667 116,368
------- ------- ------- --------
INCOME (LOSS) BEFORE INCOME TAXES, PREFERRED
SECURITIES DIVIDENDS AND ACCRETION, AND EXTRAORDINARY
ITEMS................................................... 6,239 5,460 18,720 (7,976)
Income tax expense (benefit).............................. 2,271 2,052 6,936 (2,517)
------- ------- ------- --------
INCOME (LOSS) BEFORE PREFERRED SECURITIES DIVIDENDS AND
ACCRETION, AND EXTRAORDINARY ITEMS...................... 3,968 3,408 11,784 (5,459)
Preferred Securities dividends and accretion, net of
income tax.............................................. -- (480) -- (1,387)
Trust Preferred Securities dividends and accretion, net of
income tax.............................................. (1,873) -- (5,597) --
Extraordinary loss on redemption of Pac Rim's debentures,
net of income tax....................................... -- (635) -- (635)
Extraordinary loss on early retirement of Imperial Bank
loan, net of income tax................................. -- (161) -- (161)
------- ------- ------- --------
NET INCOME (LOSS)......................................... $ 2,095 $ 2,132 $ 6,187 $ (7,642)
======= ======= ======= ========
BASIC EARNINGS PER SHARE:
INCOME (LOSS) BEFORE PREFERRED SECURITIES DIVIDENDS AND
ACCRETION, AND EXTRAORDINARY ITEMS...................... $ 0.70 $ 0.58 $ 2.04 $ (1.08)
Preferred securities dividends and accretion.............. (0.33) (0.08) (0.97) (0.27)
Extraordinary items....................................... -- (0.14) -- (0.16)
------- ------- ------- --------
NET INCOME (LOSS)......................................... $ 0.37 $ 0.36 $ 1.07 $ (1.51)
======= ======= ======= ========
DILUTED EARNINGS PER SHARE:
INCOME (LOSS) BEFORE PREFERRED SECURITIES DIVIDENDS AND
ACCRETION, AND EXTRAORDINARY ITEMS...................... $ 0.51 $ 0.44 $ 1.50 $ (0.80)
Preferred securities dividends and accretion.............. (0.24) (0.06) (0.71) (0.20)
Extraordinary items....................................... -- (0.10) -- (0.12)
------- ------- ------- --------
NET INCOME (LOSS)......................................... $ 0.27 $ 0.28 $ 0.79 $ (1.12)
======= ======= ======= ========
</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
--------------
NUMBER OF UNREALIZED PAID-IN COMPREHENSIVE
SHARES COMMON TREASURY GAIN (LOSS) CAPITAL- (LOSS) RETAINED
OUTSTANDING STOCK STOCK ON INVESTMENTS WARRANTS INCOME EARNINGS
----------- ------- -------- -------------- -------- ------------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31,
1996....................... 3,446,492 $16,022 $ -- $ (162) $2,206 $27,125
Comprehensive income
Net income................. -- -- -- -- -- $(5,141) (5,141)
-------
Other comprehensive
income, net of tax
Change in unrealized gain
(loss) on
investments............ -- -- -- 1,489 -- 1,489 --
-------
Other comprehensive
income................... 1,489
-------
Comprehensive loss........... $(3,652)
=======
Common stock issued.......... 2,390,438 18,000 -- -- -- --
Stock issued under stock
option plan................ 22,127 105 -- -- -- --
Common stock issued under
stock incentive plan....... 12,222 174 -- -- -- --
--------- ------- ------- ------ ------ -------
Balance at December 31,
1997....................... 5,871,279 34,301 -- 1,327 2,206 21,984
--------- ------- ------- ------ ------ -------
Comprehensive income Net
income..................... -- -- -- -- -- 6,187 6,187
-------
Other comprehensive
income, net of tax
Change in unrealized gain
(loss) on
investments............ -- -- -- 592 -- 592 --
-------
Other comprehensive
income................... 592
-------
Comprehensive income......... $ 6,779
=======
Common stock issued.......... -- -- -- -- -- --
Stock issued under stock
option plan................ 6,570 42 -- -- -- --
Common stock issued under
stock incentive plan....... 83,680 1,339 -- -- -- --
Treasury stock............... (245,000) -- (5,145) -- -- --
--------- ------- ------- ------ ------ -------
Balance at September 30,
1998....................... 5,716,529 $35,682 $(5,145) $1,919 $2,206 $28,171
========= ======= ======= ====== ====== =======
<CAPTION>
TOTAL
UNEARNED STOCKHOLDERS'
COMPENSATION EQUITY
------------ -------------
<S> <C> <C>
Balance at December 31,
1996....................... $ -- $45,191
Comprehensive income
Net income................. -- (5,141)
Other comprehensive
income, net of tax
Change in unrealized gain
(loss) on
investments............ -- 1,489
Other comprehensive
income...................
Comprehensive loss...........
Common stock issued.......... -- 18,000
Stock issued under stock
option plan................ -- 105
Common stock issued under
stock incentive plan....... -- 174
------- -------
Balance at December 31,
1997....................... -- 59,818
------- -------
Comprehensive income Net
income..................... -- 6,187
Other comprehensive
income, net of tax
Change in unrealized gain
(loss) on
investments............ -- 592
Other comprehensive
income...................
Comprehensive income.........
Common stock issued.......... -- --
Stock issued under stock
option plan................ -- 42
Common stock issued under
stock incentive plan....... (1,339) --
Treasury stock............... -- (5,145)
------- -------
Balance at September 30,
1998....................... $(1,339) $61,494
======= =======
</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>
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
1998 1997
--------- ----------
(RESTATED)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)........................................... $ 6,187 $ (7,642)
--------- --------
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Amortization of bonds and preferred stock................. 17 (1,004)
Amortization of investments withheld from reinsurer....... 24 --
Amortization of capital lease obligation.................. (1,123) --
(Gain) loss on sale of investments........................ (1,781) 95
Loss on termination of financing transaction with a
related party reinsurer................................. -- 15,699
Extraordinary loss........................................ -- 796
Amortization of goodwill.................................. 975 477
Interest expense on long-term debt........................ -- 4,225
Preferred securities dividends and accretion.............. 5,600 1,387
Increase in reinsurance receivables....................... (29,896) (25,593)
Increase in premiums receivable........................... (1,231) (446)
Increase in other assets.................................. (6,593) (4,840)
Decrease (increase) in deferred income taxes.............. 6,732 (2,517)
Decrease (increase) in funds held by reinsurer............ 159 (1,867)
Increase in prepaid reinsurance premiums.................. (11,779) (5,278)
Decrease in claims and claim adjustment expense
reserves................................................ (45,049) (979)
Increase (decrease) in unearned premium reserves.......... 4,026 (1,573)
Increase in reinsurance payable........................... 18,195 8,959
Decrease in accounts payable and other liabilities........ (7,414) (6,354)
--------- --------
Total adjustments....................................... (69,138) (18,813)
--------- --------
Net cash used in operating activities................... (62,951) (26,455)
--------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Paid-in-capital -- stock options.......................... 42 106
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)
Prepayment penalty on early retirement of long-term
debt.................................................... -- (244)
Receivable from a related party reinsurer................. (14,070) --
Purchase of treasury stock................................ (5,145) --
--------- --------
Net cash (used in) provided by financing activities..... (19,173) 51,869
--------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of bonds and notes:
Investments available-for-sale.......................... (171,146) (93,936)
Purchase of equity security............................... (101,877) (145)
Acquisition of Pac Rim.................................... -- (44,016)
Investments and cash for discontinued operations.......... (3,424) (3,225)
Investment in partnership................................. (50) --
Sale of property, plant and equipment..................... 8,000 --
Sales of bonds and notes: Investments
available-for-sale...................................... 197,629 37,906
Maturities of bonds and notes: Investments
available-for-sale...................................... 38,215 8,771
Sale of equity securities................................. 98,399 517
Net decrease in short-term investments.................... 4,518 59,901
--------- --------
Net cash provided by (used in) investing activities..... 70,264 (34,227)
--------- --------
Net decrease in cash.................................... (11,860) (8,813)
Cash and cash equivalents at beginning of period............ 28,742 34,423
--------- --------
Cash and cash equivalents at end of period.................. $ 16,882 $ 25,610
========= ========
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes................ $ 206 $ 4
========= ========
Cash paid during the year for interest.................... $ 5,614 $ 1,124
========= ========
</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 NINE MONTHS ENDED SEPTEMBER 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 nine months ended September 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.
7
<PAGE> 8
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
(UNAUDITED)
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.
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 nine months ended September 30, 1998 and September 30, 1997:
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30, 1998 NINE MONTHS ENDED SEPTEMBER 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.................... $11,784 5,779,978 $ 2.04 $(5,459) 5,045,255 $(1.08)
Preferred Securities....... (5,597) (0.97) (1,387) (0.27)
Extraordinary items........ -- -- (796) (0.16)
------- ------ ------- ------
Net Income................. $ 6,187 $ 1.07 $(7,642) $(1.51)
======= ====== ======= ======
EFFECT OF DILUTIVE SECURITIES
Options.................... 383,236 329,309
Warrants................... 1,674,783 1,464,379
DILUTED EPS
Income before items
below.................... $11,784 7,837,997 $ 1.50 $(5,459) 6,838,943 $(0.80)
Preferred Securities....... (5,597) (0.71) (1,387) (0.20)
Extraordinary items........ -- -- (796) (0.12)
------- ------ ------- ------
Net Income................. $ 6,187 $ 0.79 $(7,642) $(1.12)
======= ====== ======= ======
</TABLE>
8
<PAGE> 9
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
(UNAUDITED)
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 September 30, 1998 and September 30, 1997:
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30, 1998 THREE MONTHS ENDED SEPTEMBER 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.................... $ 3,968 5,632,507 $ 0.70 $3,408 5,851,858 $ 0.58
Preferred Securities....... (1,873) (0.33) (480) (0.08)
Extraordinary items........ -- -- (796) (0.14)
------- ------ ------ ------
Net Income................. $ 2,095 $ 0.37 $2,132 $ 0.36
======= ====== ====== ======
EFFECT OF DILUTIVE SECURITIES
Options.................... 390,721 348,333
Warrants................... 1,689,448 1,526,428
DILUTED EPS
Income before items
below.................... $ 3,968 7,712,676 $ 0.51 $3,408 7,726,619 $ 0.44
Preferred Securities....... (1,873) (0.24) (480) (0.06)
Extraordinary items........ -- -- (796) (0.10)
------- ------ ------ ------
Net Income................. $ 2,095 $ 0.27 $2,132 $ 0.28
======= ====== ====== ======
</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.
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
9
<PAGE> 10
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
(UNAUDITED)
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
Agreement with All American Life Insurance Company, rated "A+" by A.M. Best,
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 initially received a 35.0% ceding
commission on premiums ceded under this contract; however, the ceding commission
was amended to 34.5% effective May 1, 1998. This agreement will expire on
January 31, 1999. Effective May 1, 1998, a Quota-Share Agreement was entered
into with United States Life Insurance Company, rated "A+" by A.M. Best, under
which Superior Pacific ceded 100% of premiums and claim and claim adjustment
expenses associated with policies written through January 31, 1999 having at
least an estimated annual premium of $25,000 but less than $100,000. Superior
Pacific received a 33.5% ceding commission on premiums ceded under this
contract. This agreement will include policies having a minimum of estimated
annual premium of $25,000 and greater effective February 1, 1999. The term of
the May 1, 1998 agreement is three years, with two one-year extensions. This
agreement plays an important role in the Company's strategy going forward. These
two Quota-Share Agreements will be collectively referred to as "Large Account
Quota-Share."
NOTE B. DISCONTINUED OPERATIONS
Outstanding discontinued operations claim and claim adjustment expense
reserves were $14.3 million at September 30, 1998, which was consistent with
management's expectations. Offsetting these liabilities are $4.9 million of
reinsurance recoverable on paid and unpaid claim and claim adjustment expenses.
NOTE C. RESTATEMENT OF PRIOR PERIOD
The Condensed Consolidated Statement of Cash Flows and the Condensed
Consolidated Statement of Operations for the nine months ended September 30,
1997 were subsequently restated from that included in the Company's original
Form 10-Q filed on November 13, 1997. A reconciliation of this restatement can
be found in the Form 10-Q/A (Amendment No. 2) for the quarter ended September
30, 1997, filed on November 3, 1998.
10
<PAGE> 11
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 pending acquisition of
Business Insurance Group, Inc. ("BIG"), inherent uncertainties in estimating
claim and claim adjustment expense reserves (particularly in light of
industry-wide increases in claim severity in recent periods), 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
$8.9 million in the nine month period ended September 30, 1998, versus an
underwriting profit of $5.1 million, excluding a loss on the termination of a
financing transaction with a related party reinsurer (namely, Centre Reinsurance
Limited ("Centre Re")) in the corresponding period in the prior year. The
increase in underwriting profit from continuing operations was primarily the
result of the decrease in claim and claim adjustment expense due to the
recognition of $5.0 million of favorable development during the third quarter of
1998 on prior accident years' reserves. Also contributing to the 1998
underwriting profit was the decrease in net underwriting and general and
administrative expenses due to ceded commissions related to the Large Account
Quota-Share. During the nine months ended September 30, 1998, the Company
realized net income of $6.2 million or $0.79 per share on a diluted basis as
compared to a loss of $7.6 million or $1.12 per share on a diluted basis for the
nine months ended September 30, 1997. In addition to improved underwriting
profit, net income increased due to a $2.2 million increase in investment
income, which resulted from a $1.7 million increase in realized gains as
compared to 1997 and an increase in the average investable 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 $15.7 million charge due to the termination
of the financing transaction with Centre Re.
GENERAL FINANCIAL CONDITION
Total assets decreased by $24.6 million or 5.7% to $404.8 million for the
nine months ended September 30, 1998. The decrease is due to a $66.6 million
reduction of cash, investments, and investments withheld from reinsurer used
primarily to fund operations, a $5.1 million reduction in deferred policy
acquisition costs, and a $4.2 million decrease in deferred income taxes. These
reductions were partially offset by a $25.8 million increase in prepaid
reinsurance premiums and a $29.9 million increase in reinsurance recoverables.
Total liabilities decreased by $26.3 million or 7.1% to $343.4 million for
the nine months ended September 30, 1998. The decrease is principally due to a
$45.0 million reduction in claim and claim adjustment expense reserves, which is
partially offset by a $18.2 million increase in reinsurance payables associated
with the Large Account Quota-Share as discussed below in "Results of
Operations."
Total equity increased by $1.7 million or 2.8% to $61.5 million for the
nine months ended September 30, 1998. This increase primarily consists of $6.8
million in comprehensive income offset by $5.1 million paid by
11
<PAGE> 12
SNIC to purchase 245,000 shares of SNIG's common stock ("Common Stock"), which
are held by SNIC as an investment and are treated as treasury stock on a GAAP
basis.
RESULTS OF OPERATIONS
Effective February 1, 1998, Superior Pacific entered into an unrelated
Quota-Share Agreement with All American Life Insurance Company, rated "A+" by
A.M. Best, 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 initially received a 35.0% ceding
commission on premiums ceded under this contract; however, the ceding commission
was amended to 34.5% effective May 1, 1998. This agreement will expire on
January 31, 1999. Effective May 1, 1998, a Quota-Share Agreement was entered
into with United States Life Insurance Company, rated "A+" by A.M. Best, under
which Superior Pacific ceded 100% of premiums and claim and claim adjustment
expenses associated with policies written through January 31, 1999 having at
least an estimated annual premium of $25,000 but less than $100,000. Superior
Pacific received a 33.5% ceding commission on premiums ceded under this
contract. This agreement will include policies having a minimum of estimated
annual premium of $25,000 and greater effective February 1, 1999. The term of
the May 1, 1998 agreement is three years, with two one-year extensions. This
agreement plays an important role in the Company's strategy going forward. These
two Quota-Share Agreements will be collectively referred to as ("the Large
Account Quota-Share").
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 September 30, 1998,
as compared to the three months ended September 30, 1997. Certain prior period
amounts have been reclassified to conform to the current period presentation.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
SEPTEMBER 30,
----------------------
1998 1997
--------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Gross written premium....................................... $54,234 $43,121
Net written premium......................................... $11,415 $32,890
Net premium earned.......................................... $10,746 $34,760
Net claim and claim adjustment expenses..................... 1,319 21,316
Net underwriting and general and administrative expenses.... 5,923 9,913
Policyholder dividend expense............................... 96 --
------- -------
Underwriting profit......................................... $ 3,408 $ 3,531
Net investment income....................................... 3,421 3,723
Underwriting ratios (GAAP Basis) Claims and claim adjustment
expense ratio............................................. 12.3% 61.3%
Underwriting expense ratio.................................. 55.1% 28.5%
Policyholder dividends ratio................................ 0.9% --
------- -------
Combined ratio.............................................. 68.3% 89.8%
======= =======
</TABLE>
Gross written premium increased $11.1 million or 25.8% to $54.2 million in
the third quarter of 1998 as compared to the same period in 1997. This increase
is primarily due to the underwriting of a new large account in July 1998. Net
written premium decreased $21.5 million or 65.3% to $11.4 million in the third
quarter of 1998 as compared to the same period in 1997. This decrease is
primarily due to $38.3 million of reinsurance premium ceded under the Large
Account Quota-Share, offset by the increase in gross written premium in
12
<PAGE> 13
1998 and a decrease of $7.0 million in reinsurance premium ceded related to SPCC
run-off operations in 1998 as compared to the 1997 period. Net premium earned
decreased $24.0 million or 69.1% to $10.7 million in the third 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 $20.0 million or 93.8% to
$1.3 million in the third quarter of 1998 as compared to the same period in
1997. This decrease consists of a $32.6 million increase in ceded claim and
claim adjustment expense related to the Large Account Quota-Share, offset by a
$12.6 million increase in net claim and claim adjustment expense (excluding the
Large Account Quota-Share). The $12.6 million increase in net claim and claim
adjustment expense (excluding the Large Account Quota-Share) is primarily due a
$15.9 million increase in ceded claim and claim adjustment expense recorded in
the third quarter of 1997, mainly related to the SPCC acquisition, but not
present in the 1998 period. Partially offsetting the $15.9 million increase is
the recognition of $5.0 million favorable development on gross claim and claim
adjustment expense during the third quarter of 1998 on prior accident years'
reserves. The net claim and claim adjustment expense ratio decreased to 12.3% in
the third quarter of 1998 from 61.3% in the same period of 1997. This decrease
in the net claim and claim adjustment expense ratio is due to the recognition of
$5.0 million of favorable development during the third quarter of 1998 on prior
accident years' reserves applied to net premiums earned that were significantly
reduced by the Large Account Quota-Share.
Underwriting and general and administrative expenses increased $5.0 million
or 70.1% to $12.1 million in the third quarter of 1998, as compared to the same
period in 1997. This increase is primarily due to the increase in written
premium as a result of the Large Account program. Net commission expense
decreased $9.0 million or 324.4% to $(6.2) million in the third quarter of 1998,
as compared to the same period in 1997. The decrease in net commission expense
is mainly due to $11.5 million in ceded commission related to the Large Account
Quota-Share and partially offset by an increase in gross commission expense
related to the increase in gross written premium. Net underwriting and general
and administrative expenses decreased 40.3% to $5.9 million in the third quarter
of 1998 from $9.9 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 26.6 percentage points to 55.1% for the
third quarter of 1998 from 28.5% 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.
Policyholder dividend expense is $0.1 million in the third quarter of 1998,
as compared to zero in the same period in 1997. The $0.1 million in policyholder
dividend expense is an accrual relating to Arizona policies written in the
current year.
The Company recorded an underwriting profit from continuing operations of
$3.4 million in the third quarter of 1998, which is consistent with an
underwriting profit of $3.5 million for the same period in 1997.
Net investment income, excluding realized investment gains, decreased $1.0
million or 27.7% to $2.7 million in the third quarter of 1998 compared to the
same period in 1997. This decrease was due to a decrease in average investable
assets of $53.7 million in 1998 as a result of cash outflows relating to the
Large Account Quota-Share.
No interest expense was incurred in the third quarter of 1998 as compared
to $1.2 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 third 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.
13
<PAGE> 14
The following selected financial data and analysis provide an assessment of
the Company's financial results for the nine months ended September 30, 1998, as
compared to the nine months ended September 30, 1997. Certain prior period
amounts have been reclassified to conform to the current period presentation.
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
1998 1997
--------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Gross written premium....................................... $136,185 $114,211
Net written premium......................................... $ 53,495 $ 96,596
Net premium earned.......................................... $ 60,952 $ 99,148
Net claim and claim adjustment expenses..................... 27,638 66,311
Net underwriting and general and administrative expenses.... 24,329 27,762
Policyholder dividend expense............................... 96 --
-------- --------
Underwriting profit (loss).................................. $ 8,889 $ 5,075
Net investment income....................................... 11,435 9,244
Underwriting ratios (GAAP Basis) Claims and claim adjustment
expense ratio............................................. 45.3% 66.9%
Underwriting expense ratio.................................. 39.9% 28.0%
Policyholder dividends ratio................................ 0.2% 0.0%
-------- --------
Combined ratio.............................................. 85.4% 94.9%
======== ========
</TABLE>
Gross written premium increased $22.0 million or 19.2% to $136.2 million in
the first nine months of 1998 as compared to the same period in 1997.
Substantially all of this increase can be attributed to nine months of
additional business written in 1998 due to the SPCC acquisition as opposed to
six months of additional business written in 1997. The 1998 increase is also
attributable to the underwriting of a new large account, which was then ceded
under the Large Account program. Net written premium decreased $43.1 million or
44.6% to 53.5 million in the first nine months of 1998 as compared to the same
period in 1997. This decrease is primarily due to $69.9 million in premiums
ceded under the Large Account Quota-Share, which is partially offset by a $22.0
million increase in gross written premiums. Net premium earned decreased $38.2
million or 38.5% to $61.0 million in the first nine 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 $38.7 million or 58.3% to
$27.6 million in the first nine months of 1998 as compared to the same period in
1997. This decrease primarily reflects a $50.3 million in ceded claim and claim
adjustment expense related to the Large Account Quota-Share, offset by a $11.6
million increase in net claim and claim adjustment expense (excluding the Large
Account Quota-Share). The $11.6 million increase in net claim and claim
adjustment expense (excluding the Large Account Quota-Share) is primarily due to
a $20.3 million increase in ceded claim and claim adjustment expense recorded in
third quarter of 1997, related to the SPCC acquisition, but not present in the
1998 period. Partially offsetting the $20.3 million increase is the recognition
of $5.0 million favorable development on gross claim and claim adjustment
expense during the third quarter of 1998 on prior accident years' reserves. The
net claim and claim adjustment expense ratio decreased to 45.3% in the first
nine months of 1998 from 66.9% in the same period of 1997. This decrease in the
net claim and claim adjustment expense ratio is due to the recognition of $5.0
million of favorable development in the third quarter of 1998 on prior accident
years' reserves applied to net premiums earned that were significantly reduced
by the Large Account Quota-Share.
Underwriting and general and administrative expenses, excluding the loss on
the termination of a financing transaction with a related party reinsurer
(namely, Centre Re), increased $11.0 million or 60.7% to $29.1 million in the
first nine months of 1998, as compared to the same period in 1997. This increase
is primarily due to the increase in written premium as a result of the Large
Account program, as well as, the acquisition of SPCC. It is also partially due
to a $1.8 million expense related to the ZRNA Commutation. Net commission
expense decreased $14.4 million or 149.2% to ($4.8) million in the first nine
months of 1998, as compared to the same period in 1997. The decrease in net
commission expense is mainly due to $18.1 million
14
<PAGE> 15
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 written premium. Net underwriting and general and administrative expenses
decreased 12.4% to $24.3 million in the first nine months of 1998 from $27.8
million in the same period of 1997, reflecting the changes discussed above.
Policyholder dividend expense is $0.1 million in the first nine months of
1998, as compared to zero in the same period in 1997. The $0.1 million in
policyholder dividend expense is an accrual relating to Arizona policies written
in the current year.
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 $8.9 million in the first nine months of 1998, versus
$5.1 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 along with the decrease in underwriting and general and
administrative expenses as discussed above.
Net investment income, excluding realized investment gains, increased $0.5
million or 5.0% to $9.7 million in the first nine 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 $5.1 million or 55.1% to $4.1
million in the first nine months of 1998 as compared to the same period in 1997.
This 55.1% decrease was due to a decrease in the average investable asset of
$9.1 million as compared to the same period in 1997. The decrease in the average
investable asset is primarily due to negative cash flows as a result of the
Large Account Quota-Share arrangement and accelerated rate of claim payments for
the Workers' Compensation operations.
No interest expense was incurred in the first nine months of 1998 as
compared to $5.3 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.
In June 1997, the Company recorded a $15.7 million charge related to the
termination of a financing transaction with Centre Re, a related party
reinsurer. The termination of the financing transaction transferred $110.5
million in receivables from Centre Re in exchange for the cancellation of $94.9
million in indebtedness to The Chase Manhattan Bank. No such charges were
incurred in the 1998 period.
Distributions and accretion on preferred securities increased by $6.4
million to $8.5 million in the first nine 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 nine months ended September 30, 1998 and 1997 is as follows (in
thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
1998 1997 1998 1997
------- ------- ------- ------
<S> <C> <C> <C> <C>
Interest on bonds and notes.................... $2,652 $3,234 $ 9,337 $6,032
Interest on short-term investments, cash and
cash equivalents............................. 189 662 707 3,714
Other.......................................... 79 -- 222 --
------ ------ ------- ------
Total investment income.............. 2,920 3,896 10,266 9,746
Capital gains.................................. 752 27 1,781 46
Investment expense............................. 251 200 612 548
------ ------ ------- ------
Net investment income................ $3,421 $3,723 $11,435 $9,244
====== ====== ======= ======
</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
15
<PAGE> 16
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, 1998 was 3.02 years compared to 2.90 years at December 31, 1997. At
September 30, 1998, 100% 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
Discontinued operations had claim and claim adjustment expense reserves of
$14.3 million as of September 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 loss costs 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 $4.9 million in reinsurance
recoverable on paid and unpaid 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 sufficient 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, and
based on the expectation that the financing transactions in connection with the
previously announced Acquisition of Business Insurance Group, Inc. will be
completed, management believes that the Company's present cash resources are
sufficient to meet the needs of the Company for the foreseeable future.
Nine Month Comparison
During the first nine months of 1998, the Company used $63.0 million of
cash in its operations versus cash used of $26.5 million during the same period
in 1997. This $36.5 million increase in cash used is primarily due to the ceded
premiums paid related to the Large Account Quota-Share and also the addition of
SPCC's operations beginning April 1, 1997. The Company's continued negative cash
flow is also the result of the Company's historical in force premium bases 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 Quota-Share Arrangement for large accounts will increase negative cash flow
substantially. Although the Company has implemented its Claim Severity
Management Program to control cash outflows related to the 1995 and 1996
accident years at acceptable levels, 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 September 30, 1998, the Company had total
cash, cash equivalents, investments and investments held from reinsurers of
$175.5 million and had 92.5% of its investment portfolio invested in cash, cash
equivalents, short-term
16
<PAGE> 17
investments and fixed maturities. In addition, 98.0% of the Company's
fixed-income portfolio had ratings of "AA" or equivalent or better and 100% had
ratings of "BBB" or equivalent or better.
The Company used $19.2 million in cash from financing activities for the
nine months ended September 30, 1998, and generated $51.9 million for the
corresponding period in 1997. During the nine months ended September 30, 1998,
funds used for financing activities consisted of $14.1 million in receivable
from a related party reinsurer, and $5.1 million to purchase 245,000 shares of
Common Stock, which are held by SNIC as an investment and treated as treasury
stock on a GAAP basis. The Common Stock acquired by SNIC was purchased in a
single transaction from Thomas J. Jamieson, a director of the Company, and Jaco
Oil Company, an entity controlled by Mr. Jamieson. The purchase price of $21.00
per share represented a discount from the market price of the Common Stock at
the time of the transaction. The Company's Board of Directors, with disclosure
of the conflicts of interest, unanimously approved SNIC's purchase of Common
Stock. The cash generated by financing activities in the first nine months of
1997 was primarily associated with the Company's acquisition of SPCC. The
Company generated the necessary cash to acquire SPCC from the proceeds of a
$44.0 million term loan and the sale of approximately $18.0 million in Common
Stock. Of the approximately $62.0 million raised in those financing
transactions, approximately $42.0 million was used to fund the acquisition of
SPCC, approximately $6.6 million was used to repay an existing bank loan, $10.0
million was contributed as capital to SPCC, and the remaining funds were used
for general corporate purposes, including the payment of related transaction
costs.
Other Events
On December 3, 1997, Superior National Capital Trust I (the "Trust"), a
wholly owned subsidiary of the Company, issued its 10 3/4% Trust Preferred
Securities (the "Trust Preferred Securities"), having an aggregate liquidation
amount of $105.0 million, in a private placement, and also issued to the
Company, 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 by the Trust to purchase the Company'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 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, the Company
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. The
Company 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 Company 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, set forth in the Indenture pursuant to which the Senior
Subordinated Notes were issued (the "Subordinated Notes Indenture"), on or after
December 1, 2005, the Company 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
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, the Company 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 Subordinated Notes 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 the Company 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).
17
<PAGE> 18
Upon the termination of any Extension Period and the payment of all amounts then
due, the Company may commence a new Extension Period, subject to certain
requirements.
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, 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.
The Company has a reverse repurchase facility with a national securities
brokerage firm that allows it to engage in up to $20.0 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, 1998, 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 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,
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 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 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 by SPCC or SNIC
during 1997; however, SNIC paid $2.9 million to the Company for its current
income taxes. No dividends were paid during the nine months ended September 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 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 several 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 lease commitment with respect to these
leases in 1998, is approximately $7.8 million. These leases expire from year
2000 to 2003.
With the exception of the approximately $285.0 million in cash outlays
necessary to complete the Company's proposed acquisition of BIG, together with
fees and costs related thereto, the Company does not foresee any material
expenditures during the next twelve months other than those arising in the
ordinary course of business. See Part II -- Item 5 -- Other Information.
The effect of inflation on the Company's revenues and net income during the
nine months ended September 30, 1998 was not significant.
18
<PAGE> 19
TAXES
As of September 30, 1998, the Company had available approximately $125.5
million in net operating loss carryforwards ("NOLs") to offset taxable income
recognized by the Company in periods after September 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 has obtained
stockholder approval of a proposal to eliminate these restrictive charter
provisions at the Company's 1998 Annual Meeting of Stockholders, and such
provisions will be eliminated at the closing of the BIG acquisition.
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 and hardware 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.
19
<PAGE> 20
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
$256.5 million in cash ($285.0 million less the cost of a Loss Reserves
Guarantee (described below) provided through reinsurance) (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, a California stock insurance company, Business Insurance
Company, a Delaware stock insurance company, Combined Benefits Insurance
Company, a California stock insurance company, and Commercial Compensation
Insurance Company, a New York stock insurance company, writes workers'
compensation and group health insurance, principally in California, with branch
operations throughout the continental United States. The Company will offset the
reduction in BIG's surplus resulting from the cost of reinsurance for the Loss
Reserves Guarantee with a capital contribution to BIG, so the total cash outlays
by the Company in connection with the Acquisition will be $285.0 million,
excluding transaction expenses.
In connection with the Acquisition, FHC will provide a "Loss Reserve
Guarantee" through the purchase of reinsurance, which will provide $175 million
of adverse development protection on BIG's loss and loss adjustment expense
reserves. The Loss Reserve Guarantee will be obtained by FHC at FHC's cost. The
reinsurance policy will be procured by BIG's insurance subsidiaries and its cost
will be deducted from the purchase price payable to FHC. The Company anticipates
contributing to the capital of the BIG insurance subsidiaries an amount equal to
the cost of the reinsurance policy. Each of the Company and BIG has also 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 of senior debt financing in an aggregate principal amount of up to
$110.0 million through a credit facility or other borrowing arrangement with a
lender or lenders. On November 4, 1998, the Company and Chase Manhattan Bank and
Chase Securities, Inc. ("Chase") signed a Commitment Letter under which Chase
committed to provide the Company with a $110 million term loan (the "Senior Debt
Financing") and a $15 million revolving credit facility. 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, each as defined below) 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 Debt Financing 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.
20
<PAGE> 21
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 state insurance regulatory authorities in California, Delaware and New York.
In addition, the Stock Offering and the IP Stock Issuance were approved by the
stockholders at the 1998 Annual Meeting of Stockholders held on November 3,
1998. Furthermore, the holders of the Trust Preferred Securities are required to
consent to the Senior Debt Financing, and such consent is expected to be
obtained. The Company anticipates that the Acquisition will be consummated in
early December 1998.
The following financial information is presented with respect to the
Acquisition. Any review of the terms and circumstances of the Acquisition should
be read in conjunction with the risk factors contained in the Company's
Amendment No. 3 to Form S-1 on Form S-3 Registration Statement (No. 333-58579),
filed with the Securities and Exchange Commission on November 4, 1998, and the
certain considerations contained in the Company's definitive Proxy Statement,
filed with the Securities and Exchange Commission on October 16, 1998. Copies of
each of these documents are available from the Company.
21
<PAGE> 22
THE INSURANCE OPERATIONS OF
BUSINESS INSURANCE GROUP, INC.
CONDENSED COMBINED BALANCE SHEETS
(IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
(UNAUDITED)
<S> <C> <C>
Invested Assets:
Bonds, available-for-sale, at fair value.................. $ 228,265 $ 611,163
Bonds, held-to-maturity, at amortized cost................ 9,488 14,059
Real estate............................................... 29,332 29,821
Note from parent.......................................... 10,000 10,000
---------- ----------
Total invested assets............................. 277,085 665,043
Cash and cash equivalents................................... 477,810 98,128
Reinsurance recoverable:
Paid loss and loss adjustment expenses.................... 2,983 18,518
Unpaid loss and loss adjustment expenses.................. 306,920 206,871
Premiums receivable -- net.................................. 78,296 80,008
Earned but unbilled premiums receivable..................... 14,379 24,401
Accrued investment income................................... 7,254 10,605
Receivable from reinsurer................................... -- 4,132
Deferred policy acquisition costs........................... 22,790 23,841
Income taxes receivable from parent......................... 15,238 40,857
Deferred income taxes....................................... 17,887 15,807
Goodwill.................................................... 13,673 14,266
Property & equipment, net................................... 14,731 14,556
Prepaid reinsurance premiums................................ 19,480 --
Prepaid expenses and other assets........................... 7,119 5,373
---------- ----------
Total assets...................................... $1,275,645 $1,222,406
========== ==========
LIABILITIES AND STOCKHOLDER'S EQUITY
LIABILITIES
Loss and loss adjustment expenses......................... $ 675,705 $ 728,421
Unearned premiums......................................... 48,068 45,004
Reinsurance payable....................................... 116,272 28,027
Long-term debt due to parent.............................. 121,750 121,750
Policyholder dividends.................................... 5,473 3,015
Accounts payable and other liabilities.................... 55,376 43,843
---------- ----------
Total liabilities................................. 1,022,644 970,060
Stockholder's equity:
Invested capital.......................................... 247,879 247,476
Accumulated other comprehensive income.................... 5,122 4,870
---------- ----------
TOTAL STOCKHOLDER'S EQUITY........................ 253,001 252,346
========== ==========
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY........ $1,275,645 $1,222,406
========== ==========
</TABLE>
See notes to condensed combined financial statements.
22
<PAGE> 23
THE INSURANCE OPERATIONS OF
BUSINESS INSURANCE GROUP, INC.
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
CONDENSED COMBINED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
1998 1997 1998 1997
<S> <C> <C> <C> <C>
REVENUES:
Net premiums earned................................ $39,566 $127,084 $255,477 $373,366
Net investment income.............................. 8,980 9,157 27,195 28,440
Net realized gain on investments................... 5,982 397 6,257 681
Other income....................................... 302 1,262 402 2,790
------- -------- -------- --------
TOTAL REVENUES............................. 54,830 137,900 289,331 405,277
EXPENSES:
Losses and loss adjustment, net of reinsurance
recoveries...................................... 41,229 85,930 223,614 262,278
Underwriting expenses.............................. (2,083) 40,101 61,073 110,138
Policyholder dividends............................. 2,335 -- 4,098 --
Interest........................................... 2,359 2,054 7,077 6,270
Goodwill........................................... 141 250 588 477
------- -------- -------- --------
TOTAL EXPENSES............................. 43,981 128,335 296,450 379,163
------- -------- -------- --------
Income (loss) before income taxes.................... 10,849 9,565 (7,119) 26,114
Income tax benefit (expense)......................... (2,669) (1,300) 7,522 (3,425)
------- -------- -------- --------
NET INCOME................................. $ 8,180 $ 8,265 $ 403 $ 22,689
======= ======== ======== ========
Other comprehensive income, net of tax:
Unrealized loss on available-for-sale investments,
net of deferred taxes........................... 1,238 4,587 252 4,403
------- -------- -------- --------
COMPREHENSIVE INCOME....................... $ 9,418 $ 12,852 $ 655 $ 27,092
======= ======== ======== ========
</TABLE>
See notes to condensed combined financial statements.
23
<PAGE> 24
THE INSURANCE OPERATIONS OF
BUSINESS INSURANCE GROUP, INC.
CONDENSED COMBINED STATEMENT OF CHANGES IN STOCKHOLDER'S EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND TWELVE MONTHS ENDED DECEMBER 31, 1997
(IN THOUSANDS)
ACCUMULATED OTHER COMPREHENSIVE INCOME
<TABLE>
<CAPTION>
TOTAL
INVESTED COMPREHENSIVE STOCKHOLDER'S
CAPITAL INCOME (LOSS) EQUITY
------------ ------------- -------------
<S> <C> <C> <C>
BALANCE AT DECEMBER 31, 1996............................ $266,093 $267,892
Comprehensive loss
Net loss.............................................. (30,641) $(30,641) (30,641)
Unrealized gain on available-for-sale investments, net
of deferred taxes.................................. -- 3,071 3,071
--------
Comprehensive loss...................................... -- $(27,570) --
========
Capital contributions................................. 12,024 12,024
-------- --------
BALANCE AT DECEMBER 31, 1997............................ 247,476 252,346
-------- --------
Comprehensive loss
Net loss.............................................. 403 $ 403 403
Unrealized loss on available-for-sale investments, net
of deferred taxes.................................. 252 252
--------
Comprehensive loss...................................... -- $ 655 --
-------- ======== --------
BALANCE AT SEPTEMBER 30, 1998 (UNAUDITED)............... $247,879 $253,001
======== ========
</TABLE>
See notes to condensed combined financial statements.
24
<PAGE> 25
THE INSURANCE OPERATIONS OF
BUSINESS INSURANCE GROUP, INC.
CONDENSED COMBINED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------------
1998 1997
--------- ---------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................ $ 403 $ 22,689
Adjustments to reconcile net income to net cash provided
by (used in) operating activities:
Amortization of bonds.................................. 3,778 3,020
Depreciation on real estate............................ 489 489
Depreciation on property, plant & equipment............ 2,835 2,122
Loss (gain) on sale of investments..................... (6,257) (681)
Amortization of goodwill and intangible assets......... 593 799
(Increase) decrease in reinsurance recoverables........ (84,514) (54,033)
(Increase) decrease in premiums receivable............. 1,712 (2,817)
(Increase) decrease in earned but unbilled
receivables........................................... 10,022 2,147
(Increase) decrease in accrued investment income....... 3,351 2,159
(Increase) decrease in receivable from insurer......... 4,132 --
(Increase) decrease in deferred policy acquisition
costs................................................. 1,051 (8,750)
(Increase) decrease in income taxes receivable......... 25,619 3,232
(Increase) decrease in prepaid reinsurance premiums.... (19,480) 10,658
(Increase) decrease in deferred income taxes........... (2,232) (2,397)
(Increase) decrease in prepaid and other assets........ (1,746) (560)
(Increase) decrease in loss and loss adjustment
expenses.............................................. (52,716) 41,053
(Increase) decrease in unearned premium reserves....... 3,064 8,696
(Increase) decrease in reinsurance payable............. 88,245 (29,972)
(Increase) decrease in policyholder dividend payable... 2,458 (562)
(Increase) decrease in accounts payable and other
liabilities........................................... 11,533 2,268
--------- --------
Total adjustments................................. (8,063) (23,129)
--------- --------
Net cash provided by (used in) operating
activities...................................... (7,660) (440)
--------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of bonds available for sale..................... (198,170) (85,883)
Sales of bonds available for sale......................... 583,953 99,878
Maturities of bonds:
Bonds held to maturity................................. 4,571 1,585
Purchases of property, plant & equipment.................. (3,012) (5,936)
Purchases of real estate.................................. -- (6)
--------- --------
Net cash provided by (used in) investing
activities...................................... 387,342 9,638
--------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
ASA adjustment............................................ -- 1,965
Principal payments on long-term debt...................... -- (6,500)
Excess of book value over net assets acquired............. -- (5,535)
Capital contributions..................................... -- 8,300
--------- --------
Net cash provided by (used in) financing
activities...................................... -- (1,770)
--------- --------
Net increase (decrease) in cash and cash equivalents........ 379,682 7,428
Cash and cash equivalents at beginning of period............ 98,128 25,861
--------- --------
Cash and cash equivalents at end of period.................. $ 477,810 $ 33,289
========= ========
</TABLE>
See notes to condensed combined financial statements.
25
<PAGE> 26
THE INSURANCE OPERATIONS OF
BUSINESS INSURANCE GROUP, INC.
NOTES TO CONDENSED COMBINED FINANCIAL STATEMENTS
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
(UNAUDITED)
NOTE A.1 SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES AND BASIS OF PRESENTATION
Business Insurance Group, Inc. ("BIG"), is an insurance holding company and
ultimately a wholly owned subsidiary of Foundation Health Systems, Inc. ("FHS").
BIG serves as the immediate parent company for four workers' compensation
insurance subsidiary companies, as well as certain non-insurance entities. On
May 5, 1998, FHS entered into a definitive agreement to sell BIG and its four
insurance subsidiaries [California Compensation Insurance Company ("CalComp"),
Business Insurance Company ("BICO"), Combined Benefits Insurance Company
("CBIC"), and Commercial Compensation Insurance Company ("CCIC")] to Superior
National Insurance Group, Inc. ("Superior") of Calabasas, California. The
transaction, subject to customary closing conditions including regulatory
approvals and a favorable vote from Superior's shareholders, is expected to
close in the fourth quarter of 1998.
The accompanying combined financial statements include the accounts of BIG
and its insurance subsidiaries, CalComp, BICO, CBIC and CCIC. BIG is also the
parent company of Foundation Integrated Risk Management Solutions, Inc.
("FIRMS"), which is a workers' compensation risk management and third party
claims administrator, and Foundation Health Medical Resources Management
("ReviewCo."), which provides bill review, access to provider networks and other
managed care service for workers' compensation carriers and third party
administrators. FIRMS and ReviewCo. are not included in the sale to Superior.
Therefore, for the purposes of this report, the operations, assets and
liabilities of these non-insurance subsidiaries are not included in the
accompanying financial statements. Also, under the terms of the agreement with
Superior, certain assets and liabilities (including the note from parent,
long-term debt due to parent and other intercompany balances), will be settled
at or prior to the closing of the transaction. In addition, investment real
estate will be purchased by FHS at book value prior to or at the closing date of
the transaction.
The accompanying unaudited condensed combined financial statements of BIG
have been prepared in accordance with generally accepted accounting principles
for interim financial information. 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
fair presentation have been included. Operating results for the three and nine
months ended September 30, 1998 are not necessarily indicative of the results to
be expected for the year ending December 31, 1998.
NOTE A.2 LOSSES AND LOSS ADJUSTMENT EXPENSES ("LAE")
Losses and LAE are estimates on case-basis amounts of reported claims and
unreported losses and loss adjustment expenses based on experience and industry
data. The provision for unpaid losses and loss adjustment expenses, net of
estimated salvage and subrogation, has been established to cover the estimated
net cost of incurred claims. The amounts are necessarily based on estimates, and
accordingly, there can be no assurance the ultimate liability will not differ
from such estimates.
NOTE A.3 ACCOUNTING CHANGE
Prior to October 1, 1997, FHS provided certain services (i.e. treasury,
tax, accounts payable and networking services) to the Company without cost. In
accordance with the requirements of the Securities and Exchange Commission,
Company management has estimated the cost of the services provided and has
retroactively recorded charges to operations with an offsetting credit, net of
income taxes, to invested capital. Management believes the amount of expenses
recorded have been determined on a reasonable basis; however, they do not
necessarily equal the costs that would have been incurred on a stand-alone
basis. The effects of the change for the three and nine months ended September
30, 1998 are not considered material.
26
<PAGE> 27
BUSINESS INSURANCE GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis provides information that BIG's
management believes to be relevant to an understanding of BIG's combined results
of operations and financial condition. The discussion should be read in
conjunction with the consolidated financial statements and the notes thereto.
THREE MONTHS ENDED SEPTEMBER 30, 1998 AS COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 1997
Gross written premium for the three months ended September 30, 1998 and
1997 were $148.8 million and $175.0 million, respectively. The $26.2 million
decline was the result of a $12.8 million reduction in gross written premium in
California, as well as a premium decrease of $13.4 million outside of
California. Net premium written for the quarter was $46.1 million is $89.2
million less than the comparable quarter of 1997. Under the May 1, 1998 quota
share reinsurance treaty, $98.5 million of earned premium was ceded during the
period. In the third quarter of 1997, earned premium of $30.0 million was ceded
under an aggregate excess of loss treaty, which was not in effect during the
quarter ended September 30, 1998. Net premium earned declined $87.5 million in
the third quarter of 1998, due primarily to the effect of these reinsurance
agreements.
Net claim and claim adjustment expense for the three months ended September
30, 1998 decreased $44.7 million to $41.2 million compared to $85.9 million for
the same period in 1997. The net claim and claim adjustment expense ratio for
the period was 104.2% compared to 67.6% in 1997. The increase in claim and claim
adjustment expenses and expense ratio was primarily due to two factors. The
first factor was the expiration of BIG's aggregate excess of loss reinsurance
treaty on January 1, 1998. During the three months ended September 30, 1997, BIG
ceded $37.5 million of claims and claim adjustment expenses under this treaty,
while no comparable cession occurred during the three months ended September 30,
1998. The second factor is the continued increase in the severity of BIG's
California workers' compensation claims. The increase in California workers'
compensation severity is believed by BIG's management to be caused by several
factors: first, legal decisions in late 1996 permitting injured workers to
provide greater direction in their treatments and also allowing treating
physicians more discretion, which resulted in an increase in surgeries and
higher medical costs; second, increased claims and legal costs associated with a
change in the permanent disability rating schedule effective April 1997; third,
higher treating physician back to work restrictions and less modified work usage
by employers, as a result of a $16,000 limit on vocational rehabilitation costs.
During the three months ended September 30, 1998, BIG experienced increases in
actual versus expected case reserves, although claims paid remained consistent
with historical levels. BIG has stated to the Company that an actuarial reserve
analysis has not been performed at this time and BIG management does not believe
at this time that it would be proper to modify its overall loss reserve
estimates based on inconclusive case reserve increases that have not been
actuarially tested. The Company concurs with this conclusion. In the context of
the Acquisition, up to $175 million in adverse development protection on BIG's
loss and loss adjustment expense reserves is provided to the Company by FHC
through the Loss Reserve Guarantee. See "Pending Acquisition of Business
Insurance Group, Inc."
The Company and BIG differ on their analysis of the reasons for the losses
that were incurred by BIG in 1997 and 1998 relating to adverse development in
prior accident years. Reserve estimates, and the amount eventually paid on
claims, are a product of estimated and actual outcomes of claim frequency and
claim severity. Both the Company and BIG correctly predicted, to a large extent,
that claim frequency in California would decline after the advent of open rating
for workers' compensation in 1995. Neither the Company nor BIG correctly
predicted that claim severity would increase relative to historic levels for
accidents occurring in 1995 and 1996. The Company believes the reason it has not
suffered losses equivalent to BIG is because the Company maintained a pricing
strategy that resulted in lost premiums but reduced claim frequency. Operating
margins were admittedly eroded by the increase in claim severity for the
relevant years, but the Company did not suffer significant adverse development.
BIG added significant new premium during the 1995 - 96 period using, the Company
believes, aggressive pricing. When the increase in claim severity occurred, in
the Company's view, the magnitude of the loss at BIG was increased because of
the large volume of premium
27
<PAGE> 28
written, and because BIG had established reserves in a manner that predicted
operating margins in line with historic levels despite the more attractive
pricing offered to insureds.
BIG's view, which the Company believes is equally plausible, is that the
losses were solely attributable to changes in severity and did not arise out of
the original pricing strategy adopted in connection with the shift to open
rating. If that is the case, then factors such as court decisions, changes in
disability rating schedules, and limits on vocational rehabilitation costs that
led to increased severity are in fact of greater materiality to an understanding
of the development in BIG's reserves than if the Company's
explanation -- namely, that the development arose out of initial pricing
decisions -- was correct. The Company believes the factors listed here
contributed to the increase in claim severity, but are not as significant as the
weeding out of low dollar claims by workers' compensation reform, creating a
statistical increase in per claim severity, and a general inflation in medical
costs.
BIG's underwriting and general and administrative expenses, excluding
policyholder dividends, decreased $42.2 million for the three months ended
September 30, 1998, due primarily to the 33.5% ceding commission on the
quota-share treaty, effective May 1, 1998.
Policyholder dividend expense for the three months ended September 30, 1998
was $2.3 million due to the dividend plans on policies outside of California
with no comparable expense in 1997. The expense reflects BIG's geographic
diversification outside of California and policyholder dividend plans for the
1997 and 1998 policy years. Participating policies are now offered in 22 states
outside of California primarily in Florida, Georgia, Arizona and Colorado.
Net investment income of $9.0 million for the three months ended September
30, 1998 was $.2 million less than the same period in 1997 due to the lower
yields and higher investment expenses.
Interest expense increased $0.3 million during the third quarter of 1998
compared to the same period in 1997 on lower principal balances because the
interest rate charged to BIG by FHC on its credit facility (the "FHC Credit
Facility") increased to 7.75% in 1998 from 6.75% in 1997.
NINE MONTHS ENDED SEPTEMBER 30, 1998 AS COMPARED TO NINE MONTHS ENDED SEPTEMBER
30, 1997
Gross written premium for the nine months ended September 30, 1998 and 1997
were $448.7 million and $501.3 million, respectively. The $52.6 million decline
was the result of $44.6 million less premium in California, as well as a premium
decrease of $8.0 million outside of California. Net premium written for the
first nine months of 1998 of $253.5 million is $142.5 million less than the
first nine months of 1997. Under the May 1, 1998 quota share reinsurance treaty,
$154.8 million of earned premium was ceded during the period. In the first nine
months of 1997, earned premium of $60.0 million was ceded under an aggregate
excess of loss treaty and $21.9 million was ceded under a 7.5% quota-share
agreement. Neither of these two treaties were in effect during the nine months
ended September 30, 1998. Net premium earned declined $117.9 million in the
first nine months of 1998, due primarily to the effect of these reinsurance
agreements.
Net claim and claim adjustment expense for the nine months ended September
30, 1998 decreased $38.7 million to $223.6 million compared to $262.3 million
for the same period in 1997. The net claim and claim adjustment expense ratio
for the period was 87.5% compared to 70.2% in 1997. The increase in claim and
claim adjustment expenses and expense ratio was primarily due to two factors.
The first factor was the expiration of BIG's aggregate excess of loss
reinsurance treaty on January 1, 1998. During the nine months ended September
30, 1997, BIG ceded $74.8 million of claims and claim adjustment expenses under
this treaty, while no comparable cession occurred during the nine months ended
September 30, 1998. The second factor is the continued increase in the severity
of BIG's California workers' compensation claims. The increase in California
workers' compensation severity is believed by BIG's management to be caused by
several factors: first, legal decisions in late 1996 permitting injured workers
to provide greater direction in their treatments and also allowing treating
physicians more discretion, which resulted in an increase in surgeries and
higher medical costs; second, increased claims and legal costs associated with a
change in the permanent disability rating schedule effective April 1997; third,
higher treating physician back to work restrictions and less modified work usage
by employers, as a result of a $16,000 limit on vocational rehabilitation costs.
During the
28
<PAGE> 29
nine months ended September 30, 1998, BIG experienced increases in actual versus
expected case reserves, although claims paid remained consistent with historical
levels. BIG has stated to the Company that an actuarial reserve analysis has not
been performed at this time and BIG management does not believe at this time
that it would be proper to modify its overall loss reserve estimates based on
inconclusive case reserve increases that have not been actuarially tested. The
Company concurs with this conclusion. In the context of the Acquisition, up to
$175.0 million in adverse development protection on BIG's loss and loss expense
reserves is provided to the Company by FHC through the Loss Reserve Guarantee.
See "Pending Acquisition of Business Insurance Group, Inc."
BIG's underwriting and general and administrative expenses, excluding
policyholder dividends, decreased $49.1 million for the nine months ended
September 30, 1998, due primarily to the 33.5% ceding commission on the
quota-share treaty, effective May 1, 1998.
Policyholder dividend expense for the nine months ended September 30, 1998
was $4.1 million due to the dividend plans on policies outside of California
with no comparable expense in 1997. The expense reflects BIG's geographic
diversification outside of California and policyholder dividend plans for the
1997 and 1998 policy years. Participating policies are now offered in 22 states
outside of California with the concentration in Florida, Georgia, Arizona and
Colorado.
Net investment income of $27.2 million for the nine months ended September
30, 1998 was $1.2 million less than the same period in 1997 due to the lower
yields and higher investment expenses.
Interest expense increased $0.8 million during the first nine months of
1998 compared to the same period in 1997 on lower principal balances because the
interest rate charged to BIG by FHC on its credit facility (the "FHC Credit
Facility") increased to 7.75% in 1998 from 6.75% in 1997.
LIQUIDITY AND CAPITAL RESOURCES
BIG's cash inflows are generated from cash collected from policies sold,
investment income generated from its existing portfolio, and sales and
maturities of investments. BIG's cash outflows consist primarily of payments for
policyholders' claims, operating expenses, and debt service. For its insurance
operations, BIG must have available cash and liquid assets to meet obligations
to policyholders and claimants in accordance with contractual obligations in
addition to meeting ordinary operating costs. Absent adverse material changes in
the workers' compensation insurance market, management believes BIG's present
cash resources are sufficient to meet its needs for the foreseeable future. BIG
believes that it has adequate short-term investments and readily marketable
investment-grade securities to cover both claim payments and expenses.
During the nine months ended September 30, 1998, the net cash outflow from
operating activities was $7.7 million versus $0.4 million for the nine months
ended September 30, 1997. The reduced cash flow is due primarily to increased
loss and loss adjustment expense payments. At September 30, 1998, BIG had total
cash and cash equivalents of $477.8 million in an investable asset portfolio of
$754.9 million. Of the fixed income portfolio, 95.6% was rated "AA" or better
and 98.0% was rated "A" or better.
BIG generated $387.3 million in cash from investing activities during the
nine months ended September 30, 1998, as compared to $9.6 million in 1996. The
Company's cash and cash equivalents position increased in 1998 as a result of
the sales of bonds available for sale as BIG repositioned its portfolio since
the announced acquisition of BIG by the Company to take advantage of a decline
in long-term interest rates.
BIG had no cash activity from financing activities in the nine months ended
September 30, 1998.
The effect of inflation on the revenues and net income of BIG during the
nine months ended September 30, 1998 and the years ended December 31, 1997,
1996, and 1995 was not significant.
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. For insurance policies with
an expiration date of January 1, 2000 or later, these computer programs may fail
from an inability to interpret date codes properly, misinterpreting "00" as the
year 1900 rather than 2000. BIG
29
<PAGE> 30
believes that its computer systems are fully Year 2000 compliant; there can be
no assurance, however, that BIG's recently completed upgrade of its computer
hardware and software will successfully prevent any Year 2000 problems from
occurring. BIG does not expect the cost associated with its Year 2000 project to
be material.
SUPPLEMENTARY DATA
Summarized quarterly financial data for 1998, 1997, and 1996 is as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
----------------------------------------------
MARCH 31, JUNE 30, SEPT. 30, DEC. 31,
--------- -------- --------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
1998
Earned premiums................................. $137,675 $ 78,236 $ 39,566 $ --
Income before income taxes, preferred securities
dividends and accretion and extraordinary
items......................................... $(11,067) $ (6,901) $ 10,849 $ --
Net income (loss)............................... $ (4,879) $ (2,898) $ 8,180 $ --
1997
Earned premiums................................. $121,388 $124,894 $127,084 $141,906
Income before income taxes, preferred securities
dividends and accretion and extraordinary
items......................................... $ 12,540 $ 4,009 $ 9,565 $(86,261)
Net income (loss)............................... $ 10,146(1) $ 4,278(1) $ 8,265(1) $(53,330)
1996
Earned premiums................................. $126,212 $140,288 $109,475 $104,853
Income before income taxes, preferred securities
dividends and accretion and extraordinary
items......................................... $ 18,759 $ 20,900 $ 22,292 $(37,454)
Net income (loss)............................... $ 13,206(1) $ 15,253(1) $ 16,720(1) $(22,273)(1)
</TABLE>
- ------------------------------
(1) Restated.
30
<PAGE> 31
SUPERIOR NATIONAL INSURANCE GROUP, INC.
SUMMARY FINANCIAL DATA
<TABLE>
<CAPTION>
NINE MONTHS
ENDED SEPTEMBER 30, YEAR ENDED DECEMBER 31,
--------------------- ----------------------------------------------------
1998 1997 1997(1) 1996 1995 1994 1993
-------- ---------- ---------- ------- ------- -------- --------
(RESTATED) (RESTATED)
<S> <C> <C> <C> <C> <C> <C> <C>
(UNAUDITED)
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
REVENUES:
Net premiums earned.................... $60,952 $99,148 $140,920 $88,648 $89,735 $110,418 $153,585
Total Revenues................ 72,387 108,392 153,594 96,417 99,519 119,467 163,135
EXPENSES:
Claim and claim adjustment expenses,
net of reinsurance................... 27,638 66,311 90,447 55,638 53,970 78,761 113,817
Underwriting and general and
administrative expenses (e.g.,
commissions)......................... 24,329 27,762 37,695 34,138 29,447 21,660 28,778
Total Expenses................ 53,667 116,368 152,032 91,190 87,830 114,470 160,931
Income before income taxes, preferred
securities dividends and accretion,
discontinued operations,
extraordinary items, and cumulative
effect of change in accounting for
income taxes......................... 18,720 (7,976) 1,562 5,227 11,689 4,997 2,204
Preferred securities dividends and
accretion, net of income tax
benefit.............................. (5,597) (1,387) (3,069) (1,667) (1,488) (683) --
Net income from continuing
operations........................... $11,784 $(5,459) $ 463 $ 3,630 $11,701 $ 3,599 $ 2,734
======= ======= ======== ======= ======= ======== ========
BASIC EPS:
Per common share:
Income from continuing operations...... $ 2.04 $ (1.08) $ 0.09 $ 1.06 $ 3.41 $ 1.05 $ 0.80
Weighted average shares outstanding.... 5,780 5,045 5,250 3,433 3,430 3,430 3,430
DILUTED EPS:
Per common share:
Income from continuing operations...... $ 1.50 $ (0.80) $ 0.07 $ 0.75 $ 2.97 $ 0.70 $ 0.58
Weighted average shares outstanding.... 7,838 6,839 7,016 4,826 3,942 5,122 4,753
</TABLE>
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, DECEMBER 31,
------------------- ----------------------------------------------------
1998 1997 1997(1) 1996 1995 1994 1993
-------- -------- -------- -------- -------- -------- --------
(UNAUDITED) (IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE SHEET
ASSETS:
Total cash and investments
- -- carrying value.................. $167,205 $238,804 $242,116 $149,440 $ 49,030 $ 68,595 $ 45,982
- -- market value.................... 167,205 238,804 242,116 149,440 49,030 68,591 46,212
Investments withheld from a related
party reinsurer.................. -- -- -- -- 114,921 108,283 104,197
Reinsurance receivables............ 82,978 54,887 53,082 25,274 39,613 68,129 71,003
Total Assets.............. $404,845 $411,228 $429,473 $323,830 $240,781 $286,776 $264,098
======== ======== ======== ======== ======== ======== ========
LIABILITIES AND STOCKHOLDERS'
EQUITY:
Claim and claim adjustment
expenses......................... $156,206 $222,625 $201,255 $115,529 $141,495 $171,258 $171,038
Total Liabilities......... 242,283 328,752 268,378 255,068 176,256 227,622 224,044
Total Stockholders'
Equity.................. $ 61,494 $ 56,804 $ 59,818 $ 45,191 $ 43,480 $ 40,364 $ 40,055
======== ======== ======== ======== ======== ======== ========
</TABLE>
- ------------------------------
(1) The information for the year ended December 31, 1997 includes the financial
data of SPCC (formerly The Pacific Rim Assurance Company) from April 1,
1997.
31
<PAGE> 32
BUSINESS INSURANCE GROUP, INC.
SUMMARY FINANCIAL DATA(1)
<TABLE>
<CAPTION>
NINE MONTHS
ENDED SEPTEMBER 30, YEAR ENDED DECEMBER 31,
------------------- ----------------------------------------------------------
1998 1997 1997 1996 1995 1994 1993
-------- -------- ---------- ---------- ---------- -------- --------
(UNAUDITED) (RESTATED) (RESTATED) (RESTATED) (UNAUDITED)
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
REVENUES:
Net premiums earned................ $255,477 $373,366 $515,272 $480,828 $390,974 $340,097 $233,341
Total Revenues............ 289,331 405,277 563,508 517,860 416,894 356,278 249,591
EXPENSES:
Claim and claim adjustment
expenses, net of reinsurance..... 223,614 262,278 443,204 381,897 245,522 218,240 169,828
Underwriting and general and
administrative expenses (e.g.,
commissions)..................... 61,073 110,138 170,070 111,477 118,572 75,364 49,262
Total Expenses............ 296,450 379,163 623,655 493,363 369,844 304,926 244,698
Income (loss) before income
taxes............................ (7,119) 26,114 (60,147) 24,497 47,050 51,352 4,893
Net income (loss) from continuing
operations....................... $ 403 $ 22,689 $(30,641) 22,906 $ 35,377 $ 37,520 $ 6,354
======== ======== ======== ======== ======== ======== ========
</TABLE>
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, DECEMBER 31,
----------------------- -----------------------------------------------------------------
1998 1997 1997 1996 1995 1994 1993
---------- ---------- ---------- ---------- ----------- ----------- -----------
(UNAUDITED) (UNAUDITED) (UNAUDITED) (UNAUDITED)
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE SHEET
ASSETS:
Total cash and investments --
carrying value............. $ 754,895 $ 750,478 $ 763,171 $ 754,652 $529,515 $419,943 $362,133
-- market value............ 754,968 750,784 763,339 754,745 529,650 419,053 370,437
Reinsurance receivables...... 309,903 190,142 229,521 136,109 81,545 104,573 119,050
Total Assets........ $1,275,645 $1,146,120 $1,222,406 $1,093,773 $749,104 $627,855 $602,023
LIABILITIES AND STOCKHOLDER'S
EQUITY:
Claim and claim adjustment
expenses................... $ 675,705 $ 630,691 $ 728,421 $ 590,595 $443,600 $412,666 $386,194
Total Liabilities... 1,022,644 840,864 970,060 825,881 508,214 479,543 466,139
Total Stockholder's
Equity............ $ 253,001 $ 305,256 $ 252,346 $ 267,892 $240,890 $148,312 $135,884
========== ========== ========== ========== ======== ======== ========
</TABLE>
- ------------------------------
(1) The data reflects only the insurance operations of BIG that are being
acquired by the Company.
32
<PAGE> 33
UNAUDITED PRO FORMA FINANCIAL INFORMATION
The following Unaudited Pro Forma Financial Information of the Company for
the nine months ended September 30, 1998 and the year ended December 31, 1997
presents the results of operations for the Company as if the Acquisition had
been consummated as of the beginning of each period presented. The pro forma
adjustments are based on available information and certain assumptions the
Company currently believes are reasonable in the circumstances. The Unaudited
Pro Forma Financial Information has been derived from and should be read in
conjunction with the historical Consolidated Financial Statements and Notes of
the Company for the nine months ended September 30, 1998 (unaudited), the year
ended December 31, 1997, the historical Combined Financial Statements and Notes
of BIG for the nine months ended September 30, 1998 (unaudited), and the year
ended December 31, 1997 contained elsewhere herein, in the Company's Form 10-K/A
for the year ended December 31, 1997, and in the Company's definitive Proxy
Statement dated October 16, 1998 and should be read in conjunction with the
accompanying Notes to Unaudited Pro Forma Financial Information.
The pro forma information is presented for illustrative purposes only and
is not necessarily indicative of the results of operations that would have
occurred had the Acquisition been consummated on the dates assumed, nor is the
pro forma information intended to be indicative of the Company's future results
of operations.
33
<PAGE> 34
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 1998
---------------------------------------------------
PURCHASE PRO
SUPERIOR ACCOUNTING FORMA
NATIONAL BIG ADJUSTMENT(1) COMBINED
-------- ---------- ------------- ----------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
ASSETS
Investments:
Bonds and notes:
Available-for-sale, at market........................... $143,190 $ 228,265 $ $ 371,455
Held-to-maturity, at amortized value.................... -- 9,488 9,488
Equity securities, at market.............................. 4,753 -- 4,753
Real estate............................................... -- 29,332 (29,332)(a) --
Note from parent.......................................... -- 10,000 (10,000)(b) --
Short-term investments, at cost........................... 2,330 -- 2,330
Other investments......................................... 50 -- 50
-------- ---------- ---------- ----------
Total investments................................... 150,323 277,085 (39,332) 388,076
Cash and cash equivalents................................... 16,882 477,810 29,332(a) 549,236
10,000(b)
15,238(c)
107,000(e)
177,181(f)
(4,807)(g)
(256,500)(h)
(28,500)(h)
5,600(i)
Reinsurance recoverables.................................... 82,978 309,903 392,881
Premiums receivable......................................... 26,366 78,296 104,662
Earned but unbilled premiums receivable..................... 11,753 14,379 26,132
Accrued investment income................................... 1,813 7,254 9,067
Deferred policy acquisition costs........................... 747 22,790 23,537
Income tax receivable....................................... -- 15,238 (15,238)(c) --
Deferred income taxes....................................... 20,952 17,887 (17,887)(j) 20,952
Funds held by reinsurer..................................... 4,993 -- 4,993
Prepaid reinsurance premiums................................ 13,377 19,480 32,857
Receivable from related party reinsurer..................... 14,070 14,070
Goodwill.................................................... 34,912 13,673 (13,673)(k) 34,912
Prepaid and other........................................... 25,679 21,850 47,529
-------- ---------- ---------- ----------
Total Assets........................................ $404,845 $1,275,645 $ (31,586) $1,648,904
======== ========== ========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Claim and claim adjustment expenses......................... $156,206 $ 675,705 $ 831,911
Unearned premiums........................................... 16,939 48,068 65,007
Reinsurance payable......................................... 21,607 116,272 137,879
Long-term debt.............................................. 30 121,750 (121,750)(d) 107,030
107,000(e)
Deferred credit -- negative goodwill........................ 89,751(h) 63,791
5,600(i)
(17,887)(j)
(13,673)(k)
Policyholder dividends...................................... 1,335 5,473 6,808
Capital lease............................................... 6,503 -- 6,503
Discontinued operations liabilities......................... 9,480 9,480
Accounts payable and other liabilities...................... 30,183 55,376 (4,807)(g) 80,752
-------- ---------- ---------- ----------
Total Liabilities................................... 242,283 1,022,644 44,234 1,309,161
Trust preferred securities.................................. 101,068 -- 101,068
Stockholders' equity
Common stock................................................ 35,682 167,416 195,503(f) 228,782
(167,416)(h)
(2,403)(f)
Paid-in capital warrants.................................... 2,206 -- 2,206
Accumulated other comprehensive income
Unrealized gain on investments, net of taxes.............. 1,919 5,122 (5,122)(h) 1,919
Retained earnings........................................... 28,171 80,463 121,750(d) 28,171
(202,213)(h)
Less: Notes receivable from subscribed stock................ -- -- (15,919)(f) (15,919)
Less: Unearned compensation................................. (1,339) -- -- (1,339)
Less: 245,000 shares of treasury stock at cost.............. (5,145) -- -- (5,145)
-------- ---------- ---------- ----------
Total Stockholders' Equity.......................... 61,494 253,001 (75,820) 238,675
-------- ---------- ---------- ----------
Total Liabilities and Stockholders' Equity.......... $404,845 $1,275,645 $ (31,586) $1,648,904
======== ========== ========== ==========
</TABLE>
34
<PAGE> 35
- ---------------
(1) Description of Pro Forma Adjustments
(a) Adjustment represents the sale of real estate to FHS at current book value,
pursuant to the Acquisition Agreement.
(b) Adjustment represents FHC's repayment of an intercompany promissory note
including principal and interest, pursuant to the Acquisition Agreement.
(c) Adjustment represents repayment of the income tax receivable due BIG by
FHC, pursuant to the Acquisition Agreement.
(d) Adjustment represents FHC's forgiveness of intercompany debt at the time of
the Acquisition, pursuant to the Acquisition Agreement.
(e) Adjustment represents the issuance of debt in connection with the Senior
Debt Financing in the amount of $110.0 million, net of transaction costs in
the amount of $3.0 million, in connection with the Acquisition.
(f) Adjustment represents the Equity Financings proceeds of $200 million less
Employee Participation loans of $16.0 million which is shown as a contra
equity account, net of transaction costs in the amount of $6.9 million,
which include the $3.9 million transaction fee payable to IP under the
Stock Purchase Agreement, in connection with the Acquisition. The Company
will pay a fee to IP consisting of the Commitment Fee Warrants, which are
exercisable to purchase 734,000 shares of Common Stock at a purchase price
of $16.75, in consideration of the Standby Commitment. Zurich will receive
205,520 of these warrants in consideration of certain financing commitments
to IP II.
The Company will incur compensation expense for up to 641,809 shares issued
to employees and consultants with an "in-the-money" value, assumed for
purposes of this calculation to be $3.75 per share, which is the difference
between the $20.50 per share market price at May 4, 1998, the day
immediately prior to the public announcement of the Stock Offering, and the
$16.75 Subscription Price of the Rights. The actual compensation expense the
Company will incur will be equal to the actual number of shares purchased
pursuant to the Employee Participation multiplied by the "in-the-money"
value, if any, on the day the Rights are exercised. In the event the market
price on such date is equal to or below $16.75, the Company expects that
there may be few to no purchases under the Employee Participation, which
would result in no or substantially less borrowing than the amount
presented. On October 30, 1998, the last reported trading price for a share
of Common Stock on Nasdaq was $18.00.
(g) Adjustment to settle intercompany payable arising in the ordinary course of
business with FHS, pursuant to the Acquisition Agreement.
(h) Adjustments represent $256.5 million payable to FHC to acquire BIG, plus an
expected $28.5 million capital contribution as set forth in the Company's
applications for regulatory approval of the Acquisition, and corresponding
adjustment to Common Stock and additional paid-in capital to reflect the
elimination of BIG's stockholders' equity interest.
(i) Adjustment represents the sale of BICO to Zurich Centre Group LLC or its
designee for estimated proceeds of $5.6 million. The Company will retain
BICO's insurance business, infrastructure, liabilities, and employees.
(j) Adjustment represents the elimination of the deferred tax asset related to
the election under Section 338(h) of the Code taken by FHC.
(k) Adjustment represents the elimination of BIG's goodwill existing prior to
the Acquisition.
35
<PAGE> 36
PRO FORMA FINANCIAL INFORMATION
ACQUISITION OF BUSINESS INSURANCE GROUP, INC. BY SUPERIOR NATIONAL INSURANCE
GROUP, INC.
PURCHASE ACCOUNTING METHOD
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30, 1998
-------------------------------------------------
PRO
FORMA
ADJUST-
MENTS PRO
SUPERIOR INC. FORMA
NATIONAL BIG (DECR)(1) COMBINED
---------- -------- --------- -----------
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
REVENUES:
Net premiums earned........ $ 60,952 $255,477 $ -- $ 316,429
Net investment income and
capital gains............ 11,435 33,452 (1,827)(a) 43,060
Other income............... 402 402
---------- -------- ------- -----------
Total Revenues..... 72,387 289,331 (1,827) 359,891
EXPENSES:
Claim and claim adjustment
expenses, net of
reinsurance.............. 27,638 223,614 -- 251,252
Underwriting and general
and administrative
expenses................. 24,329 61,073 2,403(g) 87,805
Policyholder dividends..... 96 4,098 4,194
Goodwill amortization...... 975 588 (588)(c) (765)
(1,740)(d)
Interest expense........... -- 7,077 (7,077)(e) 6,600
6,600(b)
Loss on termination of
financing transaction
with a related party
reinsurer................ -- -- --
Other expense.............. 629 -- 629
---------- -------- ------- -----------
Total Expenses..... 53,667 296,450 (402) 349,715
---------- -------- ------- -----------
Income (loss) before income
taxes, preferred
securities dividends and
accretion, and
extraordinary items...... 18,720 (7,119) (1,425) 10,176
Income tax expense
(benefit)................ 6,936 (7,522) 2,874(f) 2,288
---------- -------- ------- -----------
Income (loss) before
preferred securities
dividends and accretion,
and extraordinary
items.................... $ 11,784 $ 403 $(4,299) $ 7,888
========== ======== ======= ===========
BASIC EPS:
Per Common Share:
Income (loss) before
preferred securities
dividends and accretion,
and extraordinary
items.................... $ 2.04 $ 0.45
Weighted average shares
outstanding.............. 5,779,978 17,720,276
DILUTED EPS:
Per Common Share:
Income (loss) before
preferred securities
dividends and accretion,
and extraordinary
items.................... $ 1.50 $ 0.40
Weighted average shares
outstanding.............. 7,837,997 19,888,145
<CAPTION>
YEAR ENDED DECEMBER 31, 1997
---------------------------------------------------------------
PRO
FORMA
ADJUST-
MENTS PRO
SUPERIOR PAC INC. FORMA
NATIONAL(2) RIM(3) BIG (DECR)(1) COMBINED
----------- -------- ---------- --------- -----------
(RESTATED) (RESTATED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
REVENUES:
Net premiums earned........ $ 140,920 $ 19,507 $515,272 $ -- $ 675,699
Net investment income and
capital gains............ 12,674 1,449 44,724 (1,996)(a) 56,851
Other income............... -- -- 3,512 3,512
---------- -------- -------- ------- -----------
Total Revenues..... 153,594 20,956 563,508 (1,996) 736,062
EXPENSES:
Claim and claim adjustment
expenses, net of
reinsurance.............. 90,447 25,841 443,204 559,492
Underwriting and general
and administrative
expenses................. 37,695 10,769 170,070 2,403(g) 220,937
Policyholder dividends..... -- 1,006 793 1,799
Goodwill amortization...... 1,039 -- 1,262 (1,262)(c) (1,281)
(2,320)(d)
Interest expense........... 6,335 589 8,326 (8,326)(e) 15,724
8,800(b)
Loss on termination of
financing transaction
with a related party
reinsurer................ 15,699 15,699
Other expense.............. 817 -- -- -- 817
---------- -------- -------- ------- -----------
Total Expenses..... 152,032 38,205 623,655 (705) 813,187
---------- -------- -------- ------- -----------
Income (loss) before income
taxes, preferred
securities dividends and
accretion, and
extraordinary items...... 1,562 (17,249) (60,147) (1,291) (77,125)
Income tax expense
(benefit)................ 1,099 612 (29,506) 1,137(f) (26,658)
---------- -------- -------- ------- -----------
Income (loss) before
preferred securities
dividends and accretion,
and extraordinary
items.................... $ 463 $(17,861) $(30,641) $(2,428) $ (50,467)
========== ======== ======== ======= ===========
BASIC EPS:
Per Common Share:
Income (loss) before
preferred securities
dividends and accretion,
and extraordinary
items.................... $ 0.09 $ (2.94)
Weighted average shares
outstanding.............. 5,249,736 17,190,034
DILUTED EPS:
Per Common Share:
Income (loss) before
preferred securities
dividends and accretion,
and extraordinary
items.................... $ 0.07 $ (2.66)
Weighted average shares
outstanding.............. 7,016,165 18,956,463
</TABLE>
36
<PAGE> 37
- ---------------
(1) Description of Pro Forma Adjustments.
(a) Adjustment represents the elimination of net investment income for real
estate sold to FHC and interest on the promissory note from FHC, pursuant to
the Acquisition Agreement.
(b) Adjustment represents estimated interest expense on the $110.0 million of
debt to be issued in connection with the Senior Debt Financing. The Company
is using an estimated interest rate of 8.0% for purposes of this
calculation, which assumes a benchmark ten year treasury rate plus a credit
spread that the Company believes is reasonable. A one percentage point
change in the interest rate on such debt would result in an annual
increase/decrease in interest expense of approximately $1.1 million.
(c) Adjustment represents the elimination of the amortization of BIG's goodwill
existing prior to the Acquisition.
(d) Adjustment represents the amortization of the negative goodwill (deferred
credit) on a straight line basis over 27.5 years.
(e) Adjustment represents the elimination of the interest expense at a rate of
7.75% and 6.75% in 1998 and 1997, respectively, associated with $121.7
million of intercompany debt that will be settled by FHC at the time of the
Acquisition.
(f) Adjustment represents the tax effect of the pro forma adjustments, excluding
goodwill, calculated at the statutory rate in effect during the periods
presented.
(g) Adjustment reflects the deferred compensation expense related to the Rights
distribution and is assumed for purposes of this calculation to be the
difference between the $20.50 per share market price on May 4, 1998, the day
immediately prior to the public announcement of the Stock Offering, and the
$16.75 Subscription Price of the Rights. The Rights are fully vested upon
the issuance of the Rights. The actual deferred compensation expense the
Company will incur will be equal to the number of shares purchased pursuant
to the Employee Participation multiplied by the "in-the-money" value, if
any, on the day the Rights are exercised. In the event the market price on
such date is equal to or below $16.75, the Company expects that there may be
little to no purchases under the Employee Participation, which would result
in no or substantially less borrowing than the amount presented. On October
30, 1998, the last reported trading price for a share of Common Stock on
Nasdaq was $18.00.
(2) The results of Superior National for the year ended December 31, 1997
include the results of SPCC (formerly The Pacific Rim Assurance Company) for
periods subsequent to April 1, 1997.
(3) Pac Rim was acquired on April 11, 1997. The results of operations presented
are for the period January 1, 1997 through March 31, 1997.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
27 Financial Data Schedule
</TABLE>
(b) Reports on Form 8-K: A Form 8-K/A (Amendment No. 2), containing financial
information regarding Pac Rim Holding Corporation, was filed by the Company on
October 16, 1998, related to the restatement of financial statements of the
Company and Pac Rim Holding Corporation for prior periods.
37
<PAGE> 38
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 6, 1998 SUPERIOR NATIONAL INSURANCE GROUP, INC.
By: /s/ J. CHRIS SEAMAN
---------------------------------------
J. Chris Seaman
Executive Vice President and
Chief Financial Officer
38
<PAGE> 39
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
------- DESCRIPTION
<C> <S>
27 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<EXCHANGE-RATE> 1
<DEBT-HELD-FOR-SALE> 143,190
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 4,753
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 150,323
<CASH> 16,882
<RECOVER-REINSURE> 856
<DEFERRED-ACQUISITION> 747
<TOTAL-ASSETS> 404,845
<POLICY-LOSSES> 156,206
<UNEARNED-PREMIUMS> 16,939
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 1,335
<NOTES-PAYABLE> 30
101,068
0
<COMMON> 35,682
<OTHER-SE> 25,812
<TOTAL-LIABILITY-AND-EQUITY> 404,845
60,952
<INVESTMENT-INCOME> 9,654
<INVESTMENT-GAINS> 1,781
<OTHER-INCOME> 0
<BENEFITS> 27,638
<UNDERWRITING-AMORTIZATION> 5,972
<UNDERWRITING-OTHER> 18,357
<INCOME-PRETAX> 18,720
<INCOME-TAX> 6,936
<INCOME-CONTINUING> 11,784
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 6,187
<EPS-PRIMARY> $1.07<F1>
<EPS-DILUTED> $0.79
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 0
<CUMULATIVE-DEFICIENCY> 0
<FN>
<F1>FOR PURPOSES OF THIS EXHIBIT, PRIMARY MEANS BASIC.
</FN>
</TABLE>
