<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
(MARK ONE)
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 0-25984
------------------------
SUPERIOR NATIONAL INSURANCE GROUP, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-4610936
(State of incorporation) (I.R.S. Employer
Identification No.)
26601 AGOURA ROAD, CALABASAS, CA 91302
(Address of principal executive offices) (zip code)
TELEPHONE: (818) 880-1600
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NAME OF EACH EXCHANGE ON WHICH
TITLE OF EACH CLASS REGISTERED
---------------------------------------- ---------------------------------
Common Stock, $0.01 Par Value Registered--The Nasdaq National
Market
------------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulations S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. / /
The aggregate market value of the common stock of the registrant held by
non-affiliates of the registrant on March 31, 1999, based on the closing price
of $19.00 per share of the common stock on The Nasdaq National Market on such
date was $96,499,518.
The number of shares of the registrant's common stock outstanding as of
March 31, 1999 was 17,928,055.
DOCUMENTS INCORPORATED BY REFERENCE
None.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC.
INDEX TO FORM 10-K
<TABLE>
<CAPTION>
PAGE
-----
<S> <C> <C>
PART I
ITEM 1. Business................................................................................. 1
ITEM 2. Business Properties...................................................................... 40
ITEM 3. Legal Proceedings........................................................................ 40
ITEM 4. Submission of Matters to a Vote of Security Holders...................................... 41
PART II
ITEM 5. Market Price of and Dividends on our Common Equity and Related Stockholder Matters....... 41
ITEM 6. Selected Financial Data.................................................................. 43
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.... 44
ITEM 7A. Quantitative and Qualitative Disclosure about Market Risk................................ 54
ITEM 8. Financial Statements and Supplementary Data.............................................. F-1
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure..... 55
PART III
ITEM 10. Directors and Executive Officers......................................................... 56
ITEM 11. Executive Compensation................................................................... 60
ITEM 12. Security Ownership of Principal Beneficial Owners and Management......................... 65
ITEM 13. Certain Relationships and Related Transactions........................................... 68
PART IV
ITEM 14. Exhibits, Financial Statements Schedules, and Reports on Form 8-K........................ 74
Signatures............................................................................... 78
Glossary of Terms........................................................................ 80
Index to Consolidated Financial Statements............................................... F-1
Independent Auditors' Report............................................................. F-2
</TABLE>
i
<PAGE>
PART 1
CERTAIN STATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K ARE FORWARD-LOOKING
AND ARE IDENTIFIED BY THE USE OF PHRASES SUCH AS "INTENDED," "WILL BE
POSITIONED," "EXPECTS," IS OR ARE "EXPECTED," "ANTICIPATES," AND "ANTICIPATED."
THESE FORWARD-LOOKING STATEMENTS ARE BASED ON OUR CURRENT EXPECTATIONS. TO THE
EXTENT ANY OF THE INFORMATION CONTAINED HEREIN CONSTITUTES A "FORWARD-LOOKING
STATEMENT" AS DEFINED IN SECTION 27 A(I)(1) OF THE SECURITIES ACT, THE FACTORS
SET FORTH UNDER "--RISK FACTORS" ARE CAUTIONARY STATEMENTS IDENTIFYING IMPORTANT
FACTORS THAT COULD CAUSE RESULTS TO DIFFER MATERIALLY FROM THOSE IN THE
FORWARD-LOOKING STATEMENT. FURTHER, SEE "GLOSSARY OF TERMS" FOR THE DEFINITIONS
OF SOME OF THE CAPITALIZED AND DEFINED TERMS USED HEREIN.
ITEM 1. BUSINESS
OVERVIEW
Superior National Insurance Group, Inc. ("SNIG") is the parent company of a
group of insurance companies that underwrite workers' compensation and, to a
limited extent, group health insurance. SNIG's wholly-owned insurance
subsidiaries include Superior National Insurance Company ("SNIC"), Superior
Pacific Casualty Company ("SPCC"), California Compensation Insurance Company
("CalComp"), Combined Benefits Insurance Company ("CBIC"), and Commercial
Compensation Insurance Company ("CCIC"). Our underwriting and marketing is
focused in large part in the State of California, but we also have branch
operations throughout the continental United States. Before we acquired Business
Insurance Group, Inc. ("BIG") the holding company of CalComp, CCIC, and CBIC, in
December 1998, we had no significant branch operations outside of California.
SNIG was originally incorporated in California in 1985 and reincorporated in
Delaware in 1997. Unless indicated otherwise, "we," "us," "our," and "Superior
National" refer to SNIG and its subsidiaries.
On December 10, 1998, SNIG purchased BIG, CalComp, CBIC, CCIC, and Business
Insurance Company ("BICO") from Foundation Health Corporation ("FHC"), a
wholly-owned subsidiary of Foundation Health Systems ("FHS"). Subsequently, on
December 18, 1998, BIG sold BICO to Centre Solutions Holdings (Delaware)
Limited, but CalComp and SNIC retained BICO's insurance business,
infrastructure, liabilities, and employees. As a result of the purchase of BIG,
and excluding the California State Compensation Insurance Fund (the "State
Fund"), we believe that, on a pro forma basis after giving effect to our
acquisition of BIG, we are the largest private sector California workers'
compensation insurance company based upon 1998 direct premiums written. Based
upon the same criteria we believe we are the ninth largest workers' compensation
insurer in the United States. Including BIG on a pro forma basis, our direct
premiums written would have been $723.9 million and $848.6 million for the years
ended December 31, 1998 and 1997, respectively.
Our insurance subsidiaries currently are licensed to write workers'
compensation and group health insurance in 38 states and the District of
Columbia. The combined direct premiums written of Superior National was
approximately $180.4 million in 1998. Because the acquisition of BIG occurred
December 10, 1998, about 86.4% of the 1998 direct premiums written reported in
our financial statements was attributable to premium generated by SNIC and SPCC
in California (97%) and Arizona (3%).
STRATEGY
INTEGRATION STRATEGY
Our post-acquisition strategy for improving Superior National's overall
financial performance includes:
- LEADERSHIP IN CALIFORNIA MARKET. As the largest private sector workers'
compensation insurer in California, we are positioned to offer
policyholders and producers outstanding service, innovative loss control
programs, and competitive pricing.
1
<PAGE>
- NATIONWIDE PRESENCE; OPPORTUNITIES FOR GROWTH. We intend to maintain a
nationwide presence and seek additional opportunities for growth outside
of California, using the regional and branch network already established
by BIG's insurance subsidiaries.
- UNDERWRITING. We believe we can gradually re-underwrite BIG's insurance
subsidiaries' books of business to enhance profitability. The pricing and
persistency risk associated with the re-underwriting of larger accounts is
being mitigated by ceding accounts with estimated annual premium of
$25,000 or more at inception to a reinsurer.
- INFORMATION SYSTEMS. We believe that our data processing systems give us a
significant competitive advantage by (1) enhancing the effectiveness of
our employees' underwriting, policy administration, and claims activities,
(2) providing detailed, real-time, and near real-time information to
management for control and administration purposes, and (3) providing
marketing benefits through improved customer service.
- LOSS CONTROL AND CLAIMS MANAGEMENT. We believe ourselves to be industry
leaders in loss control for workers' compensation. Additionally, once a
claim is made we expect to benefit from the service agreements we have
with affiliates of Foundation Health Systems, Inc., and the claim severity
management services we have been obtaining from Risk Enterprise Management
Limited as part of our Claim Severity Management Program. These claim
practices will continue to emphasize rapid medical intervention to
mitigate the severity of injuries.
- PRODUCER RELATIONSHIPS. We are continuing to strengthen our marketing
relationships with our producers, including nationally recognized
insurance brokers with whom we have acquired relationships through the
acquisition of BIG. We endeavor to be the primary supplier of workers'
compensation insurance for many of our producers. We will continue to
emphasize our relationships with small- and medium-sized producers who
often use us as a primary underwriter of workers' compensation insurance.
OPERATING STRATEGY
We intend to continue to focus on underwriting profits while completing the
integration of Superior National and BIG. The key elements of our strategy to
maintain operating margins in our business are:
- FOCUS ON SPECIALIZED MARKET SEGMENTS. Our experienced management team
utilizes a sophisticated information system to focus on business for
selected policy sizes and employment classifications that management
believes provide the greatest opportunity for profitability.
- UNDERWRITING DISCIPLINE. Following the advent of open rating in California
in 1995, some California workers' compensation insurers reduced premium
rates substantially to increase or maintain market share. Superior
National management has not followed this practice and has maintained
stringent underwriting policies in order to maintain profit margins.
EXPERIENCED MANAGEMENT; BUSINESS RELATIONSHIPS WITH ZURICH AFFILIATES
We have an experienced executive management team. The Chief Executive
Officer and the Chief Operating Officer have over 60 years of combined workers'
compensation insurance business experience both inside and outside of
California. The Chief Financial Officer has over 20 years of experience in a
variety of insurance related finance and accounting roles. The experience of
management and our ability to access sophisticated data processing systems allow
us to react quickly to positive and negative developments in our markets and
operations.
In addition, we benefit from our business relationships with affiliates of
Zurich Reinsurance Centre Holdings, Inc. ("Zurich"), which have provided us
financing and access to their expertise and products, including claims
management services and reinsurance. We have extensive reinsurance relationships
with
2
<PAGE>
several affiliates of Zurich, including agreements that allow us to offer
policyholders insurance policies written by a Zurich affiliate having an A.M.
Best "A" rating. Several other affiliates of Zurich are providing services that
we have integrated into our Claim Severity Management Program. In 1997, an
affiliate of Zurich purchased $10.0 million of one of our subsidiaries Trust
Preferred Securities. In addition, in connection with our purchase of BIG,
another affiliate of Zurich purchased BICO from us and established an
underwriting arrangement with us for a fee equal to 2.5% of direct written
premium plus a pass through of all related expenses.
COMPANY STRUCTURE
SNIG has two direct, wholly owned active subsidiaries: BIG and Superior
National Capital Trust I (the "Trust"), a statutory business trust created under
the laws of the State of Delaware. BIG is an intermediate holding company and
was the surviving company in its January 1999 merger with Superior Pacific
Insurance Group, Inc., a former wholly-owned subsidiary of SNIG. As a result of
this merger, BIG has seven, direct, wholly owned active subsidiaries: SNIC,
SPCC, CalComp, CCIC, CBIC, InfoNet Management Systems, Inc. ("InfoNet"), and
Superior (Bermuda) Ltd. ("SBL"). InfoNet provides data processing purchasing
services to SNIG and its subsidiaries. SBL was formed in September 1995 to
facilitate the management of the run-off of SNIC's property and casualty ("P&C")
business.
We formed the Trust in December 1997 for the sole purpose of issuing its
Trust Preferred Securities, having an aggregate liquidation amount of $105.0
million, and investing the proceeds of $105.0 million in an equivalent amount of
SNIG's Senior Subordinated Notes. SNIG owns directly all of the common
securities issued by the Trust, which SNIG purchased for approximately $3.25
million. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity and Capital Resources."
SNIC's only subsidiary is wholly owned Western Select Service Corp., which
currently provides vocational rehabilitation, legal, paralegal, and other
services to SNIC and SPCC. No other BIG subsidiary has any active subsidiaries.
THE WORKERS' COMPENSATION INSURANCE MARKET
WORKERS' COMPENSATION INSURANCE. The workers' compensation insurance market
in the United States can be viewed as three "systems." The National Council of
Compensation Insurers ("NCCI") governs workers' compensation insurance rates,
forms, regulations, and statistical reporting, in almost all states except
California. The workers' compensation laws in effect in California differ from
those adopted in states where the NCCI regulatory and rating system dominates.
In California, rates and statistical reporting are governed by the Workers'
Compensation Insurance Rating Bureau (the "WCIRB"), and forms and regulations
are governed by the California Department of Labor Division of Workers'
Compensation. Thus, California represents a second system of workers'
compensation insurance. Certain states have monopolistic workers' compensation
insurance funds administered by the states, representing a third system.
NCCI states are predominately a no-fault system with a few states offering
employers the right to option-out of the no-fault system. A few of the states
operate under a minimum rate basis. However, an increasing number of states
offer either a suggested loss cost in an open rated environment, a deviation
from a mandated loss cost, a minimum rate with schedule rating or some
combination of a deviated and schedule rating plan. There is no cost limitation
established for most benefits, however each state establishes payment thresholds
for indemnity reimbursement and medical procedures.
In California, workers' compensation is a no-fault statutory system under
which an employer is required to provide its employees with medical care and
other specified benefits for work-related injuries and diseases. There are four
types of benefits payable under workers' compensation policies: disability,
vocational rehabilitation, medical, and death benefits. The amount of benefits
payable for various types of
3
<PAGE>
claims is established by statute and varies with the nature and severity of the
injury or disease, and the wage, occupation, and age of the employee. While no
dollar limitations are set for medical benefits and dollar limitations apply
only under certain circumstances to vocational rehabilitation benefits,
reinsurance typically covers liability in excess of a specified dollar amount
agreed upon by the insurer and the reinsurer.
CALIFORNIA MARKETPLACE. California is the country's largest workers'
compensation insurance market, with total direct written premium of $5.2 billion
in 1997. The California market is composed of (i) the State Fund, (ii)
companies, including us, that write workers' compensation insurance in
California but have significant writings in other lines of business and/or in
other states, and (iii) private sector companies that write exclusively workers'
compensation insurance specifically focused in California. The State Fund, which
is obligated to write workers' compensation insurance for any applicant,
including those turned down by the private sector carriers, is the largest
underwriter of workers' compensation insurance in California, accounting for
approximately 19.8% of the direct written premium in California in 1997. Because
the State Fund must accept all risks, its combined ratios have historically been
much higher than those of the private sector carriers. Despite these results,
the State Fund has consistently achieved profitability through the investment
income earned on its large invested asset portfolio. As of December 31, 1998,
the State Fund had invested assets of $7.2 billion and statutory capital and
surplus of $1.6 billion. The State Fund currently maintains an "A" claims paying
ability rating from S&P and an "A-" rating from A.M. Best. Although the State
Fund regularly competes with us for profitable underwriting business, we view
the State Fund's role as the "insurer of last resort" to be a significant
benefit because it eliminates the need to create an assigned risk plan in which
we and other insurers conducting business in California would be required to
participate.
NATIONAL MARKETPLACE. As a result of our acquisition of BIG, we underwrite
about $132.4 million of workers' compensation insurance in states where workers'
compensation is governed by NCCI rules. Total workers' compensation direct
written premium in non-monopolistic states other than California was
approximately $24.0 billion in 1998. According to NCCI statistics, the pure loss
ratios for workers' compensation policies declined from approximately 80.0% to
90.0% from 1988 to 1992 to approximately 55.0% form 1995 to 1997. Increased
price competition resulting from the attractive loss ratios returned by the
workers' compensation line of business resulted in an increase in pure loss
ratios to approximately 61.0% in 1998, and a further increase in loss ratios in
1999 is likely as well. At the same time pure loss ratios are increasing, NCCI
statistics indicate that loss adjustment expense ratios are also increasing,
from 12.6% of premium in 1995 to an estimated 14.0% in 1998. The competition for
workers' compensation business in NCCI states is generally dominated by
national, multi-line insurance and financial service enterprises. Some states
have assigned risk pools or plans that have historically been unprofitable, and
a portion of the profits or losses arising from these pools is allocated to
workers' compensation insurers operating in the pools' jurisdiction.
CALIFORNIA PRICING. Prior to January 1, 1995, the California Department of
Insurance (the "DOI") set minimum premium rates for workers' compensation
insurance to provide a stable environment for the pricing of such insurance. On
January 1, 1995, the State of California formally converted to a system of "open
rating" for workers' compensation insurance written within the state. Insurance
companies now file and use their own actuarially defensible rates. Following the
introduction of open rating, total direct written premium in the California
market decreased from $9.0 billion in 1993 to $5.2 billion in 1997 as many
carriers engaged in price competition.
Under California's "open rating" rate regulation system, the DOI sets "pure
premium" (effectively, the estimated claim and allocated claim adjustment
expense) rates for each employment classification. Insurance companies then
apply their own "multipliers" to the pure premium rate to adjust for that
company's anticipated unallocated claim adjustment and underwriting expenses.
These rates are then subject to further adjustment for each policyholder to
account for the policyholder's historical loss experience, the presence of
stricter safety programs, dividend and commission plans, and other factors. In
practice, however, workers' compensation insurance companies in California are
not subject to meaningful
4
<PAGE>
rate regulation. Since 1994, the DOI has routinely approved rate filings both
for us and our competitors that provide such a wide range of pricing flexibility
as to constitute effectively no rate regulation whatsoever. It has been our
experience in situations where a number of competitors are bidding on a single
risk to see bids on individual policies vary as much as 500% (for example, the
low bid may be $100,000 and the high bid $500,000). Pricing variation such as
this would generally not occur under normal regulatory conditions.
NATIONAL PRICING. Rate regulation outside of California occurs in a variety
of ways, and is somewhat more stringent and closely monitored by the regulatory
authorities. For example, on occasion our rate filings have been rejected or
modified by the regulatory authorities in states other than California,
something that has never happened with a California rate filing. Rates outside
of California are usually subject to approval by each state's insurance
commissioner. The commissioner reviews historical loss data usually provided by
the NCCI (except for Texas and New Jersey, which use different rating bases) and
then makes a recommendation to either approve, disapprove, or modify the NCCI
recommended rates. Depending on the state, rates are either minimum rates
(similar to pre-open rating in California) or, similar to California, they are
loss cost rates subject to modification by each company's "multipliers" as
determined by the actuaries of the individual carriers. In some states the loss
cost rates can also be deviated rather than have a multiplier applied. These
various filings are monitored through DOI calls for information and market
conduct audits.
OUR PRESENCE WITHIN THE CALIFORNIA WORKERS' COMPENSATION MARKET. Now that
we have completed the purchase of BIG we believe that we will be better
positioned than our competitors to compete successfully in the California
workers' compensation insurance market, while also reducing somewhat our
dependence on California for growth and profitability. We believe we will
benefit from our focus on workers' compensation insurance, and that our
leadership position in the California market will allow us to offer our
customers and producers outstanding service, innovative loss control programs,
and competitive pricing. The national presence provided by the purchase of BIG
has given us some diversification from the California market, offering what we
believe are attractive growth opportunities in a number of markets. We continue
to believe that pricing and underwriting policies designed specifically for
workers' compensation insurance means that our workers' compensation insurance
business should perform better financially than that of insurers who sell
workers' compensation insurance as part of a package of insurance.
OUR PRESENCE IN THE NATIONAL WORKERS' COMPENSATION MARKET. While we are a
major player in the California market, we are much smaller in the national
marketplace. The national market is comprised of over 40 states, each one with
varying degrees of opportunities. This diversification along with our relatively
small market share presents us with many more profit opportunities than a single
state carrier. We are confident that with the combination of our quality service
and our underwriting discipline we will be able to identify profitable states in
which we can successfully grow our premium base.
MARKETING
Superior National markets its insurance products through a nationwide
network of 17 regional offices and 23 branch offices, with 11 regional offices
in California. Superior National has historically expanded into a new region by
establishing a branch office with a few employees specializing in marketing,
underwriting, and loss control. As the branch office grew and there were
demonstrated needs for further infrastructure to support growth, resources were
added and certain branches became regional offices. Regional offices have
additional local management and support the growth of additional branch offices.
Superior National's expanding presence outside of California, which was
accomplished primarily through our acquisition of BIG, is indicated by the
growth in direct premiums written outside of California from $27.1 million in
1995 to, on a proforma basis for this acquisition, $179.3 million in 1998. As of
December 31, 1998, Superior National employed a staff of approximately 282
outside California.
5
<PAGE>
Superior National markets its products through a distribution network of
approximately 2,900 producers. Of these, over 1,750 are located in California,
and approximately 1,150 are located outside of California. Superior National
markets its policies through major national brokers as well as through small-to
medium-sized producers focusing on regional customers. The top ten producers
accounted for 11.6% of direct written premium in fiscal 1998, and the top 50
producers accounted for 36.2%. Superior National enters into brokerage contracts
with producers as opposed to agency relationships. Certain states require that
all appointments be made through an agency contract. No agent in these states
has the ability to bind Superior National to issue policies, and the same basic
contract that is used for brokerage appointments is also used for agency
appointments. Superior National also has relationships with certain other
producers ("Program Administrators") that have the ability to bind Superior
National to issue coverage to a customer based on its program administration
agreement with Superior National. These agreements call for override commissions
to be paid to the Program Administrators and most of the Program Administrators'
agreements provide for direct premium billing to policyholders. These agreements
may be canceled by Superior National with no recourse whatsoever if the Program
Administrator violates the terms of the agreement. All new and renewal
policyholder applications (other than those handled under a program
administration agreement) must be submitted to Superior National for approval.
Superior National is not committed to accept a fixed portion of any producer's
business, but must accept all policies written consistent with the underwriting
and pricing templates of the program administration agreements. Superior
National also has in force a variety of override, contingency, and
profit-sharing commission agreements with certain of its producers in order to
encourage a some level of pricing and profitability.
Consolidated premium in force after giving effect to our acquisition of BIG,
including business written by Superior National's several fronting companies,
was $669.0 million, versus $702.0 million, for the policy years ended December
31, 1998 and September 30, 1998, respectively. The $33.0 million decline in
premium in force occurred entirely in the BIG book of business due to the
re-underwriting and re-pricing of BIG policies to Superior National standards.
The premium in force associated with policies having estimated annual premium
under $25,000, and which are not subject to Superior National's large account
quota share contract to varying degrees depending on the policy issue date, was
$210.9 million on 50,850 policies, versus $216.2 million on 50,570 policies, for
the policy years ended December 31, 1998 and September 30, 1998, respectively.
Superior National continues to reorient its consolidated book of business to
smaller accounts, as indicated by the reduction in average policy size from
$12,490 at September 30, 1998 to $11,900 at December 31, 1998, including
policies underwritten by BIG insurance subsidiaries. Management believes that
smaller accounts will produce better loss ratios than large accounts due to
significantly lower levels of price competition associated with smaller
accounts.
Our legal relationship with our producers is evidenced by a broker
agreement, under which the producer agrees to present potential workers'
compensation risks to us on a non-exclusive basis. The broker agreement
principally documents that the producer represents his policyholder client, not
Superior National, establishes the producer's authority to bind us to risks,
typically extremely limited, and prescribes the terms under which premium must
be remitted. Because these producers also represent one or more competing
insurance companies, Superior National views the producers as its marketing
target and delivers service that we believe surpasses normal industry levels.
Superior National's percentage of business with each of its producers, in terms
of premium volume, has a significant effect on a producer's efforts, because we
believe companies that represent a significant volume of a producer's business
typically receive the highest quality business. Superior National is one of the
primary underwriters of workers' compensation insurance for most of its
producers. During the year ended December 31, 1998, no single producer
controlled more than 5.0% of our premium in force.
Superior National closely monitors its producers through its on-line
management information systems, with special attention given to the volume and
profitability of business written through Superior National. Relationships with
producers who consistently write unprofitable business, or do not meet the
minimum guideline of annual premium per year, may be terminated. Superior
National believes that by continually
6
<PAGE>
monitoring and improving the quality of the business acquired through its
producers, long-term profitability will be enhanced. See "--Information
Services."
The marketing staff, along with the branch office managers and the
underwriting, loss control, and regional claim staffs, work closely with
producers and frequently make joint presentations with producers to potential
workers' compensation policyholders. Superior National conducts its marketing by
territory to enable its marketing representatives to better address the specific
types of accounts located in each region.
Producer commissions are generally determined by negotiation and are
dependent on the size and profit potential of the producer's accounts. Superior
National's average direct commission rate was 13.2% for the year ended December
31, 1998, and 11.1% for the years ended December 31, 1997 and 1996. The Company
believes the stabilization in the average direct commission rate for the year
ended December 31, 1997 was due primarily to a combination of firming prices and
a greater use by larger policyholders of fee-based arrangements (as opposed to
traditional commission arrangements) with their insurance producers. Superior
National's producers (other than Program Administrators) are not permitted to
bind Superior National with respect to any account. All new and renewal
policyholder applications must be submitted to Superior National for approval.
Superior National is not committed to accept a fixed portion of any producer's
business.
UNDERWRITING
Because the types of accounts that Superior National insures vary among
different geographic regions, we conduct our underwriting activities through
branch offices that are focused on the local economies. While we underwrite a
wide variety of risk classifications, we target some classifications that we
believe to be profitable. We believe that by focusing on certain employment
classifications, we can provide claim management and loss control services at a
level appropriate to each policyholder. For the year ended December 31, 1998,
five employment classifications, made up primarily of hospitality, agricultural,
schools, garment, and health care workers, represented approximately 23% of
Superior National's premium in force. We exclude most employment classifications
that represent historically higher risk exposure, including the manufacturing,
handling, and shipping of explosives; oil rig and derrick work; subway
construction; and navigation of marine vessels. Classifications that require the
approval of Superior National's principal underwriting officer include those
that represent potential exclusions from Superior National's reinsurance
treaties, unusual hazards, or catastrophic exposures such as taxicab fleets,
carnivals, ski resorts, and detective agencies. Certain risks, such as the
transportation of groups of employees, are generally ceded to reinsurers under
separate reinsurance agreements.
Prior to insuring an account, Superior National's underwriting department
reviews, among other things, the employer's prior loss experience and safety
record, premium payment and credit history, operations, geographic location, and
employment classifications. Superior National verifies employment
classifications principally through information provided by the WCIRB and, in
many instances, through its own on-site surveys of the employer's place of
business.
Superior National's underwriting system is a fully integrated, computerized,
rating, quoting, and policy issuance system for use both internally and remotely
from producers' offices. The system contains edit and blocking features that
prohibit underwriters from issuing policies associated with business that is
deemed inappropriate or undesirable by management, or that may be
inappropriately priced. See "--Information Services."
Superior National offers a number of alternative pricing plans for its
customers, including retrospectively rated policies, deductible plans,
contingent surcharge plans, and, outside of California, dividend plans.
Retrospective rating results in a return of premium to customers if certain loss
criteria are achieved. Deductible plans offer customers lower premiums in
exchange for the customers' participating in the first layer of losses.
Contingent surcharge plans add additional premium at specified dates after
expiration of
7
<PAGE>
the policy if the account exceeds an expected loss ratio. The surcharge premium
is subject to return if the loss ratio is reduced in future periods.
In many states, workers' compensation insurers issue participating policies,
which allow the insurer to declare and pay dividends to a policyholder after
expiration of the policy. Although policyholder dividends are no longer an
important component of the workers' compensation insurance marketplace in
California, they remain a significant tool for Superior National to obtain and
retain business outside of California. Policyholder dividends may be computed as
a flat rebate to the policyholder upon achievement of certain loss ratios or
expense factors, or, more commonly, reflect an amount that is not guaranteed but
is determined based on the insurer's view of a number of related factors
including loss ratio, the class of business, geographic location and premium
payment history of the policyholder, risk and expense factors, competition in
the marketplace, and the overall financial condition of the insurer.
LOSS CONTROL
In addition to its responsibility for risk evaluation as part of the
underwriting process, our loss control department may assist policyholders in
developing and maintaining safety programs and procedures to minimize on-the-job
injuries and health hazards. After analyzing the policyholder's loss profile,
our loss control consultants will help develop a loss control program and
establish accident reporting and claim follow-up activities for the
policyholder. Our loss control personnel may also consult with policyholder
management about safety and health issues, as well as about the effectiveness of
the policyholder's loss prevention procedures. Our loss control department seeks
to control claims before they occur, and loss control has formed a key component
of Superior National's business strategy. In addition, Superior National
utilizes comprehensive reports to track loss control results and key factors in
reducing claims.
CLAIM SEVERITY MANAGEMENT PROGRAM
Effective December 31, 1997, we entered into agreements with Risk Enterprise
Management Limited ("REM") and Zurich Reinsurance (North America), Inc.
("ZRNA"), affiliates of Zurich, to provide claim management services for our
"Claim Severity Management Program." Under this program, REM, acting as a third
party administrator, provides claim processing and management services to SNIC
and SPCC, and ZRNA provides SNIC and SPCC with protection predicated on REM's
ability to reduce SNIC and SPCC's claim severity. We may terminate the contract
with six months notice after the initial three-year term of the contract, with a
penalty that will not exceed $250,000 plus REM's reasonable expenses to unwind
the agreement.
REM, in its capacity as a third party administrator, provides certain claim
management services, while we provide claim facilities and data processing
systems. All of SNIC's and SPCC's claim personnel have been moved to an
independent contractor service provider as part of the Claim Severity Management
Program. The terms of the agreement bind REM to certain operational restrictions
and performance standards designed to assure quality claims administration. We
believe that combining REM's claim management techniques with our claim
processing systems produced material improvements in SNIC's and SPCC's claim
severity, more than offsetting the cost of such services. We also believe this
program has reduced SNIC's and SPCC's ultimate loss cost severity with favorable
cost-benefit trade-offs.
Under the agreement with ZRNA, ZRNA will credit SNIC's and SPCC's direct
claim costs, up to an aggregate of $30.0 million, to the extent that REM is
unsuccessful in reducing claim severity to certain prescribed levels. As of
December 31, 1998 and 1997, the $30.0 million has been recognized under the
terms of the agreement. No recoveries have been received as of December 31,
1998.
SNIC's and SPCC's claims services are provided primarily by Comprehensive
Compensation Claims Management, Inc. ("3CM"), which we formed with the support
of REM for that purpose. We, along with REM, continue to work closely with
policyholders to return injured workers to the job as quickly as is medically
appropriate. 3CM continues to maintain for SNIC and SPCC four full service claim
service
8
<PAGE>
offices ("CSOs") in California, which are located in Woodland Hills, Fresno,
Pleasanton, and Sacramento. Additionally, we use a 3CM CSO in Phoenix, Arizona.
Each CSO is managed by a claims manager. The claims technical staffs are
organized into units with, generally, one supervisor supervising four claims
examiners and two claims assistants per unit.
3CM relies extensively on our data processing systems. Our data processing
systems were developed internally through a joint effort of the claim and
management information systems departments' personnel with three goals in mind:
to capture timely and meaningful data, reduce the possibility of human error
through a series of system prompts and edit checks, and automate manual
functions. An additional benefit of the claims system is the increased
productivity that results from the claims examiners' ability to handle larger
case loads.
3CM's claims handling also includes a specialized subrogation function.
Claims examiners are responsible for the identification of potential recoupments
from third parties responsible for a work-related accident. If such a potential
is identified, the examiner notifies a subrogation specialist. The subrogation
specialist then will determine whether a subrogation situation exists, and, if
so, will assume responsibility for all aspects of subrogation to its conclusion.
BIG CLAIM MANAGEMENT
BIG's claims department is organized on the basis of claim supervisory units
consisting of four to six claims examiners, each responsible for 150-170 claims;
one claims assistant for each claims examiner; one file clerk for each
supervisory unit; and one data entry clerk/processor for each supervisory unit.
A vocational rehabilitation specialist is utilized in each unit to evaluate
vocational rehabilitation plans and attend formal and informal rehabilitation
planning conferences. Claims examiners are responsible for vocational
rehabilitation plan approval and statutory filings. Each claims unit also
employs a specialist to handle settlement negotiations. BIG's claims handling
policy includes contacting the injured worker within 24 hours of notification of
the injury, obtaining a recorded statement during the initial claimant contact,
and maintaining monthly contact while the injured worker is receiving total
disability payments. BIG uses third party administrators for the handling of
claims and loss contol services that are associated with captive programs,
representing a small portion of its estimated annual premium.
Since 1992, BIG has maintained a Special Investigations Unit to handle
potentially fraudulent claims. The group consists of former law enforcement
officers and medical and claims experts, and provides training to employees and
customers in areas of fraud recognition, trends, and legal updates.
CLAIM AND CLAIM ADJUSTMENT EXPENSE RESERVES
Several years or more may elapse between the occurrence of a workers'
compensation loss, the reporting of the loss, and final payment of the loss.
Claim and claim adjustment expense reserves are estimates of what an insurer
expects to pay claimants. We are required to maintain reserves for payment of
estimated claim and claim adjustment expense for both reported claims and claims
that have been incurred but not reported ("IBNR"). Our ultimate liability may be
materially more or less than current reserve estimates.
Reserves for reported claims are established on a case-by-case basis. Case
level reserves are determined by our claims examiners based on their judgment
and experience. Claims examiners set reserves by taking into account the type of
risk insured, the circumstances surrounding the claim or policy provisions
relating to type of loss, and historical paid claim and claim adjustment expense
data for similar claims. Case level reserves are not uniformly established for
claim adjustment expense throughout Superior National, and the entire reserve
for claim adjustment expense is established primarily based upon our historical
paid data. Our claim service providers regularly monitor reserve adequacy for
claims that have occurred and been reported and we adjust such reserves as
necessary.
9
<PAGE>
Claim and claim adjustment expense reserves for claims that are incurred but
not yet reported are estimated based on many variables. Those variables include
historical and statistical information, inflation, legal developments, the
regulatory environment, benefit levels, economic conditions, judicial
administration of claims, general frequency and severity trends, medical costs,
and other factors affecting the adequacy of loss reserves. Changes in our
operations and management philosophy may also cause actual developments to vary
from those of the past. The adoption of new data processing systems, shifts to
underwriting more or less hazardous risk classifications, the hiring of new
claims personnel, changes in claim servicing vendors and third party
administrators, may all change rates of reserve development, payments, and claim
closings, increasing or decreasing claim severity and closing rates. See "--Risk
Factors--Our estimates of reserves for unpaid claim and unpaid claim adjustment
expenses may be inaccurate and therefore insufficient to pay unreported claims
and associated costs."
Adjustments in aggregate reserves are reflected in the operating results of
the period during which such adjustments are made. Although reserves established
for claims may not be paid for several years or more, the reserves are not
discounted, except to calculate taxable income as required by the Internal
Revenue Code.
The following table provides a reconciliation of the beginning and ending
claim and claim adjustment expense reserves for each of the years in the
three-year period ended December 31, 1998, computed in accordance with GAAP.
RECONCILIATION OF LIABILITY FOR CLAIM AND CLAIM ADJUSTMENT EXPENSE
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------------
<S> <C> <C> <C>
1998 1997 1996
------------ ---------- ----------
<CAPTION>
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C>
Beginning reserve, gross of reinsurance.................................... $ 201,255 $ 115,529 $ 141,495
Less: Reinsurance recoverable on unpaid losses............................. 49,155 24,986 27,076
------------ ---------- ----------
Beginning reserve, net of reinsurance...................................... 152,100 90,543 114,419
Pac Rim reserves at acquisition............................................ -- 104,588 --
BIG reserves at acquisition................................................ 495,709 -- --
BIG funds held liability at acquisition.................................... 113,226 -- --
Provision for net claim and claim adjustment expenses
For claims occurring in current year..................................... 36,650 95,826 57,614
For claims occurring in prior years...................................... 31,692 (5,379) (1,976)
For claims existing on BIG at acquisition................................ 175,000 -- --
------------ ---------- ----------
Total claim and claim adjustment expenses................................ 243,342 90,447 55,638
------------ ---------- ----------
Reinsurance recovery on loss reserve guarantee............................. (175,000) -- --
Payments for net claim and claim adjustment expense:
Attributable to insured events incurred in current year.................. (76,823) (37,945) (19,816)
Attributable to insured events incurred in prior years................... (108,807) (95,533) (59,698)
------------ ---------- ----------
Total claim and claim adjustment expense payments........................ (185,630) (133,478) (79,514)
Change in funds withheld................................................... 12,502 -- --
Adjustment for ZRNA Quota-Share Commutation................................ 7,367 -- --
------------ ---------- ----------
Ending reserves, net of reinsurance........................................ 663,616 152,100 90,543
Reinsurance recoverable on unpaid losses................................... 237,590 49,155 24,986
Loss reserve guarantee..................................................... 175,000 -- --
------------ ---------- ----------
Ending reserves, gross of reinsurance...................................... $ 1,076,206 $ 201,255 $ 115,529
------------ ---------- ----------
------------ ---------- ----------
</TABLE>
10
<PAGE>
During 1998, Superior National experienced relatively stable frequency of
claims but continued to experience an increase in claim severity for accident
years 1995 and after. Our net claim and claim adjustment expense ratio, net of
reinsurance recovery on loss reserve guarantee, for calendar year 1998, 1997,
and 1996 was 78.5%, 64.2%, and 62.8%, respectively. The 1998 claim and claim
adjustment expense ratio does not include the BIG claim and claim adjustment
expense incurred prior to the acquisition.
In 1998, Superior National experienced approximately $31.7 million in
unfavorable development on net claim and claim adjustment expenses estimated at
December 31, 1997, and $175.0 million with respect to reserves acquired from the
BIG acquisition on December 10, 1998. The $31.7 million unfavorable development,
related to 1997 and prior accident years, is attributable to incurred claim and
claim adjustment expense associated with SPCC. The $175.0 million of unfavorable
development on BIG claims existing at the acquisition date was recorded as a
result of an independent actuarial review by the actuary who has historically
reviewed BIG's reserves. The independent actuary cited in its report the
following as the possible reasons for the apparent unfavorable development:
- Increases in permanent disability rates in California beginning in late
1996;
- The inability of California workers' compensation insurance companies to
permanently settle the vocational rehabilitation portion of a claim;
- A California court decision under which there is a presumption that a
claimant's primary treating physician's diagnosis of the claimant's injury
is automatically correct; and
- The potential miscalculation of claims closing rates in prior years as a
result of changes in the definition of a true disability claim as opposed
to a claim with medical only claims.
We are studying each of the possibilities described above, and performing
our own analysis of BIG's claim and claim adjustment expense experience, to
determine why the apparent development might have occurred and to take steps to
address the possible causes of the apparent development.
In 1997, Superior National experienced approximately $5.4 million in
favorable development on net claim and claim adjustment expense reserves
estimated at December 31, 1996. This $5.4 million favorable development is the
result of a $10.8 million favorable development on ceded reserves for accident
years 1996 and prior. The $10.8 million favorable development on ceded reserves
is attributable to SPCC and due to the post-acquisition review of all open claim
files and the subsequent adjustment to reserves, which caused many claims to
have incurred claim and claim adjustment expenses in excess of the retention on
SPCC's reinsurance treaties. The $10.8 million favorable development is offset
by a $5.4 million adverse development on direct reserves attributable to the
accident years 1995 and 1996. Superior National believes similar adverse
development has been experienced throughout the California workers' compensation
industry, perhaps due to an increase in claim severity.
In 1996, Superior National experienced approximately $2.0 million in
favorable development on net claim and claim adjustment expense reserves
estimated at December 31, 1995. This $2.0 million favorable development is the
result of $8.4 million in favorable development on direct reserves for accident
years 1994 and prior. The favorable development was offset in part by $4.1
million in adverse development on direct reserves for accident year 1995. The
net claim and claim adjustment expense ratio for accident year 1995 at the end
of calendar year 1995 was 65.6% versus 74.6% at the end of the 1996 calendar
year. Superior National believes, from its review of data obtained by the WCIRB,
that similar adverse development has been experienced throughout the California
workers' compensation industry.
On April 11, 1997, we acquired SPCC. The claim and claim adjustment expenses
related to SPCC for this analysis are reflected in our 1997 and subsequent claim
and claim adjustment expense balances regardless of the year the claim was
previously incurred by SPCC. On December 10, 1998, we acquired BIG. The claim
and claim adjustment expenses related to BIG for this analysis are reflected in
our 1998 claim and claim adjustment expense balances regardless of the year the
claim was previously incurred by BIG. To the extent that claims develop in the
future or close favorably, the results will be reflected in the calendar year
development to which it relates.
11
<PAGE>
The following table discloses the development of direct workers'
compensation claim and claim adjustment expense reserves of Superior National
from December 31, 1988 through December 31, 1998.
ANALYSIS OF DIRECT CLAIM AND CLAIM ADJUSTMENT EXPENSE DEVELOPMENT
<TABLE>
<CAPTION>
CALENDAR YEARS ENDED DECEMBER 31,
-------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1988 1989 1990 1991 1992 1993 1994 1995 1996
--------- --------- --------- --------- --------- --------- --------- --------- ---------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Reserve for Unpaid Claim
and Claim
Adjustment Expenses,
Gross of Reinsurance
Recoverables
Reserve.............. $ 42,268 $ 60,615 $ 88,270 $ 116,811 $ 136,102 $ 171,038 $ 171,258 $ 141,495 $ 115,529
Reserve Re-estimated as
of:
One Year Later......... 43,581 68,718 112,160 144,676 162,634 171,960 162,635 137,242 120,999
Two Years Later........ 46,788 79,059 111,151 143,912 148,906 161,262 145,626 145,209 124,090
Three Years Later...... 50,955 74,619 117,506 138,607 152,420 148,654 144,173 141,653
Four Years Later....... 47,696 78,112 113,029 137,939 144,898 148,983 150,294
Five Years Later....... 49,297 75,475 112,840 135,074 146,867 149,119
Six Years Later........ 47,554 75,913 109,655 138,048 145,415
Seven Years Later...... 49,470 74,149 111,871 134,327
Eight Years Later...... 48,653 75,898 109,458
Nine Years Later....... 49,451 73,295
Ten Years Later........ 47,398
Cumulative (Deficiency)
Redundancy............. (5,130) (12,680) (21,188) (17,516) (9,313) 21,919 20,964 (158) (8,561)
Cumulative Amount of
Reserve Paid Through
One Year Later......... $ 17,698 24,478 42,627 53,914 57,348 60,726 67,757 63,587 69,658
Two Years Later........ 19,879 35,195 51,160 56,299 61,648 66,077 61,952 72,946 48,446
Three Years Later...... 25,830 38,067 52,761 63,354 63,523 64,464 67,388 74,912
Four Years Later....... 26,165 38,261 57,332 64,703 66,547 66,754 67,997
Five Years Later....... 26,026 40,794 59,093 68,152 66,750 64,533
Six Years Later........ 27,181 42,032 59,917 69,052 65,735
Seven Years Later...... 27,202 43,146 60,749 67,586
Eight Years Later...... 27,947 42,898 60,731
Nine Years Later....... 27,857 43,637
Ten Years Later........ 28,488
Gross Reserve--December 31...................................................... 171,038 171,258 141,495 115,529
Reinsurance Recoverables Net of Funds Held Liability............................ (28,971) (31,897) (27,076) (24,986)
Reclassification of Amounts Recoverable from Reinsurers......................... (42,032) (34,269) (11,696) --
--------- --------- --------- ---------
Net Reserve--December 31........................................................ 100,035 105,092 102,723 90,543
--------- --------- --------- ---------
--------- --------- --------- ---------
Gross Re-estimated Reserve...................................................... 149,119 150,294 141,653 124,090
Re-estimated Reinsurance Recoverables........................................... (23,589) (25,511) (24,799) (35,835)
Reclassification of Amounts Recoverable from Reinsurers......................... (42,032) (34,269) (11,696) --
--------- --------- --------- ---------
Net Re-estimated Reserve........................................................ 83,498 90,514 105,158 88,255
--------- --------- --------- ---------
--------- --------- --------- ---------
Net Cumulative (Deficiency) Redundancy.......................................... 16,537 14,578 (2,435) 2,288
--------- --------- --------- ---------
--------- --------- --------- ---------
<CAPTION>
<S> <C> <C>
1997 1998
--------- ---------
<S> <C> <C>
Reserve for Unpaid Claim
and Claim
Adjustment Expenses,
Gross of Reinsurance
Recoverables
Reserve.............. $ 201,255 $1,076,206
Reserve Re-estimated as
of:
One Year Later......... 254,643
Two Years Later........
Three Years Later......
Four Years Later.......
Five Years Later.......
Six Years Later........
Seven Years Later......
Eight Years Later......
Nine Years Later.......
Ten Years Later........
Cumulative (Deficiency)
Redundancy............. (53,388)
Cumulative Amount of
Reserve Paid Through
One Year Later......... 99,550
Two Years Later........
Three Years Later......
Four Years Later.......
Five Years Later.......
Six Years Later........
Seven Years Later......
Eight Years Later......
Nine Years Later.......
Ten Years Later........
Gross Reserve--December 3 201,255 1,076,206
Reinsurance Recoverables (49,155) (412,590)
Reclassification of Amoun -- --
--------- ---------
Net Reserve--December 31. 152,100 663,616
--------- ---------
--------- ---------
Gross Re-estimated Reserv 254,643
Re-estimated Reinsurance (70,851)
Reclassification of Amoun --
---------
Net Re-estimated Reserve. 183,792
---------
---------
Net Cumulative (Deficienc (31,692)
---------
---------
</TABLE>
The first line of the preceding table depicts the estimated liability for
unpaid claim and claim adjustment expense recorded on our balance sheets at the
indicated balance sheet dates. This liability represents the estimated amount of
claim and claim adjustment expense for claims arising during all years prior to
the indicated balance sheet date that are unpaid as of that balance sheet date,
gross of reinsurance recoverables, including losses that have been incurred but
not yet reported. The table also shows the re-estimated liability as of the end
of each succeeding year through the latest balance sheet date, and the
cumulative payments made for such claims, at annual intervals after the initial
indicated balance sheet
12
<PAGE>
date. The claim and claim adjustment expense liability estimates change as more
information becomes known about the frequency and severity of claims for each
year. A direct reserve redundancy or deficiency is displayed for each balance
sheet date in the center of the table when the initial liability estimate is
greater (or less) than the re-estimated liability at the latest balance sheet
date.
The direct reserve deficiency associated with the year ended December 31,
1988 was due to the lack of claim and claim adjustment expense history, which
prevented management from accurately estimating ultimate claim costs. The direct
deficiencies associated with reserves as of December 31, 1989, 1990, 1991, and
1992 were due primarily to: (1) unexpected increases in claim costs resulting
from increased litigation in the California workers' compensation system, (2) an
economic recession in California, and (3) workers' compensation laws that at the
time effectively encouraged workers to file unwarranted psychiatric stress and
fraudulent claims. The direct redundancies associated with the years ended
December 31, 1993 and 1994 occurred primarily as a result of reforms in the
California workers' compensation laws that became effective January 1, 1993 and
an improvement in the California economy that were not anticipated when reserves
were established. The direct reserve deficiencies associated with the years
ended December 31, 1995, 1996, and 1997 occurred primarily as a result of
unexpected increases in severity affecting claims occurring from 1995 and after.
The 1997 deficiency also resulted from incurred claim and claim adjustment
expenses associated with SPCC.
Superior National's experience with direct reserve deficiencies occurring
for the years 1989 through 1992, and 1995 through 1997, and direct redundancies
occurring for the years 1993 and 1994, is consistent with the results
experienced by the California workers' compensation industry during the same
time periods. The direct reserve deficiencies occurring for the years ended
December 31, 1995 through 1997 resulted from unexpected increases in claim
severity, consistent with other California workers' compensation insurers'
experience. The net-of-reinsurance redundancies displayed at the bottom of the
table reflect Superior National's per risk excess of loss, quota-share, and
aggregate excess of loss reinsurance, the effects of which were to reduce
Superior National's direct redundancies/deficiencies due to the cession to a
reinsurer of a portion of Superior National's development.
We periodically perform comprehensive studies of our workers' compensation
claim and claim adjustment expense experience, and the way in which we estimate
claim and claim adjustment expense liabilities is continually modified to
consider additional information regarding trends in pricing, frequency, and
severity. However, conditions and trends that have historically affected
Superior National's claims may not necessarily be indicative of conditions and
trends that will affect future claims, and it is not appropriate to extrapolate
future reserve redundancies or deficiencies based on the data set forth above.
DISCONTINUED OPERATIONS
Superior National's discontinued operations consist of P&C business that was
discontinued effective September 30, 1993. The discontinued operations
liabilities pertain to contractors' general liability policies underwritten
during the years 1986 through 1990. There is often a significant lag between the
date of loss of construction-related claims and the date such claims are
reported to Superior National. We believe the existing provision is sufficient
to cover future claims, but there is significant uncertainty associated with the
reporting and severity of construction claims. Certain investments are allocated
to discontinued operations to fund future claim and claim adjustment expense
payments. We estimate that discontinued operations will essentially have
"run-off" by the year 2005.
In 1993, we recorded a pre-tax charge to income of $4.5 million for
estimated operating losses during the phase-out period. During the second
quarter of 1995, we increased by approximately $15.0 million our reserves for
discontinued operations for accident years 1993 and prior and have not increased
them since.
The following table provides a reconciliation of the beginning and ending
claim and claim adjustment expense reserves for discontinued operations for each
of the years in the three-year period ended December 31, 1998, computed in
accordance with GAAP.
13
<PAGE>
RECONCILIATION OF LIABILITY FOR DISCONTINUED OPERATIONS CLAIM AND CLAIM
ADJUSTMENT EXPENSE
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C>
Beginning reserve, gross of reinsurance.......................... $ 18,686 $ 25,466 $ 40,526
Less: Reinsurance recoverable on unpaid losses................... 5,216 6,976 9,159
--------- --------- ---------
Beginning reserve, net of reinsurance............................ 13,470 18,490 31,367
Provision for net claim and claim adjustment expenses
For claims occurring in current year........................... -- -- --
For claims occurring in prior years............................ -- -- --
--------- --------- ---------
Total claim and claim adjustment expenses........................ -- -- --
--------- --------- ---------
Payments for net claim and claim adjustment expense
For claims occurring in current year........................... -- -- --
For claims occurring in prior years............................ (4,557) (5,020) (12,877)
--------- --------- ---------
Total claim and claim adjustment expense....................... (4,557) (5,020) (12,877)
--------- --------- ---------
Ending reserves, net of reinsurance.............................. 8,913 13,470 18,490
Reinsurance recoverable on unpaid losses......................... 6,143 5,216 6,976
--------- --------- ---------
Ending reserves, gross of reinsurance............................ $ 15,056 $ 18,686 $ 25,466
--------- --------- ---------
--------- --------- ---------
</TABLE>
The following table discloses the development of direct discontinued
operations claim and claim adjustment expense reserves from December 31, 1988
through December 31, 1998.
14
<PAGE>
ANALYSIS OF DISCONTINUED OPERATIONS DIRECT CLAIM AND CLAIM ADJUSTMENT EXPENSE
DEVELOPMENT
<TABLE>
<CAPTION>
CALENDAR YEARS ENDED DECEMBER 31,
-------------------------------------------------------------------------------------------------
1988 1989 1990 1991 1992 1993 1994 1995 1996
--------- --------- --------- --------- --------- --------- --------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Reserve for Unpaid Claim and
Claim Adjustment Expenses,
Gross of Reinsurance
Recoverables Reserve........ $ 25,935 $ 41,088 $ 56,735 $ 65,629 $ 66,532 $ 54,898 $ 36,410 $ 40,526 $ 25,466
Reserve Re-estimated as of:
One Year Later.............. 32,395 56,093 73,295 83,770 73,298 56,041 54,855 41,293 29,403
Two Years Later............. 43,160 60,679 89,336 91,453 73,067 75,703 55,622 45,230 31,665
Three Years Later........... 43,585 72,860 98,206 90,717 96,531 76,079 59,559 47,492
Four Years Later............ 52,261 82,218 102,538 117,215 92,569 80,698 61,821
Five Years Later............ 61,539 84,304 126,431 113,084 97,647 82,542
Six Years Later............. 63,072 103,326 123,722 117,720 99,101
Seven Years Later........... 77,080 104,428 128,637 118,834
Eight Years Later........... 78,938 108,240 129,888
Nine Years Later............ 80,932 109,731
Ten Years Later............. 82,293
Cumulative (Deficiency)....... (56,358) (68,643) (73,153) (53,205) (32,569) (27,644) (25,411) (6,966) (6,199)
Cumulative Amount of Reserve
Paid Through One Year
Later....................... 13,754 19,839 27,397 29,274 26,473 23,043 14,329 15,827 10,717
Two Years Later............. 15,301 26,399 35,278 29,165 23,483 16,203 16,765 10,717 5,893
Three Years Later........... 19,844 32,188 39,203 28,136 18,380 19,649 11,857 5,893
Four Years Later............ 23,007 37,758 42,135 23,255 17,777 19,263 7,665
Five Years Later............ 28,609 38,798 41,835 22,047 18,276 15,178
Six Years Later............. 31,715 37,585 42,943 23,104 14,705
Seven Years Later........... 31,247 42,260 42,363 20,576
Eight Years Later........... 37,394 40,796 41,663
Nine Years Later............ 41,325 41,112
Ten Years Later............. 42,643
Gross Reserve--December 31........................................................... 54,898 36,410 40,526 25,466
Reinsurance Recoverables............................................................. 8,379 8,777 9,159 6,976
--------- --------- --------- ---------
Net Reserve--December 31............................................................. 46,519 27,633 31,367 18,490
--------- --------- --------- ---------
--------- --------- --------- ---------
Gross Re-estimated Reserve........................................................... 82,542 61,821 47,492 31,665
Re-estimated Reinsurance Recoverables................................................ 22,221 19,182 16,125 13,175
--------- --------- --------- ---------
Net Re-estimated Reserve............................................................. 60,321 42,639 31,367 18,490
--------- --------- --------- ---------
--------- --------- --------- ---------
Net Cumulative (Deficiency).......................................................... (13,802) (15,006) -- --
--------- --------- --------- ---------
--------- --------- --------- ---------
<CAPTION>
1997 1998
--------- ---------
<S> <C> <C>
Reserve for Unpaid Claim and
Claim Adjustment Expenses,
Gross of Reinsurance
Recoverables Reserve........ $ 18,686 $ 15,056
Reserve Re-estimated as of:
One Year Later.............. 20,948
Two Years Later.............
Three Years Later...........
Four Years Later............
Five Years Later............
Six Years Later.............
Seven Years Later...........
Eight Years Later...........
Nine Years Later............
Ten Years Later.............
Cumulative (Deficiency)....... (2,262)
Cumulative Amount of Reserve
Paid Through One Year
Later....................... 5,893
Two Years Later.............
Three Years Later...........
Four Years Later............
Five Years Later............
Six Years Later.............
Seven Years Later...........
Eight Years Later...........
Nine Years Later............
Ten Years Later.............
Gross Reserve--December 31.... 18,686 15,056
Reinsurance Recoverables...... 5,216 6,143
--------- ---------
Net Reserve--December 31...... 13,470 8,913
--------- ---------
--------- ---------
Gross Re-estimated Reserve.... 20,948
Re-estimated Reinsurance Recov 7,478
---------
Net Re-estimated Reserve...... 13,470
---------
---------
Net Cumulative (Deficiency)... --
---------
---------
</TABLE>
The first line of the preceding table depicts the estimated liability for
unpaid claim and claim adjustment expense for discontinued operations recorded
for each of the indicated periods. The table follows the form of the table
depicting workers' compensation reserve development in "Analysis of Direct Claim
and Claim Adjustment Expense Development," above.
From 1988 to 1990, the increase in ultimate claim and claim adjustment
expense for discontinued operations was due primarily to the lack of history, as
well as changes in economic and legal environments that prevented us from
reasonably estimating ultimate loss costs. Thereafter, a full actuarial analysis
has been performed semi-annually taking into account our history of reserve
development, industry claim experience, and the effects of litigation on future
loss costs.
Our pre-1991 discontinued operations claims are attributable to construction
defect claims associated with commercial package policies sold to general
contractors, developers, and artisan contractors underwritten from 1986 to 1993.
Other insurance companies writing these same lines of business have also been
negatively affected by the unfavorable increase in claims frequency and severity
that occurred as a result of
15
<PAGE>
changes in the economic and legal environment during this time. At December 31,
1998 virtually all of direct reserves for discontinued operations were
attributable to construction defect claims.
The frequency of newly reported construction defect claims increased
significantly after July 1995. The increase in new construction defect claims
was attributable to the California Supreme Court decision in MONTROSE CHEMICAL
CORPORATION V. ADMIRAL INSURANCE COMPANY ("Montrose") in July 1995. The Montrose
decision broadened the definition of "loss occurrence" to include the entire
period beginning with the construction date and ending with the date of judgment
associated with defective construction. Since July 1995 we have received notices
of claims on allegedly defective construction projects where the manifestation
of the loss, the immediate cause of the loss, and the first report of the loss,
all fall outside of our policy terms. Regardless, under the California Supreme
Court's ruling, we are compelled to defend the "insured" and contribute to loss
settlements.
We cannot predict the volume of future Montrose-related claims, the cost of
handling the claims, or the ultimate severity of loss associated with such
claims, but believe our current reserves are adequate to cover this increase in
claims activity, depending on the length of time the recent reporting trends
continue. There can be no assurance, however, that further upward development of
ultimate loss costs associated with construction defect claims will not occur.
REINSURANCE
Superior National uses reinsurance to reduce its liability on individual
claims, individual policies, and aggregate catastrophic losses, consistent with
standard insurance industry practice. The availability and cost of reinsurance
are subject to market and regulatory conditions and may affect our
profitability. The effectiveness of our reinsurance program depends on the
security of the reinsurers, the coverage provided by the reinsurers and the
price for which the reinsurers are willing to sell their product. We monitor our
reinsurers' financial condition carefully, and recoverable losses are pursued
aggressively. Reinsurance makes the assuming reinsurer liable to the insurer to
the extent of the reinsurance ceded, but it generally does not legally discharge
an insurer of its primary liability for the full amount of the policy liability.
If a reinsurer fails to meet its obligations under a reinsurance agreement, the
ceding company is required to pay the loss. Occasionally, we are involved in
disputes with our reinsurers, which, if not settled, may be resolved in
arbitration or formal legal action. At December 31, 1998, there were no
reinsurance disputes related to the workers' compensation operations.
REINSURANCE IN FORCE. We maintain a variety of quota share and excess of
loss reinsurance contracts with various reinsurers. As of December 31, 1998,
American Re-Insurance Company ("Am Re"), United States Life Insurance Company
("US Life"), and General Reinsurance Corporation ("Gen Re") accounted for 34.9%,
30.7% and 12.1%, respectively, of our reinsurance recoverables. These total
amounts recoverable by all of SNIG's insurance subsidiaries from all reinsurers
on paid and unpaid claim and claim adjustment expenses were the only reinsurers
that accounted for more than 10% of such amounts. Descriptions of these
reinsurance arrangements are provided below.
Effective January 1, 1994, SNIC entered into the "ZRNA Quota-Share." Under
the ZRNA Quota-Share, ZRNA may provide SNIC and SPCC with an Assumption of
Liability Endorsement facility ("ALE"), or, effective January 1, 1997, SNIC and
SPCC may write directly on policy forms of ZC Insurance Company ("ZCIC"), an
affiliate of Zurich (the "ZCIC Underwriting Agreement"). The ceding rate under
the contract was 20% for 1994, and we and ZRNA agreed to reduce the quota-share
participation to 5% for 1995 and 1996. Further, Superior National received
ceding commissions ranging between 22.5% and 24.5% for premiums ceded to ZRNA
under the 1994-1997 contracts. The purpose of the ceding commission is to cover
SNIC's and SPCC's cost of acquiring new business and may be changed as a result
of changes in market conditions on a quarterly basis.
16
<PAGE>
Effective January 1, 1997, the terms of the ZRNA Quota-Share were amended to
increase ZRNA's participation from 5% of premiums written in 1996 to 6.5% in
1997. In exchange for the increased participation, ZRNA no longer received a
separate fee for policies written on ALEs, but received an additional 2% of
premiums written on ZCIC Underwriting Agreement policies only.
Effective January 1, 1998, the terms of the ZRNA Quota-Share again were
amended to increase the ceding commission to 27.5% for non-ZCIC policies and on
ALE premium. The ceding commission on ZCIC policies remained at 20%. Further,
the additional 2% of premium paid to ZCIC for its underwriting was eliminated.
Effective June 30, 1998, SNIC entered into an agreement with ZRNA to settle
and commute all obligations and liabilities known and unknown associated with
the ZRNA Quota-Share and its related ALE facility for the contract years
incepting January 1, 1994 through 1997. ZRNA paid SNIC $5.6 million and SNIC
reassumed from ZRNA all of its workers' compensation claim and allocated claim
adjustment expense reserves previously ceded to ZRNA for contract years 1994
through 1997.
Effective July 1, 1998, SNIC and SPCC entered into an Aggregate Excess of
Loss Agreement with ZRNA. SNIC and SPCC will cede to ZRNA $11.0 million of claim
and allocated claim adjustment expenses for each twelve-month period ending June
30, 1999 through June 30, 2001 to the extent SNIC's and SPCC's claim and
allocated claim adjustment expenses exceed 105% of earned premium during the
twelve-month period. SNIC and SPCC paid ZRNA cash and securities with a fair
market value of $15.6 million during 1998, and will pay ZRNA eight installments
of $1.4 million at the beginning of each quarter beginning January 1, 1999. This
agreement is accounted for as a deposit due to the absence of certain risk
transfer factors under the terms of the agreement. SNIC and SPCC receive an
interest credit from ZRNA on the premium paid, and will receive the balance of a
notional experience account from ZRNA when the contract is commuted. The balance
of the deposit at December 31, 1998 was $16.1 million.
Effective December 10, 1998, CalComp entered into a 100% Quota Share
Reinsurance Agreement with Centre Insurance Company ("CIC") (formerly Business
Insurance Company) under which CIC will provide our insurance subsidiaries with
a "fronting" facility. A fronting facility is a reinsurance agreement through
which CalComp assumes from CIC, for a fee of 2.5% of written premium, all of the
premium and claims and underwriting expenses associated with insurance policies
written on CIC policies. Superior National will underwrite and price the fronted
policies, bear the expense of settling all of the claims incurred on the
policies, and be responsible for all of the underwriting expenses associated
with the policies. Superior National receives several benefits from the fronting
arrangement with CIC. Policyholders evaluate the creditworthiness of their
insurance policy based on the rating of the company issuing the policy. In this
case, CIC should ultimately have a rating similar to that of Zurich, which will
be a higher rating than Superior National's "B++" rating from A.M. Best. In
addition, Superior National will be able to use CIC's extensive rate and form
filings throughout the United States. It would be extremely time consuming and
expensive for Superior National to refile all of CIC's rates and forms. The
total amount of premium that Superior National can underwrite through CIC is
currently limited to $50.0 million of annual gross written premium.
Effective February 1, 1998, SNIC and SPCC entered into a Quota-Share
Agreement with All American Life Insurance Company, rated "A+" by A.M. Best.
Under this agreement, SNIC and SPCC ceded 100% of premiums and claim and claim
adjustment expenses associated with policies that incepted during the agreement
and have $100,000 or more of estimated annual premium. SNIC and SPCC initially
received a 35.0% ceding commission on premiums ceded under this contract from
February 1 to April 30, 1998, and 34.5% from May 1, 1998 to January 31, 1999.
This agreement expired January 31, 1999.
Effective May 1, 1998, a new Quota-Share Agreement was entered into with
United States Life Insurance Company ("US Life"), a company rated "A+" by A.M.
Best. Under this agreement SNIC and SPCC ceded 100% of premiums and claim and
claim adjustment expenses associated with policies
17
<PAGE>
incepting through January 31, 1999 having at least an estimated annual premium
of $25,000 but less than $100,000. After January 31, 1999, SNIC and SPCC will
cede 93% and 87% for policies incepting during 1999 and 2000, respectively, of
premiums and claim and allocated claim adjustment expenses associated with
policies having at least an estimated annual premium of $25,000. Under the same
agreement, CalComp, BICO, CCIC, and CBIC ceded 100% of premiums and claim and
allocated claim adjustment expenses associated with policies incepting through
December 31, 1998 having at least an estimated annual premium of $25,000. After
December 31, 1998, CalComp, CCIC, and CBIC will cede 93% and 87% for policies
incepting during 1999 and 2000, respectively, of premiums and claim and claim
adjustment expenses associated with policies incepting through December 31, 2000
having at least an estimated annual premium of $25,000. For policies incepting
during 2001, the ceding percentage for all of Superior National's insurance
companies may vary from 0.0% to 80.0%. For each percentage point below a 66.5%
cumulative ceded claim and allocated claim adjustment expense ratio for the
first three contract years, the maximum 80.0% cession will be reduced by five
percentage points, but to a number not less than 40.0% unless US Life elects to
select a lower number. For policies incepting during 2002, the ceding percentage
for all of Superior National's insurance companies may vary from 0.0% to 73.0%.
For each percentage point below a 66.5% cumulative ceded claim and allocated
claim adjustment expense ratio for the first four contract years, the maximum
73.0% cession will be reduced by five percentage points, but to a number not
less than 30.0% unless US Life elects to select a lower number. US Life may
elect to irrevocably terminate the agreement at either January 1, 2001 or 2002.
If US Life does not elect to irrevocably terminate the agreement at either
January 1, 2001 or 2002, it may, at its sole option, prior to December 1, 2002,
elect to extend the agreement to policies incepting during both of the years
2003 and 2004. If the cumulative claim and allocated claim adjustment expense
ratio is greater than or equal to 66.5%, US Life may select a ceding percentage
of 0.0% to 50.0% for both years. If the cumulative claim and allocated claim
adjustment expense ratio is less than 66.5%, US Life may select a ceding
percentage of 0.0% to 25.0% for both years.
All of the Superior National companies receive a 33.5% ceding commission on
premiums ceded under the US Life contract for policies incepting during 1998 and
1999. For policies incepting during 2000 to 2004, the ceding commission will be
33.5% less the difference in percentage points between 66.5% and the actual
cumulative claim and allocated claim adjustment expense ratio, subject to a
minimum ceding commission of 31.0%. If the cumulative claim and allocated claim
adjustment expense ratio is 66.5% or less, the ceding commission will be 33.5%
plus the difference in percentage points between 66.5% and the actual cumulative
claim and allocated claim adjustment expense ratio, subject to a maximum ceding
commission of 36.0%. In addition to the ceding commissions described above, US
Life may pay Superior National a contingent commission. The contingent
commission is equal to 25.0% of any net positive balance taking the earned
premiums ceded to US Life minus ceding commissions paid to Superior National, an
expense provision of 17.5% of earned premiums ceded, and claim and ceded
allocated claim adjustment expense. The February 1 and May 1, 1998 Quota-Share
Agreements will be collectively referred to as the "Quota-Share Arrangement."
Superior National purchases specific excess of loss reinsurance to cover
single catastrophic claims from $500,000 to $500.0 million. We purchase
reinsurance up to such high levels principally to reduce our liability to
workplace injuries that might occur if an earthquake strikes a heavily populated
area in California during working hours. Effective May 1, 1998, Superior
National and BIG entered into a specific excess of loss reinsurance contract
with US Life under which US Life reinsured $4,500,000 in excess of $500,000 of
any specific claim incurred. US Life was subsequently replaced by Trustmark Life
Insurance Company ("Trustmark") as the reinsurer on this contract from the
inception of the contract. A variety of property and casualty and life insurance
companies reinsure our specific excess of loss claims on a per-person and
per-occurrence basis in excess of $5.0 million up to $500.0 million per
occurrence.
LOSS RESERVES GUARANTEE. As part of our acquisition of BIG, FHC obtained at
its expense a guarantee on BIG's claim and allocated claim adjustment expense
reserves (the "Loss Reserves Guarantee"). The
18
<PAGE>
form of the guarantee was two reinsurance contracts covering $175.0 million in
excess of BIG's estimated claim and allocated claim adjustment expense reserves
at December 10, 1998, plus 50.0% of $75.0 million in excess of the sum of BIG's
reserves plus $175.0 million. BIG's estimated reserves at December 10, 1998, as
defined under the contracts, was $495.0 million plus 75.7% of 1998 net earned
premium excluding premium ceded under the Quota-Share Arrangement, and less
claim and allocated claim adjustment expenses paid by BIG through December 10,
1998. The $175.0 million reinsurance contract was entered into with InterOcean
Reinsurance Ltd., with a 100.0% retrocession of liability to Am Re. The $75.0
million reinsurance contract for which Superior National has a 50.0% share was
entered into with Insurance Corporation of Hanover (26.7%), Scandinavian Re
(20.0%), and Odyssey Re (3.33%). FHC bore all of the costs of the above-cited
reinsurance contracts. The terms of the $175.0 million reinsurance contact were
negotiated by officers of FHC, and the $75.0 million contract was negotiated by
Superior National's reinsurance broker.
We have accounted for the two reinsurance contracts described above in
accordance with Topic D-54 of the Emerging Issues Task Force of the Financial
Accounting Standards Board, ACCOUNTING BY THE PURCHASER FOR A SELLER'S GUARANTEE
OF THE ADEQUACY OF LIABILITIES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES OF AN
INSURANCE ENTERPRISE ACQUIRED IN A PURCHASE BUSINESS COMBINATION ("EITF D-54").
Under EITF D-54, claim and allocated claims adjustment expenses, and the related
effects of the guarantee, are separately disclosed in the consolidated
statements of operations, balance sheets, and notes to the consolidated
financial statements, including the reconciliation of claims reserves, in loss
ratio information, and in "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
At December 31, 1998, based on the recommendations of our independent
consulting actuary, we recorded direct and ceded claim and claim adjustment
expenses, gross claim and claim adjustment expense reserves, and a reinsurance
recoverable, of $175.0 million, all associated with the reserve guarantee
contracts. See "--Claim and Claim Adjustment Expense Reserves."
TERMINATED REINSURANCE. Superior National has many reinsurance contracts
that do not provide current or prospective coverage but do continue to provide
coverage on previously written policies or claims. Set forth below are
descriptions of significant reinsurance contracts that are no longer in force,
but continue to provide coverage.
Effective June 30, 1997, SNIC entered into a contract with ZRNA under which
ZRNA assumed $10.0 million of reserves associated with claims open for future
medical payments from SNIC in consideration of $1.0 million in cash and the
assignment of SNIC's rights of contribution and subrogation recoveries during
the term of the contract. In 1997, the contract was accounted for as a deposit
and no gain would be recognized until net cash payments from ZRNA were greater
than SNIC's $1.0 million premium. Effective December 31, 1998, the contract was
commuted and ZRNA paid SNIC $250,000 to commute and settle all obligations and
liabilities associated with this contract.
Prior to its acquisition, BIG entered into a treaty with Gen Re providing
for an aggregate unsecured recoverable for losses, paid and unpaid, including
incurred but not reported loss adjustment expense, and unearned premiums in
excess of 3% of BIG's surplus at December 31, 1996, of $122.2 million, and at
December 31, 1997, of $194.5 million.
Prior to its acquisition, BIG bought specific excess of loss reinsurance on
workers' compensation policies, providing coverage in excess of $1,000,000 per
occurrence for accident years 1996 through 1998, in excess of $500,000 per
occurrence for accident years 1994 and 1995, in excess of $350,000 per
occurrence for accident years 1992 and 1993, and in excess of $250,000 per
occurrence for accident years 1989 through 1991. The agreements provide coverage
up to a maximum of $200 million per occurrence, including BIG's retention. BIG's
specific excess of loss contracts were terminated effective December 31, 1998
and replaced with the specific excess of loss contract with Trustmark described
above.
19
<PAGE>
Prior to its acquisition, BIG also purchased quota share reinsurance under
which the reinsurer assumed a proportional amount of net premiums earned and
related losses. Effective July 1, 1996, BIG entered into a 30% quota-share
treaty to cede a proportional amount of net premiums earned and related loss and
loss adjustment expenses incurred. The 30% ceding rate was applicable from July
1, 1996 to December 31, 1996. Effective January 1, 1997, the quota-share
reinsurance ceding rate was reduced to 7.5% through June 30, 1997. The
quota-share treaty contains a provisional ceding commission, which adjusts based
on actual reported loss experience on the subject business. BIG stopped ceding
under this quota-share treaty effective July 1, 1997.
Prior to its acquisition, BIG entered into an aggregate excess of loss
reinsurance agreement (the "First Aggregate Treaty") with Gen Re effective
January 1, 1997. Under the terms of the First Aggregate Treaty, $32.0 million of
premiums were ceded to Gen Re and $37.3 million of losses and allocated loss
adjustment expenses were ceded to Gen Re. Effective July 1, 1997 a second
six-month Aggregate Treaty was entered into with Gen Re (the "Second Aggregate
Treaty"). Under the terms of the Second Aggregate Treaty, $61.5 million of
premiums were ceded to Gen Re and $75.0 million of losses and allocated loss
adjustment expenses were ceded to Gen Re. The First and the Second Aggregate
Treaties were commuted effective December 9, 1998.
RECENT REINSURANCE ISSUES. In late February 1999 a wave of publicity swept
the insurance industry surrounding workers' compensation reinsurance contracts
sold mainly to life reinsurance companies through an organization called
Unicover Managers, Inc. ("Unicover"). Superior National did not purchase
reinsurance through Unicover, and did not enter-into reinsurance agreements of
the type sold through Unicover's underwriting management organization commonly
known as "buy downs." A chronology and explanation of what we believe to be the
events surrounding these issues follow.
On February 24, 1999, Koelnische Rueckversicherungs-Gesellschaft AG
("Cologne Re") announced that it would set aside $275.0 million to cover
potential losses incurred by a subsidiary, Cologne Life Reinsurance Company
("Cologne"), reinsuring workers' compensation business in the United States.
Cologne Re is a Connecticut domiciled life insurance company that is 82% owned
by Gen Re, one of the largest reinsurers in the United States and a wholly-owned
subsidiary of Berkshire-Hathaway. Cologne apparently incurred the losses as a
result of its participation in a reinsurance "pool" managed by Unicover. In
addition, Cologne apparently assumed a portion of the reinsurance pool placed
with other reinsurance companies known as "retrocessionaires". A wave of
publicity surrounding the Cologne loss ensued after the announcement, followed
by speculation in the press and on the part of certain insurance industry
analysts that losses on workers' compensation reinsurance placed by Unicover
could potentially amount to billions of dollars.
Concurrently with the announcement of the Cologne losses, the press and
certain insurance industry analysts discovered and publicized a lawsuit filed by
various subsidiaries of American International Group, Inc. ("AIG") against
Unicover and ReliaStar Life Insurance Company ("ReliaStar"). ReliaStar was one
of the participants in the Unicover "pool" described above. AIG asserted in its
lawsuit that it had a valid, albeit unsigned, contract with ReliaStar. AIG
apparently believed that ReliaStar had granted authority to Unicover under which
ReliaStar would provide two specific excess of loss reinsurance to AIG in the
amounts of $482,500 in excess of $17,500 for California business and $358,250 in
excess of $41,750 for non-California business. On February 12, 1999, ReliaStar
informed AIG that it was refusing to sign the above-cited reinsurance agreements
with AIG, which led to AIG's lawsuit to enforce what it viewed as valid
reinsurance agreements. On March 3, 1999, AIG's request for a preliminary
injunction was rejected in court. ReliaStar's reluctance to reinsure AIG, and
AIG's public and confrontational response, further focused attention on
Unicover's activities.
On February 25, 1999, the Connecticut Insurance Commissioner issued a
bulletin addressing "carve-out" reinsurance underwritten by life insurance
companies. The term "carve-out" refers to the life, health, and disability
components of workers' compensation policies that are reinsured by life
insurance
20
<PAGE>
companies. The reinsurance contracts that life insurance companies enter into
with workers' compensation insurance companies do not include, or "carve-out"
from, the risks insured on the underlying insurance policy the employers'
liability and certain other exposures that life insurance companies are not
allowed to underwrite. The Connecticut Insurance Commissioner stated that life
insurance companies domiciled in Connecticut are not, and never have been,
statutorily allowed to reinsure any component of workers' compensation
insurance. The bulletin also appeared to terminate the ability of
Connecticut-domiciled life insurance companies to accept additional exposures
after February 25, 1999 on existing reinsurance contracts. On March 17, 1999,
the Connecticut Insurance Commissioner modified the February 25, 1999 bulletin
clarifying that Connecticut life reinsurance companies were expected to "...make
a good faith effort to terminate existing contracts, unless they are legally
obligated to honor commitments under an agreement that incepted prior to
February 26, 1999."
The Connecticut bulletins appear to have been a direct response to the
losses incurred by Cologne from Unicover reinsurance contracts, which appeared
to render Cologne insolvent on a stand-alone basis. The Connecticut Insurance
Commissioner focused on Unicover's reinsurance program as a problem pertaining
to all "carve-out" reinsurance underwritten by life insurance companies. The
Connecticut Insurance Commissioner also appeared to believe that life
reinsurance of workers' compensation risks was of recent origin. In fact, life
insurance companies have reinsured the "high excess" layers of workers'
compensation risks (for example, specific excess of loss cessions in excess of
$500,000 per occurrence) through "carve-out" reinsurance contracts for at least
a decade. Based on our own experience, we believe that these contracts have
historically been profitable for life reinsurers. The reinsurance contracts sold
by Unicover can be distinguished from historic "carve-out" reinsurance by the
very low specific excess of loss limits exemplified in the disputed
AIG-ReliaStar contracts cited above. Unicover reinsurance contracts are
described as "buy-down" reinsurance contracts, so-called because the ceding
company "buys-down" its limit of liability to levels that are very low by
historical workers' compensation reinsurance standards. "Buy-downs" are not
inherently unprofitable reinsurance contracts to the extent that an adequate
reinsurance premium is ceded to the reinsurer assuming such low levels of
losses.
On March 29, 1999, a London based reinsurance company affiliate of Fairfax
Financial Holdings Limited ("Fairfax"), a Canadian financial services company,
filed suit in New York alleging RICO violations and fraud by a number of
underwriting managers and reinsurance intermediaries with respect to the
placement of workers' compensation reinsurance at its affiliate. One of the
underwriting managers named in the lawsuit was WEB Management LLC ("WEB"),
through which Superior National placed its Quota Share Arrangement with US Life
and its $4.5 million excess of $500,000 per-risk excess of loss reinsurance
contract with Trustmark. Superior National is not aware that any cessions of its
business to either US Life or Trustmark were thereafter ceded to Fairfax.
Superior National has been informed, however, that an immaterial part of an
excess of loss reinsurance program that is no longer in force was ceded to
Fairfax under a third party reinsurance contract having nothing to do with
Superior National or WEB, and that Fairfax has rescinded the contract. The
recision should have no effect on Superior National's business or operations.
On April 1, 1999, the DOI announced that it would hold a public hearing in
May of 1999 to investigate the extent of potential losses arising out of
reinsurance programs sold by certain underwriting managers. The hearings will
also investigate the degree to which California companies may be involved in the
events described above. The DOI also announced that it may promote legislation
to address issues surrounding the reinsurance of workers' compensation by life
insurance companies. Several other state insurance departments also publicly
expressed their concerns regarding losses arising out of the Unicover pool and
the reinsurance of workers' compensation companies by life insurance companies.
The combination of the Connecticut bulletins, the AIG-ReliaStar dispute, the
publicity surrounding Cologne's losses, and the Fairfax lawsuit, may have
heightened the concern of regulators, including the DOI, and our reinsurers with
respect to our reinsurance contracts. The regulators may be concerned about the
statutory permissibility of our contracts with, and the solvency of, our life
reinsurers. Our reinsurers
21
<PAGE>
may be concerned about the underlying profitability of the business we are
ceding to them. Superior National relies heavily on reinsurance in its
operations, and we are concerned that actions by regulators or our reinsurers to
address the issues described above may adversely impact our operations in ways
we cannot predict.
Regardless, while we are legitimately and sensibly concerned about the
possibility of an adverse reaction by regulators and reinsurers to the issues
surrounding the Unicover issues, we do not believe that Superior National is
exposed to significant risk of adverse actions by regulators or reinsurers. The
California Insurance Code specifically permits life insurance companies to
reinsure the health and disability portion of workers' compensation risks, and
no state insurance commissioner other than the Connecticut Insurance
Commissioner has questioned "carve-out" reinsurance contracts since the events
described above. Superior National's principal life reinsurance contract with US
Life, a New York domiciled company, is subject to interpretation under
California law. The quota share or high-excess-of-loss structure of our life
reinsurance contracts is completely distinguishable from the low limit
("buy-down") structure of contracts sold through Unicover. We have not received
any regulatory inquiries regarding our reinsurance contracts with life
reinsurance companies, nor have we received any communications from reinsurers
regarding the statutory or legal validity of our reinsurance contracts.
INVESTMENTS
The amount and types of investments that may be made by us are regulated
under the California and New York Insurance Codes and the rules and regulations
promulgated thereby. Our investments are primarily managed externally, based
upon guidelines and strategies approved by management. As of December 31, 1998,
our consolidated portfolio consisted mostly of fixed-income securities. The bond
portfolio is heavily weighted toward short to intermediate term,
investment-grade securities rated "A" or better, with approximately 92.7% rated
"AA" or better.
Funds withheld assets having the same carrying and market values of $123.9
million, at December 31, 1998, were withheld from US Life as collateral under
the Quota-Share Arrangement. These investments are reported separately on our
financial statements as investments withheld from reinsurer. All investment
income and market value risk associated with these assets are assumed by US
Life. Interest expense of $0.7 million was paid to US Life during 1998.
The table below contains information concerning the composition of our
investment portfolio at December 31, 1998:
<TABLE>
<CAPTION>
CARRYING
AMOUNT MARKET
TYPE OF INVESTMENT (1) VALUE
- ---------------------------------------------------------------------- ---------- ----------
<S> <C> <C>
(IN THOUSANDS)
Fixed maturities (2)
U.S. government and agencies.......................................... $ 431,401 $ 431,401
AA/Aa rated........................................................... 70,495 70,495
A rated............................................................... 39,782 39,782
---------- ----------
Total fixed maturities.............................................. 541,678 541,678
Cash and cash equivalents, short-term investments, and other
investments......................................................... 324,179 324,179
Common stocks......................................................... 1,544 1,544
---------- ----------
Total............................................................... $ 867,401 $ 867,401
---------- ----------
---------- ----------
</TABLE>
- ------------------------
(1) Carrying amount is the amortized cost for short-term investments. Market
value is used for fixed maturities and common stocks.
22
<PAGE>
(2) Standard & Poor's Corporation defines "AAA" rated securities as "highest
rating, extremely strong security," "AA" rated securities as "very strong
security," "A" as "strong security," "BBB" as "adequate security," and "BB"
as "low quality." Moody's Investor Services, Inc. defines "Aaa" rated
securities as "best quality," "Aa" as "high quality," "A" as "strong
security," "Baa" as "adequate security," and "Ba" as "low quality."
The table below reflects investments (including investments withheld from
reinsurer) and interest earned thereon and average annual yield on investments
for each year in the five-year period ended December 31, 1998.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------
<S> <C> <C> <C> <C> <C>
1998 1997 1996 1995 1994
---------- ---------- ---------- ---------- ----------
<CAPTION>
(DOLLAR AMOUNTS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Total investments at end of period................ $ 674,478 $ 213,374 $ 115,017 $ 163,951 $ 174,345
Net investment income before taxes................ $ 16,236 $ 12,674 $ 7,769 $ 9,784 $ 9,049
Average annual yield on ending investment
portfolio (before taxes)........................ 6.2%(1) 5.9% 6.7% 5.9% 5.2%
</TABLE>
- ------------------------
(1) The average annual yield of 6.2% on ending investment portfolio is
calculated based on total investments of $227.5 million and net investment
income of $14.2 million, which excludes activities relating to BIG. Total
investments, including investments withheld from reinsurer, of $447.0
million were acquired as a result of the BIG acquisition on December 10,
1998. Net investment income of $2.0 million is related to the investment
portfolio acquired from BIG. In order to accurately present our average
annual yield on ending investment portfolio, we have excluded BIG
investments and the related net investment income from our calculation.
In monitoring our asset and liabilities match, we attempt to keep the
investment duration at the mid-point of the payout pattern. As of December 31,
1998, the investments under our management (i.e., excluding investments withheld
from reinsurer) have a modified duration of 3.72 years.
The table below sets forth the maturity profile of our bond portfolio at
market value as of December 31, 1998:
<TABLE>
<CAPTION>
BONDS RATED(1)
------------------------------------------
AAA/AAA AA/AA A TOTAL
--------- --------- --------- ---------
(DOLLAR AMOUNTS IN THOUSANDS)
<S> <C> <C> <C> <C>
1 year or less........................................ $ 7,304 -- 12,393 $ 19,697
More than 1 year, through 3 years..................... 88,684 32,375 2,688 123,747
More than 3 years, through 5 years.................... 42,506 6,130 7,621 56,257
More than 5 years, through 10 years................... 69,282 2,417 4,258 75,957
More than 10 years, through 15 years.................. 97,225 8,599 6,307 112,131
More than 15 years.................................... 126,400 20,974 6,515 153,889
--------- --------- --------- ---------
Total................................................. $ 431,401 $ 70,495 $ 39,782 $ 541,678
--------- --------- --------- ---------
--------- --------- --------- ---------
</TABLE>
- ------------------------
(1) Standard & Poor's Corporation defines "AAA" rated securities as "highest
rating, extremely strong security," "AA" rated securities as "very strong
security," "A" as "strong security," "BBB" as "adequate security," and "BB"
as "low quality." Moody's Investor Services, Inc. defines "Aaa" rated
securities as "best quality," "Aa" as "high quality," "A" as "strong
security," "Baa" as "adequate security," and "Ba" as "low quality."
Immediately prior to the purchase of BIG, we caused BIG to liquidate the
investment portfolio of CalComp, one of the BIG insurance subsidiaries. The bulk
of the investable assets obtained as a result of
23
<PAGE>
the purchase of BIG has been invested in accordance with our existing investment
policies. We also have purchased a $25.0 million Federal National Mortgage
Association Security with a market value of $48.8 million maturing in 2013 and
an $8.1 million U.S. Treasury Bond with a market value of $13.4 million maturing
in 2015. These securities have a higher investment grade rating, and generally a
higher yield coupon than the rest of our portfolio and have approximately a
nine-year duration.
INFORMATION SERVICES
We emphasize the development of personal computer based information and
processing systems for use in all areas of our business and to that end strive
to maintain a creative, flexible, and dynamic data processing capability that
(1) enhances the effectiveness of our employees' underwriting, policy
administration, and claims activities, (2) provides detailed, real-time, and
near real-time information to management for control and administration
purposes, and (3) provides marketing benefits through improved customer service.
We believe that these systems give us a significant competitive advantage over
competitors that lack such systems. We have expensed 3.3%, 3.7%, and 4.1% of
direct written premium in 1998, 1997, 1996, respectively, for developing and
upgrading these systems.
DATA WAREHOUSE DECISION SUPPORT SYSTEM. In 1993 we developed
SWAMI-Registered Trademark-, a proprietary "data warehouse decision support"
system. Beginning with the installation of SWAMI-Registered Trademark-, we
adjusted our monitor and feedback cycle to no less frequently than weekly, and,
in many respects, to a daily basis. This monitoring and feedback system is
necessary due to the information intensive nature of the insurance business
because lack of information represents a major aspect of underwriting risk.
Accordingly, SWAMI-Registered Trademark- was developed to provide quality,
detailed, real-time, and near real-time information to management as needed to
reduce the risk represented by lack of information. The
SWAMI-Registered Trademark- system has been constantly enhanced since its
implementation. We do not expect SWAMI-Registered Trademark- system to provide
significant data pertaining to BIG's operations until mid-1999.
UNDERWRITING. Our underwriting system is a fully integrated, computerized,
rating, quoting, and policy issuance system for use both internally and remotely
from producers' offices. The system contains edit and blocking features that
prohibit underwriters from issuing policies associated with business that is
deemed inappropriate or undesirable by management, or that may be
inappropriately priced. Detailed information for each producer can be
instantaneously reviewed on an accident year, policy year, or calendar year
basis. The system provides analytical information as to producers, underwriters,
or branch operations, which management uses to take corrective action with
respect to unprofitable producers or ineffective staff. The system permits us to
evaluate commissions, in force business, collections activity, and product
pricing in detail, utilizing information that is no more than 24 hours old.
POLICY ADMINISTRATION. Our policy administration, including premium
collection and audit activities, is fully automated. In addition to traditional
"agency" billing services, our collections capabilities also include direct
bill, automatic withdrawals from policyholders' bank accounts, and credit card
billings, which, management believes, dramatically improve credit experience and
policy persistency.
CLAIMS ADMINISTRATION. The core of the claims system is a proprietary
document imaging system that, combined with sophisticated workflow protocols,
improves the productivity of our claims administration.
We have comprehensive physical and virtual safeguards for our information
and processing systems. Disaster recovery programs and back-up procedures
include nightly back-up storage of all transactions and changes to the system's
database. At the end of each business day, we transfer this information to tapes
that are stored off site. We maintain back-up systems in the branch offices to
use if the main system fails. Computer access is restricted by use of codes and
passwords.
We do not believe that we will incur any material expenditures or
liabilities as a result of the "Year 2000" problem in computer software and
hardware. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Year 2000 Strategy."
24
<PAGE>
We are developing a strategy to integrate BIG's insurance subsidiaries'
policy and claims functions into our system over time. The integration of policy
functions is the first step, and this has already occurred on new or renewal
policies that have been issued after the purchase of BIG. The claims functions
of SNIC and SPCC will be separate from BIG's insurance subsidiaries in the near
future.
COMPETITION
Superior National conducts most of its business in California. California is
the country's largest workers' compensation insurance market. Competitive
pressures in the California workers' compensation market increased with the
implementation of open rating in January 1995. As a result, total direct written
premium for the California market decreased from $9.0 billion in 1993 to $5.2
billion in 1997. More recently, certain fundamentals of the workers'
compensation market in California have improved.
The workers' compensation insurance industry in California is extremely
competitive. Many of Superior National's competitors have been in business
longer, have a larger volume of business, offer more diversified types of
insurance coverage, have greater financial resources, and have greater
distribution capabilities than Superior National. Some of our competitors have
acquired reinsurance contracts on terms that appear extremely favorable, and are
utilizing that reinsurance to support prices that we will not match. The
companies who use reinsurance in this fashion include Fremont General
Corporation, American International Group, Inc., American Financial Corporation,
Clarendon Insurance Group, and Mutual Risk Management Ltd., all of whom have
greater capital resources than do we.
The California workers' compensation market is commodity-oriented, highly
fragmented, and reflective of intense price competition. Nevertheless, because
each risk is unique in terms of insurance exposure, different insurers can
develop widely divergent estimates of prospective losses. Most insurers attempt
to segment classes within markets so that they target the more profitable
sub-classes with lower, although adequate, rates given the estimated
profitability of the segment. In some cases, no statistics are available for the
sub-classes involved, and the insurer implements discounted rate structures
based solely on theoretical judgment. Finally, different insurers have widely
divergent internal expense positions, due to distribution methods, economies of
scale, and efficiency of operations. Therefore, although workers' compensation
insurance is a commodity, the price of insurance does not necessarily reflect
commodity pricing. Superior National's existing and prospective customer bases
are vulnerable to competition, especially from larger insurers that at any time
are capable of penetrating Superior National's markets with products priced at
levels substantially below Superior National's.
Competition in the NCCI states is also intense and waged by companies that
have advantages over Superior National. Those advantages include the factors
described for the competitive situation in California. Further, the manner in
which some states regulate rates puts us at a competitive disadvantage. In some
states our rate filings are several years old, and do not reflect current market
conditions. Some states are refusing to allow us to modify our rate filings,
thus putting us at a disadvantage relative to our competition.
The competitive situation in NCCI states has also been adversely affected by
regulatory problems experienced by BICO based on its statutory results for 1997,
and our inability since 1997 to offer our policyholders a product written by a
company with an A.M. Best rating of at least "A-." The NCCI market is more
sensitive to an insurers' rating than is the California market.
RATINGS
Superior National is currently rated "BBB" by S&P, a claims paying rating it
has held since 1995. Insurance companies rated "BBB" are considered by S&P to
offer adequate financial security, but capacity to meet policyholder obligations
is susceptible to adverse economic and underwriting conditions. A.M. Best has
currently assigned a "B++" (Very Good) rating to all Superior National insurance
companies. A.M. Best's ratings are based upon an evaluation of a company's (1)
financial strength (leverage/
25
<PAGE>
capitalization, capital structure/holding company, quality, appropriateness of
reinsurance program, adequacy of loss/policy reserves, quality and
diversification of assets, and liquidity); (2) operating performance
(profitability, revenue composition, and management experience and objectives);
and (3) market profile (market risk, competitive market position, spread of
risk, and event risk). A "B++" rating is assigned to companies that have on
balance, in A.M. Best's opinion, very good financial strength, operating
performance, and market profile when compared to the standards established by
A.M. Best, and have a good ability to meet their ongoing obligations to
policyholders. "B++" is A.M. Best's fifth highest rating classification out of
15 ratings. A.M. Best's and S&P's ratings represent independent opinions of a
company's financial strength and ability to meet its obligations to
policyholders and are not based upon factors concerning investors. There is no
direct relationship between an insurance rating established by A.M. Best or S&P
and the investment ratings issued by the several securities rating firms,
including S&P and Moody's. Investment ratings generally pertain to individual
securities, although the firms who issue ratings associated with specific
investments also issue insurance ratings that duplicate in some respects the
activities of A.M. Best. Insurance ratings are subject to change and are not
recommendations to buy, sell, or hold securities. One factor in an insurer's
ability to compete effectively is its A.M. Best rating. Our A.M. Best rating is
lower than that of many of our competitors. There can be no assurance that such
ratings or future changes therein will not affect our competitive position.
We currently have a reinsurance contract with ZCIC called a "fronting
arrangement" that allows Superior National to offer its policyholders insurance
policies written by ZCIC, which has an A.M. Best rating of "A". ZCIC then
reinsures the business to Superior National, which assumes the economic risk of
the ZCIC insurance policy. As part of our sale of Centre Insurance Company
("CIC", formerly BICO) to an affiliate of Zurich, we will also have the ability
to offer our policyholders a fronting arrangement with policies issued by CIC as
well as those issued by ZCIC. The total amount of premium that Superior National
can underwrite through CIC is currently limited to $50.00 million of annual
gross written premium.
REGULATION
SNIG and its insurance subsidiaries are subject to extensive governmental
regulation and supervision. Regulations relate to such matters as the filing of
premium rates and policy forms, adequacy of reserves, types and quality of
investments, minimum capital and surplus requirements, deposits of securities
for the protection of policyholders, statutory financial reporting, and
restrictions on stockholder dividends. Superior National and its insurance
subsidiaries are also subject to periodic examination by the California and New
York Departments of Insurance. In addition, assessments are made against
Superior National and other California insurers to cover liabilities to
policyholders of insolvent insurance companies. The regulation and supervision
of insurance companies by state agencies is designed only for the benefit of
policyholders, not stockholders. SNIG believes that it and its subsidiaries are
in material compliance with state regulatory requirements that are relevant to
their respective businesses.
The DOI's Triennial Examination of SNIC, which covered the three years ended
December 31, 1994, was completed in 1996 and indicated no material issues or
actions needed to be taken by SNIC in either its operations or financial
statements. SPCC's Triennial Examination, which covered the three years ended
December 31, 1994, was completed in 1996 and resulted in an additional $18.5
million of claim and claim adjustment expense reserves being recorded as of
December 31, 1996, and other significant adjustments totaling $4.1 million. An
additional $12.0 million in claim and claim adjustment expense was recorded by
SPCC in the first quarter of 1997. These events preceded our acquisition of SPCC
on April 11, 1997. CalComp's Triennial Examination, which covered the five years
ended December 31, 1995, was completed in 1997. As of December 31, 1995, CalComp
reported policyholders' surplus of $151.6 million. Based on the Triennial
Examination, the DOI reported CalComp's statutory surplus at $103.7 million, a
difference of $47.9 million from the surplus reported by CalComp. The entire
difference between CalComp's reported surplus and the surplus balance determined
by the DOI examination was included and accounted for in
26
<PAGE>
CalComp's statutory financial statements for the year ended December 31, 1996.
Of the $47.9 million difference, $10.0 million was due to the non-admission of a
promissory note due CalComp from FHC, $27.2 million was due to an increase to
CalComp's claim and claim adjustment expenses, including $6.8 million related to
the statutory excess liability, and $10.7 million was due to other miscellaneous
adjustments. During 1996, CalComp made the necessary adjustments to its internal
control structures and its policies and procedures to address the issues raised
by the DOI in connection with the Triennial Examination. A Triennial Examination
of CBIC as of December 31, 1995 was also completed by the DOI. The DOI made no
surplus adjustments to CBIC's reported statutory policyholder surplus balance of
$7.4 million at December 31, 1995. A Triennial Examination of CCIC as of
December 31, 1996 was completed by the DOI. The DOI made no surplus adjustments
to CCIC's reported statutory policyholder surplus balance of $7.5 million at
December 31, 1996.
The California Insurance Code requires the DOI to approve any proposed
change of control of Superior National. For such purposes, "control" is presumed
to exist if any person, directly or indirectly, owns, controls, holds with the
power to vote, or holds proxies representing more than 10% of the voting
securities of the Company.
The California Insurance Code also limits the amount of dividends or
distributions an insurance subsidiary may pay without DOI approval or
non-disapproval in any 12-month period to the extent it exceeds the greater of
(a) net income from operations for the preceding year or (b) 10% of statutory
policyholders' surplus as of the preceding December 31st. Payments of greater
amounts require the approval of the DOI. The maximum dividends permitted under
the California Insurance Code are not necessarily indicative of an insurer's
actual ability to pay dividends or other distributions to a parent company,
which also may be constrained by business and regulatory considerations, such as
the impact of dividends on surplus, that could affect an insurer's competitive
position, the amount of premiums that can be written, and the ability to pay
future dividends. Further, the California Insurance Code requires that the
statutory surplus of an insurance company following any dividend or distribution
by such company be reasonable in relation to its outstanding liabilities and
adequate for its financial needs. Moreover, dividends may only be paid out of
"earned surplus" as defined in the California Insurance Code. New York, the
domicile state of CCIC, also limits the amount of dividends that may be paid by
an insurance subsidiary.
In 1989, 1991, 1993, and 1995, various workers' compensation reform laws
that were passed into law by the California legislature materially impacted our
rates, claims experience, financial condition, and results of operations.
Under the last important measure, adopted in 1993 and declared effective as
of January 1995, California's minimum rate law was replaced by an open rating
system. Under this new rating system, individual insurance companies file rates
and rules not less than 30 days prior to their effective date, and such rates
and rules can only be disapproved by the DOI after a hearing and only on the
basis of solvency, market share, or improper filing. Superior National cannot
predict the ultimate effect of open rating on its workers' compensation
business, but during the first three years of open rating, the intense price
competition that ensued led to lower average premiums per policy. Rates
stabilized in 1996 and appeared to increase slightly during 1997 and 1998.
Superior National believes the rates it has filed with the DOI are adequate, but
it is unable to predict the degree to which such rates are competitive in the
marketplace.
In 1996, the California legislature implemented a set of workers'
compensation reforms, referred to as Assembly Bill 1913 ("AB 1913"), and the DOI
issued its guidelines with respect to their interpretation. AB 1913 causes,
among other things, the experience modification factor of a current workers'
compensation policy and the immediately preceding two policies regardless of
carrier to be subject to revision if a single claim used in a modification
closes on or after January 1, 1995, for a value of 60% or less of its highest
earlier reported value, if the highest reported incurred value was $10,000 or
more. AB 1913 was amended effective January 1, 1998 by Senate bill 1217 ("SB
1217"). Under the new guidelines of SB 1217, if the
27
<PAGE>
aggregate amount of incurred claims (as opposed to a single claim) changes by
the threshold amount, then the WCIRB will calculate a new experience
modification factor. Such a change in the experience modification factor will
require the current workers' compensation carrier to return a portion of a
policyholder's premium for the current and preceding two policies' periods
without regard to whether the current workers' compensation insurance carrier
was the insured's previous carrier. The WCIRB estimates the ultimate cost to
California workers' compensation underwriters will be less than 2.5% of 1996
premium; however, these estimates are based upon broad industry estimates and
could vary significantly from company to company based upon the type of claims
incurred, size of employer, and employer industry group. As of December 31,
1998, the Company has accrued an estimated liability of $1.9 million related to
AB 1913.
Proposed federal legislation has been introduced from time to time in recent
years that would provide the federal government with substantial power to
regulate P&C insurers, including state workers' compensation systems, primarily
through the establishment of uniform solvency standards. Proposals also have
been discussed to modify or repeal the antitrust exemption for insurance
companies provided by the McCarran-Ferguson Act. The adoption of such proposals
could have a material adverse impact upon the operations of Superior National.
In order to enhance the regulation of insurer solvency, the NAIC has adopted
a formula and model law to implement risk-based capital ("RBC") requirements for
P&C (including workers' compensation) insurance companies designed to assess
minimum capital requirements and to raise the level of protection that statutory
surplus provides for policyholder obligations. The NAIC model law has been
incorporated into the California Insurance Code. The RBC formula for P&C
insurance companies measures four major areas of risk: (1) underwriting, which
encompasses the risk of adverse loss developments and inadequate pricing, (2)
declines in asset values arising from credit risk, (3) declines in asset values
arising from investment risks, and (4) off-balance sheet risk arising from
adverse experience from non-controlled assets, guarantees for affiliates,
contingent liabilities, and reserve and premium growth. Pursuant to the model
law, insurers having less statutory surplus than that required by the RBC
calculation will be subject to varying degrees of regulatory action, depending
on the level of capital inadequacy.
28
<PAGE>
The RBC model law provides for four levels of regulatory action. The extent
of regulatory intervention and action increases as the level of surplus as a
percentage of the RBC amount falls. The first level, the Company Action Level
(as defined by the NAIC), requires an insurer to submit a plan of corrective
actions to the regulator if surplus falls below 200% of the RBC amount. The
Regulatory Action Level (as defined by the NAIC) requires an insurer to submit a
plan containing corrective actions and requires the relevant insurance
commissioner to perform an examination or other analysis and issue a corrective
order if surplus falls below 150% of the RBC amount. The Authorized Control
Level (as defined by the NAIC) gives the relevant insurance commissioner the
option either to take the aforementioned actions or to rehabilitate or liquidate
the insurer if surplus falls below 100% of the RBC amount. The fourth action
level is the Mandatory Control Level (as defined by the NAIC), which requires
the relevant insurance commissioner to rehabilitate or liquidate the insurer if
surplus falls below 70% of the RBC amount. Based on the foregoing formulae, as
of December 31, 1998, the RBC ratios of SNIC, SPCC, CalComp, CBIC and CCIC were
in excess of the Company Action Level, the first trigger level that would
require regulatory action.
The NAIC's Insurance Regulatory Information System ("IRIS") was developed by
a committee of state insurance regulators and is primarily intended to assist
state insurance departments in executing their statutory mandates to oversee the
financial condition of insurance companies operating in their respective states.
IRIS identifies twelve industry ratios and specifies "usual values" for each
ratio. Departure from the usual values on four or more of the ratios may lead to
increased regulatory oversight. Based on its 1998 statutory financial statement,
SNIC fell outside the usual range of one of the twelve IRIS tests, specifically
the test measuring investment yield. The unusual value was a result of the loss
portfolio transfer from BICO to SNIC that took place in December 1998. SPCC fell
outside the usual range of two of the twelve IRIS tests. SPCC was outside of the
usual range of the tests measuring change in net writings and the two-year
overall operating ratio. The unusual values for both ratios were the result of
the continuation of the runoff of SPCC's premium in force during 1998. CCIC fell
outside the usual range of two of the twelve IRIS tests. CCIC was outside of the
usual range of the tests measuring change in net writings and agents' balances
to surplus. CBIC fell outside the usual range of one of the twelve IRIS tests.
CBIC was outside of the usual range of tests measuring change in net writings.
CalComp fell outside the usual range of four of the twelve IRIS tests. CalComp
was outside of the usual range of tests measuring change in net writings,
two-year overall operating ratio, investment yield and two-year reserve
development to surplus. In May of 1998, the BIG group of companies entered into
a new Quota-Share Arrangement whereby the companies will cede 100% of the gross
premiums earned on accounts with an estimated annual premium at inception
greater than $25,000, and 100% of the net losses and allocated loss adjustment
expenses incurred on those associated policies for claims with an accident date
of May 1 and subsequent. The companies recognize a 33.5% ceded commission on
premiums ceded under this agreement. This change in the BIG reinsurance program
resulted in CalComp's, CCIC's and CBIC's falling outside the "usual" range of
the ratio for change in net writings. CalComp's falling outside the "usual"
range of the two-year overall operating ratio and the two-year reserve
development to surplus ratio was the result of 1995 and 1996 claim and claim
adjustment reserve increases. CalComp's falling outside the "usual" range of the
investment yield ratio was the result of CalComp's aggressive tax strategies in
the investment area. CCIC's agents' balances to surplus ratio fell outside the
"usual" range due to a misclassification on the balance sheet.
The financial statements contained herein have been prepared in conformity
with GAAP, as opposed to SAP prescribed or permitted for insurance companies by
regulatory authorities. SAP differs from GAAP principally in the following
respects: (a) premium income is taken into operations over the periods covered
by the policies, whereas the related acquisition and commission costs are
expensed when incurred; (b) deferred income taxes are not recognized under SAP;
(c) certain assets such as agent's balances over ninety days due and prepaid
expenses are nonadmitted assets for statutory reporting purposes; (d)
policyholder dividends are accrued when declared; (e) the cash flow statement is
not consistent with classifications and the presentation under GAAP; (f) bonds
are recorded at amortized cost, regardless of trading activities; (g) loss and
loss adjustment expense reserves and unearned premium reserves are stated
29
<PAGE>
net of reinsurance; and (h) minimum statutory reserves for losses in excess of a
company's estimates are required.
The NAIC recently approved the codification of SAP with an effective date of
January 1, 2001. Included in the codification is a change in the definition of
prescribed versus permitted policies that insurance companies use to prepare
their statutory financial statements. We have not yet determined the impact of
the adoption of the codification project.
Although we have not received any claims made under policies written in our
P&C insurance business (discontinued in 1993) related to business losses caused
by Year 2000 malfunctions or costs incurred in connection with prevention or
correction of Year 2000 problems, it is conceivable that such claims could be
made. Published estimates of Year 2000 business losses and costs are in the many
billions of dollars. If P&C insurers were required by court decision to pay
claims on policies issued between 1985 and 1993 related to Year 2000 losses we
may have to pay such claims. In such event, we would likely have inadequate
reserves in our discontinued operations and the booking of additional reserves
would have a material adverse effect on our results of operations.
It is not possible to predict the future impact of changing state and
federal regulation on our operations and there can be no assurance that laws and
regulations enacted in the future will not be more restrictive than existing
laws.
EMPLOYEES
As of December 31, 1998, we had approximately 1,378 employees, none of whom
was covered by a collective bargaining agreement.
RISK FACTORS
THE LOSSES EXPERIENCED BY BIG IN THE PAST MAY BE REPEATED AND BECOME LOSSES OF
SUPERIOR NATIONAL.
BIG's operations now represent a large portion of our business. The losses
BIG experienced in the past may be repeated and may be incurred by us in the
future. We can provide no assurance that BIG will not experience losses in the
future, and any losses experienced in the future will be reflected in our
overall results. Although we believe we can improve BIG's financial performance,
we can provide no assurance that we will be successful. As an example of losses
experienced by BIG in the past, BIG showed a net loss of $30.6 million in the
fiscal year ending December 31, 1997 with a combined ratio of 119.2% and a net
loss of $87.0 million for the year to date ended December 10, 1998, with a
combined ratio of 143.9%. A large portion of the losses in 1997 arose from
reserve strengthening of $75.2 million, booked in the fourth quarter of 1997,
and related principally to accident years 1996 and prior and revised estimates
of claim severity from those years. The losses for the year to date ended
December 10, 1998 arose from increased claim and claim adjustment expenses due
to BIG's decision not to renew an aggregate excess of loss reinsurance treaty,
as well as increasing claim severity.
IF WE EXPERIENCE DECLINES IN THE AMOUNT OF PREMIUMS WE RETAIN, OUR LEADERSHIP
POSITION IN THE CALIFORNIA WORKERS' COMPENSATION INSURANCE MARKET COULD
DETERIORATE.
Because BIG changed its underwriting and pricing criteria for policies with
inception dates after January 1, 1998, BIG experienced a decrease in direct
premium written for California of $70.9 million for the year ended December 31,
1998, as compared to the same period ended December 31, 1997. See "--
Underwriting." Uncertainties surrounding our purchase of BIG and the recent
downgrade of BIG's rating by A.M. Best from "A-" to "B++" also prompted this
decline. We may experience further reductions in direct written premium as we
re-underwrite BIG's book of business over the next three years or more,
reflecting our strategy of preserving operating margins rather than competing
for accounts solely on the basis of price. If we were to experience unexpected
declines in premium volume, our leadership position in
30
<PAGE>
the California workers' compensation insurance market could be threatened. Also,
if we are unable to spread sufficient premium over our fixed costs, that could
have a material adverse impact on our earnings.
WE MAY BE UNABLE TO EFFECTIVELY INTEGRATE OUR OPERATIONS AND BUSINESS WITH THAT
OF BIG.
Our future results of operations depend in part on our ability to coordinate
and integrate our operations and business enterprises with those of BIG. We have
begun to integrate BIG's information systems into our own in order to enhance
its competitive position. The size of BIG's operations makes this a difficult
and complex task and we can provide no assurance that we will be able to do this
successfully. As in every business combination, this coordination will require
the dedication of management resources, which will from time to time divert
their attention from our day-to-day business. See "--Information Services."
WE WILL LIKELY EXPERIENCE NEGATIVE CASH FLOW IN THE NEAR FUTURE, WHICH WOULD
LEAVE US WITH LESS MONEY TO INVEST, THEREBY REDUCING OUR INVESTMENT INCOME.
We believe that our acquisition of BIG will result in large negative cash
flows, leaving us with less money to invest. Our investment income will decrease
to the extent we have less money to invest. Negative cash flows have been
characteristic of our business since open ratings were introduced in California
at the beginning of 1995. Since then, claims arising under policies written on
the higher premium volumes that existed prior to 1995 have been run-off while
premium has decreased. The same conditions could exist at BIG. We believe BIG
tried to remain competitive under open rating by aggressively pricing its
products. As BIG's pricing structure is integrated with ours, premium volume
could decline while BIG's prior year claims are run-off. Moreover, the recently
implemented Quota-Share Arrangement will result in additional negative cash
flows. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity and Capital Resources."
OUR BUSINESS MAY BE ADVERSELY AFFECTED BY A FOCUS ON BUSINESS IN MULTIPLE STATES
AND THE LARGER ACCOUNTS THAT BIG MAINTAINS.
Since 1993 and until our acquisition of BIG in December 1998, we operated as
a workers' compensation insurer with our business focused almost entirely on
California and Arizona. In 1998, 75.2% of our premium was written in California,
on a pro forma basis for this acquisition. Additionally, we have historically
concentrated our marketing on group programs and smaller accounts generating
less than $50,000 in annual premium, believing these accounts would give us
higher margins. However, our acquisition of BIG represents a significant
departure from these strategies because BIG is a multi-state carrier in workers'
compensation insurance. In addition, BIG has traditionally marketed to larger
accounts where pricing has been more competitive. Our strategy now includes a
focus on larger accounts, the use of reinsurance to mitigate the pricing and
persistency risk associated with these large accounts, and the marketing of
workers' compensation insurance in many states. See "--Strategy." We can provide
no assurance that we will be successful in implementing these strategies, or
that the new strategies will generate the expected financial benefits. If these
strategies are not successful, our financial performance could be adversely
affected.
We have identified economies of scale that we believe can be achieved over a
period of years through the combination of BIG's business and ours. However, we
can provide no assurance that we will be able to realize the expected economies
of scale within any particular time frame or at all, or to generate additional
revenue to offset any unanticipated inability to benefit from economies of
scale. See "--Strategy."
Our operating strategy after the acquisition of BIG has included the use of
reinsurance through the Quota-Share Arrangement to reduce the pricing and
persistency risk we believe is associated with our plan to re-underwrite BIG's
large account book of business. Additionally, BIG implemented the Loss Reserves
Guarantee by purchasing reinsurance before we acquired it. The expected benefits
of the acquisition could be materially and adversely affected if the reinsurers
fail to perform their obligations. See "--Reinsurance--Recent Reinsurance
Issues."
31
<PAGE>
OUR ESTIMATES OF RESERVES FOR UNPAID CLAIM AND CLAIM ADJUSTMENT EXPENSES MAY BE
INACCURATE AND THEREFORE INSUFFICIENT TO PAY UNREPORTED CLAIMS AND ASSOCIATED
COSTS.
When we estimate the reserves that we need for unpaid claim and claim
adjustment expenses, we must base our estimates on facts and circumstances then
known. The facts and circumstances we rely on include trends in claim frequency
and severity, judicial theories of liability, market conditions, and other
factors. Because we can only estimate what our needs will be, we can provide no
assurance that our estimates will be sufficient to cover our claim and claim
adjustment expenses. If our estimates are inaccurate it may have a material
adverse effect on our results of operations and our financial condition. Over
time our reserve estimates may need to be revised in response to trends in claim
frequency and severity, judicial theories of liability, market conditions, and
other factors. Our past reserves for claim and claim adjustment expenses may not
reflect future trends in the development of these amounts. Accordingly, it may
not be appropriate to predict redundancies or deficiencies based on historical
information. See "--Claim and Claim Adjustment Expense Reserves."
OUR CLAIM SEVERITY MANAGEMENT PROGRAM MAY NOT BE EFFECTIVE AND MAY REQUIRE US TO
INCREASE OUR RESERVES.
In an effort to combat what we believe to be an industry-wide increase in
claim severity in California workers' compensation insurance, we implemented the
Claim Severity Management Program. See "-- Claims Severity Management Program."
Claim frequency has declined as expected since reforms were made in the areas of
benefits and claims after the advent of open rating in 1995 but we believe the
increase in claim severity for 1995 and subsequent accident years is a trend and
not an aberration. If we are correct, then the assumptions we made when we
estimated our reserves for the 1995 in California and subsequent accident years
were flawed, and our reserves could be materially understated. Thus, although we
have recently experienced fewer claims, the increase in the severity of claims
for injuries sustained in 1995 and later has outweighed some of the benefits of
fewer claims. We can provide no assurance that our severity management efforts
will have the effect that we anticipate. If our efforts are not successful, we
could be required to book additional reserves for 1995 and subsequent accident
years, which would adversely affect our financial condition and results of
operations.
THE LOSS RESERVES GUARANTEE MAY NOT BE SUFFICIENT TO COVER FUTURE CLAIMS AND
THEREFORE MAY REQUIRE US TO BOOK ADDITIONAL LOSS RESERVES.
We obtained the Loss Reserves Guarantee when we acquired BIG partly because
of our concern that the increase in claim severity is an industry-wide trend
that is also being experienced at BIG. See "--Reinsurance--Loss Reserves
Guarantee" and "--Claim and Claim Adjustment Expense Reserves." However, we
cannot be sure that the Loss Reserves Guarantee is adequate, particularly if the
trend towards the increased severity of claims turns out to be more severe at
BIG than at SNIC and SPCC. If the Loss Reserves Guarantee is not adequate, then
we may be required to book additional loss reserves for losses incurred before
the acquisition. We have entered into, and required BIG to enter into, the
Quota-Share Arrangement partly because we believe that the trends in claim
severity are more uncertain in larger premium accounts, like those that BIG
maintains. See "--Reinsurance--Reinsurance In Force." Although the Quota-Share
Arrangement may mitigate some of the pricing and persistency risk of large
premium accounts, we are relying solely on the Claim Severity Management Program
and the Loss Reserves Guarantee to handle those risks. In addition, we will
continue to face uncertainty in estimating the reserves needed for our current
premiums and the premiums we will obtain in the future.
OUR FINANCIAL CONDITION, RESULTS OF OPERATION, AND COMPETITIVE POSITION MAY BE
ADVERSELY AFFECTED BY OUR HEAVY RELIANCE ON REINSURANCE.
In order to reduce our underwriting risk, we follow industry practice and
reinsure a portion of our risks. Reinsurance is an important part of our
strategy to reduce pricing and persistency risks related to large premium
accounts. Reinsurance does not relieve us of liability to our insureds for the
risks ceded to our reinsurers. As a result, we may face credit risks for any
amounts we are unable to recover from
32
<PAGE>
reinsurers. We only place our workers' compensation reinsurance with reinsurers
that we believe to be financially stable, but if a significant reinsurer becomes
insolvent or unable to make payments under the terms of a reinsurance treaty, it
may have a material adverse effect on our financial condition or results of
operations. Elements of the workers' compensation reinsurance market are
currently in disarray, which may have a material adverse effect on our financial
condition or results of operations. See "--Reinsurance."
The amount and cost of reinsurance available to companies specializing in
workers' compensation insurance is based, in part, on market conditions. Our
ability to continue to provide insurance at competitive premium rates and
coverage limits depends upon our ability to obtain adequate reinsurance in
amounts and at rates that will not adversely affect our competitive position.
Finally, we can provide no assurance that we will be able to maintain our
current reinsurance coverage, which is generally subject to annual renewal. The
ability to renew reinsurance coverage often depends on market conditions,
however, the Quota-Share Arrangement that we adopted has a minimum three-year
term. If we are unable to renew our reinsurance facilities upon their expiration
and the pricing environment does not improve, we may need to reduce the levels
of our underwriting commitments, which would adversely affect the results of our
operations. See "--Reinsurance."
OUR OPERATIONS COULD BE ADVERSELY AFFECTED IF WE ARE NOT YEAR 2000 COMPLIANT OR
IF WE ARE REQUIRED TO PAY CLAIMS ON POLICIES RELATED TO YEAR 2000 LOSSES.
Much of the software that runs most of the computers in the United States
uses two-digit date codes to perform a number of computations and decision
making functions. These computer programs may fail if they are unable to
interpret date codes properly, misreading "00" for the year 1900 instead of the
year 2000. Insurance policies that expire on January 1, 2000 or later could be
affected by a Year 2000 malfunction. We believe that our Year 2000 program has
made our proprietary operating systems and application software programs Year
2000 compliant in all material respects, although we can provide no assurance in
this regard. We also believe that we have identified substantially all of those
third parties whose inability to handle date sensitive processing could
materially and adversely affect our business and operations if corrective action
is not taken and have received adequate assurances from, or otherwise determined
to our reasonable satisfaction that, these identified parties have taken
appropriate steps to be, or that they are, Year 2000 compliant in all material
respects, although there can be no assurance in this regard. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations-- Year
2000 Strategy."
It is possible that we will face claims made under policies written in our
P&C business, which was discontinued in 1993, related to business losses caused
by Year 2000 malfunctions or costs incurred in connection with prevention or
correction of Year 2000 problems. Published estimates of Year 2000 business
losses and costs are in the many billions of dollars. If P&C insurers were
required by court decisions to pay claims on policies issued between 1985 and
1993 related to Year 2000 losses, we may have to pay such claims. If this were
to occur, it is likely that our reserves for discontinued operations would be
inadequate and the booking of additional reserves would have a material adverse
effect on our results of operations.
UNANTICIPATED CHANGES THAT AFFECT THE INDUSTRY MAY PREVENT US FROM ACCURATELY
PRICING OUR POLICIES WHICH IN TURN MAY ADVERSELY AFFECT OUR PROFITABILITY.
In the workers' compensation insurance industry, insurers generally must
price their products before their costs are known because premium rates must be
determined before losses are reported. Premium rate levels are partly related to
the availability of insurance coverage to consumers in the market. When more
insurance policies are available, price competition increases among workers'
compensation insurers. We can provide no assurance that we will be able to price
our policies in a manner sufficient to cover our costs because the California
workers' compensation insurance business has experienced very competitive
33
<PAGE>
pricing conditions in recent years. If there are many competitors offering
similar products to ours, we may have difficulty increasing our prices in
response to a decline in profits or the demands of the market. Our ability to
increase our prices may also be limited by regulatory constraints. Our pricing
may also be affected by changes in case law, the passage of new statutes, or the
adoption of new regulations affecting the interpretation of insurance contracts
which can dramatically affect our liability with respect to risks which we were
aware of when the affected insurance contract was made. Product enhancements
also present us with special issues in establishing appropriate premium levels
in the absence of sufficient experience with these products' performance. See
"--The Workers' Compensation Insurance Market" and "--Underwriting."
IF A.M. BEST LOWERS OUR RATING BECAUSE OF OUR ACQUISITION OF BIG OR OTHER
FACTORS, OUR FINANCIAL CONDITION, RESULTS OF OPERATION, AND COMPETITIVE POSITION
MAY BE ADVERSELY AFFECTED.
An A.M. Best rating is considered to be an overall measure of the financial
strength of an insurance company and is used primarily by insurance consumers
and people who promote insurance products. A.M. Best gave us a "B++" (Very Good)
rating in early 1999. A.M. Best assigns "B++" ratings to companies that it
believes maintain very good financial strength, operating performance, market
profile and which are likely to meet their obligations to policyholders
according to the standards established by A.M. Best. "B++" is A.M. Best's fifth
highest rating classification out of 15 ratings and our A.M. Best rating is
lower than many of our competitors' ratings. If our rating is lowered in the
future, it may adversely affect our competitive position. Additionally, if we
fail to maintain an A.M. Best rating of at least "B" we would be in default
under our senior bank debt.
There is no direct relationship between a rating established by A.M. Best
and the investment ratings issued by the several securities rating firms,
including S&P and Moody's Investment Services, Inc. Investment ratings generally
pertain to individual securities, although the firms who issue ratings
associated with specific investments also issue insurance ratings that are
similar to the activities of A.M. Best. A.M. Best's ratings are not
recommendations to buy, sell, or hold securities and are subject to change at
any time. A.M. Best bases its ratings on factors that concern policyholders and
not necessarily upon factors concerning investors.
OUR LEVEL OF DEBT MAY LIMIT OUR FLEXIBILITY AND PUT US AT RISK OF DEFAULT.
We incurred approximately $110.0 million in senior bank debt when we
acquired BIG. This amount was in addition to existing debt and has significantly
increased our overall interest and principal payment obligations. As of December
31, 1998, we had a total of approximately $221.0 million of long term debt,
comprised of:
- $110.0 million of senior bank debt;
- $105.0 million related to the Trust Preferred Securities issued by one of
our subsidiaries; and
- $6.0 million in the form of capital leases.
The documents governing our long term debt do not permit us to incur
substantially any additional indebtedness, although we may be able to raise
additional funds to pursue acquisitions of other workers' compensation insurance
companies. While we believe our cash flow from operations and existing funds
will enable us to make the required payments under this debt, we can provide no
assurance that this will be the case. If we find that our cash flow from
operations is insufficient to meet our cash requirements, we may be able to
raise money through additional loans or equity investments, by restructuring, or
by purchasing other businesses, but only to the extent permitted by the
documents governing our long term debt. We can provide no assurance that we will
be able to raise money by these means in a timely manner, or at all. Our ability
to continue to make the required payments on this debt will depend, in part, on
our future performance which is influenced by economic, financial, business, and
other factors we cannot control.
34
<PAGE>
The amount of debt we have may also adversely affect us in the following
ways:
- a large amount of cash must be used to pay down our debt leaving us with
less money to use for other purposes;
- the amount of debt we have may make it difficult for us to obtain more
debt in the future to help fund working capital requirements, acquisitions
or other business needs;
- we may be faced with higher interest rates on our variable rate loans;
- we may have less flexibility in responding to changes in the market;
- we may have more debt than our competitors, leaving us at a competitive
disadvantage; and
- we may be more vulnerable if there is a downturn in our business.
The agreements governing our long term debt have various covenants,
including several relating to financial ratios and our A.M. Best rating that we
must maintain, which creates the risk that we may default under these
agreements, not because of our failure to make the requisite payments, but
rather because we did not maintain our required financial ratios or A.M. Best
rating. If one of these non-monetary defaults should occur, the lenders under
the applicable loan agreement may have the right to accelerate the due date for
the payment of principal, and our ability to make such a prepayment would be
uncertain. In addition, acceleration of a principal payment due date may create
similar acceleration rights for the lenders under our other loan agreements.
THE VARIABILITY OF THE WORKERS' COMPENSATION INSURANCE BUSINESS COULD CAUSE
FLUCTUATIONS IN THE RESULTS OF OUR OPERATIONS.
The workers' compensation insurance business is affected by many factors
that can cause fluctuations in the results of operations of companies
participating in this business. Many of these factors are not subject to our
control. For example, an economic downturn could result in an increase in the
number of claims and less demand for workers' compensation insurance. These
factors, together with competitive pricing and other considerations, could
result in fluctuations in our underwriting results and net income. See
"--Regulation" and "--Ratings."
WE MAY HAVE DIFFICULTY COMPETING WITH INSURANCE PROVIDERS THAT HAVE GREATER
RESOURCES AND COMPETING FOR LARGE INSURANCE PREMIUM ACCOUNTS.
The workers' compensation insurance industry is highly competitive. Some of
our competitors have substantially greater resources than we do, and we can
provide no assurance that we will be able to compete effectively against our
competitors in the future. Some of our competitors are part of financial
services organizations that have billions of dollars of assets and stockholders'
equity. If there is a major change in the marketplace, for example, an increase
in the severity of claims, our competitors that have greater resources may be in
a better position to withstand losses until conditions improve.
Our competitors include companies that, like us, serve the independent
producer market, as well as companies that sell insurance directly to the
insured persons. People who sell directly to the insureds may have competitive
advantages over those of us who sell to producers, because individuals often
recognize the name of the insurer and are loyal to the insurer rather than to an
independent producer.
In the past we have focused on marketing to group programs and smaller
accounts, but, in part due to our acquisition of SPCC, 56.3% of our premiums in
force at December 31, 1998 (excluding BIG) consisted of 755 non-group policies
and 37 group programs that provided estimated annual premiums of $25,000 or
more. BIG, by comparison, actively pursues larger accounts and at December 31,
1998, 66.9% of BIG's premiums in force consisted of policies with estimated
annual premium at inception of $25,000 or more. As a result, we have refocused
our operating strategy to pursue more actively accounts with very large annual
premiums. The market for large accounts is highly competitive, and we believe
price is the single most
35
<PAGE>
important factor large premium customers weigh when deciding which carrier will
provide their workers' compensation insurance. As mentioned earlier, BIG
primarily provided insurance to large accounts while our focus has been on
smaller accounts. In order to maintain market leadership we may have to lower
our prices to large premium volume customers. If the premiums we collect do not
provide us with acceptable operating margins on the accounts, the competitive
environment could have a material adverse effect on the results of our
operations. For at least the next three years, while we re-underwrite BIG's book
of business, we will attempt to minimize the risks associated with large
accounts through the Quota-Share Arrangement. While the Quota-Share Arrangement
is in force, we are subject to risks associated with reinsurance and our overall
financial performance will depend on the profitability of our smaller accounts.
See "--Competition" and "--Reinsurance."
BECAUSE MOST OF OUR BUSINESS IS IN CALIFORNIA, WE ARE SENSITIVE TO REGULATORY
CHANGES AND CHANGES IN THE BUSINESS CLIMATE OF CALIFORNIA.
On a pro forma basis for our acquisition of BIG, approximately 75.2% of our
premiums are written in the State of California, as of December 31, 1998.
Consequently, we are significantly affected by changes in the regulatory and
business climate in California. See "--Regulation."
LIMITATION OF USE OF NET OPERATING LOSS CARRYFORWARDS
As of December 31, 1998, we had approximately $204.0 million in net
operating loss carryforwards ("NOLs") available to offset taxable income
recognized by us for periods after December 31, 1998. For federal income tax
purposes, these NOLs will expire in material amounts beginning in the year 2006.
Because our sale of our common stock to fund the acquisition of BIG caused us to
undergo an "ownership change" under Section 382 of the Internal Revenue Code, we
will be able to use only a maximum of approximately $8.0 million per year of our
NOLs, together with additional amounts to offset "built-in gains." Built-in
gains are unrealized gains related to appreciated property, including
investments, that we own. Limitations imposed by Section 382 may cause the
availability of our NOLs to be deferred, causing us to incur tax obligations
when we otherwise would not, or may allow some portions of the NOLs to expire
before we can use them to reduce our tax obligations. Our tax obligation affects
our cash position and therefore affects our ability to make payments on our
long-term debt as it becomes due.
OUR FUTURE GROWTH AND OPERATIONS ARE DEPENDENT UPON OUR CONTINUED ACCESS TO
CAPITAL.
Underwriting workers' compensation insurance requires a large amount of
capital. We must maintain minimum levels of surplus in our insurance
subsidiaries in order to continue writing policies and to comply with standards
set by insurance regulatory authorities and insurance rating bureaus. See
"--Regulation." We can provide no assurance that we will have access to the
capital we need to meet our regulatory obligations.
Furthermore, if we do not have access to capital, it will be difficult for
us to grow our business through additional acquisitions. In 1997 our premiums
grew after we purchased SPCC. We would like to continue to grow by purchasing
other companies, as we recently did by acquiring BIG in 1998. In order to raise
the money we need to grow we may have to take on additional debt, use equity
financing or use our retained earnings. We cannot be sure that we will have
access to enough money from any of these sources, which would then limit our
ability to grow. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources."
POOR PERFORMANCE BY OUR INVESTMENTS WILL ADVERSELY AFFECT THE RESULTS OF OUR
OPERATIONS.
The results of our operations are partly dependent on how well our
investments perform. On December 31, 1998, virtually all of our investments were
investment-grade securities. Some of the risks that are inherent to fixed-income
securities include loss upon default, drastic changes in prices due to changes
in interest rates, general market factors, and in the case of certain
asset-backed securities, risks that follow prepayment and reinvestment risk. See
"--Investments."
36
<PAGE>
THE INSURANCE INDUSTRY IS HEAVILY REGULATED AND FUTURE LEGISLATIVE CHANGES MAY
ADVERSELY AFFECT OUR BUSINESS.
Our operations are heavily regulated by state government agencies in every
state where we are licensed. Most insurance regulations are meant to benefit
customers rather than the insurance companies or their interests. It is possible
that later changes in the state regulations or future developments in proposed
federal legislation will harm our business. See "--Regulation." Some of the
areas regulated by state agencies include:
- the purchase or control of another insurance company or any company
controlling an insurance company;
- certain transactions that an insurance company may enter into with parties
that it is closely associated with;
- limitations on the amount of dividends that can be paid;
- the filing of premium rates and policy forms;
- the creation of standards regarding the solvency of the insurance company
and the minimum amounts of capital and surplus that the insurance company
must maintain;
- the placement of limitations on types and amounts of investments;
- the placement of restrictions on the size of risks that can be insured by
a single company;
- the regulation of the right to cancel or to fail to renew policies in some
lines of insurance;
- the regulation of the right to withdraw from areas where insurance is
being provided;
- requirements to participate in residual markets;
- the licensing of insurers and agents;
- the deposit of securities for the benefit of policyholders;
- a requirement that insurance companies report and satisfy certain
standards governing their financial condition;
37
<PAGE>
- a requirement that insurance companies allow the state insurance
department to review their financial and market conduct periodically; and
- a requirement that insurance companies use certain accounting practices
when reporting to regulatory authorities.
SNIG'S ABILITY TO OBTAIN THE MONEY IT NEEDS TO PAY ITS DEBT OBLIGATIONS AND ITS
CORPORATE EXPENSES MAY BE LIMITED BY RESTRICTIONS ON ITS SUBSIDIARIES' ABILITY
TO PAY DIVIDENDS.
SNIG is a holding company and its principal asset is the capital stock of
its subsidiaries. It relies primarily on dividends and other payments from its
insurance subsidiaries to meet its obligations to creditors and to pay corporate
expenses, including the principal and interest due on the debt it incurred
during the acquisition of BIG and in connection with the Trust Preferred
Securities issued by a subsidiary. The ability of its subsidiaries to pay
dividends is limited by the states where they are located. SNIC, SPCC, CBIC, and
CalComp are regulated by the State of California. In California, an insurance
subsidiary may pay a dividend, without prior approval by the DOI, the maximum
amount of the greater of net income from operations for the preceding year or
10% the statutory policyholders' surplus as of the preceding December 31. CCIC
is regulated by the State of New York, which has similar restrictions. State
insurance laws and regulations also require that the statutory surplus of an
insurance company be reasonable in relation to its outstanding liabilities and
adequate for its financial needs after the payment of dividends or any other
distribution. See "--Regulation" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital Resources."
BECAUSE WE DEPEND ON OUTSIDE PRODUCERS TO PROVIDE US WITH CUSTOMERS, IF WE WERE
TO LOSE ANY SIGNIFICANT PRODUCER OR IF THEY WERE TO DECIDE TO MOVE A SIGNIFICANT
NUMBER OF CUSTOMERS, OUR BUSINESS COULD BE ADVERSELY AFFECTED.
We depend on outside producers to provide us with insurance business. The
producers own the right to renew any of the business they provide. We believe
that our relationships with our producers are generally excellent, and we
believe that BIG and its producers have a strong relationship. Still, we cannot
be sure that producers will not move the business we carry for them to another
carrier. Our earnings could be adversely affected if renewal rates were to drop
because producers move business to our competitors, or if producers were to
deliver less of the business we prefer to carry.
A large part of our business is derived from a small number of producers and
a loss of any of them could have a material adverse effect on our business. SNIC
and SPCC obtained approximately 25.0% of their combined business in 1998, 26.8%
in 1997, and 25.0% in 1996, from its ten leading producers. BIG's insurance
subsidiaries' top ten producers accounted for 8.1% of their combined business in
1998 and 18.5% of their business in 1997. See "--Marketing."
WE CURRENTLY CARRY A COMBINED CARE BENEFIT BUSINESS WHICH DID NOT DO WELL FOR
BIG AND WHICH MAY HARM OUR UNDERWRITING RESULTS AND NET INCOME IF WE ARE UNABLE
TO IMPROVE ITS PERFORMANCE.
BIG has, through several of its insurance subsidiaries, marketed a program
of "24-hour care," which provides its insureds' employees with workers'
compensation insurance and group health benefits. The combined care benefits
business constituted approximately 2.7% of BIG's direct written premium in 1998.
If we are unable to achieve adequate operating margins in this business we may
have to incur costs to restructure or sell the group health benefits business.
We are inexperienced in the group health benefits business and may be in a poor
position to operate that business profitably.
Market acceptance of the concept of 24-hour care and the combination of
group health insurance with workers' compensation insurance into a single
program has been weaker than expected to date. Since first offering this product
in December of 1995, BIG has been unable to generate enough business to allow it
to price the product so as to generate adequate operating margins. These
factors, together with competitive pricing and other considerations, could
result in fluctuations in our underwriting results and net income.
38
<PAGE>
IF WE ARE UNABLE TO PAY DIVIDENDS ON OUR PARTICIPATING POLICIES, WE MAY FACE A
LOSS OF PRODUCER SUPPORT AND HARM OUR MARKETING EFFORTS FOR THESE POLICIES,
WHICH WOULD ADVERSELY AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
BIG uses participating policies that pay dividends to policyholders as a
marketing tool to sell workers' compensation insurance outside of California.
Participating policies may require payment of dividends to the policyholder at
the end of the policy term. Policyholder dividends may be based on a flat
percentage of premium, or more commonly, several factors relating to loss
experience.
BIG has a limited history of issuing participating workers' compensation
insurance policies in states outside of California. As participating policies
expire and come up for dividend consideration, BIG performs a calculation based
on its dividend plan, and its board of directors declares policyholder dividends
based on current loss experience. If adverse loss developments occur on policies
that have been paid dividends, our financial condition and results of operations
could suffer. To the extent that producers and policyholders expect BIG to
declare and pay policyholder dividends according to the policyholder dividend
proposals at the inception of the policies, if the loss experience of accounts
written on a participating basis do not support policyholder dividend
declarations, the absence of dividend payments could have a negative impact on
BIG's producer support and marketing efforts and could have a material adverse
affect on our financial condition and results of operations. See
"--Underwriting."
THE CONCENTRATED OWNERSHIP OF OUR COMMON STOCK BY A FEW ENTITIES MAY HAVE AN
ADVERSE EFFECT ON YOUR ABILITY TO INFLUENCE THE DIRECTION SUPERIOR NATIONAL WILL
TAKE.
Currently the ownership of our common stock is concentrated with a few
entities. Insurance Partners, L.P. ("IP Delaware"), Insurance Partners Offshore
(Bermuda), L.P. ("IP Bermuda"), and Capital Z Financial Services Fund II, L.P.
("IP II") played significant roles in the equity financing of our acquisition of
BIG and now approximately 64.5% of the total number of shares of our outstanding
common stock, or the same percentage on a diluted basis, is held in the
aggregate by the IP partnerships and certain related parties. Certain affiliates
of Zurich are limited partners of IP Delaware and IP Bermuda and hold
approximately 23% of the limited partnership interests in those funds on an
aggregate basis. They also hold a large portion of the limited partnership
interests in IP II. In addition, certain affiliates of Zurich collectively own
warrants to acquire approximately 5.5% of our common stock on a fully diluted
basis, approximately 1.8% of which are subject to a revocable agency
relationship with International Insurance Advisors, Inc. See "Security Ownership
of Principal Beneficial Owners and Management."
As a result of this concentration of ownership, absent agreements to the
contrary, the IP partnerships and related parties could, if they acted together,
potentially exercise control over Superior National and our Board of Directors.
Five of our eleven directors either have relationships with, or became directors
because the IP partnerships and certain related parties exercised their rights
to nominate directors. The concentrated ownership of our common stock by these
parties could materially and adversely affect our financial condition or the
price of our common stock because:
- These parties have significant influence over the management of Superior
National and have a significant portion of the votes needed to approve any
action that requires stockholder approval. This includes adopting
amendments to our Certificate of Incorporation and approving certain
actions, such as mergers or sales of all or substantially all of our
assets;
- This concentration of ownership may delay or prevent a change in control
of Superior National because unaffiliated stockholders may not have enough
votes to approve a strategic offer for Superior National by a third party
that might otherwise be attractive to unaffiliated stockholders; and
- The concentration of ownership could also have a depressive effect on the
trading market for our common stock.
39
<PAGE>
Some of these effects may be mitigated because the IP partnerships and some
of their related parties have agreed to limitations on their ability to acquire
additional equity securities of Superior National and to certain limitations on
their ability to vote the shares they have. However, the members of the Board of
Directors that are not affiliated with the IP partnerships or their related
parties could decide it is in the best interests of Superior National to waive,
limit, or revoke these limitations, which would leave the IP partnerships in
control of Superior National. See "Certain Relationships and Related
Transactions--Sale of Common Stock to the IP Partnerships and Limitations on
Related Party Control of Superior National."
OUR FUTURE SUCCESS IS DEPENDENT ON OUR KEY PERSONNEL, WHO WE MAY NOT BE ABLE TO
RETAIN.
Our future success depends significantly upon the efforts and continued
employment of several key management personnel, including William L. Gentz, a
director and the President and Chief Executive Officer; J. Chris Seaman, a
director, an Executive Vice President and the Chief Financial Officer; and
Arnold J. Senter, an Executive Vice President and the Chief Operating Officer. A
loss of any of these officers or other key employees could materially and
adversely affect our business. See "Directors and Executive Officers."
THE MARKET PRICE OF OUR COMMON STOCK COULD EXPERIENCE WIDE FLUCTUATIONS DUE TO A
NUMBER OF FACTORS BEYOND OUR CONTROL.
The market price of our common stock could experience wide fluctuations in
response to a number of factors, including actual or anticipated variations in
the results of our operations, the introduction by us or our competitors of new
products or services, changes in financial estimates by securities analysts and
general market conditions. Stock markets, and in particular Nasdaq, have
experienced extreme price and volume fluctuations that have particularly
affected the market prices of the common stock of companies like ours that
maintain a relatively low "float". These changes are often unrelated or
disproportionate to the actual performance of the affected companies. We can
provide no assurance that the trading price and price-to-earnings ratios seen in
the equity markets generally will be sustained. These broad market factors may
adversely affect the market price of our common stock. These market
fluctuations, as well as general economic, political, and market conditions,
such as recessions or interest rate fluctuations, may adversely affect the
market price of our common stock. Securities class action litigation often
follows drastic changes in the market price of a corporations' securities. If we
were to be involved in litigation, it could result in our incurring substantial
costs and require our management to divert their attention and resources, which
could have a material adverse effect on our business, results of operations, and
financial condition. See "Market Price of and Dividends on Our Common Equity and
Related Stockholder Matters."
ITEM 2. BUSINESS PROPERTIES
Our principal executive offices are located in Calabasas, California and are
subject to a lease that expires in 2000. We have 46 other office leases across
the United States. Lease expiration dates range from 1999 to 2005.
Our principal executive office is located at 26601 Agoura Road, Calabasas,
California 91302, and our telephone number is (818) 880-1600.
ITEM 3. LEGAL PROCEEDINGS
We are parties to various legal proceedings, all of which are considered
routine and incidental to our business and not material to the financial
condition and operation of our business. We are not party to any litigation that
could reasonably be expected to have a material adverse effect upon our business
or financial position.
We are subject to class action litigation that was filed against all
workers' compensation insurers in California, related principally to claims
paying practices. We are vigorously contesting this litigation. Although the
likelihood of a material adverse result in this matter is regarded by the
defendants as low,
40
<PAGE>
there can be no assurance that, should a trial be held, the class plaintiffs
will not receive a substantial award.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On November 3, 1998, we held our Annual Meeting of Stockholders. Our
stockholders voted to elect eleven directors to our Board of Directors and to
approve the following proposals: (1) "The Stock Offering"; (2) "The IP Stock
Issuance"; (3) "Amendment to 1995 Stock Incentive Plan"; (4) "Employee Stock
Purchase Plan"; (5) "Amendment to Certificate of Incorporation to Increase
Number of Authorized Shares"; (6) "Amendment to Certificate of Incorporation to
Remove Transfer Restrictions"; and (7) "Ratification of the Appointment of KPMG
LLP as Independent Auditors."
Our stockholders re-elected the following directors: Bradley E. Cooper,
William L. Gentz, Steven D. Germain, Roger W. Gilbert, Steven B. Gruber, Thomas
J. Jamieson, Gordon E. Noble, C. Len Pecchenino, Craig F. Schwarberg, J. Chris
Seaman, and Robert A. Spass. The results of each other matter voted on were as
follows:
<TABLE>
<CAPTION>
VOTES
AGAINST/ VOTES ABSTAINED/
VOTES FOR WITHHELD BROKER NON-VOTES
---------- ------------- -----------------
<C> <S> <C> <C> <C>
(1) The Stock Offering............................................ 4,000,741 14,200 8,782
(2) The IP Stock Issuance......................................... 4,000,741 14,200 8,782
(3) Amendment to the 1995 Stock Incentive Plan.................... 3,967,691 43,250 12,782
(4) Employee Stock Purchase Plan.................................. 3,993,816 20,925 8,982
(5) Amendment to Certificate of Incorporation to Increase the
Number of Authorized Shares................................... 5,395,219 19,425 3,282
(6) Amendment to Certificate of Incorporation to Remove Transfer
Restrictions.................................................. 3,995,241 22,675 5,807
(7) Ratification of the Appointment of KPMG LLP as Independent
Auditors...................................................... 5,404,254 1,200 12,472
</TABLE>
PART II
ITEM 5. MARKET PRICE OF AND DIVIDENDS ON OUR COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
Our common stock is listed and traded on The Nasdaq National Market under
the trading symbol "SNTL." The Nasdaq National Market or "Nasdaq" is a
highly-regulated electronic securities market comprised of competing market
makers whose trading is supported by a communications network linking them to a
quotation dissemination, trade reporting, and order execution system. This
market also provides specialized automation services for screen-based
negotiations of transactions, on-line comparison of transactions, and a range of
informational services tailored to the needs of the securities industry,
investors and issuers. Nasdaq is operated by The Nasdaq Stock Market, Inc., a
wholly-owned subsidiary of the National Association of Securities Dealers, Inc.
Set forth below are the quarterly high and low closing sale prices for our
common stock as reported by Nasdaq. Because our common stock was not approved
for
41
<PAGE>
listing on Nasdaq until March 5, 1996, quotations prior to then are inter-dealer
prices without retail mark-up, mark-down, or commission and may not necessarily
represent actual transactions.
<TABLE>
<CAPTION>
HIGH LOW
--------- ---------
<S> <C> <C>
1998
Fourth quarter........................................................... $ 20.06 $ 15.25
Third quarter............................................................ $ 23.25 $ 15.75
Second quarter........................................................... $ 25.75 $ 17.75
First quarter............................................................ $ 21.19 $ 14.25
1997
Fourth quarter........................................................... $ 15.25 $ 14.00
Third quarter............................................................ $ 15.50 $ 13.25
Second quarter........................................................... $ 13.63 $ 11.63
First quarter............................................................ $ 15.25 $ 11.25
1996
Fourth quarter........................................................... $ 13.75 $ 9.88
Third quarter............................................................ $ 10.75 $ 7.13
Second quarter........................................................... $ 8.00 $ 4.87
First quarter............................................................ $ 5.63 $ 4.87
</TABLE>
On March 31, 1999, the number of stockholders of record of our common stock
was 301 and 17,928,055 shares of common stock were outstanding.
We believe the increase in price in the third and fourth quarter of 1996 and
the first quarter of 1997 was primarily due to the announcement of our impending
acquisition of Pac Rim. The Pac Rim acquisition was completed on April 11, 1997.
Our current policy is to retain earnings for use in our business. We have
not paid any cash dividends to our stockholders in the three most recent fiscal
years and have no present intention of paying cash dividends in the foreseeable
future. The payment of dividends in the future is subject to the discretion of
the Board of Directors and will depend on our operating results, financial
condition and capital requirements, general business conditions, and other
relevant factors, including legal restrictions applicable to the payment of
dividends by SNIC, SPCC, CalComp, CBIC, and CCIC. The California Insurance Code
restricts the dividends or distributions an insurance subsidiary may pay in any
12-month period to the greater of (a) net income for the preceding year, or (b)
10% of statutory policyholders' surplus as of the preceding December 31.
Payments of greater amounts require the approval of the DOI. CCIC is regulated
by the State of New York, which has similar restrictions. See
"Business--Regulations." Because SNIG conducts no substantial business other
than through SNIC, SPCC, CalComp, CBIC, and CCIC, SNIG is dependent upon
dividends from these subsidiaries in order to pay dividends to SNIG's
stockholders.
UNREGISTERED SALES OF OUR EQUITY SECURITIES DURING 1998
Superior National's acquisition of BIG was financed in part by our issuance
and sale on December 10, 1998 to IP Delaware of 2,949,594 shares of common
stock, to IP Bermuda of 1,196,588 shares of common stock, and to IP II of
5,276,960 shares of common stock. These shares were sold in a private
transaction at $16.75 per share for a total purchase price of approximately $158
million. In addition, Superior National paid a commitment fee to IP Delaware, IP
Bermuda and designees of IP II in the form of warrants, which are immediately
exercisable, to purchase an aggregate of 734,000 shares of common stock of
$16.75 per share. These warrants expire on December 10, 2003. See "Certain
Relationships and Related Transactions--Sale of Common Stock to the IP
Partnerships and Limitations in Related Party Control of Superior National." In
issuing and selling these shares of common stock and warrants, Superior National
relied upon the exemption from registration provided by Section 4(2) of the
Securities Act, based upon certain representations made by IP Delaware, IP
Bermuda and IP II.
42
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
SELECTED FINANCIAL DATA
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
OPERATIONS FOR THE YEAR ENDED DECEMBER 31,
-----------------------------------------------------
<S> <C> <C> <C> <C> <C>
1998(2) 1997(1) 1996 1995 1994
--------- --------- --------- --------- ---------
REVENUES:
Gross premiums written.......................................... $ 192,070 $ 159,352 $ 99,282 $ 97,084 $ 134,769
Net premiums written............................................ 79,695 136,929 87,715 89,139 105,946
Net premiums earned............................................. 87,089 140,920 88,648 89,735 110,418
Net investment income (excluding capital gains and losses)...... 14,382 12,630 7,738 10,309 9,014
Net capital gain (loss)......................................... 1,854 44 31 (525) 35
--------- --------- --------- --------- ---------
Total revenues................................................ 103,325 153,594 96,417 99,519 119,467
EXPENSES:
Claim and claim adjustment expenses, net of reinsurance......... 243,342 90,447 55,638 53,970 78,761
Reinsurance recovery on loss reserve guarantee.................. (175,000) -- -- -- --
Underwriting and general and administrative expenses............ 38,180 37,695 34,138 29,447 21,660
Policyholder dividends.......................................... 1,158 -- (5,927) (5,742) 4,983
Interest expense................................................ 1,324 6,335 7,527 9,619 8,726
Loss on termination of financing transaction with a related
party reinsurer............................................... -- 15,699 -- -- --
Other expense (income), net..................................... 2,065 1,856 (186) 536 340
--------- --------- --------- --------- ---------
Income (loss) from continuing operations before preferred
securities and extraordinary items--pre-tax................... (7,744) 1,562 5,227 11,689 4,997
Income tax (expense) benefit.................................... 5,461 1,788 (739) 5,849 (4)
Accretion on preferred securities--pre-tax...................... (11,319) (4,650) (2,525) (2,255) (1,035)
(Loss) from operations of discontinued P&C
operations--pre-tax(3)........................................ -- -- -- (14,912) --
Extraordinary (loss)--pre-tax................................... -- (3,841) -- -- (3,064)
--------- --------- --------- --------- ---------
Net income (loss)............................................... $ (13,602) $ (5,141) $ 1,963 $ 371 $ 894
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
BASIC EPS(4)
Income before items below--after all taxes...................... $ (0.34) $ 0.64 $ 1.31 $ 5.12 $ 1.45
Preferred Securities--pre-tax................................... (1.67) (0.89) (0.74) (0.66) (0.30)
Discontinued Operations--pre-tax................................ -- -- -- (4.35) --
Extraordinary Items--pre-tax.................................... -- (0.73) -- -- (0.89)
Cumulative Effect of Change in Accounting--pre-tax.............. -- -- -- -- --
--------- --------- --------- --------- ---------
Net income (loss)............................................... $ (2.01) $ (0.98) $ 0.57 $ 0.11 $ 0.26
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
DILUTED EPS(4)
Income before items below-- after all taxes..................... $ (0.34) $ 0.47 $ 0.93 $ 4.44 $ 0.97
Preferred Securities--pre-tax................................... (1.67) (0.66) (0.52) (0.57) (0.20)
Discontinued Operations--pre-tax................................ -- -- -- (3.78) --
Extraordinary Items--pre-tax.................................... -- (0.55) -- -- (0.60)
Cumulative Effect of Change in Accounting pre-tax............... -- -- -- -- --
--------- --------- --------- --------- ---------
Net income (loss)............................................... $ (2.01) $ (0.74) $ 0.41 $ 0.09 $ 0.17
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
GAAP RATIOS:(5)
Claim and claim adjustment expense ratio(6)..................... 78.5% 64.2% 62.8% 60.1% 71.3%
Expense ratio................................................... 45.2% 26.7% 31.8% 26.4% 24.1%
--------- --------- --------- --------- ---------
Continuing operations combined ratios, net of reinsurance....... 123.7% 90.9% 94.6% 86.5% 95.4%
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
FINANCIAL POSITION:
Total cash and investments(7)
Carrying value................................................ $ 867,401 $ 242,116 $ 149,440 $ 49,030 $ 68,595
Market value.................................................. 867,401 242,116 149,440 49,030 68,591
Investments withheld from a related party reinsurer............. -- -- -- 114,921 108,283
Investments withheld from reinsurer............................. 123,863 -- -- -- --
Total assets.................................................... 1,719,642 429,473 323,830 240,781 286,776
Long-term debt.................................................. 105,820 30 98,961 8,530 9,730
Claim and claim adjustment expense liability.................... 1,076,206 201,255 115,529 141,495 171,258
Total liabilities............................................... 1,394,596 268,378 255,068 176,256 227,622
1994 preferred securities issued by affiliate -- -- 23,571 21,045 18,790
Company-obligated trust preferred securities.................... 101,084 101,277 -- -- --
Net stockholders' equity........................................ 223,962 59,818 45,191 43,480 40,364
Book value per share(4)......................................... $ 12.68 $ 10.19 $ 13.11 $ 12.68 $ 11.77
Outstanding shares(4)........................................... 17,662,314 5,871,279 3,446,492 3,430,373 3,429,873
</TABLE>
- ------------------------------
(1) The information for the year ended December 31, 1997 includes the financial
data of SPCC for the period beginning April 1, 1997.
43
<PAGE>
(2) The information for the year ended December 31, 1998 includes the financial
data of BIG for the period beginning December 10, 1998.
(3) Superior National's losses from discontinued operations resulted principally
from contractors' and developers' liability business underwritten from 1986
to 1993.
(4) Adjusted to reflect a four-into-one reverse stock split effective as of May
24, 1995. The 1998 outstanding shares was adjusted by 245,000 shares of
Treasury Stock.
(5) These ratios are for continuing operations. The claim and claim adjustment
expense ratio is calculated by dividing the claim and claim adjustment
expenses by net premiums earned. The expense ratio is calculated by dividing
the sum of commissions (net of reinsurance ceding commissions), policyholder
dividends, and general and administrative expenses by net premiums earned.
The combined ratio is the sum of the claim and claim adjustment expense
ratio and the expense ratio.
(6) Claim and claim adjustment expense ratio for 1998 is calculated by dividing
the sum of the net claim and claim adjustment expenses and reinsurance
recovery on loss reserve guarantee by net premiums earned.
(7) Investments as of December 31, 1998, 1997, 1996 and 1995 are reflected at
market value. As of December 31, 1994 a portion of the portfolio was
classified as held to maturity and was therefore reflected at amortized cost
and the remaining portfolio was shown at market value. The changes in
portfolio valuation reflect the adoption of Statement of Financial
Accounting Standard No. 115, effective for fiscal years following December
15, 1993.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis provides information that management
believes to be relevant for an understanding of our consolidated results of
operations and financial condition. The discussion should be read in conjunction
with the consolidated financial statements and the notes thereto.
OVERVIEW
During 1998, we completed three significant transactions. First, we
completed the required financing to fund our acquisition of BIG by obtaining
$110.0 million in senior bank debt financing and $200.1 million in equity
financing. Second, we completed the acquisition of BIG and its wholly owned
insurance subsidiaries (CalComp, CBIC, CCIC, and BICO) on December 10, 1998 for
total consideration of $285.0 million in cash. Third, we completed the sale of
BICO on December 18, 1998 to Centre Solutions Holdings (Delaware) Limited for a
purchase price of approximately $12.3 million ($0.6 million of which was
withheld and, subject to possible downward adjustments, will be paid in
September 1999). SNIG's loss before preferred securities' dividends and
accretion, discontinued operations and extraordinary items was $6.2 million in
1998, as compared to income of $0.5 million in 1997. This $6.7 million decrease
was primarily the result of a $34.6 million loss associated with the Pac Rim
book of business, of which $28.0 million related to claims and claim adjustment
expense and $6.6 million related to the write-off of goodwill. Partially
offsetting the decrease associated with the loss related to the Pac Rim book of
business was a $23.2 million pre-tax reduction in commission expense net of
reinsurance in 1998 and a $3.6 million pre-tax increase in investment income in
1998. Additionally, we had a $17.0 million pre-tax increase (excluding the $6.6
million write-off of unamortized goodwill) in underwriting and general and
administrative expenses in 1998, which was primarily offset by a $15.7 million
loss on the termination of a financing transaction with a related party
reinsurer realized in 1997. The reduction of $23.2 million in commission expense
net of reinsurance is mainly due to an increase in ceded commission related to
the Quota-Share Arrangement. The increase of $3.6 million in net investment
income is due to $1.8 million in realized gains and a $2.0 million increase in
net investment income which was the result of an increase of approximately
$773.6 million in assets available for investment from the acquisition of BIG.
For the year ended December 31, 1998, we recorded a net loss of $13.6
million after preferred securities' dividends and accretion, discontinued
operations, and extraordinary items, as compared to a net loss of $5.1 million
for the year ended December 31, 1997. Net loss per share for the year ended
December 31, 1998 was $2.01 (diluted) versus net loss per share of $0.74
(diluted) in 1997. During 1997, we recorded a $2.5 million extraordinary loss as
the result of retirement of debt; no such charges were recorded in 1998.
Further, during 1998, we recorded $7.4 million in dividend expense and accretion
on preferred securities, as compared to $3.0 million in 1997.
44
<PAGE>
During 1997, we completed three significant transactions. First, in April
1997 we acquired Pac Rim Holding Corporation, the parent of SPCC, for a purchase
price of $42.0 million and completed the related senior bank debt financing of
$44.0 million and private offering of our common stock for $18.0 million.
Second, in June 1997 we terminated a financing transaction with a related party
reinsurer, which transferred $110.5 million in receivables from the related
party reinsurer in exchange for the cancellation of $94.9 million of long-term
debt. Third, the issuance of $105.0 million in Trust Preferred Securities by one
of our subsidiaries, was completed December 3, 1997. SNIG's income before
preferred securities' dividends and accretion, discontinued operations and
extraordinary items was $0.5 million in 1997, as compared to $3.6 million in
1996. This $3.1 million decrease was primarily the result of a $15.7 million
loss on the termination of a financing transaction with a related party
reinsurer. The $15.7 million charge was offset in part by a $4.9 million
increase in investment income before taxes in 1997 and a $5.9 million pre-tax
reduction in the accrual for policyholder dividends in 1996. The increase of
$4.9 million in net investment income was primarily due to increases of $92.7
million and $93.1 million in assets available for investment that resulted,
respectively, from the acquisition of SPCC and the November 1996 financing
transaction with The Chase Manhattan Bank ("Chase"). See "--Liquidity and
Capital Resources."
For the year ended December 31, 1997, we recorded a net loss of $5.1 million
after preferred securities' dividends and accretion, discontinued operations,
and extraordinary items, as compared to net income of $2.0 million for the year
ended December 31, 1996. Net loss per share for the year ended December 31, 1997
was $0.74 (diluted) versus net income per share of $0.41 (diluted) in 1996.
During 1997, we recorded a $3.0 million in dividend expense and accretion on
preferred securities, as compared to $1.7 million in 1996.
YEAR ENDED DECEMBER 31, 1998 AS COMPARED TO YEAR ENDED DECEMBER 31, 1997
Gross premiums written for the years ended December 31, 1998 and 1997 were
$192.1 million and $159.4 million, respectively. This increase in gross premiums
written represents an increase of $32.7 million or 20.5% for the 1998 policy
year as compared to the 1997 policy year. This increase in gross premiums
written can be primarily attributed to $25.1 million of business written by BIG
insurance subsidiaries. The 1998 increase is also attributable to twelve months
of additional business written in 1998 related to the SPCC acquisition as
opposed to only nine months of business written in 1997. Net premiums written
decreased $57.2 million or 41.8% to $79.7 million for the year ended December
31, 1998, as compared to the year ended December 31, 1997. This decrease is
primarily due to a $94.1 million increase in ceded premium related to the
Quota-Share Arrangement, which is partially offset by the increase reflected in
gross written premium. Net premiums earned decreased $53.8 million or 38.2% to
$87.1 million for the year ended December 31, 1998, as compared to the year
ended December 31, 1997, reflecting the decrease in net written premiums.
Net claim and claim adjustment expenses increased $152.9 million or 169.0%
to $243.3 million for the year ended December 31, 1998 as compared to $90.4
million for the year ended December 31, 1997. The increase in claim and claim
adjustment expense is due to $175.0 million in claim and claim adjustment
expenses related to the Loss Reserves Guarantee and a $28.0 million loss
associated with the Pac Rim book of business. These increases are partially
offset by a $50.1 million decrease in claim and claim adjustment expenses
primarily due to an increase in ceded claim and claim adjustment expense related
to the Quota-Share Arrangement. The net claim and claim adjustment expense ratio
increased to 279.4% for the year ended December 31, 1998, as compared to 64.2%
for the year ended December 31, 1997. The increase in the claim and claim
adjustment expense ratio is due to $175.0 million in claim and claim adjustment
expenses related to the Loss Reserves Guarantee which has no associated premium.
Excluding the $175.0 million in claim and claim adjustment expenses related to
the Loss Reserves Guarantee, the claim and claim adjustment expense ratio was
78.5% for the year ended December 31, 1998. This 78.5% claim and claim
adjustment expense ratio represents a 14.3 percentage point increase over the
same period
45
<PAGE>
in 1997. This increase is due to adverse development on net claim and claim
adjustment expense liabilities of prior years.
Reinsurance recovery on loss reserve guarantee is $175.0 million for the
year ended December 31, 1998, as compared to no such recovery for the same
period in 1997. This $175.0 million was recorded in association with the Loss
Reserves Guarantee.
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 $23.7 million or 99.2% to $47.5 million for the
year ended December 31, 1998, as compared to the same period in 1997. This
increase consists of a $6.6 million write-off of goodwill, associated with the
Pac Rim acquisition, reflected in underwriting expense. In addition to the $6.6
million write-off of goodwill, a $9.9 million increase was primarily due to the
increase in written premium as a result of the Quota-Share Arrangement, as well
as, the acquisition of SPCC and a $5.6 million increase related to the addition
of BIG insurance subsidiaries. This increase was also partially due to a $1.8
million expense related to the ZRNA Commutation. Net commission expense
decreased $23.2 million or 167.5% to ($9.3) million for the year ended December
31, 1998, as compared to the same period in 1997. The decrease in net commission
expense was mainly due to $31.1 million in ceded commission related to the
Quota-Share Arrangement, which was partially offset by an increase in gross
commission expense related to the BIG insurance subsidiaries, as well as, an
increase in gross written premium. Net underwriting and general and
administrative expenses, excluding the loss on the termination of a financing
transaction with a related party reinsurer, increased 1.3% to $38.2 million for
the year ended December 31, 1998 from $37.7 million in the same period of 1997,
reflecting the changes discussed above.
Policyholder dividend expense was $1.2 million for the year ended December
31, 1998, as compared to no such expense in the same period in 1997. The $1.2
million increase in policyholder dividend expense was comprised of $1.0 million
from BIG insurance subsidiaries and $0.2 million of accrual relating to policies
written in Arizona in fiscal year 1998 for SNIC and SPCC.
We recorded an underwriting loss, excluding the loss on the termination of a
financing transaction with a related party reinsurer, from continuing operations
of $20.6 million for the year ended December 31, 1998, versus an underwriting
profit of $12.8 million for the same period in 1997. The decrease in
underwriting profit from continuing operations was primarily the result of
losses associated with the Pac Rim book of business.
Net investment income, excluding realized investment gains, increased $1.8
million or 13.9% to $14.4 million for the year ended December 31, 1998 compared
to the same period in 1997. The increase in investment income was due to an
increase in assets available for investment of approximately $773.6 million that
resulted from the purchase of BIG.
Interest expense decreased $5.0 million or 79.1% to $1.3 million for the
year ended December 31, 1998, as compared to the year ended December 31, 1997.
The decline in interest expense was primarily 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. The $1.3 million interest expense for 1998
consisted primarily of interest from the funds withheld balance associated with
the Quota-Share Arrangement and interest from the $110.0 million in senior debt
financing incurred in December 1998.
In June 1997, we recorded a $15.7 million charge related to the termination
of a financing transaction with a related party reinsurer. The termination of
the financing transaction transferred $110.5 million in receivables from the
reinsurer in exchange for the cancellation of $94.9 million in indebtedness to a
lender. No such charges were incurred during 1998.
Discontinued operations claim counts and net claim and claim adjustment
expense reserves as of December 31, 1998 were 226 and $8.9 million,
respectively, as compared to 215 and $13.5 million as of December 31, 1997.
These amounts and estimates are consistent with management's expectations. We
have
46
<PAGE>
significant exposure to construction defect liabilities on P&C insurance
policies underwritten from 1986 to 1993. We continue to monitor closely our
potential exposure to construction defect claims and have not changed our
estimates of ultimate claim and claim adjustment expense on discontinued
operations since 1995. We believe our current reserves are adequate to cover our
claim liabilities. There can be no assurance, however, that further upward
development of ultimate loss costs associated with construction defect claims
will not occur. See "Business--Discontinued Operations."
YEAR ENDED DECEMBER 31, 1997 AS COMPARED TO YEAR ENDED DECEMBER 31, 1996
Gross premiums written for the years ended December 31, 1997 and 1996 were
$159.4 million and $99.3 million, respectively. This increase in gross premiums
written represents an increase of $60.1 million or 60.5% for the 1997 policy
year as compared to the 1996 policy year. Substantially all of this increase can
be attributed to business written related to SPCC. Net premiums written
increased $49.2 million or 56.1% to $136.9 million for the year ended December
31, 1997, as compared to the year ended December 31, 1996. This increase
reflects the increase in gross premiums written. Net premiums earned increased
$52.3 million or 59.0% to $140.9 million for the year ended December 31, 1997,
as compared to the year ended December 31, 1996.
For the year ended December 31, 1997, net claim and claim adjustment
expenses increased $34.8 million or 62.6% to $90.4 million as compared to $55.6
million for the year ended December 31, 1996. The entire increase of claim and
claim adjustment expense relates to the acquisition of SPCC. The net claim and
claim adjustment expense ratio increased to 64.2% for the year ended December
31, 1997, as compared to 62.8% for the year ended December 31, 1996. The
increase in the claim and claim adjustment expense ratio is due primarily to the
1997 accident year. Although we have continued to experience a reduction in the
frequency of claims, at the same time there has been an increase in claims
severity for injuries sustained in 1995 and thereafter. To address the
increasing severity trend, management has put into place the Claims Severity
Management Program that is intended to reduce our average ultimate loss cost per
claim and claim adjustment expense for 1995 and subsequent dates of injury. See
"Business-- Claim Severity Management Program."
Underwriting and general and administrative expenses, excluding policyholder
dividends and a loss on the termination of a financing transaction with a
related party reinsurer, increased $3.6 million or 10.4% to $37.7 million for
the year ended December 31, 1997, as compared to the same period in 1996. This
increase primarily resulted from the SPCC acquisition. Excluding the one-time
expense of $5.3 million for the cancellation in 1996 of a reinsurance contract,
underwriting expenses for 1997 increased $8.9 million or 30.9%. Our expense
ratio decreased to 26.7% from 38.5% for the year ended December 31, 1997, as
compared to 1996. The decrease in the expense ratio from 1997 to 1996 is due to
the 1996 expense of $5.3 million in connection with a negotiated settlement of a
reinsurance contract with Centre Re, and an increase in premium without a
corresponding increase in expense resulting from the SPCC acquisition.
No policyholder dividends were paid during the year ended December 31, 1997,
as compared to $1.3 million of such dividends during fiscal 1996. Prior to open
rating in California, policyholder dividends served both as an economic
incentive to employers for safe operations and as a means of price
differentiation. As a result of consumers' preference for the lowest price at a
policy's inception under open rating, dividends are currently no longer a
significant factor in the marketing of workers' compensation insurance in
California. In 1995, as a result of the diminishing value of policyholder
dividends as a marketing tool, we declared a moratorium in the payment of
policyholder dividends for California policies. In December 1996, we
discontinued policyholder dividend payments. Estimated amounts to be returned to
policyholders were accrued when the related premium was earned by us. As a
result of the change in policyholder dividend practices, a $5.9 million accrual
(pre-tax) was reversed in 1996. Dividends were paid to the extent that a surplus
was accumulated from premium paid on the specific workers' compensation
policies.
47
<PAGE>
Net investment income increased $4.9 million or 63.1% to $12.7 million for
the year ended December 31, 1997, as compared to the year ended December 31,
1996. The increase in investment income is due to a $92.7 million increase in
assets available for investment that resulted from the acquisition of SPCC.
Interest expense decreased 15.8% to $6.3 million for the year ended December
31, 1997, as compared to the year ended December 31, 1996. The decline in
interest expense is due primarily to the elimination of funds withheld balance.
In June 1997, we recorded a $15.7 million charge related to the termination
of a financing transaction with a related party reinsurer. The termination of
the financing transaction transferred $110.5 million in receivables from a
related party reinsurer in exchange for the cancellation of $94.9 million in
indebtedness to Chase. No such charges were incurred in the 1996 period.
Discontinued operations claim counts and net claim and claim adjustment
expense reserves as of December 31, 1997 were 215 and $13.5 million,
respectively. These amounts and estimates are consistent with management's
expectations. We have significant exposure to construction defect liabilities on
P&C insurance policies underwritten from 1986 to 1993. Management continues to
monitor closely our potential exposure to construction defect claims and has not
changed our estimates of ultimate claim and claim adjustment expense on
discontinued operations since 1995. Management believes our current reserves are
adequate to cover our claim liabilities. There can be no assurance, however,
that further upward development of ultimate loss costs associated with
construction defect claims will not occur. See "Business--Discontinued
Operations."
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is a measure of an entity's ability to secure sufficient cash to
meet its contractual obligations and operating needs. Our cash inflows are
generated from cash collected from policies sold, investment income generated
from our existing portfolio, and sales and maturities of investments. Our cash
outflows consist primarily of payments for policyholders' claims, operating
expenses and debt service. For our insurance operations, we must have available
cash and liquid assets to meet obligations to our 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, we believe our present cash resources will be sufficient to
meet our needs for the foreseeable future.
YEAR TO YEAR COMPARISON
During the year ended December 31, 1998, we used $149.8 million of cash in
our operations versus $52.4 million cash used in the year ended December 31,
1997. This $97.4 million increase in cash used was due to $43.9 million in ceded
premiums paid related to the Quota-Share Arrangement, an increase of $27.6
million in funds held by reinsured primarily related to the loss portfolio
transfer from BICO, and an increase of $8.4 million of interest paid associated
with the $105.0 million in Trust Preferred Securities. Another factor
contributing to our continued negative cash flow is the impact of our premium
inforce being significantly higher historically versus our current level and
higher than expected payments of claim and claim adjustment expense in the 1995
and 1996 accident years. We anticipate that we will continue to experience the
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 as a result of the Quota-Share Arrangement will increase
negative cash flow substantially. In any event, we believe that we have adequate
short-term investments and readily marketable investment grade securities to
cover both claim payments and expenses. At December 31, 1998, we had total cash
and cash equivalents, and investments of $867.4 million and had 99.8% of our
investment portfolio invested in cash, cash equivalents, and fixed maturities.
In addition, 92.7% of our fixed-income portfolio had ratings of "AA" or
equivalent or better and 100% had ratings of "BBB" or equivalent or better.
48
<PAGE>
We generated $277.5 million in cash from financing activities during the
year ended December 31, 1998, as compared to cash generated of $81.6 million in
1997. During 1998, we received approximately $298.2 million from the issuance
and sale of common stock and the incurrence of senior debt in connection with
our acquisition of BIG. Partially offsetting the proceeds from these financing
activities was $15.9 million in reinsurance deposits to ZRNA associated with a
reinsurance contract, and $5.1 million to purchase 245,000 shares of our common
stock, which are held by SNIC 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 SNIG, and Jaco Oil Company, an entity controlled by Mr.
Jamieson. The purchase price of $21.00, for total consideration of $5,145,000.
The closing sales price per share of common stock on June 10, 1998 was $22.88.
SNIG's Board of Directors, with disclosure of the conflicts of interest,
unanimously approved SNIC's purchase of the common stock. During 1997, we repaid
outstanding bank debts and redeemed the outstanding preferred stock issued in
1994 by an affiliate for a total use of cash of $79.2 million. Partially
offsetting the use of cash were the proceeds from the sale of the Trust
Preferred Securities and the incurrence of bank debt and the issuance and sale
of common stock in connection with our acquisition of SPCC totaling $160.8
million. Our financing activities in 1996 consisted primarily of the November
1996 Chase loan discussed below.
OTHER EVENTS
The acquisition of BIG was funded with (a) senior debt financing in the
amount of $110.0 million and (b) equity financing in the amount of $200.1
million. The senior debt financing was obtained pursuant to the terms of a
Credit Agreement dated as of December 10, 1998, among SNIG, Chase, as
administrative agent, and various lending institutions. In addition, we obtained
a working capital credit facility under the terms of the Credit Agreement, and
had $15.0 million in unused availability as of December 31, 1998. Prior to
incurring the indebtedness, we obtained the consent of holders of the
outstanding Trust Preferred Securities of the Trust, a subsidiary of SNIG,
authorizing the Preferred Trustee of the Trust to waive a provision of the
covenant limiting the incurrence of indebtedness set forth in the Senior
Subordinated Indenture dated as of December 3, 1997 between SNIG, as issuer, and
Wilmington Trust Company, as trustee. This waiver was effected pursuant to the
First Supplemental Indenture, dated as of November 17, 1998, between SNIG and
the Wilmington Trust Company, as trustee.
The equity financing was obtained pursuant to (a) the sale of 1,902,233
shares of our common stock for $31.9 million, in connection with the exercise of
subscription rights ("Rights") to purchase common stock distributed to existing
stockholders (other than IP Delaware and IP Bermuda) and warrant holders (the
"Rights Offering"), (b) the sale of 620,610 shares of common stock for $10.4
million, all paid in the form of promissory notes in favor of SNIG, in
connection with the Rights Offering to holders of SNIG's stock options and
restricted common stock (the "Employee Participation"), and (c) the private
placement (the "IP Stock Issuance") pursuant to the Stock Purchase Agreement (as
defined below) of (i) 5,276,960 shares of common stock for $88.4 million to IP
II, (ii) 2,949,594 shares of common stock for $49.4 million to IP Delaware and
(iii) 1,196,588 shares of common stock for $20.0 million to IP Bermuda. All of
the shares were sold at $16.75 per share. Employees purchasing common stock in
the Employee Participation included William L. Gentz and J. Chris Seaman, who
are directors and executive officers of Superior National. Prior to the
consummation of the acquisition of BIG, IP Delaware and IP Bermuda beneficially
owned approximately 23% and 13%, respectively, of the then outstanding shares of
common stock. IP II owned no shares of common stock prior to the consummation of
the acquisition of BIG. Robert A. Spass, Steven B. Gruber and Bradley E. Cooper,
directors of Superior National, own certain direct and indirect limited
partnership interests some of the limited partnerships that are the direct or
indirect general partners of IP Delaware and IP Bermuda. Messrs. Gruber and
Spass are officers of the ultimate general partners of IP Delaware and IP
Bermuda and Messrs. Spass and Cooper are officers of Capital Z Partners, Ltd.
("Cap Z"), the ultimate general partner of IP II. Certain members of SNIG's
management are investors in an investment fund that is a limited partner of IP
II.
49
<PAGE>
Pursuant to the terms of the Stock Purchase Agreement dated as of May 5,
1998 (the "Stock Purchase Agreement") among SNIG and IP Delaware, IP Bermuda and
Cap Z (Cap Z subsequently assigned its rights and obligations thereunder to IP
II) (collectively, the "Purchasers"), SNIG agreed to pay a commitment fee in the
form of warrants to purchase an aggregate of 734,000 shares of our common stock
at $16.75 per share to the Purchasers or their designees (or, in the case of Cap
Z, assignee) and Zurich Centre Investments Limited ("ZCIL") or its designee as
compensation, in the case of the Purchasers, for agreeing to purchase that
number of shares necessary to bring the total proceeds of the Rights Offering,
Employee Participation and the IP Stock Issuance to $200.0 million, and, in the
case of ZCIL, for ZCIL's providing certain financing commitments to the
Purchasers under the Stock Purchase Agreement. See "Certain Relationships and
Related Transactions--Sale of Common Stock to the IP Partnerships and
Limitations on Related Party Control of Superior National." In addition, SNIG
paid to designees of the Purchasers fees totaling $3.9 million in consideration
of their providing SNIG with the opportunity to undertake the acquisition of
BIG, originating a portion of the financing for the acquisition of BIG and
assisting in negotiating the terms of the acquisition of BIG.
On December 3, 1997, the Trust, a wholly owned subsidiary of SNIG, issued
its Trust Preferred Securities, having an aggregate liquidation amount of $105
million, in a private placement and also issued to SNIG, for an aggregate
consideration of approximately $3.25 million, all of the Trust's common
securities. The proceeds from the sale of these securities were used by the
Trust to purchase SNIG's Senior Subordinated Notes. On January 16, 1998, SNIG
and the Trust completed the registration with the Securities and Exchange
Commission of an exchange offer for the outstanding Trust Preferred Securities,
Senior Subordinated Notes and related Company Guarantee, pursuant to which
substantially all of these securities were exchanged for substantially similar
securities. SNIG used the proceeds it received from the issuance of the Senior
Subordinated Notes to repay the $40.3 million outstanding balance on the term
loan used to acquire SPCC, to redeem approximately $27.7 million in preferred
stock issued by one of our affiliates to an affiliate of Zurich, 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, commencing 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, SNIG
has the right to redeem the Senior Subordinated Notes, in whole or in part at
any time, at call prices 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, SNIG has the
right, at any time, subject to certain conditions, to defer payments of interest
on the Senior Subordinated Notes for Extension Periods (as defined in the
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 SNIG
of the interest payment period, distributions on the Trust Preferred Securities
would be deferred (though such distributions would continue to accrue interest
at a rate of 10.75% per annum compounded semi-annually). Upon the termination of
any Extension Period and the payment of all amounts then due, SNIG may commence
a new Extension Period, subject to certain requirements.
In addition, during 1997 we repaid approximately $0.6 million of an existing
bank loan and, at the time due, $3.7 million of the principal of the term loan
used to acquire SPCC.
In November 1996, we entered into a financing transaction involving Centre
Re and The Chase Manhattan Bank ("Chase") pursuant to which Chase extended a
$93.1 million term loan, net of transaction costs. We used the proceeds from the
transaction to purchase from SNIC reinsurance receivables due from Centre Re. As
a result, our investable assets increased $93.1 million. The additional
investments contributed to the increase in investment income in 1997.
50
<PAGE>
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 our
$94.9 million debt due to Chase under the term loan. The retirement of the term
loan resulted in our recognizing a $15.7 million charge.
We have a reverse purchase facility with a national securities brokerage
firm that allows us to engage in up to $20.0 million in reverse purchase
transactions secured by either U.S. Treasury instruments, U.S. Agency debt, or
corporate debt. This arrangement provides us with additional short-term
liquidity. Reverse purchase transactions may be rolled from one period to the
next, at which time the transaction is repriced. This type of financing allows a
great deal of flexibility to manage short-term investments, avoiding unnecessary
realization of losses to satisfy short-term cash needs. Further, this method of
financing is less expensive than bank debt. As of December 31, 1998, we had no
obligation outstanding under this facility.
SNIG, as a holding company, depends on dividends and intercompany tax
allocation payments from its operating subsidiaries for its net cash flow
requirements, which consist primarily of periodic payments on its outstanding
debt obligations. Absent other sources of cash flow, SNIG cannot expend funds
materially in excess of the amount of dividends or tax allocation payments that
could be paid to SNIG by SNIC, SPCC, CalComp, CBIC, and CCIC. Further, insurance
companies are subject to restrictions affecting the amount of shareholder
dividends and advances that may be paid within any year without the prior
approval of the DOI. The California Insurance Code provides that amounts may be
paid as dividends on an annual noncumulative basis (generally up to the greater
of (i) net income for the preceding year and (ii) 10% of statutory surplus as
regards policyholders as of the preceding December 31) without prior notice to,
or approval by, the DOI. CCIC is regulated by the State of New York. Dividends
may only be paid out of "earned surplus" as defined in the California Insurance
Code. Prior to the sale of BICO, BICO paid a $35.0 million dividend to SNIG via
BIG. In addition, SNIC and SPCC paid $8.2 million and $0.3 million,
respectively, to SNIG for their current income taxes.
We are party to several leases principally associated with our home and
branch office space, as well as our fixed assets. These leases contain
provisions for scheduled lease charges and escalations in base rent over the
lease term. Our minimum lease commitment with respect to these leases in 1999 is
approximately $21.9 million. These leases expire from 2000 to 2003.
While we do not presently foresee any expenditures during the next twelve
months other than those arising in the normal course of business, we may seek to
expand market share without deviating from our pricing strategy, by seeking
strategic alliances, investment opportunities or acquisitions. However there can
be no assurances any such opportunities will be realized.
The effect of inflation on our revenues and net income during the years
ended December 31, 1998, 1997, and 1996 was not significant.
TAXES
As of December 31, 1998, Superior National had available $204.0 million in
NOLs to offset taxable income recognized by us in periods after December 31,
1998. For federal income tax purposes, these NOLs will expire in material
amounts beginning in the year 2006. Because our sale of our common stock to fund
the acquisition of BIG caused us to undergo an "ownership change" under Section
382 of the Internal Revenue Code, we will be able to use only a maximum of
approximately $8.0 million per year of our NOLs, together with additional
amounts to offset "built-in gains." Built-in gains are unrealized gains related
to appreciated property, including investments, that we own. Limitations imposed
by Section 382 may cause the availability of our NOLs to be deferred, causing us
to incur tax obligations when we otherwise would not, or may allow some portions
of the NOLs to expire before we can use them to reduce our tax obligations. Our
tax obligation affects our cash position and therefore affects our ability to
make payments on our long-term debt as it becomes due.
51
<PAGE>
YEAR 2000 STRATEGY
Information technology is an integral part of our business. We also
recognize the critical nature and technological challenges of the Year 2000
issue. The Year 2000 issue results from computer programs and computer hardware
that utilize only two digits to identify a year in the date field, rather than
four digits.
We have identified the stages involved in managing Year 2000 issues which
include (a) identifying information technology ("IT") and non-information
technology ("non-IT") systems that are non-compliant, (b) formulating strategies
to remedy any problems, (c) making the changes necessary to upgrade existing
systems to Year 2000 compliance, (d) testing the changes, and (e) developing
contingency plans.
We believe that we have identified substantially all of our IT systems that
require modification in order to become Year 2000 compliant. Most of our IT
systems, which are developed in-house, have been modified for Year 2000
compliance. These systems include underwriting, policy administration, claims
administration and data warehouse decision support systems, which are accessed
through a Pentium processor-based personal computer network. See
"Business--Information Services." Software purchased from vendors (for example,
e-mail software, accounting software and other non-insurance applications) in
most cases has been upgraded to be Year 2000 compliant. In certain instances we
have received certifications of Year 2000 compliance from the developers of the
software manufacturers used by us. We have begun testing these modified,
upgraded and certified systems.
We have performed significant testing of our modified, in-house developed
systems in order to confirm expected Year 2000 compliance. Significant testing
of these systems will continue and will be completed by the end of the second
quarter of 1999. In addition, we have contacted a large number of our business
partners, including medical providers, third party administrators and financial
business partners, to obtain information regarding the progress on their Year
2000 remediation. We have not been informed by any significant business partners
that they will not be Year 2000 compliant in a timely manner. However, there can
be no assurance that significant Year 2000 related issues will not ultimately
arise with our business partners.
We are utilizing primarily internal resources to meet our Year 2000 goals.
The cost of Year 2000 related efforts were approximately $250,000 for the year
ended 1998. Remediation costs are expected to total about $250,000 during 1999.
Due to the complexities of estimating the cost of modifying all IT and non-IT
systems to become Year 2000 compliant, and the difficulties in assessing our
vendors' and business partners' abilities to become Year 2000 compliant,
estimates are likely to change.
We are developing a contingency plan to deal with certain IT and non-IT Year
2000 issues. We expect to fully develop this plan by the third quarter of 1999
to address specific areas of need. We believe that most functions currently
performed by our information systems could be performed manually or outsourced
if certain systems were not to be Year 2000 compliant by January 1, 2000. We
believe that we are not exposed to the risk of significant data loss because our
IT systems are backed-up at the end of each business day.
We expect that by the end of 1999, all critical systems, in-house or
vendor-obtained, that are not Year 2000 compliant will be corrected or replaced.
However, there can be no assurance that all of our systems or those of our
business partners will be Year 2000 compliant, that the costs to be Year 2000
compliant will not exceed our current expectations, or that the failure of our
systems or those of our business partners to be Year 2000 compliant will not
have a material and adverse effect on our business. See "Business--Risk
Factors--Our operations could be adversely affected if we are not Year 2000
compliant or if we are required to pay claims on policies related to Year 2000
losses."
52
<PAGE>
SUPPLEMENTARY DATA
Summarized quarterly financial data for 1998 and 1997 is as follows (in
thousands, except per share data):
<TABLE>
<CAPTION>
QUARTER-TO-DATE ENDED
--------------------------------------------
<S> <C> <C> <C> <C>
MARCH JUNE SEPT. DEC.
31, 30, 30, 31,
--------- ---------- --------- ----------
1998
Earned premiums..................................................... $ 30,587 $ 19,619 $ 10,746 $ 26,137
Income (loss) before income taxes, preferred securities dividends
and accretion and extraordinary items............................. $ 6,078 $ 6,403 $ 6,239 $ (26,464)
Net income (loss)................................................... $ 1,895 $ 2,197 $ 2,095 $ (19,789)
Basic earnings per share............................................ $ 0.32 $ 0.37 $ 0.37 $ (2.04)
Diluted earnings per share.......................................... $ 0.24 $ 0.27 $ 0.27 $ (2.04)
1997
Earned premiums..................................................... $ 18,978 $ 45,410 $ 34,760 $ 41,772
Income before income taxes, preferred securities dividends and
accretion and extraordinary items................................. $ 1,881 $ (15,317) $ 5,460 $ 9,538
Net income (loss)................................................... $ 756 $ (10,530) $ 2,132 $ 2,501
Basic earnings per share............................................ $ 0.22 $ (1.80) $ 0.36 $ 0.42
Diluted earnings per share.......................................... $ 0.14 $ (1.39) $ 0.28 $ 0.32
</TABLE>
NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS
130"). Effective for periods beginning in 1998, including interim periods, SFAS
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. We
have adopted SFAS 130 in the first quarter of 1998.
Also, in June 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standard, 131, "Disclosures about Segments of
an Enterprise and Related Information" ("SFAS 131"). This statement specifies
revised guidelines for determination of an entity's operating segments and the
type and level of financial information to be disclosed. SFAS 131 is effective
for periods ending after December 15, 1997, including interim periods. Our
adoption of SFAS 131 has not had any impact on our current financial reporting
practices.
In December 1997, the AICPA Accounting Standards Executive Committee issued
Statement of Position (SOP) 97-3, "Accounting by Insurance and Other Enterprises
for Insurance-Related Assessments," which focuses on the timing of recognition
and measurement of liabilities for insurance-related assessments. The SOP is
effective for fiscal years beginning after December 15, 1998. The adoption of
this pronouncement is not expected to have a material effect on our financial
statements.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"). SFAS 133 is effective for fiscal years
beginning after June 15, 1999 and establishes standards for the reporting for
derivative instruments. It requires changes in the fair value of a derivative
instrument and the changes in fair value of assets or liabilities hedged by that
instrument to be included in income. To the extent that the hedge transaction is
effective, income is equally offset by both investments. Currently the changes
in fair value of derivative instruments and hedged items are reported in net
unrealized gain (loss)
53
<PAGE>
on securities. We have not adopted SFAS 133. However, the effect of adoption on
the consolidated financial statements at December 31, 1998 would not be
material.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our consolidated balance sheet includes a substantial amount of assets and
liabilities whose fair values are subject to market risks. Due to our
significant level of investments in fixed maturity securities (bonds), interest
rate risk represents the largest market risk factor affecting our consolidated
financial position, although we also have limited exposure to equity price risk.
The following sections address the significant market risks associated with our
financial activities as of December 31, 1998.
Caution should be used in evaluating our overall market risk from the
information below, since actual results could differ materially from the
estimates and assumptions used below and because unpaid claim and claim
adjustment expenses and reinsurance recoverables on unpaid claim and claim
adjustment expenses are not included in the hypothetical effects of changes in
market conditions discussed below. As of December 31, 1998 unpaid claim and
claim adjustment expenses represent 77.2% of our total liabilities and
reinsurance recoverables on unpaid claim and claim adjustment expenses
represents 13.8% of our total assets.
INTEREST RATE RISK
We employ a conservative investment strategy emphasizing asset quality and
the matching of maturities of our fixed maturity investments to our anticipated
claim payments, expenditures and other liabilities. Our fixed maturity portfolio
includes investments in CMO's which are exposed to accelerated prepayment risk
generally caused by interest rate movements. As of December 31, 1998, our fixed
maturity portfolio represented 31.5% of our total assets and 62.4% of our
invested assets. Management intends to hold all of our fixed maturity
investments for indefinite periods of time but these investments are available
for sale in response to changes in interest rates, tax planning considerations
or other aspects of asset/liability management. We do not utilize stand-alone
derivatives to manage interest rate risks.
Our fixed maturity investments, including CMOs, notes payable and notes
payable to bank are subject to interest rate risk. Increases and decreases in
prevailing interest rates generally translate into decreases and increases in
fair values of those instruments. Additionally, fair values of interest rate
sensitive instruments may be affected by the credit worthiness of the issuer,
CMO prepayment rates, relative values of alternative investments, the liquidity
of the instrument and other general market conditions.
The table below summarizes the estimated effects of hypothetical increases
and decreases in interest rates. It is assumed that the changes occur
immediately and uniformly to each category of instrument containing interest
rate risks. The hypothetical changes in market interest rates reflect what could
be deemed best or worst case scenarios. The hypothetical fair values are based
upon the same prepayment assumptions utilized in computing fair values as of
December 31, 1998. Should interest rates decline, mortgage holders are more
likely to refinance existing mortgages at lower rates. Acceleration of
repayments could adversely affect future investment income, if reinvestment of
the cash received from repayments is in lower yielding securities. Such changes
in prepayment rates are not taken into account in the following disclosures.
54
<PAGE>
INTEREST RATE RISK
<TABLE>
<CAPTION>
(IN THOUSANDS)
---------------------------------------------------------
ESTIMATED HYPOTHETICAL
FAIR VALUE PERCENTAGE
AFTER INCREASE/
HYPOTHETICAL HYPOTHETICAL (DECREASE)
FAIR VALUE AT CHANGE IN CHANGE IN IN
DECEMBER 31, INTEREST RATE INTEREST STOCKHOLDERS'
1998 (BP=BASIS PTS.) RATE EQUITY
-------------- --------------- ----------- -----------
<S> <C> <C> <C> <C>
Assets:
United States Government Agencies
and Authorities................... $ 133,629 100 bp decrease $ 140,577 $ 6,948
100 bp increase $ 126,762 $ (6,867)
200 bp increase $ 119,975 $ (13,654)
Municipals.......................... $ 124,298 100 bp decrease $ 131,553 $ 7,255
100 bp increase $ 117,426 $ (6,872)
200 bp increase $ 110,936 $ (13,362)
Corporate Instruments............... $ 54,966 100 bp decrease $ 56,762 $ 1,796
100 bp increase $ 53,330 $ (1,636)
200 bp increase $ 51,854 $ (3,112)
Collateralized Mortgage Obligations
and Other Asset Backed
Securities........................ $ 228,785 100 bp decrease $ 233,102 $ 4,317
100 bp increase $ 224,155 $ (4,630)
200 bp increase $ 219,211 $ (9,574)
Liabilities:
Long-term Debt...................... $ 105,820 100 bp decrease $ 102,291 $ (3,529)
100 bp increase $ 109,349 $ 3,529
200 bp increase $ 112,879 $ 7,059
Trust Preferred Securities.......... $ 102,144 100 bp decrease $ 93,099 $ (7,985)
100 bp increase $ 109,069 $ 7,985
200 bp increase $ 117,055 $ 15,971
</TABLE>
The interest rate on our long-term debt is adjustable based on market
indices.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
55
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
DIRECTORS
Information is set forth below concerning our directors and the year in
which each was first elected as a director.
<TABLE>
<CAPTION>
DIRECTOR
DIRECTORS AGE POSITION SINCE
- ------------------------------------ --- ----------------------------------------------------------- -----------
<S> <C> <C> <C>
C. Len Pecchenino(1)................ 71 Director, Chairman of the Board 1988
Steven D. Germain(2)................ 45 Director 1995
Steven B. Gruber(3)................. 41 Director 1997
Thomas J. Jamieson(1)(3)............ 55 Director 1985
Gordon E. Noble(2).................. 70 Director 1990
Craig F. Schwarberg(1)(3)........... 43 Director 1992
Robert A. Spass..................... 43 Director 1992
Bradley E. Cooper(2)(3)............. 32 Director 1992
William L. Gentz.................... 58 President, Chief Executive Officer and Director 1994
J. Chris Seaman(3).................. 44 Executive Vice President, Chief Financial Officer and 1993
Director
Roger W. Gilbert(1)................. 67 Director 1997
</TABLE>
- ------------------------
(1) Member of Audit Committee
(2) Member of Compensation Committee
(3) Member of Investment Committee
No arrangement or understanding exists between any director and any other
person under which a director was or is to be selected as a director or nominee
to be a director, except that IP Delaware and IP Bermuda nominated Steven B.
Gruber to the Board of Directors in April 1997, under the terms of the Stock
Purchase Agreement pursuant to which IP Delaware, IP Bermuda and others
purchased our common stock in connection with our acquisition of Pac Rim. Under
the Stock Purchase Agreement, under which IP Delaware, IP Bermuda, and IP II
purchased our common stock in December 1998 in connection with our acquisition
of BIG, IP Delaware, IP Bermuda, IP II and certain related parties agreed that
they would not elect more than five directors to our eleven-member Board.
C. LEN PECCHENINO became a director of Superior National in May 1988 and was
elected as our Chairman in June 1994. He served as our Chief Executive Officer
from September 1991 to February 1992 and as our President and Chief Executive
Officer from February 1994 to May 1994. He also served as our Chairman from
September 1991 to August 1992. Until he retired in 1986, Mr. Pecchenino held
various executive officer positions, including President and Chief Operating
Officer, with IC Industries, Inc. and Pneumo Corporation.
STEVEN D. GERMAIN was elected to the Board of Directors in April 1995. From
1988 to 1994 he served as General Counsel to the Centre Reinsurance Group of
Companies. Since 1994 he has served as General Counsel of Zurich Centre Group
LLC, a company that provides management services to the Centre Reinsurance Group
of Companies. Mr. Germain continues to serve as a Senior Vice President, General
Counsel and Secretary to Centre Re and as a director, Senior Vice President,
General Counsel and Secretary of CentreLine. Mr. Germain is also a director of
Home Holdings, Inc.
STEVEN B. GRUBER became a director of Superior National in April 1997. He
was a founder of, and since February 1994, has served as a Managing Partner of,
Insurance Partners Advisors, L.P. ("IPA"). Since
56
<PAGE>
May 1990, Mr. Gruber has served as a Managing Director of Oak Hill Partners,
Inc. and since October 1992, has served as a Vice President of Keystone, Inc.
From 1981 to April 1990 he was associated with Lehman Brothers Inc., most
recently as Managing Director and Co-Head of high-yield securities. From 1994 to
1997, he served as a director of Unionamerica Holdings plc. From 1990 to 1996,
he served as a director of National Reinsurance Holding, Corp. He is also a
director of Reliant Building Products, Inc., Grove Worldwide L.L.C., and MVE
Inc.
THOMAS J. JAMIESON has been a director of Superior National since December
1985. Since 1971, he has served as President of Jaco Oil Company, and since
1993, he has been a director of Berry Oil Co.
GORDON E. NOBLE became a director of Superior National in October 1990.
Since July 1990, he has been Chairman and Chief Executive Officer of Commodore
Insurance Services. Previously he served as Executive Vice President and as a
director and member of the Executive Committee of Sedgwick James, an
international insurance brokerage and risk management firm.
CRAIG F. SCHWARBERG was appointed to the Board of Directors in March 1992.
From 1991 to 1997, Mr. Schwarberg worked for IIA, serving as a Managing Director
through February 1994. From 1994 to March 1996, Mr. Schwarberg was a director
and Chairman of the Board of NACOLAH Holding Corporation. Prior to 1991, he held
various positions at Lehman Brothers Inc., most recently as Senior Vice
President.
ROBERT A. SPASS was appointed to the Board of Directors in March 1992. From
1998 to present, Mr. Spass has served as Deputy Chairman of the Board of Capital
Z Management, Inc. and Capital Z Partners, Ltd., and has served as Managing
Partner of Insurance Partners Advisors, L.P. since 1994. Mr. Spass served as
President and Chief Executive Officer of International Insurance Advisors, Inc.
from 1990 to 1994. Prior to 1990, Mr. Spass held various positions at Salomon
Brothers, Inc., most recently as a Director. Mr. Spass is a director of
Highlands Insurance Group, MMI Companies and Ceres Group, Inc. In addition, he
served as director of NACOLAH Holding Corporation until March 1996 and of
National Re Corporation until October 1996.
BRADLEY E. COOPER became a director of Superior National in May 1992. From
1998 to present, Mr. Cooper has served as Senior Vice President of Capital Z
Management, Inc. and Capital Z Partners, Ltd., and has served as a partner of
Insurance Partners Advisors, L.P. since 1994. Mr. Cooper served as Vice
President of International Insurance Advisors, Inc. from 1990 to 1994. Prior to
1990, Mr. Cooper was an analyst with Salomon Brothers, Inc. Mr. Cooper is a
director of Highlands Insurance Group, Inc. and Ceres Group, Inc.
WILLIAM L. GENTZ became a director of Superior National in June 1994. Mr.
Gentz has held the position of President and Chief Executive Officer since June
1994. Mr. Gentz joined us after seventeen years at Zenith Insurance Company,
where he was responsible for marketing, underwriting, loss control, and field
operations for Zenith's workers' compensation operations. He began his insurance
career in 1958, and from 1958 to 1968 worked in the marketing and underwriting
departments of a variety of insurance companies in the mid-west and California.
J. CHRIS SEAMAN became a director of Superior National in March 1993. Mr.
Seaman has held the positions of Executive Vice President since February 1995
and Chief Financial Officer since July 1991. Prior to joining us, Mr. Seaman was
the Chief Financial Officer of a private company engaged in insurance company
acquisitions, which he joined after spending ten years with Ernst & Whinney. Mr.
Seaman previously held staff positions at Industrial Indemnity Insurance Company
and management positions at Allianz of America Corporation.
ROGER W. GILBERT became a director of Superior National in April 1997. From
May 1988 until he retired in June 1993, Mr. Gilbert served simultaneously as the
Chief Executive Officer and Chairman of the Board of TIC Indemnity Co., the
Chief Executive Officer of TMIC Insurance Co. Inc., and a California Special
57
<PAGE>
Deputy Insurance Commissioner, a position to which he was appointed by the
California Insurance Commissioner. Prior to 1988, Mr. Gilbert served as Senior
Vice President and director of Great American Insurance Companies, and as
President of Great America West Inc.
COMMITTEES
The standing committees of the Board of Directors are the Audit Committee,
the Compensation Committee, and the Investment Committee.
The Audit Committee recommends to the Board of Directors the engagement or
discharge of our independent auditors; reviews with the independent auditors the
scope, timing and plan for the annual audit, any non-audit services, and the
fees for audit and other services; reviews outstanding accounting and auditing
issues with the independent auditors; and supervises or conducts such additional
projects as may be relevant to its duties. The Audit Committee is also
responsible for reviewing and making recommendations with respect to our
financial condition, financial controls, and accounting practices and
procedures. The Audit Committee, which presently consists of Messrs. Pecchenino,
Jamieson, Schwarberg, and Gilbert held three meetings during 1998. Mr. Gilbert
was elected to the Audit Committee in November 1998.
The Compensation Committee reviews and approves our executive compensation
policies and bonus distributions to officers and key employees. The Compensation
Committee, which during 1998 held four meetings, consists of Messrs. Noble,
Cooper, and Germain.
The Investment Committee reviews the investment practices of our primary
insurance subsidiaries, and oversees the relationship between these subsidiaries
and their investment manager. The Investment Committee, which presently consists
of Messrs. Jamieson, Cooper, Seaman, Schwarberg, and Gruber held three meetings
during 1998. Mr. Gruber was elected to the Investment Committee in November
1998.
MEETINGS AND REMUNERATION
During 1998, the Board of Directors held 16 meetings and took various
actions by unanimous written consent. Each incumbent director attended at least
75% of (1) the total number of meetings held by the Board of Directors during
1998 and (2) the total number of meetings held by all Committees of the Board of
Directors on which he served during that period, other than Bradley E. Cooper
and J. Chris Seaman, each of whom attended 66 2/3% of his respective Committee
meetings.
Each director is elected to hold office until the next annual meeting of
stockholders and until his successor is elected and qualified. Each incumbent
director who is not an officer of Superior National is paid a fee of $4,000 for
each regularly scheduled Board meeting attended and $500 for each regularly
scheduled committee meeting attended. The Board of Directors regularly meets
once each quarter. All directors are reimbursed for their out-of-pocket expenses
in serving on the Board and any committee.
C. Len Pecchenino, the Chairman of the Board, is paid $50,000 per year so
long as he remains Chairman of the Board and serves on the Audit Committee. This
amount is in addition to the fees he normally receives for attendance at
regularly scheduled Board and committee meetings.
Messrs. Spass, Cooper, Gruber, and Germain hold management positions with
several entities that either engaged in transactions with us or are affiliated
with entities that engaged in transactions with us during 1998. These
transactions are described in "Certain Relationships and Related Transactions."
Additionally, Mr. Gentz and Mr. Seaman purchased common stock from us in
connection with the rights offering we completed in December 1998 to help
finance our acquisition of BIG. As employees of Superior National, they were
able to borrow from us the funds they used to purchase this common stock, as
further described in "Certain Relationships and Related Transactions."
58
<PAGE>
EXECUTIVE OFFICERS
Set forth in the table below are the names, ages and current offices held by
our executive officers.
<TABLE>
<CAPTION>
EXECUTIVE
NAME AGE POSITION OFFICER SINCE
- ------------------------------------ --- ------------------------------------------------------- ---------------
<S> <C> <C> <C>
William L. Gentz.................... 58 President and Chief Executive Officer 1994
J. Chris Seaman..................... 44 Executive Vice President and Chief Financial Officer 1991
Arnold J. Senter.................... 57 Executive Vice President and Chief Operating Officer 1997
Robert E. Nagle..................... 50 Senior Vice President, General Counsel and Secretary 1996
Thomas I. Boggs, Jr................. 52 Senior Vice President--Underwriting 1995
Edward C. Shoop..................... 54 Senior Vice President and Chief Actuary 1997
Theresa A. Sealy.................... 50 Senior Vice President--California Operations 1998
Doris K.T. Lai...................... 43 Vice President--Finance and Treasurer 1998
Stephen J. Weiss.................... 51 Senior Vice President--National Field Operations 1999
Ronald J. Tonani.................... 57 Senior Vice President--Marketing 1997
</TABLE>
Our Board of Directors elects the executive officers, who serve at the
Board's discretion. No arrangement exists between any executive officer and any
other person under which any executive officer was or is to be selected as an
executive officer. None of the executive officers has any family relationship to
any director or to any other executive officer.
WILLIAM L. GENTZ has held the positions of President and Chief Executive
Officer since mid-1994, and has served as a director of Superior National since
June 1994. Mr. Gentz joined us after seventeen years at Zenith Insurance
Company, where he was responsible for marketing, underwriting, loss control, and
field operations for Zenith's workers' compensation operations. He began his
insurance career in 1958, and from 1958 to 1968 worked in the marketing and
underwriting departments of a variety of insurance companies in the mid-west and
California.
J. CHRIS SEAMAN has held the positions of Executive Vice President since
February 1995 and Chief Financial Officer since July 1991, and has served as a
director of Superior National since March 1993. Prior to joining us, Mr. Seaman
was the Chief Financial Officer of a private company engaged in insurance
company acquisitions, which he joined after spending ten years with Ernst &
Whinney. He previously held staff positions at Industrial Indemnity Insurance
Company and management positions at Allianz of America Corporation.
ARNOLD J. SENTER has held the positions of Executive Vice President and
Chief Operating Officer since February 1997. Prior to joining us, Mr. Senter
most recently served as Senior Vice President, Southwest and Southeast
Operations at Zenith National Insurance Company, and had previously held various
operational positions in nearly every functional area for Zenith since 1981. Mr.
Senter has 30 years experience with both regional and national carriers.
THOMAS I. BOGGS, JR. was appointed Senior Vice President--Underwriting on
March 1995. From October 1993 to March 1995, he served as Assistant Vice
President of Fremont Compensation Insurance Company and from October 1991 to
October 1993, served as Business Development Executive for the Southern
California Commercial Insurance Center for Fireman's Fund Insurance Company.
Prior to October 1991, Mr. Boggs held various underwriting and marketing
positions at Cypress Insurance Company, Industrial Indemnity Company, and
Safeco.
59
<PAGE>
ROBERT E. NAGLE has held the positions of Senior Vice President, General
Counsel, and Secretary since January 1996. From 1986 until he joined us, Mr.
Nagle was corporate counsel and senior corporate counsel for Farmers Group, Inc.
EDWARD C. SHOOP was appointed Senior Vice President and Chief Actuary in
October 1997. From April 1995 to August 1997 he served as Senior Vice President
and Actuary with Zenith Insurance Company, and from March 1994 to April 1995
served as Vice President and Actuary with Great States Insurance Company. Prior
to that, Mr. Shoop was Vice President and Actuary with the Workers' Compensation
Insurance Rating Bureau of Massachusetts from November 1991 to March 1994. Mr.
Shoop's 31 years of actuarial experience also includes working for Fireman's
Fund Insurance Company and Royal Insurance Company of Canada, as a Vice
President, and for Aetna Life and Casualty Company.
THERESA A. SEALY was appointed Senior Vice President--California Operations
in July 1998. From November 1997 to June 1998 she served as a Vice President of
Superior National. From June 1997 until she joined us, she served as regional
manager for CalComp and, prior to that, served as a Senior Vice President of
Allianz Insurance Company since February 1992.
DORIS K.T. LAI has held the position of Vice President--Finance and
Treasurer since August 1998. From November 1997 until she joined us, Ms. Lai was
employed by Zenith National Insurance Company as director of financial services.
From October 1996 to November 1997 she served as Vice President and controller
with Fremont Financial Corporation and from May 1994 to October 1996 she served
as a controller with Superior National. Prior to that, Ms. Lai served as SEC
Reporting Manager with TIG Holdings, Inc. from April 1991 to April 1994.
STEPHEN J. WEISS was appointed Senior Vice President--National Field
Operations in December 1998. From May 1997 to December 1998, he was Vice
President--Field Operations at BIG. Prior to that, Mr. Weiss served from January
1993 to May 1996 as resident Vice President of Royal Insurance, plc. He has 29
years experience in insurance management and marketing.
RONALD J. TONANI has held the position of Senior Vice President--Marketing
since April 1997. From 1987 to April 1997, Mr. Tonani held the position of
Senior Vice President--Sales with Pacific Rim Assurance Company. Prior to that,
he held various positions with Fairmont Insurance, Insurance Company of the
West, Pacific Compensation Insurance Company and Employee Benefits Insurance
Company.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Exchange Act requires our insiders, who are our
directors, executive officers, and persons who own more than ten percent of our
common stock, to file reports of ownership and changes in ownership with the
SEC. Insiders are required by SEC regulations to furnish us with copies of all
Section 16(a) forms they file.
Based solely on our review of the copies of the forms we have received, or
written representations from our insiders that no Forms 5 were required to be
filed by those persons, we believe that our insiders complied with Section 16(a)
filing requirements for fiscal 1998, with the exception of Gordon E. Noble, a
director, who filed a late Form 5 to report several gifts of common stock.
ITEM 11. EXECUTIVE COMPENSATION
The following table provides information concerning the compensation we paid
for services in all capacities to Superior National for the fiscal years ended
December 31, 1998, 1997, and 1996 to those persons who were, at December 31,
1998, (1) the chief executive officer and (2) the other four most highly
compensated officers of Superior National.
60
<PAGE>
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG TERM COMPENSATION
---------------------------------------------
AWARDS
------------------------------
ANNUAL COMPENSATION RESTRICTED PAYOUTS
------------------------------------------------------ STOCK SECURITIES -------------
NAME AND PRINCIPAL SALARY BONUS ALL OTHER AWARDS UNDERLYING LTIP
POSITION YEAR ($)(1) ($)(2) COMPENSATION($) ($)(3) OPTIONS SARS(#) PAYOUTS($)
- ----------------------- --------- --------- --------- --------------------- ----------- ----------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
William L. Gentz ...... 1998 $ 326,615 $ 210,000 -- $ --(5) -- --
President and Chief 1997 298,300 -- -- 121,250 18,800 --
Executive Officer 1996 298,300 278,500 -- 46,874 17,875 --
J. Chris Seaman ....... 1998 241,997 175,000 -- -- -- --
Executive Vice 1997 231,616 -- -- 109,125 17,500 --
President and Chief 1996 235,298 128,500 -- 36,223(6) 13,813 --
Financial Officer
Arnold J. Senter(7) ... 1998 235,128 175,000 -- -- 27,500 --
Executive Vice 1997 229,335 -- -- -- 25,000 --
President and Chief 1996 -- -- -- -- -- --
Operating Officer
Thomas I. Boggs, 1998 176,731 30,000 -- --(8) 3,000 --
Jr. ................. 1997 164,261 -- -- 30,313 4,643 --
Senior Vice 1996 155,800 32,000 -- 21,306 8,125 --
President--
Underwriting
Robert E. Nagle ....... 1998 153,492 30,000 -- --(9) 5,000 --
Senior Vice 1997 144,133 -- -- 18,188 2,786 --
President, General 1996 138,165 20,000 -- -- 4,650 --
Counsel and Secretary
<CAPTION>
ALL OTHER
NAME AND PRINCIPAL COMPENSATION
POSITION ($)(4)
- ----------------------- ---------------
<S> <C>
William L. Gentz ...... $ 2,400
President and Chief 2,250
Executive Officer 2,250
J. Chris Seaman ....... 2,400
Executive Vice 2,250
President and Chief 2,250
Financial Officer
Arnold J. Senter(7) ... 2,400
Executive Vice 2,250
President and Chief --
Operating Officer
Thomas I. Boggs, 2,400
Jr. ................. 2,250
Senior Vice 2,163
President--
Underwriting
Robert E. Nagle ....... 2,400
Senior Vice 2,250
President, General 1,913
Counsel and Secretary
</TABLE>
- ------------------------------
(1) The amounts in this column include salary and other cash compensation paid
in that year, other than amounts listed in the column entitled "Bonus."
(2) Bonus amounts represent cash payments and are presented in the year to which
they apply, although payment typically is made in April of the following
year. No bonus payments were made for fiscal year 1997.
(3) Represents the fair market value of the underlying shares on the date of
grant. All restricted stock grants vest in nine equal annual increments
following the date of grant.
(4) Represents contributions we made on behalf of the employee under our 401(k)
plan.
(5) As of December 31, 1998, Mr. Gentz held an aggregate of 29,950 shares of
restricted stock valued at $600,887, based upon the $20.063 per share fair
market value of the common stock on that date.
(6) As of December 31, 1998, Mr. Seaman held an aggregate of 24,163 shares of
restricted stock valued at $484,782, based upon the $20.063 per share fair
market value of the common stock on that date.
(7) Mr. Senter began his employment with us in February 1997.
(8) As of December 31, 1998, Mr. Boggs held an aggregate of 9,375 shares of
restricted stock valued at $188,091, based upon the $20.063 per share fair
market value of the common stock on that date.
(9) As of December 31, 1998, Mr. Nagle held an aggregate of 1,500 shares of
restricted stock valued at $30,095, based upon the $20.063 per share fair
market value of the common stock on that date.
EMPLOYMENT AGREEMENTS
We have employment agreements with the following executive officers:
WILLIAM L. GENTZ, President and Chief Executive Officer. Mr. Gentz's
agreement expires on June 1, 1999, but automatically renews in one-year
increments unless notification of non-renewal is given sixty days prior to the
expiration of the then-current term. His salary was set as of June 1, 1994 at
$275,000 annually, plus benefits and incidentals generally provided to officers,
and is thereafter determined by the Board. Mr. Gentz's annual salary was
increased to $287,500 effective August 1, 1995. If we terminate Mr. Gentz's
employment other than for cause, we are obligated to pay his salary and benefits
for the then-remaining term of his agreement. This termination benefit shall be
a minimum of two years' salary. In the event of a
61
<PAGE>
change in control of Superior National, Mr. Gentz would be deemed terminated
without cause and his employment agreement would be deemed to have a three-year
remaining term.
ARNOLD J. SENTER, Executive Vice President and Chief Operating Officer. Mr.
Senter's agreement expired on February 17, 1999, but was renewed under a
provision providing that the agreement would automatically renew in one-year
increments unless notification of non-renewal is given sixty days prior to the
expiration of the then-current term. His salary was set as of February 17, 1997
at $200,000 annually, plus benefits and incidentals generally provided to
officers, and is thereafter determined by the Board. If we terminate Mr.
Senter's employment other than for cause, we are obligated to pay his salary and
benefits for the then-remaining term of his agreement. This termination benefit
shall be a minimum of two years' salary. In the event of a change in control of
Superior National, Mr. Senter would be deemed terminated without cause and his
employment agreement would be deemed to have a three-year remaining term.
J. CHRIS SEAMAN, Executive Vice President and Chief Financial Officer. Mr.
Seaman's agreement expires on June 1, 1999, but automatically renews in one-year
increments unless notification of non-renewal is given sixty days prior to the
expiration of the then-current term. His annual salary under the agreement is
$200,000, plus benefits and incidentals generally provided to officers, and is
thereafter determined by the Board. If we terminate Mr. Seaman's employment
other than for cause, we are obligated to pay his salary and benefits for the
then-remaining term of his agreement. This termination benefit shall be a
minimum of two years' salary. In the event of a change in control of Superior
National, Mr. Seaman would be deemed terminated without cause and his employment
agreement would be deemed to have a three-year remaining term.
EDWARD C. SHOOP, Senior Vice President and Chief Actuary. Mr. Shoop's
agreement expires on October 6, 1999 and provides that, if his employment is
terminated as a result of a change in control, we will be obligated to pay his
salary and benefits for two years from the date of his termination.
DORIS K.T. LAI, Vice President--Finance and Treasurer. Ms. Lai's agreement
is open-ended. Her compensation and benefits are determined by the Board. If we
terminate Ms. Lai's employment other than for cause, we are obligated to pay her
salary and benefits for one year from the date of the termination. Ms. Lai's
agreement does not provide any special rights in the event of a change in
control.
CHANGE IN CONTROL ARRANGEMENTS
In addition to the rights described above with respect to Messrs. Gentz,
Senter, Seaman, and Shoop, the only change in control arrangements that we have
are in our stock incentive plans. Under the terms of our 1986 Non-Statutory
Stock Option and 1986 Non-Statutory Stock Purchase Plan (the "1986 Plan"), in a
reorganization, merger, or consolidation in which Superior National does not
survive or in which a change in control takes place, unless replacement options
to purchase stock in the new or recapitalized entity are offered, all option
holders will have thirty days to exercise their outstanding options, excluding
those that have then not yet vested. Under the terms of our 1995 Stock Incentive
Plan (the "1995 Plan"), under similar circumstances, the Compensation Committee
may, in its discretion, allow each person holding an option or share of
restricted stock who did not receive a replacement equity incentive grant to
exercise that option without regard to its vesting provisions, or to retain that
share of restricted stock without regard to Superior National's repurchase
right.
EQUITY INCENTIVE GRANTS
Officers, key employees, including directors who are key employees, and
consultants chosen by the Compensation Committee are eligible to participate in
our 1995 Plan.
Under our 1995 Plan, officers, key employees, and consultants of ours or our
subsidiaries may be granted options to purchase shares of our common stock or
they may be given the opportunity to purchase shares of our restricted stock.
Our 1995 Plan allows us to grant both options that qualify for treatment as
62
<PAGE>
incentive stock options under Section 422 of the Internal Revenue Code and those
that do not, referred to as nonqualified stock options. Our 1995 Plan also
allows us to issue shares of restricted stock that we can repurchase upon the
occurrence of certain events such as the termination of a participant's
employment. Our repurchase right expires over time following the grant date of
the restricted stock.
Our 1986 Plan allowed us to issue to employees of ours and our subsidiaries
nonqualified stock options and rights to purchase shares of common stock. The
Board terminated the purchase right aspect of the 1986 Plan in 1989. Following
our adoption of the 1995 Plan, the Board of Directors decided to make no further
grants under the 1986 Plan.
STOCK PURCHASE PLAN
Under our Employee Stock Purchase Plan, which became effective January 1,
1999, we have made available for sale to our employees a total of 500,000 shares
of our common stock. A committee that our Board designates will administer the
plan and we intend for it to qualify as an employee stock purchase plan within
the meaning of the Internal Revenue Code. Any employee of Superior National, or
of a designated subsidiary, whom we have employed for at least thirty continuous
days and whom we have scheduled to work regularly at least twenty hours per week
may participate.
Under the plan, at least fifteen days before the beginning of each calendar
quarter, an employee must designate either a fixed dollar amount or a fixed
percentage of his or her compensation which we will withhold from his or her
paycheck throughout the forthcoming calendar quarter. During that quarter, the
employee may not change this designated amount although he or she may elect, at
any time, to withdraw from the plan. An employee may contribute up to $25,000
during each calendar year with a minimum contribution per payroll period of $10.
We deposit these funds into separate accounts for each employee and at the end
of each calendar quarter automatically purchase shares of our common stock using
the accumulated amounts. The price of each share purchased under the plan is 85%
of Superior National's closing price on Nasdaq on the final day of the calendar
quarter.
Our Board may amend or terminate the plan at any time, except as to then
outstanding rights to purchase common stock under the plan. However, our
stockholders must approve any change that pertains either to the class of
employees who may participate or to the maximum number of shares that employees
may purchase under the plan.
OPTION GRANTS IN 1998
The following table provides information on options we granted during 1998
to each executive officer named in the Summary Compensation Table set forth
above under "--Executive Compensation."
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE
---------------------------------------------------------- VALUE AT ASSUMED
PERCENTAGE ANNUAL RATES OF
NUMBER OF OF TOTAL STOCK PRICE
SECURITIES OPTIONS/SARS EXERCISE APPLICATION
UNDERLYING GRANTED TO OR BASE FOR OPTION TERM
OPTIONS/SARS EMPLOYEES IN PRICE EXPIRATION ----------------------
NAME GRANTED(#) FISCAL YEAR(%) ($/ SH)(1) DATE 0%(2) 5%($)(3)
- ----------------------------------------- ------------- ----------------- ----------- ----------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
William L. Gentz......................... -- -- -- -- -- --
J. Chris Seaman.......................... -- -- -- -- -- --
Arnold J. Senter......................... 12,500(4) 5.5 16.375 02/24/08 -- 128,728
15,000(4) 6.6 16.875 11/20/08 -- 159,190
Thomas I. Boggs, Jr...................... 3,000(4) 1.3 16.375 02/24/08 -- 30,895
Robert E. Nagle.......................... 5,000(4) 2.2 16.375 02/24/08 -- 51,491
<CAPTION>
NAME 10%($)(3)
- ----------------------------------------- -----------
<S> <C>
William L. Gentz......................... --
J. Chris Seaman.......................... --
Arnold J. Senter......................... 326,210
403,405
Thomas I. Boggs, Jr...................... 78,290
Robert E. Nagle.......................... 130,484
</TABLE>
- ------------------------
(1) Represents the fair market value of the underlying shares of common stock at
the time of the grant.
63
<PAGE>
(2) Unless our common stock price increases, which will benefit all stockholders
commensurately, an option holder will realize no gain.
(3) Represents the value of the shares of common stock issuable upon the
exercise of the option, assuming the stated rates of price appreciation for
ten years, compounded annually, with the aggregate exercise price deducted
from the final appreciated value. The 5% and 10% rates are established by
the SEC as examples only and are not intended to forecast future
appreciation in the common stock price.
(4) Represents a ten-year, incentive stock option grant, vesting at a rate of
20% per year for five years from the date of grant, granted under the 1995
Plan.
OPTION EXERCISES AND YEAR-END VALUE
The following table sets forth information about the aggregate number of
options exercised during 1998 by each executive officer named in the Summary
Compensation Table set forth above under "--Executive Compensation," and about
outstanding options that each of these officers held on December 31, 1998.
<TABLE>
<CAPTION>
NUMBER OF
SECURITIES
UNDERLYING
UNEXERCISED
OPTIONS/SARS AT VALUE OF UNEXERCISED
OPTIONS/SARS AT IN-THE-MONEY
FISCAL OPTIONS/SARS AT
YEAR-END(#) FISCAL YEAR-END$(1)
NUMBER OF SHARES ----------------- --------------------
ACQUIRED ON VALUE EXERCISABLE/ EXERCISABLE/
NAME EXERCISE(#) REALIZED($) UNEXERCISABLE UNEXERCISABLE
- ------------------------------------------ ------------------- --------------- ----------------- --------------------
<S> <C> <C> <C> <C>
William L. Gentz.......................... -- -- 47,415/39,685 $681,051/$489,226
J. Chris Seaman........................... -- -- 57,619/28,019 851,975/322,232
Arnold J. Senter.......................... -- -- 5,000/47,500 43,415/267,578
Thomas I. Boggs, Jr....................... -- -- 11,471/16,447 165,120/186,830
Robert E. Nagle........................... -- -- 2,426/10,010 32,138/77,530
</TABLE>
- ------------------------
(1) Uses a fair market value at December 31, 1998 of $20.063 per share, with the
aggregate exercise price deducted from the total value of the common stock
underlying the options.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
During 1998, the Compensation Committee consisted of Messrs. Noble, Cooper,
and Germain, each of whom is a non-employee director. Mr. Cooper is an employee
of IIA, which we paid $250,000 in 1998 for investment banking and financial
consulting services. Mr. Germain is an officer and a director of Centre Re and
an officer of Zurich. Centre Re and several affiliates of Zurich were involved
in transactions with Superior National during 1998 involving payments in excess
of $60,000. See "Certain Relationships and Related Transactions."
During 1998, no officers participated in deliberations of the Compensation
Committee concerning executive officer compensation, except Mr. Gentz, our
President and Chief Executive Officer.
64
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF PRINCIPAL BENEFICIAL OWNERS AND MANAGEMENT
SECURITY OWNERSHIP OF PRINCIPAL BENEFICIAL OWNERS
The table below sets forth certain information regarding the beneficial
ownership of our common stock as of March 15, 1999 by each person we know to own
beneficially more than 5% of the outstanding shares of our common stock.
PRINCIPAL BENEFICIAL OWNERS
<TABLE>
<CAPTION>
NAME AND ADDRESS SHARES PERCENT(1)
- -------------------------------------------------------------------------------------- ---------- -----------
<S> <C> <C>
"IP II" .............................................................................. 5,276,960(2) 29.44%
Capital Z Financial Services Fund II, L.P.
One Chase Manhattan Plaza
New York, New York 10005
"IP Delaware" ........................................................................ 4,554,895(3) 25.09
Insurance Partners, L.P.
201 Main Street
Suite 2600
Ft. Worth, Texas 76102
"IP Bermuda" ......................................................................... 2,055,098(4) 11.40
Insurance Partners Offshore (Bermuda), L.P.
Cedar House
41 Cedar Avenue
P.O. Box HM 1179
Hamilton HM HX, Bermuda
"IIA" ................................................................................ 1,230,149(5) 6.42
International Insurance Advisors, Inc.
One Chase Manhattan Plaza
44th Floor
New York, New York 10005
"TJS" ................................................................................ 986,406(6) 5.45
TJS Partners, L.P.
115 East Putnam Avenue
Greenwich, Connecticut 06830
"Centre Solutions" ................................................................... 974,484(7) 5.16
Centre Solutions (Bermuda) Limited
One Victoria Street
Seventh Floor
Hamilton HM HX, Bermuda
</TABLE>
- ------------------------
(1) Percent ownership is based on 17,926,826 shares of common stock outstanding
on March 15, 1999, plus any shares issuable with respect to warrants held by
the entity in question that may be exercised within 60 days after March 15,
1999.
(2) Robert A. Spass and Bradley E. Cooper, who are directors of Superior
National, are officers of Capital Z, the ultimate general partner of IP II.
In addition, Messrs. Spass and Cooper each owns 9.9% of the voting capital
stock of Capital Z. No person or entity owns 10% or more of the voting
capital stock of Capital Z. Messrs. Spass and Cooper each disclaims
beneficial ownership (as defined in Rule 13d-3 under the Exchange Act) of
all shares of our common stock that are beneficially owned by IP II. Some
members of our management are investors in an investment fund that is a
limited partner of IP II.
65
<PAGE>
(3) Includes 229,754 shares issuable upon exercise of warrants. Robert A. Spass
and Steven B. Gruber, who are directors of Superior National, are the
President and a Vice President, respectively, of the ultimate general
partner of IP Delaware. Mr. Spass owns 40% and Messrs. Gruber and Daniel L.
Doctoroff each owns 30% of the voting capital stock of the ultimate general
partner of IP Delaware. In addition, Messrs. Spass, Gruber, Doctoroff, and
Bradley E. Cooper, a director of Superior National, own direct or indirect
limited partnership interests in some of the limited partnerships that are
the direct or indirect general partners of IP Delaware. Messrs. Spass,
Gruber, Cooper, and Doctoroff each disclaims beneficial ownership (as
defined in Rule 13d-3 under the Exchange Act) of the warrants and all shares
of our common stock beneficially owned by IP Delaware. See "Certain
Relationships and Related Transactions--Sale of Common Stock to the IP
Partnerships and Limitations on Related Party Control of Superior National,"
regarding restrictions on IP Delaware's ability to acquire additional equity
securities of Superior National.
(4) Includes 93,206 shares issuable upon exercise of warrants. Robert A. Spass
and Steven B. Gruber, who are directors of Superior National, are the
President and a Vice President, respectively, of the ultimate general
partner of IP Bermuda. Robert A. Spass owns 40% and Messrs. Gruber and
Doctoroff each owns 30% of the voting capital stock of the ultimate general
partner of IP Bermuda. In addition, Messrs. Spass, Gruber, and Doctoroff and
Bradley E. Cooper, a director of Superior National, own direct or indirect
limited partnership interests in some of the limited partnerships that are
the direct or indirect general partners of IP Bermuda. Messrs. Spass,
Gruber, Cooper, and Doctoroff each disclaims beneficial ownership (as
defined in Rule 13d-3 under the Exchange Act) of the warrants and all shares
of our common stock beneficially owned by IP Bermuda. See "Certain
Relationships and Related Transactions--Sale of Common Stock to the IP
Partnerships and Limitations on Related Party Control of Superior National,"
regarding restrictions on IP Bermuda's ability to acquire additional equity
securities of Superior National.
(5) Represents warrants to purchase shares of common stock that are subject to a
revocable agency relationship that IIA has with Centre Solutions and the
limited partners and the general partner of International Insurance
Investors, L.P. As agent, IIA has the revocable authority to exercise rights
set forth in the warrants and to vote any shares of common stock issuable
upon exercise of the warrants. Robert A. Spass, a director of Superior
National, is an officer of IIA and, as such, has the authority to exercise
these rights. See "Certain Relationships and Related Transactions--Sale of
Common Stock to the IP Partnerships and Limitations on Related Party Control
of Superior National," regarding restrictions on IIA's ability to acquire
additional equity securities of Superior National.
(6) Includes 186,406 shares issuable upon exercise of warrants. TJS Corporation
and its controlling stockholder, sole director, and executive officer,
Thomas J. Salvatore, are the general partners of TJS Management, L.P., the
general partner of TJS. TJS Corporation, Mr. Salvatore, and TJS Management,
L.P. exercise voting control and dispositive power over all warrants and
shares of common stock owned by TJS and are the beneficial owners of all
those securities. The information contained in this footnote is based, in
part, on an Amendment No. 3 to Schedule 13D/A that was filed by TJS and
others with the SEC in December 1998.
(7) Represents warrants to purchase 395,128 shares of common stock held by
Centre Solutions and warrants to purchase 579,356 shares of common stock
held by CentreLine. The warrants held by Centre Solutions are subject to
IIA's revocable agency relationship, which is described in footnote 5 above.
CentreLine is an affiliate of Centre Solutions. Steven D. Germain, who is a
director of Superior National, is an officer and director of Centre
Solutions and CentreLine. In addition to Mr. Germain, Scott Levine, Tara
Leonard, and David A. Brown are directors of Centre Solutions and
CentreLine. Messrs. Germain, Levine, and Brown and Ms. Leonard disclaim any
beneficial interest in the warrants held by Centre Solutions and CentreLine
and the shares of common stock issuable upon their exercise. However, as
officers and/or directors of both Centre Solutions and CentreLine, they
share voting and/or investment power over these securities (subject to IIA's
agency relationship with
66
<PAGE>
respect to the warrants held by Centre Solutions). See "Certain
Relationships and Related Transactions--Sale of Common Stock to the IP
Partnerships and Limitations on Related Party Control of Superior National,"
regarding restrictions on Centre Solution's and CentreLine's ability to
acquire additional equity securities of Superior National. The reported
number of shares issuable upon exercise of warrants does not include
warrants to purchase 75,262 shares of common stock held by International
Insurance Investors, L.P. (subject to IIA's revocable agency relationship)
in reserve for the payment by Centre Solutions to IIA and Centre Re of their
incentive fee under International Insurance Investors, L.P.'s investment
advisory agreements with IIA and Centre Re.
SECURITY OWNERSHIP OF MANAGEMENT
The following table sets forth certain information regarding the beneficial
ownership of our common stock on March 15, 1999 by (1) each director and the
executive officers named in the Summary Compensation Table set forth under
"Management--Executive Compensation" and (2) all directors and executive
officers as a group.
OWNERSHIP OF MANAGEMENT
<TABLE>
<CAPTION>
NAME SHARES PERCENT(1)
- -------------------------------------------------------------------------------------- ---------- -------------
<S> <C> <C>
William L. Gentz...................................................................... 253,925(2) 1.14%
J. Chris Seaman....................................................................... 393,449(3) 2.18%
Arnold J. Senter...................................................................... 39,730(4) *
Thomas I. Boggs, Jr................................................................... 64,940(5) *
Robert E. Nagle....................................................................... 28,315(6) *
Thomas J. Jamieson.................................................................... 300(7) *
Gordon E. Noble....................................................................... 1,200 *
C. Len Pecchenino..................................................................... 14,250 *
Robert A. Spass....................................................................... 43,041(8) *
Craig F. Schwarberg................................................................... 2,790(9) *
Bradley E. Cooper..................................................................... 21,343 10) *
Steven D. Germain..................................................................... 984,644 11) 5.21%
Steven B. Gruber...................................................................... -- 12) --
Roger W. Gilbert...................................................................... -- --
Directors and Executive Officers as a Group (19 persons).............................. 1,860,667 13) 9.70%
</TABLE>
- ------------------------
* Less than 1%
(1) Percent ownership is based on the 17,926,826 shares of common stock
outstanding on March 15, 1999, plus any shares issuable with respect to
options or warrants held by the person in question that may be exercised
within 60 days after March 15, 1999.
(2) Includes 58,585 shares issuable upon exercise of options that are
exercisable within 60 days of March 15, 1999, and 37,356 shares of
restricted stock awarded under our 1995 Plan, 27,331 of which remain subject
to our repurchase right.
(3) Includes 58,795 shares issuable upon exercise of warrants and 66,747 shares
issuable upon exercise of options, each of which is exercisable within 60
days of March 15, 1999, and 31,447 shares of restricted stock awarded under
our 1995 Plan, 23,524 of which remain subject to our repurchase right.
(4) Includes 12,500 shares issuable upon exercise of options that are
exercisable within 60 days of March 15, 1999, and 7,284 shares of restricted
stock awarded under our 1995 Plan, all of which are subject to our
repurchase right.
67
<PAGE>
(5) Includes 17,054 shares issuable upon exercise of options that are
exercisable within 60 days of March 15, 1999, and 9,375 shares of restricted
stock awarded under our 1995 Plan, 6,234 of which remain subject to our
repurchase right.
(6) Includes 4,911 shares issuable upon exercise of options that are exercisable
within 60 days of March 15, 1999, and 1,500 shares of restricted stock
awarded under our 1995 Plan, 1,162 of which remain subject to our repurchase
right.
(7) Represents shares owned of record by Jaco Oil Company, which is controlled
by Mr. Jamieson.
(8) Includes 8,000 shares of common stock owned directly by Mr. Spass. Also
includes (1) warrants to purchase 32,825 shares of common stock held by Mr.
Spass and (2) warrants to purchase 7,216 shares of common stock owned by Mr.
Spass that are subject to IIA's revocable agency relationship, which is
described in footnote 5 of the preceding "Principal Beneficial Owners"
table. Also see footnotes 2 through 5 of the same table for information on
Mr. Spass' relationship to IP II, IP Delaware, IP Bermuda, and IIA.
(9) Represents warrants to purchase common stock that are subject to a revocable
agency relationship with IIA, which is described in footnote 5 of the
preceding "Principal Beneficial Owners" table.
(10) Includes 4,000 shares of common stock owned directly by Mr. Cooper. Also
includes (1) warrants to purchase 16,413 shares of common stock and (2)
warrants to purchase 930 shares of common stock that are subject to a
revocable agency relationship with IIA, which is described in footnote 5 of
the preceding "Principal Beneficial Owners" table. Also see footnotes 2, 3,
and 4 of the same table for information on Mr. Cooper's relationship to IP
II, IP Delaware and IP Bermuda.
(11) Includes (1) 8,400 shares of common stock owned directly, (2) 1,760 shares
of common stock owned indirectly as custodian for the benefit of his
children, (3) warrants to purchase 579,356 shares of common stock held by
CentreLine, and (4) warrants to purchase 395,128 shares of common stock held
by Centre Solutions, which are subject to IIA's revocable agency
relationship. See footnotes 5 and 7 to the preceding "Certain Beneficial
Owners" table for information on IIA's agency relationship and Mr. Germain's
relationship to CentreLine and Centre Solutions. Mr. Germain disclaims any
beneficial interest in the warrants held by CentreLine and Centre Solutions
and the common stock issuable upon their exercise.
(12) See footnotes 3 and 4 to the preceding "Principal Beneficial Owners" table
for information concerning Mr. Gruber's relationship to IP Delaware and IP
Bermuda.
(13) Includes (1) 1,093,453 shares issuable upon exercise of warrants and (2)
165,547 shares issuable upon exercise of options, each of which are
exercisable within 60 days of March 15, 1999. Also includes 86,962 shares of
restricted stock awarded under our 1995 Plan, 65,535 of which remain subject
to our repurchase right. See footnotes 2, 3, 4, 5, and 7 to the preceding
"Principal Beneficial Owners" table for information on several of the
directors' relationships to some of the principal beneficial owners of our
common stock.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
TRANSACTIONS WITH IIA
Messrs. Spass and Cooper, who are directors of Superior National, are
employees of IIA. Mr. Spass is also an officer and director of IIA. Mr.
Schwarberg, who is a director of Superior National, is a former employee of IIA.
We paid $250,000 to IIA during 1998 for investment banking and financial
consulting services. We made this payment under a consulting agreement that we
entered into with IIA in 1992. This agreement will terminate at the end of 1999.
68
<PAGE>
TRANSACTIONS WITH AFFILIATES OF ZURICH, INCLUDING CENTRE RE
Zurich, Centre Solutions, Centre Re, and CentreLine are affiliates of each
other. Mr. Germain, who is a director of Superior National, is an officer and
director of Centre Solutions, Centre Re, and CentreLine and an officer of
Zurich.
FINANCING TRANSACTIONS
Effective June 11, 1998, ZRNA, which is an affiliate of Zurich, advanced to
SNIC $5.5 million of a reinsurance commutation amount to be paid to SNIC in July
1998. SNIC used the proceeds of the advance to purchase shares of our common
stock from a director and for other investments. See "--Purchase of Common Stock
by SNIC from Thomas J. Jamieson, Director." ZRNA received interest on the funds
that it advanced at short-term borrowings rates.
REINSURANCE
Under a 1993 aggregate excess of loss reinsurance contract, we owe Centre Re
$45.0 million of funds withheld premiums, and Centre Re owes us $45.0 million of
experience refunds, neither of which have been accruing interest or accreting
since June 30, 1996. Because Superior National and Centre Re enjoy the right of
offset under this contract, the two amounts offset to zero in the balance sheet.
This contract has no further economic effect on either us or Centre Re, and we
will neither receive from nor pay to Centre Re any cash at the future
commutation date of the contract.
Effective January 1, 1998, the terms of the ZRNA Quota-Share again were
amended to increase the ceding commission to 27.5% for non-ZCIC policies and on
ALE premium. The ceding commission on ZCIC policies remained at 20%. Further,
the additional 2% of premium paid to ZCIC for its underwriting was eliminated.
See "Business--Reinsurance."
Effective July 1, 1998, SNIC and SPCC entered into an Aggregate Excess of
Loss Agreement with ZRNA. SNIC and SPCC will cede to ZRNA $11.0 million of claim
and allocated claim adjustment expenses for each 12-month period ended June 30,
1999 through June 30, 2001 to the extent SNIC's and SPCC's claim and allocated
claim adjustment expenses exceed 105% of earned premium during this 12-month
period. SNIC and SPCC paid ZRNA cash and securities with a fair market value of
$15.6 million during 1998, and will pay ZRNA eight installments of $1.4 million
at the beginning of each quarter beginning January 1, 1999. This agreement is
accounted for as a deposit due to the absence of certain risk transfer factors
under the terms of the agreement. SNIC and SPCC receive an interest credit from
ZRNA on the premium paid, and will receive the balance of a notional experience
account from ZRNA when the contract is commuted. The balance of the deposit at
December 31, 1998 was $16.1 million, including advance reinsurance premiums of
$2.8 million.
Effective June 30, 1997, SNIC entered into a contract with ZRNA. ZRNA
assumed $10.0 million of reserves associated with claims open for future medical
payments from SNIC in consideration of $1.0 million in cash and the assignment
of SNIC's rights of contribution and subrogation recoveries during the term of
the contract. In 1997, the contract is accounted for as a deposit and no gain
would be recognized until net cash payments from ZRNA are greater than SNIC's
$1.0 million premium. Effective December 31, 1998, the contract was commuted and
ZRNA paid SNIC $250,000 to commute and settle all obligations and liabilities
associated with this contract.
Effective October 1, 1998, SNIC entered into a contract with Centre Re under
which SNIC assumed $30.0 million of property and casualty reserves from Centre
Re in return for cash consideration of $28.9 million. The contract was commuted
effective December 15, 1998, at which time SNIC paid Centre Re $30.5 million and
Centre Re reassumed all of the reserves ceded to SNIC.
Effective June 30, 1998, SNIC entered into an agreement with ZRNA to settle
and commute all obligations and liabilities known and unknown associated with
the ZRNA Quota-Share contract and its
69
<PAGE>
related Assumption of Liability Endorsement facility for the contract years
incepting January 1, 1994 through 1997. ZRNA paid SNIC $5.6 million and SNIC
reassumed from ZRNA all of its workers' compensation claim and allocated claim
adjustment expense reserves previously ceded to ZRNA for contract years 1994
through 1997.
CLAIM SEVERITY MANAGEMENT PROGRAM
Beginning December 31, 1997 the Company entered into agreements with Risk
Enterprise Management Limited ("REM") and an affiliate of REM to provide the
Claim Severity Management Program. REM is an affiliate of Zurich. The total
costs of this program to us is expected to be approximately the same as our
regular claim management functions would have cost us over the expected
five-year life of the program. We believe our operating costs would have been
similar had we not determined to pursue the program, while our claim severity
risk has been reduced. See "Business--Claim Severity Management Program." In
1998 we paid an aggregate of $8.3 million to REM and its affiliate under the
terms of the program.
SALE OF BICO; ISSUANCE OF WARRANTS
In mid-December 1998, we sold BICO to Centre Solutions Holdings (Delaware)
Limited ("Centre Holdings") for approximately $11.7 million. We arrived at the
BICO purchase price by means of arm's length bargaining with Centre Holdings.
BICO was a subsidiary of BIG, both of which we acquired in early December 1998.
An additional $0.6 million of the purchase price was withheld by Centre Holdings
and, subject to possible downward adjustments specified in the purchase
agreement, will be paid to us in September 1999. Prior to the sale of BICO,
under the terms of the Loss Portfolio Transfer and 100% Quota Share Reinsurance
Contract among BICO, CalComp and SNIC, CalComp, as the reinsurer, assumed BICO's
insurance business (excluding BICO's licenses and statutory capital) and
liabilities, and received assets with the fair market value equal to the
liabilities assumed. SNIC unconditionally guarantees the performance and payment
of CalComp's obligations under this contract.
As a condition to the sale of BICO, CalComp entered into a 100% Quota Share
Reinsurance agreement with CIC (formerly BICO) under which CIC will provide
Superior National with a "fronting" facility. See "Business--Reinsurance."
Centre Holdings is an affiliate Zurich and Zurich is the owner of CentreLine
and Centre Solutions, both of which have invested in our securities. In
addition, several affiliates of Zurich are significant investors in IP II, IP
Delaware and/or IP Bermuda. IP II, IP Delaware, and IP Bermuda purchased a
significant percentage of the common stock we sold to finance our acquisition of
BIG. See "--Sale of Common Stock to the IP Partnerships and Limitations on
Related Party Control of Superior National" below.
In December 1998, we issued warrants to purchase 205,520 shares of common
stock to Zurich Centre Group Holdings Limited. The warrants have an exercise of
$16.75 per share and expire on December 10, 2003. These warrants represented a
portion of the warrants to purchase an aggregate of 734,000 shares of common
stock that we simultaneously issued to IP Delaware and IP Bermuda in connection
with our December 1998 sale of common stock to help fund our acquisition of BIG.
See "Sale of Common Stock to the IP Partnerships and Limitations on Related
Party Control of Superior National" below for additional information concerning
these warrants.
PURCHASE OF COMMON STOCK BY SNIC FROM THOMAS J. JAMIESON, DIRECTOR
Effective June 11, 1998, SNIC agreed to purchase an aggregate of 245,000
shares of our common stock from Thomas J. Jamieson, who is a director of
Superior National, and Jaco Oil Company, an entity controlled by Mr. Jamieson.
The price per share paid was $21.00, for total consideration of $5,145,000. The
closing sales price per share of common stock on June 10, 1998 was $22.88. The
common stock purchased
70
<PAGE>
by SNIC is held as an investment on a GAAP basis. The Board of Directors, with
disclosure of the conflicts of interest of Mr. Jamieson, and also Mr. Germain,
due to ZRNA's advance of funds discussed above, unanimously approved SNIC's
purchase of our common stock from Mr. Jamieson and Jaco Oil Company.
SALE OF COMMON STOCK TO THE IP PARTNERSHIPS AND LIMITATIONS ON RELATED PARTY
CONTROL OF SUPERIOR NATIONAL
SALE OF COMMON STOCK TO THE IP PARTNERSHIPS
In December 1998, we privately sold approximately $158 million of our common
stock to IP II, IP Delaware, and IP Bermuda. At the same time we also completed
our public rights offering under which we offered subscription rights to
purchase our common stock to all of our stockholders (except for IP Delaware and
IP Bermuda), warrant holders and to holders of our stock options and shares of
restricted stock. Those directors and executive officers of Superior National
who owned common stock and warrants, by virtue of these holdings, had the
opportunity to purchase shares of common stock in the rights offering. These
offerings provided a significant portion of the financing we needed to purchase
BIG.
Robert A. Spass and Bradley E. Cooper, who are directors of the Company, are
officers of the ultimate general partner of IP II and each owns 9.9% of its
voting capital stock. In addition, some members of our management, including
William L. Gentz, Arnold J. Senter, and J. Chris Seaman, are investors in an
investment fund that is a limited partner of IP II.
Mr. Spass and Steven B. Gruber, who is a director of Superior National, are
executive officers of the ultimate general partner of IP Delaware and IP
Bermuda. In addition, Messrs. Spass, Gruber, and Cooper own direct or indirect
limited partnership interests in some of the limited partnerships that are the
direct or indirect general partners of IP Delaware and IP Bermuda.
The Board of Directors, without Messrs. Spass, Gruber, and Cooper, who
disclosed their conflict of interest, withdrew from the discussion, and
abstained from the voting, unanimously approved the terms of the sale of common
stock to the IP partnerships.
Under the terms of our stock offering to the IP partnerships, they agreed to
purchase 5,611,940 shares of our common stock at $16.75 per share, for a total
of $94.0 million. They also agreed to provide a standby commitment under which
they would purchase up to an additional 6,328,358 shares of common stock at
$16.75 per share in an amount of shares necessary to bring the total proceeds of
the private sale to the IP partnerships and the public sale of common stock
under the rights offering to $200.0 million. Our independent directors, on
behalf of Superior National, negotiated the $16.75 subscription price and the
terms of the stock purchase agreement governing the sale to the IP partnerships.
Because the $16.75 price equaled the subscription price in the rights offering
and this price was set with the intention of inducing participation by our
stockholders, the $16.75 price represented a discount to the market price of our
common stock at the time the price was determined.
On December 10, 1998 the IP partnerships exercised their standby commitment,
which, combined with the minimum number of shares of common stock they agreed to
purchase, resulted in (1) IP II purchasing 5,276,960 shares of common stock for
$88.4 million, (2) IP Delaware purchasing 2,949,594 shares of common stock for
$49.4 million, and (3) IP Bermuda purchasing 1,196,588 shares of common stock
for $20.0 million.
On December 10, 1998 we paid a commitment fee to the IP partnerships in the
form of warrants to purchase an aggregate of 734,000 shares of common stock at
$16.75 per share for agreeing to provide the standby commitment. The warrants
expire on December 10, 2003. IP II assigned the warrants it was entitled to
receive to Zurich Centre Group Holdings Limited as compensation for its
providing certain financing commitments to the IP partnerships under the stock
purchase agreement. We paid this commitment fee by issuing (1) 229,754 warrants
to IP Delaware, (2) 93,206 warrants to IP Bermuda, (3) 205,520 warrants to
Zurich Centre Group Holdings Limited, and (4) 205,520 warrants to various
principals and
71
<PAGE>
designees of the ultimate general partner of IP II. Robert A. Spass and Bradley
E. Cooper, who are directors of Superior National and officers and equity
holders of that general partner, received 32,825 warrants and 16,413 warrants,
respectively, from the general partner. See footnotes 2, 3 and 4 to the
preceding "Principal Beneficial Owners" table for additional information
concerning the relationship of Mssr. Spass, Gruber, and Cooper to IP Delaware,
IP Bermuda, and IP II.
In connection with our stock offering to the IP partnerships, we also
entered into a Registration Rights Agreement under which we agreed to provide
the IP partnerships and some of their affiliates with registration rights that
allow them to require Superior National to prepare and file with the SEC
registration statements under the Securities Act covering the public offer and
sale of shares they hold and to use its best efforts to cause these registration
statements to be declared effective. We also agreed under this agreement to
provide these same stockholders with customary "piggyback" registration rights
that allow them to register shares if and when Superior National proposes to
sell any of its common stock to the public in a transaction registered under the
Securities Act. This agreement superseded an earlier Registration Rights
Agreement that we entered into in 1996 with IP Delaware and IP Bermuda that
contained similar provisions.
In addition, we paid to designees of the IP partnerships fees totaling $3.9
million in consideration of the IP partnerships providing us with the
opportunity to undertake the BIG acquisition, originating a portion of the
financing for the acquisition, and assisting us in negotiating the terms of the
acquisition.
LIMITATIONS ON RELATED PARTIES CONTROL OF SUPERIOR NATIONAL
The stock purchase agreement governing the terms of the stock sale to the IP
partnerships contains, in addition to customary terms and provisions, including
customary representations and warranties, covenants, and reciprocal
indemnification provisions, several covenants by the IP partnerships that shall
remain effective so long as the IP partnerships and their associates
beneficially own an aggregate of 15% or more of our common stock on a diluted
basis. As used in the stock purchase agreement, the term "associates" means
CentreLine, Centre Re, Centre Solutions, IIA, and any person or entity that
controls, is under common control with, or is controlled by any of the IP
partnerships or those persons or entities, and all individuals who are officers,
directors, or control persons of any those entities, including IP II, IP
Delaware and IP Bermuda.
Some of the covenants provide that:
1. The IP partnerships and their associates will not elect more than five
directors or the highest number that is less than a majority of the Board of
Directors.
2. The IP partnerships will not transfer any of their shares of our common
stock except in specified types of transactions.
3. Except for the election of directors, with respect to any other vote of the
stockholders of Superior National on a particular matter, if the aggregate
number of all shares that are voted in like manner by the IP partnerships
and their associates shall be greater than 35% of the total number of shares
voted, then those votes that exceed the 35% threshold shall be voted in the
same proportion as the other stockholders voted their shares with respect to
that matter.
4. With limited exceptions, the IP partnerships and their associates will not
(a) acquire additional shares of our common stock, (b) enter into a business
combination involving Superior National, (c) participate in any solicitation
of proxies with respect to our common stock, or (d) participate in any group
with respect to any of the foregoing.
Covenant number 4 above may be waived by a two-third majority vote of (1)
the directors not affiliated with the IP partnerships or their associates or (2)
the stockholders other than the IP partnerships and their associates.
72
<PAGE>
This stock purchase agreement superseded a previous stock purchase agreement
that we entered into in 1996 with IP Delaware, IP Bermuda, and others that
contained similar covenants.
PARTICIPATION BY MANAGEMENT IN THE RIGHTS OFFERING
In approving the rights offering to Superior National's stockholders
described above, the Board of Directors decided to allow employees and
consultants of Superior National who held stock options and shares of restricted
stock to receive similar subscription rights. We distributed to these holders
the same form of subscription right issued in the rights offering, including an
identical $16.75 subscription price, except that each employee and consultant
was required to agree that his or her rights were non-transferable.
In addition, the Board of Directors authorized Superior National to lend
funds to the participants sufficient to pay the purchase price for the common
stock and any resulting tax liability if the participant signed a promissory
note, and pledged to Superior National, as collateral, stock options, warrants
and shares of common stock and restricted stock (including shares of common
stock purchased in the rights offering). The amount of money that could be
borrowed was limited to 66% of the total value of the collateral that was
pledged. The value of a share of our common stock was based on an average of the
closing sales price and the value of an option or warrant was equal to this
value minus its exercise price. The annual interest rate on the promissory notes
is 5.4% and accrued interest is payable on each December 31. The principal
amount of each promissory note will be due in a lump sum on the earlier of
December 10, 2008, or the date on which the borrower is no longer an employee or
consultant of Superior National (unless his or her termination results from
death or permanent disability, in which case the payment terms extend). The loan
can be partially or entirely prepaid at any time without penalty.
Under the terms of this pledge, if the amount outstanding under any
promissory note (including interest) exceeds the value of the collateral, then
the borrower is obligated to either prepay a portion of the promissory note or
pledge additional securities as collateral, in either case, in an amount equal
to the shortfall. If a borrower decides to sell any of the securities he or she
has pledged as collateral, then a portion of the proceeds must be used to pay
all accrued and unpaid interest and a percentage of the outstanding principal of
the promissory note based upon the number of shares sold and the number of
shares purchased with the promissory note. In addition, if a borrower should
default under the terms of the pledge, which includes his or her ceasing to be
an employee or consultant of Superior National (other than in the case of death
or permanent disability), then Superior National shall have the right to sell
all or any part of the pledged securities.
Employees and consultants of Superior National purchased a total of 618,309
shares of common stock under this portion of the rights offering and borrowed a
total of $10.4 million from Superior National to pay for them. All of the
participants borrowed money from us and pledged to us a sufficient number of
stock options, warrants and shares of our common stock and restricted stock. The
following table provides information concerning our executive officers and their
participation in this offering.
EXECUTIVE OFFICER PARTICIPATION
<TABLE>
<CAPTION>
SHARES AMOUNT
NAME PURCHASED BORROWED
- ---------------------------------------------------------------------------------------- ----------- ------------
<S> <C> <C>
William L. Gentz........................................................................ 120,000 $ 2,010,000
J. Chris Seaman......................................................................... 193,828 3,246,619
Arnold J. Senter........................................................................ 17,946 300,595
Thomas I. Boggs, Jr..................................................................... 35,191 589,449
Robert E. Nagle......................................................................... 17,920 300,160
Edward C. Shoop......................................................................... 3,592 60,166
Theresa A. Sealy........................................................................ 1,106 17,018
Ronald J. Tonani........................................................................ 1,698 28,442
</TABLE>
73
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS:
Consolidated Balance Sheets as of December 31, 1998 and 1997
Consolidated Statements of Operations for the Years Ended December 31, 1998,
1997 and 1996
Consolidated Statements of Changes in Stockholders' Equity for the Years
Ended December 31, 1998, 1997 and 1996
Consolidated Statements of Cash Flows, as Restated for the Years Ended
December 31, 1998, 1997 and 1996
Notes to Consolidated Financial Statements
(a)(2) FINANCIAL STATEMENT SCHEDULES:
Condensed Financial Information of Registrant, Superior National Insurance
Group, Inc.
Valuation and Qualifying Accounts and Reserves
Supplemental Insurance Information
Reinsurance
Supplemental Property and Casualty Insurance Information
(a)(3) EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ----------- ------------------------------------------------------------
<C> <S>
2.1 Purchase Agreement dated as of May 5, 1998 by and between
FHC and Superior National(8)
2.2 Purchase Agreement dated as of December 7, 1998 between
Centre Solutions Holdings (Delaware) Limited and Superior
National(11)
3.1 Amended and Restated Certificate of Incorporation of
Superior National, as currently in effect(11)
3.2 Bylaws of Superior National, as currently in effect
4.1 Amended and Restated Declaration of Trust of the Trust,
dated as of December 3, 1997, including the Trust's
Certificate of Trust and the forms of Trust Common
Securities, Trust Preferred Securities, and Exchange Trust
Preferred Securities(6)
4.3 Senior Subordinated Indenture, including forms of the Senior
Subordinated Notes and Exchange Senior Subordinated Notes,
dated as of December 3, 1997, between Superior National
and Wilmington Trust Company, as trustee, providing for
the sale by Superior National to the Trust of the Senior
Subordinated Notes(6)
4.4 Guarantee Agreement, dated as of December 3, 1997, between
Superior National and Wilmington Trust Company, as
trustee, with respect to the Trust Preferred Securities(6)
4.5 Guarantee Agreement with Respect to Common Securities, dated
as of December 3, 1997, by Superior National(6)
4.6 Form of Exchange Guarantee Agreement between Superior
National and Wilmington Trust Company, as trustee, with
respect to the Exchange Trust Preferred Securities(6)
4.7 First Supplemental Indenture dated as of November 17, 1998
between Superior National and Wilmington Trust Company, as
trustee(11)
</TABLE>
74
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ----------- ------------------------------------------------------------
<C> <S>
EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS
10.1 Employment Agreement, dated June 1, 1997, by and between Mr.
William L. Gentz, President and Chief Executive Officer,
and Superior National(5)
10.2 Employment Agreement, dated February 17, 1997, by and
between Mr. Arnold J. Senter, Executive Vice President and
Chief Operating Officer, and Superior National(3)
10.3 Employment Agreement, dated June 1, 1997, by and between Mr.
J. Chris Seaman, Executive Vice President and Chief
Financial Officer, and Superior National(5)
10.4 Letter Agreement dated September 8, 1997 governing the terms
of employment of Edward C. Shoop, Senior Vice President
and Chief Actuary
10.5 Letter Agreement dated July 13, 1998 governing the terms of
employment of Doris K.T. Lai, Vice President--Finance and
Treasurer
10.6 1986 Non-Statutory Stock Option and 1986 Non-Statutory Stock
Purchase Plan(2)
10.7 1995 Stock Incentive Plan(2)
OTHER MATERIAL CONTRACTS
10.8 Lease, dated 27th day of October 1988, by and between
Corporate Center at Malibu Canyon, a California Limited
Partnership and Superior National, relating to the lease
of our home office and Calabasas Branch Facilities(1)
10.9 Purchase warrant, dated as of the 30th of June 1994,
entitling Centreline Reinsurance Limited to purchase
579,356 shares of Common Stock(1)
10.10 Form of Common Stock Purchase Warrant, held by those members
of Superior National's management and other parties set
forth on the schedule attached thereto, to purchase an
aggregate of 1,566,465 shares of our common stock(6)
10.11 Registration Rights Agreement, dated as of December 3, 1997,
among Superior National, the Trust, and the Initial
Purchasers named therein(6)
10.12 Agreement with Prime Advisors regarding Investment
Management Services provided to Superior National dated
April 12, 1997(4)
10.13 Agreement for Services between REM and SNIC, relating to the
Claim Severity Management Program(7)
10.14 Average Existing Claim Severity Agreement, effective
December 31, 1997, between ZRNA and Superior Pacific(7)
10.15 Stock Purchase Agreement, dated as of May 5, 1998, among
Superior National, IP Delaware, IP Bermuda, and Capital Z
Partners Ltd.(8)
10.16 Form of Common Stock Purchase Warrant dated as of December
10, 1998 held by those parties set forth on the schedule
attached thereto, to purchase an aggregate of 734,000
shares of our common stock(8)
10.17 Amended and Restated Registration Rights Agreement dated
December 10, 1998 among Superior National, IP Delaware, IP
Bermuda, and IP II(8)
10.18 Retainer and Consulting Agreement dated as of December 31,
1997 between Superior National, SNIC, SPCC, and REM(10)
</TABLE>
75
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ----------- ------------------------------------------------------------
<C> <S>
10.19 Workers' Compensation Quota Share Large Account Business
Reinsurance Contract, effective February 1, 1998, issued
to Superior National(10)
10.20 Credit Agreement dated as of December 10, 1998 (the "Credit
Agreement") among Superior National, various lending
institutions and The Chase Manhattan Bank(11)
10.21 Subsidiary Guaranty dated as of December 10, 1998 made by
certain subsidiaries of Superior National in connection
with the Credit Agreement(11)
10.22 Pledge Agreement dated as of December 10, 1998 made by
Superior National and certain subsidiaries of Superior
National in connection with the Credit Agreement(11)
10.23 Receivables Purchase and Sale Agreement dated as of December
9, 1998 among CalComp, CBIC, CCIC, BICO and Insurance
Funding LLC(11)
10.24 Support Agreement dated as of December 9, 1998 by Superior
National in favor of Insurance Funding LLC, EagleFunding
Capital Corporation and BancBoston Robertson Stephens,
Inc.(11)
10.251 Receivables Purchase Agreement dated as of December 9, 1998
among Insurance Funding LLC, EagleFunding Capital
Corporation, BancBoston Robertson Stephens, Inc. and
Superior National(11)
10.26 Loss Portfolio Transfer and 100% Quota Share Reinsurance
Contract between BICO and CalComp(11)
10.27 Aggregate Excess of Loss Reinsurance Agreement, dated as of
September 3, 1998, between Inter-Ocean Reinsurance Company
Ltd. and BIG acting solely on behalf of the following
subsidiaries: CalComp, BICO, CBIC and CCIC(11)
10.28 Master Lease Finance Agreement dated as of December 1, 1998
by and between BancBoston Leasing Inc. and BIG and its
subsidiaries
10.29 Commutation and Settlement Agreement, effective as of June
30, 1998, by and between Superior National and ZRNA(10)
11 Computation of Earnings per Share
21 Subsidiaries of Superior National
27 Financial Data Schedule
</TABLE>
- ------------------------
(1) Previously filed as an exhibit to Superior National's Registration
Statement on Form 10, as filed with the SEC on May 1, 1995 (File No.
0-25984).
(2) Previously filed as an exhibit to Superior National's Annual Report on Form
10-K for the fiscal year ended December 31, 1995, as filed with the SEC on
March 29, 1996.
(3) Previously filed as an exhibit to Superior National's Annual Report on Form
10-K for the fiscal year ended December 31, 1996, as filed with the SEC on
March 10, 1997.
(4) Previously filed as an exhibit to Superior National's Quarterly Report on
Form 10-Q for the quarter ended March 31, 1997, as filed with the SEC on
May 15, 1997.
(5) Previously filed as an exhibit to Superior National's Quarterly Report on
Form 10-Q for the quarter ended September 30, 1997, as filed with the SEC
on November 13, 1997.
76
<PAGE>
(6) Previously filed as an exhibit to Superior National's and the Trust's
Registration Statement on Form S-4 (Registration No. 333-43505) on December
30, 1997.
(7) Previously filed as an exhibit to Superior National's Annual Report on Form
10-K for the fiscal year ended December 31, 1997, as filed with the SEC on
March 31, 1998.
(8) Previously filed as an exhibit to Superior National's Quarterly Report on
Form 10-Q for the quarter ended March 31, 1998, as filed with the SEC on
May 15, 1998.
(9) Previously filed as an exhibit to Superior National's Quarterly Report on
Form 10-Q for the quarter ended June 30, 1998, as filed with the SEC on
August 14, 1998.
(10) Previously filed as an exhibit to Superior National's Registration
Statement on Form S-1 (Registration No. 333-58579) on July 7, 1998.
(11) Previously filed as an exhibit to Superior National's Current Report on
Form 8-K, as filed with the SEC on December 24, 1998.
(a)(4)
(1) Current Report on Form 8-K, filed with the SEC on December 24, 1998,
related to the acquisition of BIG.
(2) Current Report on Form 8-K/A, as filed with the SEC on January 27, 1999,
related to the acquisition of BIG.
77
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
<TABLE>
<S> <C> <C>
Date: April 15, 1999 SUPERIOR NATIONAL INSURANCE GROUP, INC.
By: /s/ J. CHRIS SEAMAN
-----------------------------------------
J. Chris Seaman
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
</TABLE>
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed below by the following persons on
behalf of the Registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ------------------------------ -------------------------- -------------------
<C> <S> <C>
Director, President and
/s/ WILLIAM L. GENTZ Chief Executive Officer
- ------------------------------ (Principal Executive April 15, 1999
William L. Gentz Officer)
Director, Executive Vice
President and Chief
/s/ J. CHRIS SEAMAN Financial Officer
- ------------------------------ (Principal Financial April 15, 1999
J. Chris Seaman Officer and Accounting
Officer)
/s/ STEVEN D. GERMAIN
- ------------------------------ Director April 15, 1999
Steven D. Germain
/s/ THOMAS J. JAMIESON
- ------------------------------ Director April 15, 1999
Thomas J. Jamieson
/s/ GORDON E. NOBLE
- ------------------------------ Director April 15, 1999
Gordon E. Noble
/s/ C. LEN PECCHENINO
- ------------------------------ Director April 15, 1999
C. Len Pecchenino
</TABLE>
78
<PAGE>
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ------------------------------ -------------------------- -------------------
<C> <S> <C>
/s/ CRAIG F. SCHWARBERG
- ------------------------------ Director April 15, 1999
Craig F. Schwarberg
/s/ ROBERT A. SPASS
- ------------------------------ Director April 15, 1999
Robert A. Spass
/s/ BRADLEY E. COOPER
- ------------------------------ Director April 15, 1999
Bradley E. Cooper
- ------------------------------ Director April , 1999
Steven B. Gruber
/s/ ROGER W. GILBERT
- ------------------------------ Director April 15, 1999
Roger W. Gilbert
</TABLE>
79
<PAGE>
GLOSSARY OF TERMS
DEFINED TERMS AND SELECTED INSURANCE TERMS
<TABLE>
<S> <C>
Admitted Assets.............................. Assets recognized and accepted by state
insurance regulatory authorities for their
purposes in determining the financial
condition of an insurance company.
BIG.......................................... Business Insurance Group, Inc.
CalComp...................................... California Compensation Insurance Company, a
wholly-owned subsidiary of SNIG.
CBIC......................................... Combined Benefits Insurance Company, a
wholly-owned subsidiary of SNIG.
CCIC......................................... Commercial Compensation Insurance Company, a
wholly-owned subsidiary of SNIG.
Centre Re.................................... Centre Reinsurance Limited.
Claim and Claim Adjustment Expenses.......... The estimated ultimate cost of claims,
whether reported or unreported, charged
against earnings when claims occur, including
the estimated expenses of settling claims
(claim adjustment expenses).
Claim and Claim Adjustment Expense Ratio..... The ratio of claim and claim adjustment
expenses to net premiums earned.
Combined Ratio............................... The sum of the claim and claim adjustment
expense ratio and the expense ratio for
continuing operations. A combined ratio under
100% generally indicates an underwriting
profit, and a combined ratio over 100%
generally indicates an underwriting loss.
Direct Premiums Written...................... Direct premiums written include all premiums
arising from policies issued by the Company
acting as primary insurance carrier, adjusted
for any return or additional premiums arising
from endorsements, cancellations, audits and
retrospective rating plans.
DOI.......................................... California Department of Insurance.
Exchange Act................................. Securities Exchange Act of 1934, as amended.
Expense Ratio................................ The ratio of commissions (net of reinsurance
ceding commissions), policyholder dividends,
and general and administrative expenses to
net premiums earned.
</TABLE>
80
<PAGE>
<TABLE>
<S> <C>
GAAP......................................... Generally Accepted Accounting Principles of
the United States of America, including those
set forth in: (i) the opinions and
pronouncements of the Accounting Principles
Board of the American Institute of Certified
Public Accounts, (ii) statements and
pronouncements of the Financial Accounting
Standards Board, (iii) in such other
statements by such other entity as approved
by a significant segment of the accounting
profession, and (iv) the rules and
regulations of the SEC governing the
inclusion of financial statements in periodic
reports required to be filed pursuant to
Section 13 of the Exchange Act, including
opinions and pronouncements in staff
accounting bulletins and similar written
statements from the accounting staff of the
SEC.
Gross Premiums Written....................... Gross premiums written include all premiums
arising from policies issued by the Company
acting as primary insurance carrier and
policies issued through fronting facilities,
adjusted for any additional or return
premiums arising from endorsements,
cancellations, audits and retrospective
rating plans.
IIA.......................................... International Insurance Advisors, Inc., a New
York corporation.
IP Bermuda................................... Insurance Partners Offshore (Bermuda), L.P.,
a Bermuda limited partnership.
IP Delaware.................................. Insurance Partners, L.P., a Delaware limited
partnership.
IP II........................................ Capital Z Financial Services Fund II, L.P.
NAIC......................................... National Association of Insurance
Commissioners.
Net Premiums Earned.......................... The portion of net premiums written
applicable to the insurance coverage provided
in any particular accounting period.
Net Premiums Written......................... Premiums retained by an insurance company
after deducting premiums on business
reinsured with others.
P&C.......................................... Property and casualty.
Policy Acquisition Costs..................... Agents' or brokers' commissions, premium
taxes, marketing, underwriting, and other
expenses associated with the production of
premium.
Premium in Force............................. Premium in force is the sum of the estimated
annual gross written premiums for policies on
which the Company is currently providing
workers' compensation coverage.
</TABLE>
81
<PAGE>
<TABLE>
<S> <C>
Reinsurance.................................. An agreement whereby an insurer transfers
("cedes") a portion of the insurance risk to
a reinsurer in exchange for the payment of a
premium. Reinsurance can be effected by
"treaties," which automatically cover all
risks of a defined category, amount, and
type, or by "facultative reinsurance," which
is negotiated between an original insurer and
the reinsurer on an individual,
contract-by-contract basis.
REM.......................................... Risk Enterprise Management Limited, a
Delaware corporation, an affiliate of Zurich.
SEC.......................................... Securities and Exchange Commission.
Securities Act............................... Securities Act of 1933, as amended.
SNIC......................................... Superior National Insurance Company, a
wholly-owned insurance subsidiary of SNIG.
SNIG......................................... Superior National Insurance Group, Inc., a
Delaware corporation, the holding company of
SPIG, BIG, SNIC, SPCC, CalComp, CBIC, and
CCIC.
SPCC......................................... Superior Pacific Casualty Company, a wholly-
owned insurance subsidiary of SNIG.
Statutory Accounting Practices ("SAP")....... An accounting method prescribed or permitted
by state insurance regulators. The more
significant differences from GAAP are: (a)
premium income is taken into operations over
the periods covered by the policies, whereas
the related acquisition and commission costs
are expensed when incurred; (b) deferred
income taxes are not recognized; (c) certain
assets such as agents' balances over ninety
days due and prepaid expenses are nonadmitted
assets for statutory reporting purposes; (d)
policyholder dividends are accrued when
declared; (e) the cash flow statement is not
consistent with classifications and the
presentation under GAAP; (f) bonds are
recorded at amortized cost, regardless of
trading activities; (g) loss and loss
adjustment expense reserves and unearned
premium reserves are stated net of
reinsurance; and (h) minimum statutory
reserves for losses in excess of the
Company's estimates are required.
Superior National............................ SNIG and its subsidiaries.
Triennial Examination........................ A regularly scheduled triennial review of the
operations and financial condition of a
regulated California insurance company by the
DOI as required under various provisions of
the California Insurance Code.
</TABLE>
82
<PAGE>
<TABLE>
<S> <C>
Underwriting................................. The process whereby an insurer reviews
applications submitted for insurance
coverage, determines whether it will accept
all or part of the coverage requested, and
determines the premiums to be charged.
Underwriting Expenses........................ The aggregate of commissions and other policy
acquisition costs, as well as the portion of
administrative, general, and other expenses
attributable to the underwriting operations.
Underwriting Profit (Loss)................... The excess (deficiency) resulting from the
difference between net premiums earned and
the sum of claim and claim adjustment
expenses, underwriting expenses, and
policyholder dividends.
Unpaid Claim and Claim Adjustment Expenses... An estimate of claims that have occurred,
both reported and unreported (including claim
adjustment expenses), and have been charged
against earnings but remain unpaid.
WCIRB........................................ California Workers' Compensation Insurance
Rating Bureau.
ZRNA......................................... Zurich Reinsurance (North America), Inc., a
Connecticut corporation, an affiliate of
Zurich.
ZCIC......................................... ZC Insurance Company, an affiliate of Zurich.
Zurich....................................... Zurich Reinsurance Centre Holdings, Inc., a
Delaware corporation.
</TABLE>
83
<PAGE>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
SUPERIOR NATIONAL INSURANCE GROUP, INC.
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS................................................................. F-1
INDEPENDENT AUDITORS' REPORT............................................................................... F-2
AUDITED CONSOLIDATED FINANCIAL STATEMENTS:
Consolidated Balance Sheets as of December 31, 1998 and 1997............................................. F-3
Consolidated Statements of Operations for the years ended December 31, 1998, 1997 and 1996............... F-4
Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1998, 1997
and 1996............................................................................................... F-5
Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996............... F-6
Notes to Consolidated Financial Statements............................................................... F-7
FINANCIAL STATEMENTS SCHEDULES:
Schedule I: Condensed Financial Information of Registrant, Superior National Insurance Group, Inc........ F-43
Schedule II: Valuation and Qualifying Accounts and Reserves.............................................. F-47
Schedule V: Supplemental Insurance Information, Reinsurance and Supplemental Property and Casualty
Insurance Information.................................................................................. F-48
</TABLE>
F-1
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Superior National Insurance Group, Inc.:
We have audited the consolidated financial statements of Superior National
Insurance Group, Inc. and subsidiaries as listed in the accompanying index. In
connection with our audits of the consolidated financial statements, we also
have audited the financial statement schedules as listed in the accompanying
index. These consolidated financial statements and financial statement schedules
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements and financial
statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Superior National
Insurance Group, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1998, in conformity with generally accepted
accounting principles. Also in our opinion, the related financial statement
schedules, when considered in relation to the basic consolidated financial
statements taken as a whole, present fairly, in all material respects, the
information set forth therein.
KPMG LLP
Los Angeles, California
April 6, 1999
F-2
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
<TABLE>
<CAPTION>
1998
----------
(IN
THOUSANDS,
EXCEPT
SHARE
DATA)
<S> <C>
ASSETS
Investments:
Fixed Maturities
Available-for-sale, at market (cost: 1998, $539,557; 1997, $203,373)......................................... $ 541,678
Equity securities, at market (cost: 1998, 1,634; 1997, $1,356)................................................. 1,544
Short-term investments, at cost................................................................................ 7,343
Other Investments--Related Party............................................................................... 50
----------
TOTAL INVESTMENTS.......................................................................................... 550,615
Cash and cash equivalents (restricted cash: 1998, $34,713; 1997, $651)........................................... 316,786
Reinsurance recoverable:
Paid claim and claim adjustment expenses....................................................................... 14,429
Unpaid claim and claim adjustment expenses
Related party................................................................................................ 10,749
Other........................................................................................................ 226,841
Reinsurance recoverable on loss reserve guarantee................................................................ 175,000
Premiums receivable
Related party................................................................................................ 5,464
Other........................................................................................................ 69,787
Allowance for doubtful accounts.............................................................................. (18,941)
Earned but unbilled premiums receivable.......................................................................... 22,540
Accrued investment income........................................................................................ 6,140
Deferred policy acquisition costs................................................................................ 17,136
Deferred income taxes............................................................................................ 49,049
Funds held by reinsured
Related party................................................................................................ 32,732
Other........................................................................................................ 7,000
Receivable from a related party reinsurer........................................................................ 16,075
Prepaid reinsurance premiums
Related party................................................................................................ 1,077
Other........................................................................................................ 19,690
Goodwill......................................................................................................... 33,821
Investments withheld from reinsurer.............................................................................. 123,863
Prepaid and other assets
Related party................................................................................................ 8,490
Other........................................................................................................ 31,299
----------
TOTAL ASSETS............................................................................................... $1,719,642
----------
----------
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Claim and claim adjustment expenses
Related party................................................................................................ 118,690
Other........................................................................................................ 957,516
Unearned premiums
Related party................................................................................................ 7,644
Other........................................................................................................ 45,284
Reinsurance payable
Related party................................................................................................ 724
Other........................................................................................................ 28,537
Long-term debt................................................................................................. 105,820
Policyholder dividends......................................................................................... 9,635
Capital lease obligation....................................................................................... 6,035
Discontinued operations liability.............................................................................. 8,151
Payable to purchaser of receivables............................................................................ 34,474
Accounts payable and other liabilities
Related party................................................................................................ 24,364
Other........................................................................................................ 47,722
----------
TOTAL LIABILITIES.......................................................................................... 1,394,596
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 1998 and 1997............................ 101,084
STOCKHOLDERS' EQUITY
Common stock, $0.01 par value; authorized 40,000,000 shares in 1998 and 25,000,000 shares in 1997; issued
17,907,314 shares in 1998 and 5,871,279 shares in 1997......................................................... 177
Paid-in capital excess of par.................................................................................... 228,512
Unrealized gain on investments, net of taxes..................................................................... 1,320
Paid-in capital--warrants........................................................................................ 2,206
Retained earnings................................................................................................ 8,382
Unearned compensation............................................................................................ (1,107)
Less: Notes receivable from subscribed stock..................................................................... (10,385)
Less: 245,000 shares of treasury stock at cost................................................................... (5,143)
----------
NET STOCKHOLDERS' EQUITY................................................................................... 223,962
----------
TOTAL LIABILITIES, PREFERRED SECURITIES AND NET STOCKHOLDERS' EQUITY....................................... $1,719,642
----------
----------
<CAPTION>
<S> <C>
ASSETS
Investments:
Fixed Maturities
Available-for-sale, at market (cost: 1998, $539,557; 1997, $203,373)......................................... $ 205,214
Equity securities, at market (cost: 1998, 1,634; 1997, $1,356)................................................. 1,526
Short-term investments, at cost................................................................................ 6,634
Other Investments--Related Party............................................................................... --
---------
TOTAL INVESTMENTS.......................................................................................... 213,374
Cash and cash equivalents (restricted cash: 1998, $34,713; 1997, $651)........................................... 28,742
Reinsurance recoverable:
Paid claim and claim adjustment expenses....................................................................... 3,927
Unpaid claim and claim adjustment expenses
Related party................................................................................................ 13,011
Other........................................................................................................ 36,144
Reinsurance recoverable on loss reserve guarantee................................................................ --
Premiums receivable
Related party................................................................................................ 304
Other........................................................................................................ 24,860
Allowance for doubtful accounts.............................................................................. (800)
Earned but unbilled premiums receivable.......................................................................... 12,524
Accrued investment income........................................................................................ 2,661
Deferred policy acquisition costs................................................................................ 5,879
Deferred income taxes............................................................................................ 25,104
Funds held by reinsured
Related party................................................................................................ 5,152
Other........................................................................................................ --
Receivable from a related party reinsurer........................................................................ --
Prepaid reinsurance premiums
Related party................................................................................................ 1,158
Other........................................................................................................ 440
Goodwill......................................................................................................... 35,887
Investments withheld from reinsurer.............................................................................. --
Prepaid and other assets
Related party................................................................................................ --
Other........................................................................................................ 21,106
---------
TOTAL ASSETS............................................................................................... $ 429,473
---------
---------
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Claim and claim adjustment expenses
Related party................................................................................................ 4,879
Other........................................................................................................ 196,376
Unearned premiums
Related party................................................................................................ 514
Other........................................................................................................ 12,399
Reinsurance payable
Related party................................................................................................ 1,736
Other........................................................................................................ 1,676
Long-term debt................................................................................................. 30
Policyholder dividends......................................................................................... 1,370
Capital lease obligation....................................................................................... 7,626
Discontinued operations liability.............................................................................. 12,904
Payable to purchaser of receivables............................................................................ --
Accounts payable and other liabilities
Related party................................................................................................ 219
Other........................................................................................................ 28,649
---------
TOTAL LIABILITIES.......................................................................................... 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 1998 and 1997............................ 101,277
STOCKHOLDERS' EQUITY
Common stock, $0.01 par value; authorized 40,000,000 shares in 1998 and 25,000,000 shares in 1997; issued
17,907,314 shares in 1998 and 5,871,279 shares in 1997......................................................... 59
Paid-in capital excess of par.................................................................................... 34,242
Unrealized gain on investments, net of taxes..................................................................... 1,327
Paid-in capital--warrants........................................................................................ 2,206
Retained earnings................................................................................................ 21,984
Unearned compensation............................................................................................ --
Less: Notes receivable from subscribed stock..................................................................... --
Less: 245,000 shares of treasury stock at cost................................................................... --
---------
NET STOCKHOLDERS' EQUITY................................................................................... 59,818
---------
TOTAL LIABILITIES, PREFERRED SECURITIES AND NET STOCKHOLDERS' EQUITY....................................... $ 429,473
---------
---------
</TABLE>
See accompanying notes to consolidated financial statements.
F-3
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
(IN THOUSANDS,
EXCEPT
PER SHARE DATA)
REVENUES:
Gross premiums written
Related party....................................................................................... $ 10,886 $ 6,823
Other............................................................................................... 181,184 152,529
Ceded premiums written
Related party....................................................................................... (12,604) (12,334)
Other............................................................................................... (99,771) (10,089)
--------- ---------
Net premiums written.................................................................................. 79,695 136,929
Net change in unearned premiums
Related party....................................................................................... 548 (50)
Other............................................................................................... 6,846 4,041
--------- ---------
Net premiums earned................................................................................... 87,089 140,920
Net investment income................................................................................. 16,236 12,674
--------- ---------
TOTAL REVENUES.................................................................................... 103,325 153,594
--------- ---------
EXPENSES:
Gross claim and claim adjustment expense
Related party....................................................................................... 13,769 4,878
Other............................................................................................... 361,269 117,952
Ceded claim and claim adjustment expense
Related party....................................................................................... (11,217) (10,574)
Other............................................................................................... (120,479) (21,809)
--------- ---------
Net claim and claim adjustment expense................................................................ 243,342 90,447
--------- ---------
Reinsurance recovery on loss reserve guarantee........................................................ (175,000) --
Gross commissions expense
Related party....................................................................................... 2,710 1,556
Other............................................................................................... 22,735 17,150
Ceded commissions expense
Related party....................................................................................... (3,372) (2,741)
Other............................................................................................... (31,415) (2,127)
--------- ---------
Net commissions (income) expense...................................................................... (9,342) 13,838
--------- ---------
Policyholder dividends................................................................................ 1,158 --
Interest
Related party....................................................................................... 222 374
Other............................................................................................... 1,102 5,961
General and administrative
Underwriting
Related party..................................................................................... (3,217) 301
Other............................................................................................. 50,739 23,556
Loss on termination of financing transaction with a related party reinsurer........................... -- 15,699
Other
Related party....................................................................................... (682) --
Other............................................................................................... 2,747 1,856
--------- ---------
TOTAL EXPENSES.................................................................................... 111,069 152,032
--------- ---------
Income (loss) before income taxes, preferred securities dividends and accretion, and extraordinary
items................................................................................................. (7,744) 1,562
Income tax expense (benefit)............................................................................ (1,499) 1,099
--------- ---------
Income (loss) before preferred securities dividends and accretion, and extraordinary items.............. (6,245) 463
Preferred Securities dividends and accretion, net of income tax benefit of $1,260, and $858 in 1997 and
1996 respectively..................................................................................... -- (2,445)
Trust Preferred Securities dividends and accretion, net of income tax benefit of $3,962 and $321 in 1998
and 1997 respectively................................................................................. (7,357) (624)
Extraordinary loss on retirement of long-term debt, net of income tax benefit of $762 in 1997........... -- (1,480)
Extraordinary loss on redemption of Pac Rim's outstanding debentures, net of income tax benefit of $327
in 1997............................................................................................... -- (635)
Extraordinary loss on retirement of preferred securities, net of income tax benefit of $134 in 1997..... -- (259)
Extraordinary loss on early retirement of Imperial Bank loan net of income tax benefit of $83 in 1997... -- (161)
--------- ---------
NET INCOME (LOSS)................................................................................. $ (13,602) $ (5,141)
--------- ---------
--------- ---------
BASIC EARNINGS (LOSS) PER SHARE:
Income (loss) before preferred securities dividends and accretion, and extraordinary Items............ $ (0.92) $ 0.09
Preferred securities dividends and accretion.......................................................... (1.09) (0.58)
Extraordinary items................................................................................... -- (0.49)
--------- ---------
NET INCOME (LOSS)................................................................................. $ (2.01) $ (0.98)
--------- ---------
--------- ---------
DILUTED EARNINGS (LOSS) PER SHARE:
Income (loss) before preferred securities dividends and accretion, and extraordinary Items............ $ (0.92) $ 0.07
Preferred securities dividends and accretion.......................................................... (1.09) (0.44)
Extraordinary items................................................................................... -- (0.37)
--------- ---------
NET INCOME (LOSS)................................................................................. $ (2.01) $ (0.74)
--------- ---------
--------- ---------
<CAPTION>
1996
---------
<S> <C>
REVENUES:
Gross premiums written
Related party....................................................................................... $ 2,877
Other............................................................................................... 96,405
Ceded premiums written
Related party....................................................................................... (9,309)
Other............................................................................................... (2,258)
---------
Net premiums written.................................................................................. 87,715
Net change in unearned premiums
Related party....................................................................................... 68
Other............................................................................................... 865
---------
Net premiums earned................................................................................... 88,648
Net investment income................................................................................. 7,769
---------
TOTAL REVENUES.................................................................................... 96,417
---------
EXPENSES:
Gross claim and claim adjustment expense
Related party....................................................................................... 2,263
Other............................................................................................... 59,439
Ceded claim and claim adjustment expense
Related party....................................................................................... (7,118)
Other............................................................................................... 1,054
---------
Net claim and claim adjustment expense................................................................ 55,638
---------
Reinsurance recovery on loss reserve guarantee........................................................ --
Gross commissions expense
Related party....................................................................................... 633
Other............................................................................................... 11,823
Ceded commissions expense
Related party....................................................................................... (2,030)
Other............................................................................................... --
---------
Net commissions (income) expense...................................................................... 10,426
---------
Policyholder dividends................................................................................ (5,927)
Interest
Related party....................................................................................... 4
Other............................................................................................... 7,523
General and administrative
Underwriting
Related party..................................................................................... 5,606
Other............................................................................................. 18,106
Loss on termination of financing transaction with a related party reinsurer........................... --
Other
Related party....................................................................................... --
Other............................................................................................... (186)
---------
TOTAL EXPENSES.................................................................................... 91,190
---------
Income (loss) before income taxes, preferred securities dividends and accretion, and extraordinary
items................................................................................................. 5,227
Income tax expense (benefit)............................................................................ 1,597
---------
Income (loss) before preferred securities dividends and accretion, and extraordinary items.............. 3,630
Preferred Securities dividends and accretion, net of income tax benefit of $1,260, and $858 in 1997 and
1996 respectively..................................................................................... (1,667)
Trust Preferred Securities dividends and accretion, net of income tax benefit of $3,962 and $321 in 1998
and 1997 respectively................................................................................. --
Extraordinary loss on retirement of long-term debt, net of income tax benefit of $762 in 1997........... --
Extraordinary loss on redemption of Pac Rim's outstanding debentures, net of income tax benefit of $327
in 1997............................................................................................... --
Extraordinary loss on retirement of preferred securities, net of income tax benefit of $134 in 1997..... --
Extraordinary loss on early retirement of Imperial Bank loan net of income tax benefit of $83 in 1997... --
---------
NET INCOME (LOSS)................................................................................. $ 1,963
---------
---------
BASIC EARNINGS (LOSS) PER SHARE:
Income (loss) before preferred securities dividends and accretion, and extraordinary Items............ $ 1.06
Preferred securities dividends and accretion.......................................................... (0.49)
Extraordinary items................................................................................... --
---------
NET INCOME (LOSS)................................................................................. $ 0.57
---------
---------
DILUTED EARNINGS (LOSS) PER SHARE:
Income (loss) before preferred securities dividends and accretion, and extraordinary Items............ $ 0.75
Preferred securities dividends and accretion.......................................................... (0.34)
Extraordinary items................................................................................... --
---------
NET INCOME (LOSS)................................................................................. $ 0.41
---------
---------
</TABLE>
See accompanying notes to consolidated financial statements.
F-4
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
<TABLE>
<CAPTION>
ACCUMULATED OTHER
COMPREHENSIVE
COMMON INCOME (LOSS)
STOCK NOTES -------------------
PAID-IN RECEIVABLE UNREALIZED
NUMBER OF COMMON CAPITAL FROM GAIN (LOSS)
SHARES STOCK EXCESS TREASURY SUBSCRIBED ON
OUTSTANDING PAR VALUE OF PAR STOCK STOCK INVESTMENTS
----------- ----------- --------- ----------- ----------- -------------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995................ 3,430,373 $ 34 $ 15,909 $ -- $ -- $ 169
Comprehensive income
Net Income.................................. -- -- --
Other comprehensive
Unrealized loss on available-for-sale
investments arising during period, net of
income tax benefit of $149................ (290)
Unrealized loss on equity securities arising
during period, net of income tax benefit
of $10.................................... (19)
Less: reclassification adjustments for gains
included in net income, net of income tax
benefit of $12............................ (22)
Other comprehensive income, net of tax......
Comprehensive income........................
Common stock issued......................... -- -- -- -- -- --
Stock issued under a stock option plan...... 3,100 -- 12 -- -- --
Common stock issued under stock incentive
plan...................................... 13,019 -- 67 -- -- --
----------- ----- --------- ----------- ----------- ------
Balance at December 31, 1996................ 3,446,492 34 15,988 -- -- (162)
----------- ----- --------- ----------- ----------- ------
Comprehensive income (loss)
Net (loss).................................. -- -- -- -- -- --
Other comprehensive
Unrealized gain on available- for-sale
investments arising during period, net of
income tax expense of $715................ 1,390
Unrealized gain on equity securities arising
during period, net of income tax expense
of $67.................................... 129
Less: reclassification adjustments for gains
included in net income, net of income tax
benefit of $15............................ (30)
Other comprehensive income, net of tax......
Comprehensive (loss)........................
Common stock issued......................... 2,390,438 24 17,976 -- -- --
Stock issued under a stock option plan...... 22,127 1 104 -- -- --
Common stock issued under stock incentive
plan...................................... 12,222 -- 174 -- -- --
----------- ----- --------- ----------- ----------- ------
Balance at December 31, 1997................ 5,871,279 59 34,242 -- -- 1,327
----------- ----- --------- ----------- ----------- ------
Comprehensive income (loss)
Net (loss).................................. -- -- -- -- -- --
Other comprehensive
Unrealized gain on available-for-sale
investments arising during period, net of
income tax expense of $732................ 1,307
Unrealized loss on equity securities arising
during period, net of income tax benefit
of $56.................................... (109)
Less: reclassification adjustments for gains
included in net income, net of income tax
benefit of $649........................... (1,205)
Other comprehensive income, net of tax......
Comprehensive (loss)........................
Common stock issued......................... 11,945,385 119 192,888 -- -- --
Stock issued under a stock option plan...... 6,970 -- 44 -- -- --
Common stock issued under stock incentive
plan...................................... 83,680 1 1,338 -- -- --
Notes receivable from subscribed stock...... -- -- -- -- (10,385) --
Purchase of treasury stock from director.... (245,000) (2) -- (5,143) -- --
----------- ----- --------- ----------- ----------- ------
Balance at December 31, 1998................ 17,662,314 $ 177 $ 228,512 $ (5,143) $ (10,385) $ 1,320
----------- ----- --------- ----------- ----------- ------
----------- ----- --------- ----------- ----------- ------
<CAPTION>
PAID IN COMPREHENSIVE TOTAL
CAPITAL-- (LOSS) RETAINED UNEARNED STOCKHOLDERS'
WARRANTS INCOME EARNINGS COMPENSATION EQUITY
----------- -------------- --------- ------------- ------------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1995................ $ 2,206 $ 25,162 $ -- $ 43,480
Comprehensive income
Net Income.................................. -- $ 1,963 1,963 -- 1,963
--------------
Other comprehensive
Unrealized loss on available-for-sale
investments arising during period, net of
income tax benefit of $149................ (290)
Unrealized loss on equity securities arising
during period, net of income tax benefit
of $10.................................... (19)
Less: reclassification adjustments for gains
included in net income, net of income tax
benefit of $12............................ (22)
--------------
Other comprehensive income, net of tax...... (331)
--------------
Comprehensive income........................ 1,632
--------------
Common stock issued......................... -- -- -- --
Stock issued under a stock option plan...... -- -- -- 12
Common stock issued under stock incentive
plan...................................... -- -- -- 67
----------- --------- ------------- ------------
Balance at December 31, 1996................ 2,206 27,125 -- 45,191
----------- --------- ------------- ------------
Comprehensive income (loss)
Net (loss).................................. -- (5,141) (5,141) -- (5,141)
--------------
Other comprehensive
Unrealized gain on available- for-sale
investments arising during period, net of
income tax expense of $715................ 1,390
Unrealized gain on equity securities arising
during period, net of income tax expense
of $67.................................... 129
Less: reclassification adjustments for gains
included in net income, net of income tax
benefit of $15............................ (30)
--------------
Other comprehensive income, net of tax...... 1,489
--------------
Comprehensive (loss)........................ (3,652)
--------------
Common stock issued......................... -- -- -- 18,000
Stock issued under a stock option plan...... -- -- -- 105
Common stock issued under stock incentive
plan...................................... -- -- -- 174
----------- --------- ------------- ------------
Balance at December 31, 1997................ 2,206 21,984 -- 59,818
----------- --------- ------------- ------------
Comprehensive income (loss)
Net (loss).................................. -- $ (13,602) (13,602) -- (13,602)
--------------
Other comprehensive
Unrealized gain on available-for-sale
investments arising during period, net of
income tax expense of $732................ 1,307
Unrealized loss on equity securities arising
during period, net of income tax benefit
of $56.................................... (109)
Less: reclassification adjustments for gains
included in net income, net of income tax
benefit of $649........................... (1,205)
--------------
Other comprehensive income, net of tax...... (7)
--------------
Comprehensive (loss)........................ $ (13,609)
--------------
--------------
Common stock issued......................... -- -- -- 193,007
Stock issued under a stock option plan...... -- -- -- 44
Common stock issued under stock incentive
plan...................................... -- -- (1,107) 232
Notes receivable from subscribed stock...... -- -- -- (10,385)
Purchase of treasury stock from director.... -- -- -- (5,145)
----------- --------- ------------- ------------
Balance at December 31, 1998................ $ 2,206 $ 8,382 $ (1,107) $ 223,962
----------- --------- ------------- ------------
----------- --------- ------------- ------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-5
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
(AMOUNTS IN
THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income.......................................................................................... $ (13,602) $ (5,141)
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Amortization of bonds and preferred stock................................................................ (1,231) (1,073)
Amortization of investments withheld from reinsurer...................................................... 42 --
Amortization of long-term debt........................................................................... -- 68
Amortization of capital lease obligation................................................................. (1,591) --
(Gain) loss on sale of investments....................................................................... (1,854) 98
Gain on sale of Centre Re investments.................................................................... -- --
Amortization and write-off of goodwill................................................................... 7,957 1,039
Loss on termination of financing transaction with a related party reinsurer.............................. -- 15,699
Extraordinary loss....................................................................................... -- 2,535
Interest expense on long-term debt....................................................................... 596 3,581
Preferred securities dividends and accretion............................................................. 7,360 3,069
Increase in paid reinsurance recoverable................................................................. (10,502) (3,639)
Decrease (increase) in unpaid reinsurance recoverable--related party..................................... 2,262 (3,714)
(Increase) decrease in unpaid reinsurance recoverable--other............................................. (243,938) (16,436)
Decrease in investments withheld from a related party reinsurer.......................................... -- --
Increase in premiums receivable--related party........................................................... (5,160) (304)
(Increase) decrease in premiums receivable--other........................................................ (11,620) (1,544)
Increase in premiums receivable--allowance for doubtful accounts......................................... -- --
Decrease (increase) in earned but unbilled premiums receivable........................................... 3,900 (3,131)
Decrease (increase) in accrued investment income......................................................... 2,764 (986)
Decrease (increase) in deferred policy acquisition costs................................................. 10,539 (2,837)
(Increase) decrease in deferred taxes.................................................................... (1,758) 1,095
Increase in funds held by reinsured--related party....................................................... (27,579) (3,204)
Increase in funds held by reinsured--other............................................................... (7,000) --
Increase in receivable from a related party reinsurer.................................................... -- --
(Decrease) increase in prepaid reinsurance premiums--related party....................................... 81 (119)
Increase in prepaid reinsurance premiums--other.......................................................... (2,600) (2,287)
Increase in investments withheld from reinsurer.......................................................... (11,946) --
Increase in other assets--related party.................................................................. (8,490) --
(Increase) decrease in other assets--other............................................................... (5,616) 1,637
Increase in claim and claim adjustment expense reserves--related party................................... 113,811 2,918
Increase (decrease) in claim and claim adjustment expense reserves--other................................ 44,564 (27,441)
Increase in unearned premium reserves--related party..................................................... 7,130 168
Decrease in unearned premium reserves--other............................................................. (12,201) (3,816)
(Decrease) increase in reinsurance payable--related party................................................ (1,012) 960
Increase (decrease) in reinsurance payable--other........................................................ 1,041 1,578
Increase (decrease) in policyholder dividends payable.................................................... 755 --
Increase in accounts payable and other liabilities--related party........................................ 24,145 89
(Decrease) increase in accounts payable and other liabilities--other..................................... (9,048) (11,232)
--------- ---------
Total adjustments........................................................................................ (136,199) (47,229)
--------- ---------
Net cash used in operating activities.................................................................. (149,801) (52,370)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Paid-in-capital--stock options taken..................................................................... 276 279
Proceeds from issuance of common stock................................................................... 193,007 18,000
Proceeds from Trust Preferred Securities net of $3.7 million issuance costs.............................. -- 101,272
Long-term debt--Chase Manhattan Bank, net of $4.8 million issuance costs................................. 105,194 41,257
Retirement of long-term debt--Chase Manhattan Bank....................................................... -- (44,000)
Retirement of 1994 Preferred Securities.................................................................. -- (27,668)
Retirement of long-term debt............................................................................. -- (7,250)
Prepayment penalty on long-term debt..................................................................... -- (244)
Retirement of long-term debt--Chase financing............................................................ -- --
Receivable from a related party reinsurer................................................................ (15,879) --
Purchase of treasury stock............................................................................... (5,145) --
Proceeds from Chase Financing............................................................................ -- --
--------- ---------
Net cash provided by financing activities.............................................................. 277,453 81,646
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments available-for-sale.............................................................. (446,873) (226,749)
Purchases of common stock................................................................................ (137,231) (1,496)
Purchase of Pacific Rim Holding Company.................................................................. -- (44,016)
Purchase of Business Insurance Group, Inc................................................................ (287,852) --
Investments and cash for discontinued operations......................................................... (4,753) (4,357)
Investment in partnership................................................................................ (50) --
Sale of property, plant and equipment.................................................................... 8,000 --
Sales of investments available-for-sale.................................................................. 260,216 109,082
Maturities of investments available-for-sale............................................................. 43,030 15,042
Sales of equity securities............................................................................... 137,049 1,197
Sale of BICO............................................................................................. 11,756 --
Net decrease (increase) in short-term investment......................................................... 577,100 116,340
--------- ---------
Net cash provided by (used in) investing activities...................................................... 160,392 (34,957)
--------- ---------
Net increase (decrease) in cash.......................................................................... 288,044 (5,681)
Cash and cash equivalents at beginning of period......................................................... 28,742 34,423
--------- ---------
--------- ---------
Cash and cash equivalents at end of period............................................................... $ 316,786 $ 28,742
--------- ---------
--------- ---------
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes............................................................. $ 259 $ 4
--------- ---------
--------- ---------
Cash paid during the year for interest................................................................. $ 11,228 $ 2,803
--------- ---------
--------- ---------
<CAPTION>
1996
---------
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income.......................................................................................... $ 1,963
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Amortization of bonds and preferred stock................................................................ (1,581)
Amortization of investments withheld from reinsurer...................................................... --
Amortization of long-term debt........................................................................... --
Amortization of capital lease obligation................................................................. --
(Gain) loss on sale of investments....................................................................... (31)
Gain on sale of Centre Re investments.................................................................... (2,036)
Amortization and write-off of goodwill................................................................... --
Loss on termination of financing transaction with a related party reinsurer.............................. --
Extraordinary loss....................................................................................... --
Interest expense on long-term debt....................................................................... --
Preferred securities dividends and accretion............................................................. 2,526
Increase in paid reinsurance recoverable................................................................. (262)
Decrease (increase) in unpaid reinsurance recoverable--related party..................................... 145
(Increase) decrease in unpaid reinsurance recoverable--other............................................. 14,456
Decrease in investments withheld from a related party reinsurer.......................................... 117,980
Increase in premiums receivable--related party........................................................... --
(Increase) decrease in premiums receivable--other........................................................ 2,484
Increase in premiums receivable--allowance for doubtful accounts......................................... (300)
Decrease (increase) in earned but unbilled premiums receivable........................................... (2,101)
Decrease (increase) in accrued investment income......................................................... 792
Decrease (increase) in deferred policy acquisition costs................................................. (262)
(Increase) decrease in deferred taxes.................................................................... 735
Increase in funds held by reinsured--related party....................................................... (976)
Increase in funds held by reinsured--other............................................................... --
Increase in receivable from a related party reinsurer.................................................... (110,527)
(Decrease) increase in prepaid reinsurance premiums--related party....................................... (287)
Increase in prepaid reinsurance premiums--other.......................................................... --
Increase in investments withheld from reinsurer.......................................................... --
Increase in other assets--related party.................................................................. --
(Increase) decrease in other assets--other............................................................... (1,287)
Increase in claim and claim adjustment expense reserves--related party................................... 1,240
Increase (decrease) in claim and claim adjustment expense reserves--other................................ (27,206)
Increase in unearned premium reserves--related party..................................................... 219
Decrease in unearned premium reserves--other............................................................. (864)
(Decrease) increase in reinsurance payable--related party................................................ 508
Increase (decrease) in reinsurance payable--other........................................................ (4)
Increase (decrease) in policyholder dividends payable.................................................... (8,094)
Increase in accounts payable and other liabilities--related party........................................ 20
(Decrease) increase in accounts payable and other liabilities--other..................................... 5,301
---------
Total adjustments........................................................................................ (9,412)
---------
Net cash used in operating activities.................................................................. (7,449)
---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Paid-in-capital--stock options taken..................................................................... 79
Proceeds from issuance of common stock................................................................... --
Proceeds from Trust Preferred Securities net of $3.7 million issuance costs.............................. --
Long-term debt--Chase Manhattan Bank, net of $4.8 million issuance costs................................. --
Retirement of long-term debt--Chase Manhattan Bank....................................................... --
Retirement of 1994 Preferred Securities.................................................................. --
Retirement of long-term debt............................................................................. (1,250)
Prepayment penalty on long-term debt..................................................................... --
Retirement of long-term debt--Chase financing............................................................ (1,410)
Receivable from a related party reinsurer................................................................ --
Purchase of treasury stock............................................................................... --
Proceeds from Chase Financing............................................................................ 93,091
---------
Net cash provided by financing activities.............................................................. 90,510
---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments available-for-sale.............................................................. (43,257)
Purchases of common stock................................................................................ (513)
Purchase of Pacific Rim Holding Company.................................................................. --
Purchase of Business Insurance Group, Inc................................................................ --
Investments and cash for discontinued operations......................................................... 17,261
Investment in partnership................................................................................ --
Sale of property, plant and equipment.................................................................... --
Sales of investments available-for-sale.................................................................. 25,343
Maturities of investments available-for-sale............................................................. 12,771
Sales of equity securities............................................................................... --
Sale of BICO............................................................................................. --
Net decrease (increase) in short-term investment......................................................... (66,431)
---------
Net cash provided by (used in) investing activities...................................................... (54,826)
---------
Net increase (decrease) in cash.......................................................................... 28,235
Cash and cash equivalents at beginning of period......................................................... 6,188
---------
---------
Cash and cash equivalents at end of period............................................................... $ 34,423
---------
---------
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes............................................................. $ 4
---------
---------
Cash paid during the year for interest................................................................. $ 641
---------
---------
</TABLE>
See accompanying notes to consolidated financial statements.
F-6
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Superior
National Insurance Group, Inc. ("SNIG") and all subsidiaries (together with
SNIG, referred to as "we," "us," "our" and the "Company"). Our principal
insurance subsidiaries (collectively referred to as "Superior National") are
comprised of Superior National Insurance Company ("SNIC"), Superior Pacific
Casualty Company ("SPCC"), California Compensation Insurance Company
("CalComp"), Combined Benefits Insurance Company ("CBIC"), and Commercial
Compensation Insurance Company ("CCIC"), are licensed to write workers'
compensation, employee group health insurance, and property and casualty
insurance in a combined 38 states and the District of Columbia.
We operate in one industry segment: workers' compensation insurance. During
the third quarter of 1993, we adopted a plan to discontinue underwriting
commercial property and casualty risks. Earned premiums reported in 1998, 1997,
and 1996 reflect workers' compensation premiums from policies that were
primarily located in California, except the multi-state operations of CalComp,
CBIC, and CCIC (collectively referred to as the "BIG insurance subsidiaries")
from December 10, 1998 through December 31, 1998. BIG insurance subsidiaries
were acquired on December 10, 1998. See Note 2.
Our consolidated financial statements have been prepared on the basis of
generally accepted accounting principles that vary in certain respects from
accounting practices prescribed or permitted by state insurance regulatory
authorities. The results of all significant intercompany transactions have been
eliminated.
Certain reclassifications have been made to prior year financial statements
to conform to the 1998 presentation.
CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
Cash includes currency on hand and demand deposits with financial
institutions. Cash equivalents includes short-term, highly liquid investments
with an original maturity date of less than 90 days. Short-term investments
represents short-term, highly liquid investments, with an original maturity date
of less than a year and greater than 90 days. Short-term investments are carried
at cost, which approximates market.
Restricted cash represents amounts held on deposit with various insurance
regulatory authorities and amounts held under Receivable Purchase and Sale
Agreement. See Note 2.
INVESTMENTS
Investments in fixed maturities consist primarily of bonds and
collateralized mortgage obligations. Debt instruments and equities are
classified as "available-for-sale" and are carried at market with differences
between cost and market being reflected as a separate component of stockholders'
equity, net of applicable income tax effect. The premiums and discounts on fixed
maturities and collateralized mortgage obligations are amortized using the
interest method. Amortization and accretion of premiums and discounts on
collateralized mortgage obligations are adjusted for principal paydowns and
changes in expected maturities. Current market values of investments are
obtained from published sources. Declines
F-7
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
in market value that are considered other than temporary are charged to
operations. For determining realized gains or losses on securities sold, cost is
based on average cost.
Investments in equity securities are carried at fair value. Unrealized gains
or losses on equity securities are reflected, net of applicable tax, in
stockholders' equity.
PREMIUMS RECEIVABLE
Superior National records premiums receivable for both billed and unbilled
amounts. Earned but unbilled premiums receivable, primarily represent Superior
National's estimate of the difference between amounts billed on installment
policies and the amount to be ultimately billed on the policy. Unbilled premiums
receivable also include estimated billings on payroll reporting policies which
were earned but not billed prior to year end. Superior National uses its
historical experience to estimate earned but unbilled amounts which are recorded
as earned but unbilled premiums receivable. These unbilled amounts are
estimates, and while we believe such amounts are reasonable, there can be no
assurance that the ultimate amounts received will equal the recorded unbilled
amounts. The ultimate collectability of the unbilled receivables can be affected
to a greater degree by general changes in the economy and the regulatory
environment than billed receivables due to the increased time required to
determine the billable amount. We attempt to consider these factors when
estimating the receivable for unbilled premiums.
DEFERRED POLICY ACQUISITION COSTS
Acquisition costs, consisting principally of commissions, premium taxes,
certain marketing, loss control, policy issuance, and underwriting costs related
to the production of Superior National's workers' compensation business, are
deferred and amortized ratably over the terms of the policies. If recoverability
of such costs is not anticipated, the amounts not considered recoverable are
charged to income. In determining estimated recoverability, the computation
gives effect to the premium to be earned, related investment income, claim and
claim adjustment expenses, and certain other costs expected to be incurred as
the premium is earned. Deferred policy acquisition costs are net of ceding
commissions received under reinsurance agreements.
Policy acquisition costs incurred and amortized into income are as follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- ---------- ----------
<S> <C> <C> <C>
Balance at beginning of year............................... $ 5,879 $ 3,042 $ 2,780
BIG deferred acquisition costs at acquisition.............. 16,152 -- --
Cost deferred during the year.............................. 4,866 22,814 17,132
Amortization charged to expense............................ (9,761) (19,977) (16,870)
--------- ---------- ----------
Balance at end of year..................................... $ 17,136 $ 5,879 $ 3,042
--------- ---------- ----------
--------- ---------- ----------
</TABLE>
CLAIM AND CLAIM ADJUSTMENT EXPENSES
Claim and claim adjustment expenses are based on case-basis estimates of
reported claims and on estimates, based on experience and industry data, for
unreported claim and claim adjustment expenses.
F-8
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The provision for unpaid claim and claim 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.
There is a high level of uncertainty inherent in the evaluation of the
required claim and claim adjustment expense reserves. Management has selected
ultimate claim and claim adjustment expenses that it believes will reasonably
reflect anticipated ultimate experience. The ultimate costs of such claims are
dependent upon future events, the outcomes of which are affected by many
factors. Claims reserving procedures and settlement philosophy, current and
perceived social and economic factors, inflation, current and future court
rulings and jury attitudes, and many other economic, scientific, legal,
political, and social factors all can have significant effects on the ultimate
costs of claims.
Changes in Company operations and management philosophy also may cause
actual developments to vary from the past. The adoption of new data processing
systems, shifts to underwriting more or less hazardous risk classifications, the
hiring of new claims personnel, changes in claims servicing vendors and third
party administrators, may all change rates of reserve development, payments, and
claims closings, increasing or decreasing claims severity and closing rates.
POLICYHOLDER DIVIDENDS
Estimated amounts for policyholder dividends are accrued when the related
premium is earned. At December 31, 1998, the percentage of participating
policies' was 65.1% of total estimated annual premium on non-California
business.
PREMIUM INCOME RECOGNITION
Insurance premiums are earned ratably over the terms of the policies.
Unearned premiums are computed on a daily pro-rata basis.
INCOME TAXES
We file a consolidated Federal income tax return which includes all
qualifying subsidiaries.
Deferred income taxes are provided for temporary differences between
financial statement and tax return bases using the asset and liability method,
in accordance with Statement of Financial Accounting Standard No. 109,
"Accounting for Income Taxes" ("SFAS 109"). Under the asset and liability
method, deferred taxes are measured using enacted tax rates in effect for the
year in which those temporary differences are expected to be settled. Tax rate
changes are accounted for in the year in which the tax law is enacted.
EARNINGS PER SHARE ("EPS")
Basic earnings per share is calculated using the weighted average shares
outstanding. Fully diluted earnings per share considers the effects of anti
dilutive securities. Note 15 contains the required disclosures which make up the
calculation of basic and diluted earnings per share.
F-9
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
PROPERTY, EQUIPMENT, LEASEHOLD IMPROVEMENTS AND ASSETS UNDER CAPITAL LEASE
Property, equipment, and leasehold improvements are stated at cost, net of
accumulated depreciation and amortization. The accumulated depreciation and
amortization as of December 31, 1998 and 1997 was $5.7 million and $2.2 million
respectively. Depreciation and amortization are provided principally on the
straight-line method over the estimated useful lives of the assets, or, if less,
the term of the lease. Property, equipment, and leasehold improvements are
included as a component of "Prepaid and other assets" on the consolidated
balance sheets.
GOODWILL
Goodwill is amortized ratably over 27.5 years with respect to acquisitions
accounted for under the purchase method. We periodically review goodwill to
determine if events or changes in circumstances indicate that the carrying
amount of goodwill may not be recoverable.
RESERVE GUARANTEE
As part of the acquisition of Business Insurance Group, Inc., a Delaware
corporation ("BIG"), Foundation Health Corporation, a Delaware corporation
("FHC"), obtained at its expense a guarantee on BIG's claim and allocated claim
adjustment expense reserves. The form of the guarantee was two reinsurance
contracts covering $175.0 million in excess of BIG's estimated claim and
allocated claim adjustment expense reserves at December 10, 1998, plus 50.0% of
$75.0 million in excess of the sum of BIG's reserves plus $175.0 million. BIG's
estimated reserves at December 10, 1998, as defined under the contracts, was
$495.0 million plus 75.7% of 1998 net earned premium excluding premium ceded to
the Quota-Share Arrangement, and less claim and allocated claim adjustment
expenses paid by BIG through December 10, 1998. The $175.0 million reinsurance
contract was entered-into with InterOcean Reinsurance Ltd., with a 100.0%
retrocession of liability to American Re-Insurance Company ("Am Re"). The $75.0
million reinsurance contract for which Superior National has a 50.0% share was
entered-into with Scandinavian Re. FHC bore all of the costs of the above-cited
reinsurance contracts.
We have accounted for the two reinsurance contracts described above in
accordance with Topic D-54 of the Emerging Issues Task Force of the Financial
Accounting Standards Board, ACCOUNTING BY THE PURCHASER FOR A SELLER'S GUARANTEE
OF THE ADEQUACY OF LIABILITIES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES OF AN
INSURANCE ENTERPRISE ACQUIRED IN A PURCHASE BUSINESS COMBINATION ("EITF D-54").
Under EITF D-54, claim and allocated claims adjustment expenses, and the related
effects of the guarantee, are separately disclosed in the consolidated
statements of operations, balance sheets, and notes to the consolidated
financial statements, and included in the reconciliation of claims reserves.
At December 31, 1998, we have recorded $175.0 million of direct claim and
claim adjustment expenses, reinsurance recovery on loss reserve guarantee, gross
claim and claim adjustment expense reserves, and reinsurance recoverable on loss
reserve guarantee. This was recorded associated with the reserve guarantee
contracts. See Note 8.
F-10
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
USE OF MANAGEMENT ESTIMATIONS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts of assets, liabilities, and disclosures of
contingent assets and liabilities at the date of the financial statements. We
have provided such estimates for such items as our workers' compensation claim
and claim adjustment expenses, discontinued operations, policyholder dividends,
earned but unbilled premiums, and deferred tax balances in its financial
statements. While these estimates are based upon analyses performed by
management, outside consultants, and actuaries, the amounts we will ultimately
pay may differ materially from the amounts presently estimated.
STOCK-BASED COMPENSATION
We have elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and Related
Interpretations in accounting for its employee stock options.
(2) ACQUISITIONS AND DISPOSITION OF ASSETS
ACQUISITION--BIG
On December 10, 1998, we completed the acquisition of BIG, and its
wholly-owned subsidiaries: CalComp, a California Corporation, Business Insurance
Company, a Delaware corporation ("BICO"), and CBIC, a California Corporation,
pursuant to the terms of a Purchase Agreement entered into on May 5, 1998 (the
"Purchase Agreement") by and between FHC, and us. In accordance with the terms
of the Purchase Agreement, BIG became a wholly owned subsidiary of SNIG and
CalComp, CBIC and BICO became indirect operating subsidiaries of SNIG (the
subsequent sale of BICO is discussed in Disposition of Assets). Additionally,
pursuant to the Purchase Agreement, on December 17, 1998, we acquired CCIC, a
New York corporation, from FHC, upon receipt of all required regulatory
approvals. For the sale of its shares of BIG, including the subsequent sale of
CCIC (collectively, the "acquisition of BIG"), FHC received total consideration
consisting of $285.0 million in cash. ($36.0 million was paid by FHC to provide
the Registrant with a $212.5 million Loss Reserves Guarantee obtained through
the purchase of the reinsurance on behalf of CalComp, CBIC, CCIC, and BICO.)
Prior to the closing, FHC caused all of BIG's intercompany balances and real
estate holdings related to FHC and its parent, Foundation Health Systems, Inc.
("FHS"), and their affiliates, to be settled in cash. FHC contributed an
additional $12.6 million in Capital to BIG prior to the closing.
The acquisition of BIG was funded with (a) senior debt financing in the
amount of $110.0 million and (b) equity financing in the amount of $200.1
million. See Note 16. The senior debt financing was obtained pursuant to the
terms of a Credit Agreement dated as of December 10, 1998, among SNIG, The Chase
Manhattan Bank, as Administrative Agent, and various lending institutions. In
addition, SNIG obtained a working capital credit facility in the amount of $15.0
million under the terms of the Credit Agreement, and had $15.0 million in unused
availability as of December 31, 1998. Prior to incurring the indebtedness, SNIG
obtained the consent of holders of the outstanding 10 3/4% Trust Preferred
Securities of SNIG's subsidiary, Superior National Capital Trust I, a Delaware
statutory trust (the "Trust"), authorizing the Preferred Trustee of the Trust to
waive a provision of the covenant limiting the incurrence of the
F-11
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(2) ACQUISITIONS AND DISPOSITION OF ASSETS (CONTINUED)
indebtedness set forth in the Senior Subordinated Indenture dated as of December
3, 1997 between SNIG, as issuer, and Wilmington Trust Company, as trustee. This
waiver was effected pursuant to the First Supplemental Indenture, dated as of
November 17, 1998, between SNIG and the Wilmington Trust Company, as trustee.
The cost of the waiver is included as part of the debt issuance costs.
Prior to the acquisition of BIG, BIG and the BIG insurance subsidiaries
completed the following transactions:
(1) A sale leaseback agreement with BancBoston Leasing, Inc. pursuant to which
BancBoston Leasing, Inc. acquired certain of the BIG insurance subsidiaries
information systems and related assets for approximately $8.4 million, and
BIG and the BIG insurance subsidiaries agreed to leaseback such assets. This
lease agreement has been accounted for as an operating lease and has a
one-year minimum term and is renewable from year to year thereafter.
(2) A Receivable Purchase and Sale Agreement dated as of December 9, 1998 among
the BIG insurance subsidiaries and Insurance Funding LLC pursuant to which
the BIG insurance subsidiaries sold approximately $67.1 million in certain
premium and reinsurance receivables and received proceeds of approximately
$62.8 million in cash with 5.5% or $3.7 million of the receivables sold held
in reserve pending collection of the receivables. In addition, SNIG entered
into a Support Agreement and Receivables Purchase Agreement, each of which
are dated as of December 9, 1998, pursuant to which SNIG agreed to certain
matters related to the sale of such receivables, including, among other
things, the servicing and administering of those receivables. As of December
31, 1998, the amounts collected and therefore payable under this agreement
is $34.5 million.
(3) On December 9, 1998, the BIG insurance subsidiaries agreed with General Re
Insurance Corporation ("Gen Re") to commute outstanding reinsurance
contracts, effective on that date. Upon the commutation, Gen Re paid $99.7
million to the BIG insurance subsidiaries, and the BIG insurance
subsidiaries re-assumed the claim and claim adjustment expense reserves of
$119.4 million.
The transaction was accounted for using the purchase method and the results
of operations since the acquisition have been included in operations.
The purchase price was allocated to the fair value of assets acquired and
liabilities assumed: investments of $203.0 million, cash and cash equivalents of
$576.2 million, and other assets of $485.6 million. Liabilities assumed in the
acquisition included claim and claim adjustment expense reserves of $716.6
million, and other liabilities of $260.3 million.
F-12
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(2) ACQUISITIONS AND DISPOSITION OF ASSETS (CONTINUED)
The unaudited pro forma consolidated results of operations presented below
assume the acquisition of BIG had taken place at the beginning of each period
presented.
<TABLE>
<CAPTION>
PRO FORMA RESULTS
FOR THE
YEAR ENDED DECEMBER
31,
--------------------
1998 1997
--------- ---------
(IN THOUSANDS,
EXCEPT PER SHARE
DATA)
<S> <C> <C>
Revenues............................................... $ 427,055 $ 736,062
Loss before income taxes, preferred securities
dividends and accretion, and extraordinary items..... $(101,889) $ (78,032)
Net (loss)............................................. $ (67,030) $ (52,164)
Basic earnings per share............................... $ (3.78) $ (3.03)
Diluted earnings per share............................. $ (3.78) $ (3.03)
</TABLE>
These unaudited pro forma results are not necessarily indicative of the
results of operations that would have occurred had the acquisition taken place
at the beginning of each period or of future operations of the combined
companies.
ACQUISITION--PAC RIM
On April 11, 1997, we acquired all of the outstanding stock of Pac Rim
Holding Corporation ("Pac Rim") for aggregate consideration of $42.0 million in
cash. This consideration resulted in payments of $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, we incurred $2.0
million in transaction fees and related expenses. We financed the acquisition of
Pac Rim through a $44.0 million term loan and the sale of $18.0 million of newly
issued shares of common stock. The term loan was subsequently retired from funds
raised from the sale of $105.0 million of 10.75% Trust Preferred Securities. As
a result of the term loan's being retired, we recorded an extraordinary loss,
net of federal income taxes, of $1.5 million in 1997.
The transaction was accounted for using the purchase method and the results
of operations since the date of the acquisition have been included in
operations.
The purchase price was allocated to the fair value of assets acquired and
liabilities assumed: investments of $105.9 million, cash of $2.6 million, and
other assets of $82.4 million. Liabilities assumed in the acquisition included
claim and claim adjustment expense reserves of $107.7 million, and other
liabilities of $39.2 million.
F-13
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(2) ACQUISITIONS AND DISPOSITION OF ASSETS (CONTINUED)
The unaudited pro forma consolidated results of operations presented below
assume the acquisition of Pac Rim had taken place at the beginning of the period
presented.
<TABLE>
<CAPTION>
PRO FORMA RESULTS
FOR THE YEAR
ENDED
DECEMBER 31,
1997
-----------------
(IN THOUSANDS,
EXCEPT PER SHARE
DATA)
<S> <C>
Revenues................................................................... $ 174,550
Loss before income taxes, preferred securities dividends and accretion, and
extraordinary items...................................................... $ (253)
Net (loss)................................................................. $ (23,280)
Basic earnings per share................................................... $ (4.43)
Diluted earnings per share................................................. $ (3.32)
</TABLE>
These unaudited pro forma results are not necessarily indicative of the
results of operations that would have occurred had the acquisition taken place
at the beginning of each period or of future operations of the combined
companies.
DISPOSITION OF ASSETS
On December 18, 1998, SNIG completed the sale of BICO to Centre Solutions
Holdings (Delaware) Limited ("Holdings") a related party, (see Note 16) pursuant
to a Purchase Agreement dated December 7, 1998 (the "BICO Purchase Agreement")
between Holdings and SNIG for a purchase price of approximately $11.7 million.
No gain or loss was recognized in connection with the sale. An additional $0.6
million was withheld by Holdings and, subject to possible downward adjustments
specified in the BICO Purchase Agreement, will be paid to SNIG on September 18,
1999 (or such sooner time as specified in the BICO Purchase Agreement). Prior to
the sale of BICO, under the terms of the Loss Portfolio Transfer and 100% Quota
Share Reinsurance Contract between BICO, CalComp and SNIC, SNIC, as the
reinsurer, assumed BICO's insurance business (excluding BICO's licenses and
statutory capital) and liabilities, and received assets with the fair market
value equal to the liabilities assumed. CalComp assumed all other assets and
liabilities. SNIC, as Guarantor, unconditionally guarantees the performance and
payment of CalComp's obligations under this contract.
F-14
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(3) INVESTMENTS
The amortized cost and market values of fixed maturities classified as
available-for-sale at December 31, 1998 are as follows:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ----------- ----------- ----------
<S> <C> <C> <C> <C>
Available-for-sale:
United States government agencies and
authorities.............................. $ 132,370 $ 1,614 $ (355) $ 133,629
Collateralized mortgage obligations........ 55,817 342 (180) 55,979
Corporate instruments...................... 54,605 373 (12) 54,966
Other assets backed securities............. 172,457 476 (127) 172,806
Municipals................................. 124,308 289 (299) 124,298
---------- ----------- ----- ----------
Total available-for-sale................... $ 539,557 $ 3,094 $ (973) $ 541,678
---------- ----------- ----- ----------
---------- ----------- ----- ----------
</TABLE>
The market values of equity securities as of December 31, 1998 are as
follows:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
----------- ------------- ----------- ---------
<S> <C> <C> <C> <C>
Equity Securities:
Corporate instruments......................... $ 1,634 $ 11 $ (101) $ 1,544
----------- --- ----- ---------
Total Equity Securities....................... $ 1,634 $ 11 $ (101) $ 1,544
----------- --- ----- ---------
----------- --- ----- ---------
</TABLE>
The amortized cost and market values of investments withheld from reinsurer
as of December 31, 1998 are as follows:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ------------- ------------- ----------
<S> <C> <C> <C> <C>
Investments withheld from reinsurer:
Corporate instruments...................... $ 120,190 $ 56 $ (15) $ 120,231
Other assets backed securities............. 3,673 -- (38) 3,635
---------- --- --- ----------
Total investments withheld from
reinsurer................................ $ 123,863 $ 56 $ (53) $ 123,866
---------- --- --- ----------
---------- --- --- ----------
</TABLE>
The amortized cost and estimated market values of investments classified as
available for sale at December 31, 1998 by contractual maturity are shown below.
Expected maturities are likely to differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without
penalty. Mortgage-backed and other asset-backed securities are included based
upon the expected payout
F-15
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(3) INVESTMENTS (CONTINUED)
pattern and duration of the fixed income security. Changes in interest rates,
investor expectations, and political agendas could cause the ultimate payout
pattern to differ.
<TABLE>
<CAPTION>
AVAILABLE FOR SALE
----------------------
<S> <C> <C>
AMORTIZED FAIR
COST VALUE
---------- ----------
Due in one year or less............................................... $ 19,689 $ 19,697
Due after one year through five years................................. 179,242 180,004
Due after five years through ten years................................ 75,788 75,957
Due after ten years................................................... 264,838 266,020
---------- ----------
Total................................................................. $ 539,557 $ 541,678
---------- ----------
---------- ----------
</TABLE>
The amortized cost and market values of fixed maturities classified as
available-for-sale at December 31, 1997 are as follows:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ----------- ----------- ----------
<S> <C> <C> <C> <C>
Available-for-sale:
United States government agencies and
authorities.............................. $ 89,884 $ 420 $ (207) $ 90,097
Collateralized mortgage obligations........ 72,478 1,100 (97) 73,481
Corporate instruments...................... 41,011 657 (32) 41,636
---------- ----------- ----- ----------
Total available-for-sale................... $ 203,373 $ 2,177 $ (336) $ 205,214
---------- ----------- ----- ----------
---------- ----------- ----- ----------
</TABLE>
The market values of equity securities as of December 31, 1997 are as
follows:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
----------- ------------- ------------- ---------
<S> <C> <C> <C> <C>
Equity Securities:
Corporate Instruments......................... $ 1,356 $ 171 $ (1) $ 1,526
--
----------- ----- ---------
Total Equity Securities....................... $ 1,356 $ 171 $ (1) $ 1,526
--
--
----------- ----- ---------
----------- ----- ---------
</TABLE>
F-16
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(3) INVESTMENTS (CONTINUED)
A summary of net investment income for the years ended December 31, are as
follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Interest on fixed maturities.................................. $ 12,534 $ 9,124 $ 6,628
Interest on short-term investments, cash and cash
equivalents................................................. 2,559 4,068 1,609
Realized gains................................................ 1,854 44 31
Other......................................................... 99 190 --
--------- --------- ---------
Total investment income....................................... 17,046 13,426 8,268
Investment expense............................................ (810) (752) (499)
--------- --------- ---------
Net investment income......................................... $ 16,236 $ 12,674 $ 7,769
--------- --------- ---------
--------- --------- ---------
</TABLE>
Included in net investment income are fixed maturities and other securities
with a carrying value of $123.9 million that is classified as investments
withheld from reinsurer. Interest expense of $0.7 million was recorded in 1998
associated with the investments withheld from reinsurer.
Realized gains on investments for the years ended December 31, are as
follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- ----- -----
<S> <C> <C> <C>
Fixed maturities....................................................... $ 1,759 $ 44 $ 31
Equity securities...................................................... 95 -- --
--------- --- ---
Total.................................................................. $ 1,854 $ 44 $ 31
--------- --- ---
--------- --- ---
</TABLE>
The changes in unrealized gains (losses) on debt instruments held as
available-for-sale and equity security investments at December 31, are as
follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Fixed maturities................................................... $ 280 $ 2,060 $ (472)
Equity securities.................................................. (260) 196 (29)
--------- --------- ---------
Total.............................................................. $ 20 $ 2,256 $ (501)
--------- --------- ---------
--------- --------- ---------
</TABLE>
Proceeds from sales of fixed maturities held as available-for-sale for the
years ended December 31, 1998, 1997, and 1996 were $260.2 million, $109.1
million, and $25.3 million, respectively. Gross gains of $2.2 million and gross
losses of $0.4 million were realized on those sales in 1998. Realized gains or
losses were de minimus in 1997 and 1996.
Fixed maturities and other securities with a market value of $714.0 million
at December 31, 1998, $180.4 million at December 31, 1997 and $127.1 million at
December 31, 1996, were on deposit with various insurance regulatory
authorities. The deposit of $714.0 million at December 31, 1998 includes fixed
maturities and other securities with a market value of $123.9 million that is
classified as investments withheld from reinsurer.
F-17
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(4) FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table represents the carrying amounts and estimated fair
values of the Company's financial liabilities at December 31, 1998 and 1997.
Statement of Financial Accounting Standard No. 107, "Disclosure about Fair Value
of Financial Instruments," ("SFAS 107") defines the fair value of a financial
instrument as the amount at which the instrument could be exchanged in a current
transaction between willing parties. Fair values with respect to fixed maturity
and equity securities investments are presented in Note (3) and the fair value
of all other investments approximates their fair value.
The carrying amounts shown in the table below are included in the
Consolidated Balance Sheet under the indicated captions:
<TABLE>
<CAPTION>
1998 1997
---------------------- ----------------------
<S> <C> <C> <C> <C>
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
---------- ---------- ---------- ----------
Financial liabilities:
Long-term debt:
Chase Manhattan Bank Loan.................. $ 105,790 $ 110,596 $ -- $ --
Trust Preferred Securities issued by
affiliate................................ $ 101,084 $ 102,144 $ 101,277 $ 104,990
</TABLE>
F-18
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(4) FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
Fair value for the 1997 Trust Preferred Securities is estimated based on the
quoted market prices for similar issues or by discounting expected cash flows at
the rates currently offered to the Company for debt of the same remaining
maturities. However, there can be no assurances that in the event the assets and
liabilities would be required to be liquidated that the amounts received or due
would be the amounts reflected herein.
Fair value for the Chase Manhattan Bank Loan is based on the outstanding
principal balance on the loan at December 31, 1998 plus accrued interest at the
rate of 8.06%.
(5) CLAIM AND CLAIM ADJUSTMENT EXPENSE RESERVES
The activity in the claim and claim adjustment expense reserve account is
summarized as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C>
Beginning reserve, gross of reinsurance..... $ 201,255 $ 115,529 $ 141,495
Less: Reinsurance recoverable on unpaid
losses.................................... 49,155 24,986 27,076
--------- --------- ---------
Beginning reserve, net of reinsurance....... 152,100 90,543 114,419
Pac Rim reserves at acquisition............. -- 104,588 --
BIG reserves at acquisition................. 495,709 -- --
BIG funds held liability at acquisition..... 113,226 -- --
Provision for net claim and claim adjustment
expenses
For claims occurring in current year........ 36,650 95,826 57,614
For claims occurring in prior years......... 31,692 (5,379) (1,976)
For claims existing on BIG at acquisition... 175,000 -- --
--------- --------- ---------
Total claim and claim adjustment expenses... 243,342 90,447 55,638
--------- --------- ---------
Reinsurance recovery on loss reserve
guarantee................................. (175,000) -- --
Payments for net claim and claim adjustment
expense:
Attributable to insured events incurred in
current year.............................. (76,823) (37,945) (19,816)
Attributable to insured events incurred in
prior years............................... (108,807) (95,533) (59,698)
--------- --------- ---------
Total claim and claim adjustment expense
payments.................................. (185,630) (133,478) (79,514)
Change in funds withheld.................... 12,502 -- --
Adjustment for ZRNA Quota-Share
Commutation............................... 7,367 -- --
--------- --------- ---------
Ending reserves, net of reinsurance......... 663,616 152,100 90,543
Reinsurance recoverable on unpaid losses.... 237,590 49,155 24,986
Loss reserve guarantee...................... 175,000 -- --
--------- --------- ---------
Ending reserves, gross of reinsurance....... $1,076,206 $ 201,255 $ 115,529
--------- --------- ---------
--------- --------- ---------
</TABLE>
F-19
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(5) CLAIM AND CLAIM ADJUSTMENT EXPENSE RESERVES (CONTINUED)
During 1998, Superior National experienced relatively stable frequency of
claims but continued to experience an increase in claim severity for accident
years 1995 and thereafter. Our net claim and claim adjustment expense ratio, net
of reinsurance recovery on loss reserve guarantee, for calendar year 1998, 1997,
and 1996 and 78.5%, 64.2%, and 62.8%, respectively. The 1998 claim and claim
adjustment expense ratio does not include the BIG claim and claim adjustment
expense incurred prior to the acquisition.
In 1998, Superior National experienced approximately $31.7 million in
unfavorable development on net claim and claim adjustment expenses estimated at
December 31, 1997, and $175.0 million with respect to reserves acquired from the
BIG acquisition on December 10, 1998. The $31.7 million unfavorable development,
related to 1997 and prior accident years, is attributable to incurred claim and
claim adjustment expense associated with SPCC. The $175.0 million of unfavorable
development on BIG claims existing at the acquisition date was recorded as a
result of an independent actuarial review by the actuary who has historically
reviewed BIG's reserves.
In 1997, the Company experienced approximately $5.4 million in favorable
development on net claim and claim adjustment expense reserves estimated at
December 31, 1996. This $5.4 million favorable development is the result of a
$10.8 million favorable development on ceded reserves for accident years 1996
and prior. The $10.8 million favorable development on ceded reserves is
attributable to SPCC and due to the post-acquisition review of all open claim
files and the subsequent adjustment to reserves, which caused many claims to
have incurred claim and claim adjustment expenses in excess of the retention on
SPCC's reinsurance treaties. The $10.8 million favorable development is offset
by a $5.4 million adverse development on direct reserves attributable to the
accident years 1995 and 1996.
In 1996, the Company experienced approximately $2.0 million in favorable
development on net claim and claim adjustment expense reserves estimated at
December 31, 1995. This $2.0 million favorable development is the result of $8.4
million in favorable development on direct reserves for accident years 1994 and
prior. The favorable development was offset in part by $4.1 million adverse
development on direct reserves for accident year 1995, and $2.3 million adverse
development on ceded reserves for accident years 1995 and prior. The Company's
1995 accident year net claim and claim adjustment expense ratio for accident
year 1995 at the end of calendar year 1995 was 65.6%, verses 74.6% at the end of
the 1996 calendar year. Offsetting the favorable development in large part was
the re-estimation during 1995 of reinsurance receivables recorded at December
31, 1994, from approximately $66.2 million to approximately $59.9 million at
December 31, 1995.
(6) DISCONTINUED OPERATIONS
During the third quarter of 1993, the Company adopted a plan to discontinue
underwriting commercial property and casualty risks. At December 31, 1998 and
1997, liabilities of discontinued operations relating to unpaid claim and claim
adjustment expenses, off-set by certain assets, are disclosed separately
F-20
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(6) DISCONTINUED OPERATIONS (CONTINUED)
on the balance sheet. Management estimates the discontinued operations will be
"run off" by the year 2005. The assets and liabilities of discontinued
operations are summarized below.
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
<S> <C> <C>
1998 1997
--------- ---------
Assets:
Reinsurance recoverables.............................................. $ 7,039 $ 5,937
--------- ---------
Total Assets...................................................... $ 7,039 $ 5,937
--------- ---------
--------- ---------
Liabilities:
Claim and claim adjustment expense reserves........................... $ 15,056 $ 18,686
Other liabilities..................................................... 134 155
--------- ---------
Total Liabilities................................................... $ 15,190 $ 18,841
--------- ---------
--------- ---------
</TABLE>
(7) INCOME TAXES
Total income tax expense (benefit) for the years ended December 31, 1998,
1997, and 1996 was allocated as follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Continuing operations.......................................... $ (1,499) $ 1,099 $ 1,597
Dividend accrued on preferred securities....................... (3,962) (1,581) (858)
Extraordinary items............................................ -- (1,305) --
--------- --------- ---------
Total........................................................ $ (5,461) $ (1,787) $ 739
--------- --------- ---------
--------- --------- ---------
</TABLE>
Income tax expense (benefit) from continuing operations for the years ended
December 31, 1998, 1997, and 1996 is composed of the following amounts:
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Current......................................................... $ 259 $ 4 $ 4
Deferred........................................................ (1,758) 1,095 1,593
--------- --------- ---------
Total......................................................... $ (1,499) $ 1,099 $ 1,597
--------- --------- ---------
--------- --------- ---------
</TABLE>
F-21
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(7) INCOME TAXES (CONTINUED)
Taxes computed at the statutory rate of 35% for 1998 and 34% for years 1997
and 1996 are reported in the consolidated statements of operations as follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Income taxes at statutory rates................................. $ (2,713) $ 531 $ 1,777
Effect of tax-exempt interest................................... (69) (10) (22)
Effect of meals and entertainment............................... 51 42 38
Effect of goodwill amortization................................. 1,670 353 --
Change in tax rate.............................................. (727) -- --
Research and development........................................ -- 179 (200)
State taxes..................................................... 259 4 4
Other........................................................... 30 -- --
--------- --------- ---------
Total......................................................... $ (1,499) $ 1,099 $ 1,597
--------- --------- ---------
--------- --------- ---------
</TABLE>
F-22
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(7) INCOME TAXES (CONTINUED)
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and liabilities at December 31, 1998 and
1997 are presented below:
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforward........................................ 71,661 43,918
Alternate minimum tax credit carryforward.............................. 1,035 1,035
Loss reserve discounting............................................... 30,434 7,787
Unearned premium liability............................................. 2,157 878
Policyholder dividends................................................. 480 466
Deferred gain on capital lease......................................... 500 546
Research and development credit........................................ 21 21
Other.................................................................. 509 403
--------- ---------
Total gross deferred tax assets........................................ 106,797 55,054
Less: Valuation allowance.............................................. (8,368) (8,129)
--------- ---------
Total................................................................ 98,429 46,925
--------- ---------
Deferred tax liabilities:
Discontinued operations................................................ (3,036) (3,039)
Reinsurance experience refunds......................................... (15,750) (15,300)
Deferred acquisition costs............................................. (1,770) (1,999)
Direct collection allowance............................................ (822) (799)
Unrealized gain on available-for-sale investments...................... (712) (684)
Reinsurance Receivable................................................. (4,941) --
Present value of future profits........................................ (7,629) --
Fixed maturity investment.............................................. (14,720) --
--------- ---------
Total gross deferred tax liabilities................................... (49,380) (21,821)
--------- ---------
Net deferred tax asset............................................... 49,049 25,104
--------- ---------
--------- ---------
</TABLE>
Management believes it is more likely than not that the existing net
deductible temporary differences will reverse during the periods in which the
Company generates net taxable income or avails itself to tax planning
strategies. However, there can be no assurance the Company will generate any
earnings or any specific level of continuing earnings in future years. Certain
tax planning strategies could be implemented to supplement income from
operations to fully realize recorded tax benefits.
At December 31, 1998, the Company had a tax net operating loss carryforward
of $204 million that begins to expire in the year 2006. Based on projections of
taxable income expected to be realized during the carryforward period for the
Company's net operating losses, there is a possibility that up to $24.0 million
of such net operating loss carryforwards may expire prior to their utilization.
Accordingly, a valuation allowance has been established to reflect the
possibility that this portion of the net operating loss carryforwards may
expire.
F-23
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(8) REINSURANCE
Superior National cedes claim and claim adjustment expenses to reinsurers
under various contracts that cover individual risks, classes of business, or
claims that occur during specified periods of time. Reinsurance is ceded on
pro-rata, per-risk, excess-of-loss, and aggregate bases. These reinsurance
arrangements provide greater diversification of risk and limit claims arising
from large risks or from hazards of an unusual nature. Superior National is
contingently liable to the extent that any reinsurer becomes unable to meet its
contractual obligations. Therefore, we evaluate the financial condition of our
reinsurers and monitor concentrations of credit risks arising from reinsurance
activities and economic characteristics to minimize our exposure to significant
losses from reinsurer insolvencies.
Effective June 30, 1991, SNIC entered into an aggregate excess of loss
reinsurance contract ("1991 Contract") with Centre Reinsurance Limited ("Centre
Re"). See Note 16. Under the 1991 Contract, SNIC purchased for $50 million
reinsurance for claim and claim adjustment expenses incurred on or prior to June
30, 1991 to the extent that these amounts were unpaid at June 30, 1991. The
coverage obtained amounted to $87.5 million in excess of SNIC's retention.
Additionally, SNIC ceded approximately $69.1 million of earned premiums to
Centre Re through December 31, 1992. Claim and claim adjustment expenses
occurring prior to December 31, 1992 were ceded to Centre Re in the amount of
$165.6 million under the 1991 Contract. Prospective cessions of premium and
claims were terminated by mutual consent of SNIC and Centre Re effective
December 31, 1992; however, all other terms of the 1991 Contract remained in
effect until the treaty was commuted in June 1997. This transaction resulted in
the recognition of a $5.3 million loss to the Company.
Effective January 1, 1993, SNIC entered into an aggregate excess of loss
reinsurance contract ("1993 Contract") with Centre Re. From SNIC's perspective,
the 1993 Contract substantively operated as a one-year contract with at least
four one-year options to renew that were exercisable solely at the Company's
election during the first five years of the contract. The 1993 Contract required
the Company to cede not less than $15 million and not more than $20 million of
premium to Centre Re with respect to any covered accident year. Claim and
allocated claim adjustment expenses occurring during the accident year are ceded
to Centre Re in excess of a variable percentage of earned premium (60%, 56.5%,
and 57.5% for the 1995, 1994, and 1993 accident years, respectively) and are
subject to a limit of 130% of ceded earned premium, such limit not to exceed $26
million for any accident year. Subsequent to January 1, 1998, however, the 1993
Contract could have been canceled by either SNIC or Centre Re upon 30 days
notice. Any accident year covered by the 1993 Contract may be commuted at SNIC's
option alone on any January 1 subsequent to December 31, 1997.
SNIC ceded $15 million to Centre Re during each of the years 1993-1995
resulting in an aggregate cession of $45 million of premium to Centre Re under
the 1993 Contract. Because SNIC's loss and allocated expense ratios for accident
years 1993-1995 were not expected to exceed the percentages set forth above, no
losses were ceded to Centre Re under the 1993 Contract to date. Under the terms
of the contract, however, SNIC will receive a refund at least equal to the $45
million of premium ceded to Centre Re at any future commutation date for the
1993 Contract. Because the ceded premium was required by statutory reinsurance
rules to be held in a "funds withheld" arrangement, the Company did not actually
transfer to Centre Re the premiums due under the 1993 Contract. Hence, the 1993
Contract contemplates that the refund due would be offset against the premiums
held in the funds withheld account.
F-24
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(8) REINSURANCE (CONTINUED)
The 1993 Contract was canceled prospectively effective January 1, 1996, as a
result of which SNIC has not ceded premium or loss under the 1993 Contract to
Centre Re subsequent to accident year 1995. The cancellation of the 1993
Contract did not affect the measurement or recognition of income or loss
previously recorded in the Company's financial statements at any time the 1993
Contract was in force. The reinsurance premiums ceded and experience account
balance due from Centre Re with respect to accident years 1993-1995 were not
affected by the cancellation of the contract. SNIC retains the right, however,
to exercise its option to commute the 1993-1995 accident years at a future date
in accordance with the terms of the contract.
Effective January 1, 1996, the 1993 Contract was canceled prospectively at
the Company's election, however, because the 1993 Contract was not commuted from
its January 1, 1993 inception date the Company was still subject to the
contract's provisions applying to the 1993-1995 accident years. No losses were
ceded under the 1993 Contract, and the Company's only recoveries were through
the contract's experience account, which would be payable no earlier than
January 1, 1998. The experience account accreted at varying rates depending on
the commutation date selected by the Company.
Because Centre Re is an offshore reinsurer, statutory reinsurance security
rules required Centre Re to secure the experience account balance via a "funds
withheld" arrangement. The Company did not actually transfer to Centre Re
premiums due under the 1993 Contract, but withheld the premiums for security
purposes. In conjunction with the funds withheld arrangement, the Company agreed
to pay Centre Re interest at the Company's average portfolio rate of interest.
The interest on the funds withheld balance significantly exceeded the
accretion to the experience account. Thus, the Company made a business decision
to terminate the funds withheld arrangement via a negotiated settlement with
Centre Re. In 1996, after lengthy negotiations with Centre Re, the Company
agreed to freeze the experience account at $45 million and expensed $5.3 million
in consideration of termination of the funds withheld arrangement. The $5.3
million was paid to Centre Re in 1997.
At present, the Company owes Centre Re $45 million of funds withheld
premiums, and Centre Re owes the Company $45 million of experience refunds,
neither of which have been accruing interest or accreting since June 30, 1996.
Because the Company and Centre Re enjoy the legal right of contractual offset
under the 1993 Contract, the two amounts offset to zero in the balance sheet.
The 1993 Contract has no further economic effect on either the Company or Centre
Re, and the Company will neither receive from nor pay to Centre Re any cash at
the future commutation date of the 1993 Contract. See Note 16.
Effective January 1, 1994, SNIC entered into the ZRNA Quota-Share with ZRNA.
Under the ZRNA Quota-Share, ZRNA may provide SNIC and SPCC with an Assumption of
Liability Endorsement facility ("ALE"), or, effective January 1, 1997, SNIC and
SPCC may write directly on policy forms of ZC Insurance Company ("ZCIC"), an
affiliate of Zurich (the "ZCIC Underwriting Agreement"). The ceding rate under
the Quota-Share Contract was 20% for 1994, and ZRNA and Superior National
mutually agreed to reduce the quota-share participation to 5% for 1995 and 1996.
Further, Superior National receives ceding commissions ranging between 22.5% and
24.5% for premiums ceded to ZRNA. The purpose of the ceding commission is to
cover Superior National's cost of acquiring new business and may be changed as a
result of changes in market conditions on a quarterly basis.
F-25
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(8) REINSURANCE (CONTINUED)
Effective January 1, 1997, the terms of the Quota-Share Contract were
amended. Under the amended terms of the Quota-Share Contract, ZRNA increased its
participation from 5% of premiums written in 1996 to 6.5% in 1997. In exchange
for the increased participation, ZRNA will no longer receive a separate fee for
policies written on ALEs, but will receive 2% of premiums written on ZCIC Front
policies only.
Effective January 1, 1998, the terms of the ZRNA Quota-Share again were
amended to increase the ceding commission to 27.5% for non-ZCIC policies and on
ALE premium. The ceding commission on ZCIC policies remained at 20%. Further,
the additional 2% of premium paid to ZCIC for its underwriting was eliminated.
Effective June 30, 1998, SNIC entered into an agreement with ZRNA to settle
and commute 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.
Effective June 30, 1997, SNIC entered into a contract with ZRNA. ZRNA
assumed $10.0 million of reserves associated with claims open for future medical
payments from SNIC in consideration of $1.0 million in cash and assignment of
SNIC's rights of contribution and subrogation recoveries during the term of the
contract. In 1997, the contract is accounted for as a deposit and no gain would
be recognized until net cash payments from ZRNA are greater than SNIC's $1.0
million premium. Effective December 31, 1998, the contract was commuted and ZRNA
paid SNIC $250,000 to commute and settle all obligations and liabilities
associated with this contract, which resulted in a $750,000 loss to the Company.
Effective July 1, 1998, SNIC and SPCC entered into an Aggregate Excess of
Loss Agreement with ZRNA. SNIC and SPCC will cede to ZRNA $11.0 million of claim
and allocated claim adjustment expenses for each fiscal year ended June 30, 1999
through June 30, 2001 to the extent SNIC and SPCC claim and allocated claim
adjustment expenses exceed 105% of earned premium during the fiscal period. SNIC
and SPCC paid ZRNA cash and securities with a fair market value of $15.6 million
during 1998, and will pay ZRNA eight installments of $1.4 million at the
beginning of each quarter beginning January 1, 1999. This agreement is accounted
for as a deposit due to the absence of certain risk transfer factors under the
terms of the agreement. SNIC and SPCC receive an interest credit from ZRNA on
the premium paid, and will receive the balance of a notional experience account
from ZRNA when the contract is commuted. The balance of the deposit at December
31, 1998 is $16.1 million.
Effective December 10, 1998, CalComp entered into a 100% Quota Share
Reinsurance agreement with Centre Insurance Company ("CIC") (formerly Business
Insurance Company) under which CIC will provide our insurance subsidiaries with
a "fronting" facility. A fronting facility is a reinsurance agreement through
which CalComp assumes from CIC, for a fee of 2.5% of written premium, all of the
premium and claims and underwriting expenses associated with insurance policies
written on CIC policies. Superior National will underwrite and price the fronted
policies, bear the expense of settling all of the claims incurred on the
policies, and be responsible for all of the underwriting expenses associated
with the policies. Superior National receives several benefits from the fronting
arrangement with CIC. Policyholders evaluate the creditworthiness of their
insurance policy based on the rating of the company issuing the policy. In this
case, CIC will ultimately have a rating similar to that of the Zurich Insurance
Organization,
F-26
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(8) REINSURANCE (CONTINUED)
which will be a higher rating than Superior National's B++ rating from A.M.
Best. In addition, Superior National will be able to use CIC's extensive rate
and form filings throughout the United States. It would be extremely time
consuming and expensive for Superior National to refile all of CIC's rates and
forms. The total amount of premium that Superior National can underwrite through
CIC is currently limited to $50.0 million of annual gross written premium.
Effective February 1, 1998, SNIC and SPCC entered into a Quota-Share
Agreement with All American Life Insurance Company, rated "A+" by A.M. Best.
Under the All American agreement, SNIC and SPCC ceded 100% of premiums and claim
and claim adjustment expenses associated with policies that incepted during the
agreement and have $100,000 or more of estimated annual premium. SNIC and SPCC
initially received a 35.0% ceding commission on premiums ceded under this
contract from February 1 to April 30, 1998, and 34.5% from May 1, 1998 to
January 31, 1999. This agreement expired January 31, 1999.
Effective May 1, 1998, a new Quota-Share Agreement was entered-into with
United States Life Insurance Company ("US Life"), a company rated "A+" by A.M.
Best. Under this agreement SNIC and SPCC ceded 100% of premiums and claim and
claim adjustment expenses associated with policies incepting through January 31,
1999 having at least an estimated annual premium of $25,000 but less than
$100,000. After January 31, 1999, SNIC and SPCC will cede 93% and 87% for
policies incepting during 1999 and 2000, respectively, of premiums and claim and
claim adjustment expenses associated with policies having at least an estimated
annual premium of $25,000. Under the same arrangement, CalComp, BICO, CCIC, and
CBIC ceded 100% of premiums and claim and claim adjustment expenses associated
with policies incepting through December 31, 1998 having at least an estimated
annual premium of $25,000. After December 31, 1998, CalComp, CCIC, and CBIC will
cede 93% and 87% for policies incepting during 1999 and 2000, respectively, of
premiums and claim and claim adjustment expenses associated with policies
incepting through December 31, 2000 having at least an estimated annual premium
of $25,000. For policies incepting during 2001, the ceding percentage for all of
Superior National's insurance companies may vary from 0.0% to 80.0%. For each
percentage point below a 66.5% cumulative ceded claim and allocated claim
adjustment expense ratio for the first three contract years, the maximum 80.0%
cession will be reduced by five percentage points, but to a number not less than
40.0% unless US Life elects to select a lower number. For policies incepting
during 2002, the ceding percentage for all of Superior National's insurance
companies may vary from 0.0% to 73.0%. For each percentage point below a 66.5%
cumulative ceded claim and allocated claim adjustment expense ratio for the
first four contract years, the maximum 73.0% cession will be reduced by five
percentage points, but to a number not less than 30.0% unless US Life elects to
select a lower number. US Life may elect to irrevocably terminate the agreement
at either January 1, 2001 or 2002.
If US Life does not elect to irrevocably terminate the agreement at either
January 1, 2001 or 2002, it may, at its sole option, prior to December 1, 2002,
elect to extend the agreement to policies incepting during both of the years
2003 and 2004. If the cumulative claim and allocated claim adjustment expense
ratio is greater than or equal to 66.5%, US Life may select a ceding percentage
of 0.0% to 50.0% for both years. If the cumulative claim and allocated claim
adjustment expense ratio is less than 66.5%, US Life may select a ceding
percentage of 0.0% to 25.0% for both years.
F-27
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(8) REINSURANCE (CONTINUED)
All of the Superior National companies receive a 33.5% ceding commission on
premiums ceded under the US Life contract for policies incepting during 1998 and
1999. For policies covered by the US Life agreement incepting during 2000 to
2004, the ceding commission will be 33.5% less the difference in percentage
points between 66.5% and the actual cumulative claim and allocated claim
adjustment expense ratio, subject to a minimum ceding commission of 31.0%. If
the cumulative claim and allocated claim adjustment expense ratio is 66.5% or
less, the ceding commission for the will be 33.5% plus the difference in
percentage points between 66.5% and the actual cumulative claim and allocated
claim adjustment expense ratio, subject to a maximum ceding commission of 36.0%.
In addition to the ceding commissions described above, US Life will pay Superior
National a contingent commission. The contingent commission is equal to 25.0% of
any net positive balance taking the earned premiums ceded to US Life minus
ceding commissions paid to Superior National, an expense provision of 17.5% of
earned premiums ceded, and claim and ceded allocated claim adjustment expense.
Superior National purchases specific excess of loss reinsurance to cover
single catastrophic claims from $500,000 to $500 million. We purchase
reinsurance up to such high levels principally to reduce our liability to
workplace injuries that might occur if an earthquake strikes a heavily populated
area in California during working hours. Effective May 1, 1998, Superior
National and BIG entered into a specific excess of loss reinsurance contract
with US Life under which US Life reinsured $4,500,000 in excess of $500,000 of
any specific claim incurred. US Life was subsequently replaced by Trustmark Life
Insurance Company as the reinsurer on this contract from the inception of the
contract. A variety of property and casualty and life companies reinsure our
specific excess of loss claims on a per-person and per-occurrence basis in
excess of $5.0 million up to $500.0 million per occurrence.
RESERVE GUARANTEE. As part of the acquisition of BIG, FHC obtained at its
expense a guarantee on BIG's claim and allocation claim adjustment expense
reserves. The form of the guarantee was two reinsurance contracts covering
$175.0 million in excess of BIG's estimated claim and allocated claim adjustment
expense reserves at December 10, 1998, plus 50.0% of $75.0 million in excess of
the sum of BIG's reserves plus $175.0 million. BIG's estimated reserves at
December 10, 1998, as defined under the contracts, was $495.0 million plus 75.7%
of 1998 net earned premium excluding premium ceded to the Quota-Share
Arrangement, and less claim and allocated claim adjustment expenses paid by BIG
through December 10, 1998. The $175.0 million reinsurance contract was
entered-into with InterOcean Reinsurance Ltd., with a 100.0% retrocession of
liability to American Re-Insurance Company ("Am Re"). The $75.0 million
reinsurance contract for which Superior National has a 50.0% share was
entered-into with Hanover, 26.7%, Scandinavian Re, 20.0%, and Odyssey Re, 3.33%.
FHC bore all of the costs of the above-cited reinsurance contracts. At December
31, 1998, we have recorded direct and ceded claim and claim adjustment expenses,
gross claim and claim adjustment expense reserves, and a reinsurance
recoverable, of $175.0 million, all associated with the reserve guarantee
contracts.
Prior to the acquisition, BIG bought specific excess of loss reinsurance on
workers' compensation policies, providing coverage in excess of $1,000,000 per
occurrence for accident years 1996 through 1998, in excess of $500,000 per
occurrence for accident years 1994 and 1995, in excess of $350,000 per
occurrence for accident years 1992 and 1993, and in excess of $250,000 per
occurrence for accident years 1989 through 1991. The agreements provide coverage
up to a maximum of $200 million per occurrence, including BIG's
F-28
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(8) REINSURANCE (CONTINUED)
retention. BIG's specific excess of loss contracts were terminated effective
December 31, 1998 and replaced with the specific excess of loss contract with
Trustmark described above.
As of December 31, 1998, American Reinsurance Company, United States Life
Insurance, and General Reinsurance Corporation account for 34.9%, 30.7%, and
12.1%, respectively, of total amounts recoverable from all reinsurers on paid
and unpaid claim and claim adjustment expenses.
Amounts included in the income and expense accounts in continuing operations
in connection with all ceded reinsurance at December 31, are as follows:
<TABLE>
<CAPTION>
1998 1997 1996
---------- ---------- ---------
<S> <C> <C> <C>
Net Premiums written:
Premiums written......................................... $ 192,070 $ 159,352 $ 99,282
Premiums ceded........................................... (112,375) (22,423) (11,567)
---------- ---------- ---------
Net premiums written................................... $ 79,695 $ 136,929 $ 87,715
---------- ---------- ---------
---------- ---------- ---------
Net change in unearned premiums:
Direct................................................... $ 5,070 $ 3,649 $ 645
Ceded.................................................... 2,324 342 288
---------- ---------- ---------
Net change in unearned premiums........................ $ 7,394 $ 3,991 $ 933
---------- ---------- ---------
---------- ---------- ---------
Net claim and claim adjustment expenses:
Claim and claim adjustment expenses...................... $ 375,038 $ 122,830 $ 61,702
Reinsurance recoveries................................... (131,696) (32,383) (6,064)
---------- ---------- ---------
Net claim and claim adjustment expenses................ $ 243,342 $ 90,447 $ 55,638
---------- ---------- ---------
---------- ---------- ---------
Net commission expense (income):
Direct................................................... $ 25,445 $ 18,706 12,456
Ceded.................................................... (34,787) (4,868) (2,030)
---------- ---------- ---------
Net commission expense (income)........................ $ (9,342) $ 13,838 $ 10,426
---------- ---------- ---------
---------- ---------- ---------
</TABLE>
(9) LONG-TERM DEBT
The following is a summary of the Company's long-term debt balances at
December 31:
<TABLE>
<CAPTION>
1998 1997
---------- -----
<S> <C> <C>
Chase Manhattan Bank Loan.................................................. $ 105,790 $ --
Voting Notes due 2002...................................................... 30 30
---------- ---
Balance at end of period................................................... $ 105,820 $ 30
---------- ---
---------- ---
</TABLE>
Voting notes ("Voting Notes") in the amount of $30 thousand related to
SNIG's 14.5% Senior Subordinated Series A and Series B Notes ("14.5% Senior
Subordinated Notes") were still outstanding as of December 31, 1998. The 14.5%
Senior Subordinated Notes were retired in 1994. The Voting Notes of
F-29
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(9) LONG-TERM DEBT (CONTINUED)
$30 thousand will mature in the year 2002. Warrants related to the 14.5% Senior
Subordinated Notes remain outstanding and provide their holders the right to
purchase 1,566,465 shares of SNIG common stock at a strike price of $4 per
share. These warrants, which are currently exercisable and expire on April 1,
2002, are held by senior management and a nominee for III.
Effective December 10, 1998, to obtain part of the funding required for the
acquisition of BIG we entered into a Credit Agreement with The Chase Manhattan
Bank, as Administrative Agent, and various lending institutions for $110.0
million in senior debt less $4.8 million in transaction costs. In addition, we
obtained a working capital credit facility of $15.0 million under the terms of
the Credit Agreement, and had $15.0 million in unused availability as of
December 31, 1998.
This senior debt is to be fully amortized over six years with semi-annual
principal paydowns of $10 million beginning June 30, 2000 and continuing on
through December 31, 2002. After December 31, 2002, the principal paydown will
increase to $12.5 million and continue until maturity at December 10, 2004. The
senior debt interest rate is equivalent to the Eurodollar rate plus 3%. We have
the option to select various interest periods varying from one, two, three or
six month periods. As of December 31, 1998, the interest rate for the current
period is 8.06% which will be reset in June 1999.
We must adhere to certain requirements and provisions to be in compliance
with the terms of the Credit Agreement. The provisions require us to maintain
certain financial ratios, as well as other customary covenants. As of December
31, 1998, we are in compliance with all loan covenants.
Effective June 30, 1994, we entered into a $10 million term loan agreement
("1994 Loan") with Imperial Bank, which was used to retire subordinated notes
issued during 1992. This term loan was to be fully amortized over seven years
with quarterly payments of $300 plus interest per quarter for years one and two,
$350 plus interest per quarter for years three and four, and $400 plus interest
per quarter for years five, six and seven. Effective July 1, 1995, the borrowing
rate was changed from Imperial Bank's prime rate plus one- half percent to a
fixed rate of 8% per annum. Additionally, under the amended terms of the 1994
Loan, the Company could not prepay it until July 1, 1996.
The Company adhered to certain requirements and provisions in compliance
with the terms of the 1994 Loan. The provisions required SNIC to maintain
certain financial ratios and SNIG to maintain Imperial Bank certificates of
deposit in an amount equal to 20% of the Company's outstanding balance under the
1994 Loan. At December 31, 1996, the Imperial Bank certificates of deposit were
$1.5 million, all of which was restricted. On April 11, 1997, the Company
retired its outstanding 1994 Loan with Imperial Bank. As a result of the early
extinguishment, the Company recognized an extraordinary loss of $0.2 million,
net of a tax benefit of $0.1 million.
During 1996, we entered into a financing transaction involving Centre Re and
Chase. Chase extended a $93.1 million term loan (net of transaction costs). We
used the proceeds from the financing to purchase from SNIC reinsurance
receivables due from Centre Re. The principal balance of the loan was
collateralized by receivables due from the reinsurer and amortized based upon
the payout pattern of the underlying claims of the reinsurance receivables. In
June 1997, the $93.1 million term loan was retired, $110.5 million of
receivables from a related party reinsurer, in connection with a financing
transaction, was transferred to Chase in exchange for the cancellation of the
Company's $94.9 million debt due to Chase under the loan.
F-30
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(9) LONG-TERM DEBT (CONTINUED)
The retirement of this collateralized financing resulted in the Company's
recognizing a $15.7 million charge.
We have an agreement with a national brokerage house to allow it to enter
into $20 million of reverse repurchase transactions that must be secured by
either U.S. treasuries, government agency bonds, or corporate debt. There were
no outstanding transactions at December 31, 1998.
(10) PREFERRED SECURITIES ISSUED BY AFFILIATES
On June 30, 1994, SNIG completed the sale of $20 million of preferred
securities and warrants to affiliates of Centre Re in a transaction approved by
the shareholders and the California Department of Insurance ("DOI"). The
preferred securities were subordinate to the 1994 Loan. A special purpose
investment partnership, Superior National Capital, L.P. (the "Limited
Partnership"), was formed in Bermuda to issue $20 million face amount of 9.7%
redeemable preferred securities ("1994 Preferred Securities") to Centre
Reinsurance Services (Bermuda) III, Limited in exchange for $18 million.
CentreLine Reinsurance Limited paid the Company $2 million for warrants to
purchase 579,356 shares of SNIG's common shares at $5.20 per share. The warrants
may be exercised at any time and expire in 2002.
In December 1997, SNIG formed a trust, whose sole purpose was to issue
10 3/4% Trust Preferred Securities (the "Trust Preferred Securities"), having an
aggregate liquidation amount of $105 million, and to invest the proceeds thereof
in an equivalent amount of 10 3/4% Senior Subordinated Notes due 2017 of the
Company (the "Senior Subordinated Notes"). The Company owns directly all of the
common securities issued by the Trust, which it purchased for an aggregate
consideration of $3.25 million. The proceeds from the sale of the Trust
Preferred Securities were used solely to purchase SNIG's Senior Subordinated
Notes. In addition, the Company entered into several contractual undertakings,
that 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. Holders of the Trust Preferred Securities are
entitled to receive cumulative cash distributions at an annual rate of 10 3/4%
of the stated liquidation amount of $1,000 per Trust Preferred Security,
accruing from the date of original issuance of the Trust Preferred Securities
and payable semi-annually, in arrears, commencing on June 1, 1998. The Company
has the right to defer payments at any time or from time to time for a period
not exceeding 10 consecutive semi-annual periods, provided that no extension
period may extend beyond the stated maturity date. In the event there is a
change in control, holders of the Trust Preferred Securities may redeem their
securities at 101% of the principal.
The Company used the net proceeds from the sale of the 10 3/4% Senior
Subordinated Notes in the amount of approximately $101.2 million, (i) to repay
outstanding debt, consisting of $40.8 million of bank debt and interest incurred
in connection with the acquisition of Pac Rim that would have matured in April
2003, bearing an average effective interest rate of 10.2%, (ii) to redeem from
an affiliate of Zurich $27.7 million of principal and interest, with an
effective rate of 11.7%, of the 1994 Preferred Securities, and (iii) to make a
$15 million capital contribution to SNIC. The remaining proceeds are invested in
short-term, income-generating, investment-grade securities.
F-31
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(10) PREFERRED SECURITIES ISSUED BY AFFILIATES (CONTINUED)
The difference between the face value and the carrying value of the Trust
Preferred Securities is amortized over their nineteen-year maturity using the
scientific method. The amortization, net of tax benefits and accrued dividends,
is charged to current year income after continuing operations, net of taxes.
The following is a summary of the preferred securities balance as of
December 31:
<TABLE>
<CAPTION>
1998 1997
---------- ----------
<S> <C> <C>
Beginning balance..................................................... $ 101,277 $ 23,571
Dividends and accretion............................................... (193) 3,709
Retirement of 1994 Preferred Securities............................... -- (27,275)
Issuance of Trust Preferred Securities................................ -- 101,272
---------- ----------
Balance at end of period.............................................. $ 101,084 $ 101,277
---------- ----------
---------- ----------
</TABLE>
(11) STATUTORY SURPLUS AND DIVIDEND RESTRICTIONS
SNIC, SPCC, CalComp and CBIC are domiciled in the State of California and
CCIC is domiciled in the State of New York. Each entity prepares their statutory
financial statements in accordance with accounting practices prescribed or
permitted by state insurance regulators. Prescribed statutory accounting
practices include a variety of publications of the National Association of
Insurance Commissioners ("NAIC"), as well as state laws, regulations, and
general administrative rules. Permitted statutory accounting practices encompass
all accounting practices not so prescribed.
Statutory accounting practices for the insurance subsidiaries are prescribed
or permitted by the Department of Insurance of the State of California
("California DOI"). Prescribed accounting practices include a variety of
publications of the National Association of Insurance Commissioners ("NAIC") as
well as state laws, regulations and general administrative rules. Permitted
statutory accounting practices encompass all accounting practices that are not
prescribed; such practices differ from state to state, may differ from company
to company within a state and may change in the future. Furthermore, the NAIC's
project to codify statutory accounting practices was approved by the NAIC in
March 1998. The approval included a provision for commissioner discretion in
determining appropriate statutory accounting for insurers in their state.
Consequently, prescribed and permitted accounting practices may continue to
differ from state to state. The California DOI has indicated that codification
will become effective on January 1, 2001. The Company has not determined how
implementation will affect its insurance subsidiaries' statutory financial
statements.
Superior National's statutory policyholders' surplus as reported to
regulatory authorities was $340.2 million ($230.7 million related to the BIG
insurance subsidiaries) and $102.2 million at December 31, 1998, and 1997,
respectively. Superior National's statutory net income (loss), as reported to
regulatory authorities, was $11.5 million, $(3.2) million and $0.8 million for
the years ended December 31, 1998, 1997, and 1996 respectively.
F-32
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(11) STATUTORY SURPLUS AND DIVIDEND RESTRICTIONS (CONTINUED)
Insurance companies are subject to insurance laws and regulations
established by the states in which they transact business. The laws of various
states establish supervisory agencies with broad administrative and supervisory
powers. Most states have also enacted legislation regulating insurance holding
company systems, including acquisitions, extraordinary dividends, the terms of
affiliate transactions, and other related matters. The Company has registered as
holding company systems pursuant to such legislation in California. The NAIC has
formed committees and appointed advisory groups to study and formulate
regulatory proposals on such diverse issues as the use of surplus debentures and
accounting for reinsurance transactions. It is not possible to predict the
future impact of changing state and federal regulation on the operations of the
Company.
The Risk Based Capital Model ("RBC") for property and casualty insurance
companies was adopted by the NAIC in December 1993, and starting in 1995,
companies were required to report their RBC ratios to the NAIC. SNIC, SPCC,
CalComp, CBIC and CCIC have calculated and met their RBC requirements.
Insurance companies are also subject to restrictions affecting the amount of
stockholder dividends and advances that may be paid within any one year without
the prior approval of the DOI. The California Insurance Code provides that the
maximum amount that may be paid as dividends on an annual noncumulative basis
without prior notice to, or approval by, the DOI is the greater of (1) net
income for the preceding year or (2) 10% of statutory surplus as regards
policyholders as of the preceding December 31. At December 31, 1998, SNIC, SPCC,
CalComp and CBIC could pay approximately $8.5 million, $3.7 million, $21.0
million, and $4.2 million respectively, in dividends and advances to the Company
without the DOI's prior approval. The maximum amount of dividends which can be
paid by State of New York insurance companies to stockholders without the prior
approval is subject to restrictions relating to statutory earned surplus. CCIC's
statutory surplus at December 31, 1998, was $9.1 million. At December 31, 1998,
CCIC had negative earned surplus and, as such, cannot declare and pay any
stockholders' dividends in 1999 without the prior approval of the New York
Commissioner of Insurance.
(12) EMPLOYEE BENEFIT PLANS
SNIG has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
Interpretations in accounting for its employee stock options. As discussed below
in management's opinion, the alternative fair value accounting provided for
under SFAS 123, requires use of option valuation models that were not developed
for use in valuing employee stock options. Under APB 25, because the exercise
price of the Company's employee stock options equals the market price of the
underlying stock on the date of the grant, no compensation expense is
recognized.
SNIG has two equity option plans, the 1986 Stock Option Plan ("1986 Plan")
and the 1995 Stock Incentive Plan ("1995 Plan"). The terms of the 1986 Plan
permit SNIG, at the Board of Directors' discretion, to grant options to its
management to purchase up to 225,000 shares of common stock. Options granted
under the 1986 Plan are not intended to qualify as incentive stock options
within the meaning of Section 422 of the Internal Revenue Code ("Code"). The
1995 Plan permits the granting of both options that qualify for treatment as
incentive stock options under Section 422 of the Code and options that do not
qualify as incentive stock options. Under the 1995 Plan, officers and key
employees of the Company may be granted options to purchase shares of SNIG
common stock or may be given the opportunity to receive
F-33
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(12) EMPLOYEE BENEFIT PLANS (CONTINUED)
restricted stock of SNIG. Under the 1995 Plan, the aggregate number of shares of
common stock that may be granted, either through the exercise of options or the
issuance of restricted stock, is 3,000,000 shares. Under both plans, the
exercise price of each option equals the market price of SNIG's stock on the
date of grant and options have a maximum term of ten years. The Board of
Directors may grant options at any point during a year and the options generally
vest over five years.
Pro forma information regarding net income and earnings per share is
required by SFAS 123, and has been determined as if the Company had accounted
for its employee stock options under the fair value method of that Statement.
The fair value for these options was estimated at the date of grant using a
Black-Scholes option pricing model with the following weighted-average
assumptions. The risk free interest rate used in the calculation is the 10-year
Treasury Note rate on the date the options were granted. The risk free interest
rate range used for options granted during 1998, 1997, and 1996 was 4.6% to
5.7%, 5.8% to 6.9%, and 5.6% to 6.8%, respectively. The volatility factors for
the expected market price of the common stock of 69%, 65%, and 70% were used for
options granted in 1998, 1997, and 1996 respectively. A weighted average
expected life of ten years was used as the Company has little history of
options' being exercised prior to their expiration.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options that do not have vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's stock options have characteristics significantly different
from those of traded options, and because changes in the subjective input
assumptions can materially affect the value of an estimate, in management's
opinion the existing models do not necessarily provide a reliable single measure
of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized into expense over the options' vesting period. The
Company's pro forma information follows (in thousands except for earnings per
share information):
<TABLE>
<CAPTION>
1998 1997
---------- ---------
<S> <C> <C>
Pro forma net (loss).................................................... $ (14,091) $ (5,366)
Pro forma earnings per share
Basic................................................................. $ (2.08) $ (1.02)
Diluted............................................................... $ (2.08) $ (0.77)
</TABLE>
F-34
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(12) EMPLOYEE BENEFIT PLANS (CONTINUED)
A summary of the Company's stock option activity, and related information
for the years ended December 31, is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
-------------------------- ---------------------------- ----------------------------
<S> <C> <C> <C> <C> <C> <C>
WEIGHTED-
AVERAGE WEIGHTED- WEIGHTED-
NUMBER EXERCISE NUMBER AVERAGE NUMBER AVERAGE
OF SHARES PRICE OF SHARES EXERCISE PRICE OF SHARES EXERCISE PRICE
----------- ------------- ----------- --------------- ----------- ---------------
Stock options outstanding beginning of
year..................................... 461,079 $ 7.17 389,516 $ 5.13 252,500 $ 4.90
Stock options granted...................... 228,950 16.84 132,257 12.43 146,516 5.46
Stock options exercised.................... (6,970) 6.36 (22,127) 4.74 (3,100) 4.00
Stock options canceled..................... (14,830) 10.45 (38,567) 5.94 (6,400) 4.61
----------- ----------- -----------
Stock options outstanding, end of year..... 668,229 $ 10.42 461,079 $ 7.17 389,516 $ 5.13
----------- ------ ----------- ----- ----------- -----
----------- ------ ----------- ----- ----------- -----
Exercisable at end of year................. 236,491 -- 152,525 -- 102,200 --
Weighted-average fair value of options
granted during the year.................. $ 13.32 $ 9.76 $ 4.41
</TABLE>
Exercise prices for options outstanding as of December 31, 1998 ranged from
$4 to $17.875. The weighted-average remaining contractual life of those options
is 7.99 years. Since the range of exercise prices is wide, the following is a
summary of information for each exercise price range:
<TABLE>
<CAPTION>
WEIGHTED- AVERAGE
NUMBER WEIGHTED- WEIGHTED-AVERAGE NUMBER OF EXERCISE PRICE
OF OPTIONS AVERAGE REMAINING OPTIONS (SHARES) OF CURRENTLY
(SHARES) EXERCISE CONTRACTUAL LIFE CURRENTLY EXERCISABLE
EXERCISE PRICE RANGE OUTSTANDING PRICE (YEARS) EXERCISABLE OPTIONS
- ------------------------------ ------------- ----------- ----------------- ---------------- -----------------
<S> <C> <C> <C> <C> <C>
$ 4.00-$ 4.99................. 109,316 $ 4.55 6.55 67,856 $ 4.35
$ 5.00-$ 5.99................. 175,200 5.18 6.67 129,670 5.18
$ 6.00-$ 6.99................. 30,662 6.25 8.00 12,026 6.25
$ 7.00-$11.99................. 28,850 10.89 8.85 6,540 10.51
$12.00-$12.99................. 77,001 12.15 8.96 15,949 12.17
$13.00-$14.99................. 24,850 14.65 9.10 4,450 14.64
$15.00-$16.99................. 164,000 16.52 10.00 -- --
$17.00-$17.99................. 58,350 17.88 10.00 -- --
------------- -------
668,229 $ 10.42 7.99 236,491 $ 5.79
------------- ----------- ----- ------- -----
------------- ----------- ----- ------- -----
</TABLE>
F-35
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(12) EMPLOYEE BENEFIT PLANS (CONTINUED)
The following is a summary of the transactions under the 1986 Plan for the
years ended December 31:
<TABLE>
<CAPTION>
1998 1997 1996
-------------------------- -------------------------- --------------------------
<S> <C> <C> <C> <C> <C> <C>
NUMBER OPTION NUMBER OPTION NUMBER OPTION
OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE
----------- ------------- ----------- ------------- ----------- -------------
Stock options outstanding beginning of
year...................................... 108,750 $ 4.00-$5.20 120,000 $ 4.00-$5.20 127,500 $ 4.00-$5.20
Stock options granted....................... -- -- -- -- -- --
Stock options exercised..................... (2,500) 4.00-5.20 (9,125) 4.00 (3,100) 4.00
Stock options canceled...................... (1,000) 4.00-5.20 (2,125) 4.00 (4,400) 4.00-5.20
----------- ----------- -----------
Stock options outstanding, end of year...... 105,250 $ 4.00-$5.20 108,750 $ 4.00-$5.20 120,000 $ 4.00-$5.20
----------- ------------- ----------- ------------- ----------- -------------
----------- ------------- ----------- ------------- ----------- -------------
</TABLE>
At December 31, 1998, 90,750 vested options were exercisable under the 1986
Plan. No additional options or purchase rights will be granted under the 1986
Plan.
The following is a summary of the transactions under the 1995 Plan for the
years ended December 31:
<TABLE>
<CAPTION>
1998 1997 1996
---------------------------- ---------------------------- --------------------------
<S> <C> <C> <C> <C> <C> <C>
NUMBER OPTION NUMBER OPTION NUMBER OPTION
OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE
----------- --------------- ----------- --------------- ----------- -------------
Stock Options:
Stock options outstanding beginning
of year............................ 352,329 $ 4.87-$14.875 269,516 $ 5.20-$7.70 125,000 $ 5.20
Stock options granted................ 228,950 14.75-17.875 132,257 11.375-14.875 146,516 5.20-7.70
Stock options exercised.............. (4,470) 6.25-12.50 (13,002) 4.87-7.70 -- --
Stock options canceled............... (13,830) 6.25-16.375 (36,442) 4.87-12.125 (2,000) 5.20
----------- ----------- -----------
Stock options outstanding end of
year............................... 562,979 $ 4.87-$17.875 352,329 $ 4.87-$14.875 269,516 $ 5.20-$7.70
----------- --------------- ----------- --------------- ----------- -------------
----------- --------------- ----------- --------------- ----------- -------------
</TABLE>
<TABLE>
<CAPTION>
1998 1997 1996
---------------------------- ---------------------------- --------------------------
<S> <C> <C> <C> <C> <C> <C>
NUMBER OPTION NUMBER OPTION NUMBER OPTION
OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE
----------- --------------- ----------- --------------- ----------- -------------
Restricted Options:
Shares outstanding beginning of
year............................... 83,680 $ 4.87-$12.125 69,265 $ 4.87-$6.25 36,350 $ 5.20
Shares granted....................... -- -- 36,450 12.125 45,934 4.87-6.25
Shares issued........................ (83,680) 4.87-12.125 (12,222) 4.87-12.125 (13,019) 4.87-5.20
Shares canceled...................... -- -- (9,813) 4.87-12.125 -- --
----------- ----------- -----------
Shares outstanding end of year....... -- $ 4.87-$12.125 83,680 $ 4.87-$12.125 69,265 $ 4.87-$6.25
----------- --------------- ----------- --------------- ----------- -------------
----------- --------------- ----------- --------------- ----------- -------------
</TABLE>
At December 31, 1998, 145,741 vested options were exercisable under the 1995
Plan. Shares available for future grants under the 1995 Plan at December 31,
1998 were 2,437,021.
F-36
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(12) EMPLOYEE BENEFIT PLANS (CONTINUED)
Effective January 1, 1990, the Company implemented a 401(k) Plan ("Company
Plan") which is available for substantially all employees and under which the
Company matches a percentage of the participant's compensation. The employer
contributions are discretionary and vest over a five-year period. The employer
contributions for plan years 1998, 1997, and 1996 were $229 thousand, $186
thousand, and $170 thousand, respectively.
The Pac Rim Assurance Company 401(k) Plan ("Pac Rim Plan") permits employees
of Pac Rim who attain the age of 21 and complete 30 days of employment to elect
to make tax-deferred contributions of a specified percentage of their
compensations during each year through payroll deductions. As of December 31,
1998, there were 20 participants in the Pac Rim Plan employed by the Company.
Under the Pac Rim Plan, the Company, as successor to Pac Rim, has discretion to
make additional contributions. The Company made a $200 thousand discretionary
employer contribution to the Pac Rim Plan in April 1997. The Company merged the
Pac Rim Plan into the Company Plan on January 1, 1999.
(13) COMMITMENTS
The Company occupies offices under various operating leases and leases
substantially all of its fixed assets through a capital lease. The future
minimum lease payments at December 31, 1998, are as follows:
<TABLE>
<CAPTION>
OPERATING CAPITAL INTEREST ON CAPITAL TOTAL LEASE
COMMITMENTS COMMITMENTS COMMITMENTS COMMITMENTS
------------- ------------- ------------------- -------------
<S> <C> <C> <C> <C>
1999......................... $ 19,330 $ 2,005 $ 552 $ 21,887
2000......................... 16,601 2,232 325 19,158
2001......................... 13,988 1,797 16 15,801
2002......................... 6,010 -- -- 6,010
2003......................... 3,149 -- -- 3,149
------------- ------ ----- -------------
$ 59,078 $ 6,034 $ 893 $ 66,005
------------- ------ ----- -------------
------------- ------ ----- -------------
</TABLE>
Rental expenses totaled approximately $8.1 million, $4.0 million, and $1.9
million for the years ended December 31, 1998, 1997, and 1996 respectively.
Effective December 1, 1997, the Company entered into an $8.0 million capital
lease with BancBoston for substantially all of the property and equipment of
both SNIC and SPCC acquired on or before March 31, 1997. The transaction
resulted in a deferred gain of $1.7 million that is being amortized over 36
months.
Prior to the acquisition of BIG, BIG and the BIG insurance subsidiaries
entered into a sale leaseback agreement with BancBoston Leasing, Inc. pursuant
to which BancBoston Leasing, Inc. acquired certain of the BIG insurance
subsidiaries information systems and related assets for approximately $8.4
million, and BIG and the BIG insurance subsidiaries agreed to leaseback such
assets. This lease agreement has been accounted for as an operating lease and
has a one-year minimum term and is renewable from year to year thereafter.
In connection with the acquisition of BIG, Superior National entered into an
agreement with Foundation Health Medical Resource Management to provide
occupational medical management services.
F-37
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(13) COMMITMENTS (CONTINUED)
This agreement has a five-year term and provides for annual payments up to 3% of
direct premiums earned.
As part of an investment transaction by Capital Z Financial Services Fund IP
("IP II"), a related party, we have committed to participate in debt financing
of up to $5 million.
In a transaction associated with the sale of the 14.5% Senior Subordinated
Notes to III, the Company and SNIC agreed to pay International Insurance
Advisors, Inc., agent for each of the III limited partners and for the general
partner of III, a consulting fee in the amount of $250 thousand beginning on
April 1, 1993, and on each April 1 thereafter, to and including April 1, 1999.
The retirement of the 14.5% Senior Subordinated Notes in 1994 did not affect the
obligation of the Company and the consulting fees were paid by SNIC.
(14) LITIGATION
The Company is subject to various litigation which arises in the ordinary
course of business. Management is of the opinion that such litigation will not
have a material adverse effect on the consolidated financial position of the
Company or its consolidated results of operations.
(15) EARNINGS PER SHARE RECONCILIATION
The following is an illustration of the reconciliation of the numerators and
denominators of the basic and diluted earnings per share (EPS) computations:
<TABLE>
<CAPTION>
1998 1997 1996
----------------------------------------- ------------------------------------------- ---------------
SHARES PER SHARE SHARES PER SHARE
(DENOMINATOR) AMOUNT (DENOMINATOR) AMOUNT
INCOME ------------- ----------- INCOME ------------- ----------- INCOME
(NUMERATOR) (NUMERATOR) (NUMERATOR)
------------- --------------- ---------------
(IN (IN THOUSANDS) (IN THOUSANDS)
THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
BASIC EPS
Income before
items Below.... $ (6,245) 6,759,598 $ (0.92) $ 463 5,249,736 $ 0.09 $ 3,630
Preferred
Securities..... (7,357) (1.09) (3,069) (0.58) (1,667)
Discontinued
Operations..... -- -- -- -- --
Extraordinary
Items.......... -- -- (2,535) (0.49) --
------------- ----------- ------- ----------- -------
Net Income....... $ (13,602) $ (2.01) $ (5,141) $ (0.98) $ 1,963
------------- ----------- ------- ----------- -------
------------- ----------- ------- ----------- -------
EFFECT OF DILUTIVE
Securities
Options........ N/A 295,065
Warrants....... N/A 1,471,364
DILUTED EPS
Income before
items Below.... $ (6,245) 6,759,598 $ (0.92) $ 463 7,016,165 $ 0.07 $ 3,630
Preferred
Securities..... (7,357) (1.09) (3,069) (0.44) (1,667)
Discontinued
Operations..... -- -- -- -- --
Extraordinary
Items.......... -- -- (2,535) (0.37) --
------------- ----------- ------- ----------- -------
Net Income....... $ (13,602) $ (2.01) $ (5,141) $ (0.74) $ 1,963
------------- ----------- ------- ----------- -------
------------- ----------- ------- ----------- -------
<CAPTION>
PER SHARE AMOUNT
SHARES (DENOMINATOR)
----------- ---------------
<S> <C> <C>
BASIC EPS
Income before
items Below.... 3,432,679 $ 1.06
Preferred
Securities..... (0.49)
Discontinued
Operations..... --
Extraordinary
Items.......... --
------
Net Income....... $ 0.57
------
------
EFFECT OF DILUTIVE
Securities
Options........ 226,183
Warrants....... 1,167,178
DILUTED EPS
Income before
items Below.... 4,826,040 $ 0.75
Preferred
Securities..... (0.34)
Discontinued
Operations..... --
Extraordinary
Items.......... --
------
Net Income....... $ 0.41
------
------
</TABLE>
Options to purchase 1,250 shares at $14.81, 12,500 shares at $14.875, 7,250
shares at $14.25, and 1,250 shares at $14.31 were outstanding during the last
quarter of 1997 but were not included in the computation
F-38
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(15) EARNINGS PER SHARE RECONCILIATION (CONTINUED)
of diluted EPS because the options' exercise price was greater than the average
market price of the common shares. The options, which expire in 2002, were still
outstanding at the end of year 1998.
(16) RELATED PARTY TRANSACTIONS
Effective June 11, 1998, SNIC agreed to purchase an aggregate of 245,000
shares of our common stock from Thomas J. Jamieson, who is a director of
Superior National, and Jaco Oil Company, an entity controlled by Mr. Jamieson.
The price per share paid was $21.00, for total consideration of $5,145,000. The
closing sales price per share of common stock on June 10, 1998 was $22.88. The
common stock purchased by SNIC is held as an investment and carried in treasury
stock in the consolidated financial statements.
During 1998, we invested $50.0 thousand, with a $0.5 million commitment, in
a related party investment partnership whose sole investment is in IP II.
In December 1998, we privately sold approximately $158 million of our common
stock to IP II, Insurance Partners, L.P. ("IP Delaware") and Insurance Partners
(Offshore) Bermuda, ("IP Bermuda and, together with IP Delaware, "IP"). At the
same time we also completed our public rights offering under which we offered
subscription rights to purchase our common stock to all of our stockholders
(except for IP Delaware and IP Bermuda), warrant holders and to holders of our
stock options and shares of restricted stock. Those directors and executive
officers of Superior National who owned common stock and warrants, by virtue of
these holdings, had the opportunity to purchase shares of common stock in the
rights offering. These offerings provided a significant portion of the financing
we needed to purchase BIG.
Robert A. Spass and Bradley E. Cooper, who are directors of the Company, are
officers of the ultimate general partner of IP II and each owns 9.9% of its
voting capital stock. In addition, some members of our management, including
William L. Gentz, Arnold J. Senter, and J. Chris Seaman are investors in an
investment fund that is a limited partner of IP II.
Mr. Spass and Steven B. Gruber, who is a director of Superior National, are
executive officers of the ultimate general partner of IP Delaware and IP
Bermuda. In addition, Messrs. Spass, Gruber, and Cooper own direct or indirect
limited partnership interests in some of the limited partnerships that are the
direct or indirect general partners of IP Delaware and IP Bermuda.
The Board of Directors, without Messrs. Spass, Gruber, and Cooper, who
disclosed their conflict of interest, withdrew from the discussion, and
abstained from the voting, unanimously approved the terms of the sale of common
stock to the IP partners.
Under the terms of our stock offering to the IP partnerships, they agreed to
purchase 5,611,940 shares of common stock at $16.75 per share, for a total of
$94.0 million. They also agreed to provide a standby commitment under which they
would purchase up to an additional 6,328,358 shares of common stock at $16.75
per share in an amount of shares necessary to bring the total proceeds of the
private sale to the IP partnerships and the public sale of common stock under
the rights offering to $200.0 million. Our independent directors, on behalf of
the Company, negotiated the $16.75 subscription price and the terms of the stock
purchase agreement governing the sale to the IP partnerships. Because the $16.75
price equals the subscription price in the rights offering and this price was
set with the intention of inducing
F-39
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(16) RELATED PARTY TRANSACTIONS (CONTINUED)
participation by our stockholders, the $16.75 price represented a discount to
the market price of our common stock at the time the price was determined.
On December 10, 1998 the IP partnerships exercised their standby commitment,
which, combined with the minimum number of shares of common stock they agreed to
purchase, resulted in (1) IP II purchasing 5,276,960 shares of common stock for
$88.4 million, (2) IP Delaware purchasing 2,949,594 shares of common stock for
$49.4 million, and (3) IP Bermuda purchasing 1,196,588 shares of common stock
for $20.0 million.
On December 10, 1998 we paid a commitment fee to the IP partnerships in the
form of warrants to purchase an aggregate of 734,000 shares of common stock at
$16.75 per share for agreeing to provide the standby commitment. The warrants
expire on December 10, 2003. IP II assigned the warrants it was entitled to
receive to Zurich Centre Group Holdings Limited as compensation for its
providing certain financing commitments to the IP partnerships under the stock
purchase agreement. We paid this commitment fee by issuing (1) 229,754 warrants
to IP Delaware, (2) 93,206 warrants to IP Bermuda, (3) 205,520 warrants to
Zurich Centre Group Holdings Limited, and (4) 205,520 warrants to various
principals and designees of the ultimate general partner of IP II. Robert A.
Spass and Bradley E. Cooper, who are directors of the Company and officers and
equity holders of that general partner, received 32,825 warrants and 16,413
warrants, respectively, from the general partner.
In connection with our stock offering to the IP partnerships, we agreed to
provide the IP partnerships and some of their affiliates with certain customary
registration rights that allow them to require the Company to prepare and file
with the SEC registration statements under the Securities Act covering the
public offer and sale of shares they hold and to use its best efforts to cause
these registration statements to be declared effective.
In addition, we paid to designees of the IP partnerships fees totaling $3.9
million in consideration of their providing us with the opportunity to undertake
the BIG acquisition, originating a portion of the financing for the acquisition,
and assisting us in negotiating the terms of the acquisition.
In approving the rights offering to the Company's stockholders described
above, the Board of Directors decided to allow employees and consultants of the
Company who held stock options and shares of restricted stock to receive similar
subscription rights. We distributed to these holders the same form of
subscription right issued in the rights offering, including an identical $16.75
subscription price, except that each employee or consultant was required to
agree that his or her rights were non-transferable.
In addition, the Board of Directors authorized the Company to lend funds to
the participants sufficient to pay the purchase price for the common stock and
any resulting tax liability if the participant signed a promissory note, and
pledged to the Company, as collateral, stock options, warrants and shares of
common stock and restricted stock (including shares of common stock purchased in
the rights offering). The amount of money that could be borrowed was limited to
be 66% of the total value of the collateral that was pledged.
Employees and consultants of the Company purchased a total of 618,309 shares
of common stock under this portion of the rights offering and borrowed a total
of $10.4 million from the Company to pay for
F-40
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(16) RELATED PARTY TRANSACTIONS (CONTINUED)
them. All of the participants borrowed money from us and pledged to us a
sufficient number of stock options and shares of our common stock and restricted
stock.
In April 1997, IP Delaware and IP Bermuda purchased 2,124,834 shares of
common stock at $7.53 per share, for an aggregate purchase price of $16.0
million. Certain affiliates of Zurich Reinsurance Centre Holdings LLC ("Zurich")
are limited partners of IP Delaware and IP Bermuda and hold approximately 23% of
the limited partnership interests in those partnerships on an aggregate basis.
In March 1992, we issued warrants (the "Warrants") to purchase 1,616,886
shares of common stock in connection with the sale of our 14.5% Senior
Subordinated promissory notes in an aggregate principal amount of $11.0 million.
These notes have since been redeemed. The Warrants are exercisable at $4.00 per
share and expire April 1, 2002. International Insurance Investors, L.P. ("III")
purchased 1,474,306 of the Warrants (which have since been distributed to III's
partners and some of which were subsequently sold to unrelated parties),
1,230,149 of which are subject to a revocable agency relationship with
International Insurance Advisors, Inc. ("IIA"), pursuant to which IIA exercises
the voting or consent rights of such Warrants and the underlying shares of
common stock. Management acquired the remaining 142,580 Warrants. Centre
Solutions (Bermuda) Limited ("Centre Solutions"), an affiliate of Zurich, holds
395,128 of the Warrants (subject to the revocable agency relationship with IIA).
As of December 31, 1998, Warrants to purchase 1,566,465 shares of Common Stock
were outstanding.
In June 1994, in connection with a $20.0 million investment in the Company
(and its affiliate, Superior National Capital, L.P.) by CentreLine Reinsurance
Limited ("Centre Line"), an affiliate of Zurich, the Company issued to
CentreLine a warrant to purchase 579,356 shares of common stock at an exercise
price of $5.20 per share, which expires April 1, 2002.
Robert A. Spass and Bradley E. Cooper, directors of the Company, are
employees of IIA. Mr. Spass is also an officer and director of IIA. Mr.
Schwarberg, a director of the Company, is a former employee of IIA. IIA was paid
$250,000 by the Company during each of fiscal 1998, 1997, and 1996 for
investment banking and financial consulting services. Such payments were made
pursuant to a consulting agreement entered into in 1992 that continues through
the end of 1999.
The Company has several reinsurance contracts with certain affiliates of
Zurich which are discussed in Note 8. The following is a summary of significant
reinsurance transactions with affiliates of Zurich occurring in 1998 and 1997.
- Effective July 1, 1998, SNIC and SPCC entered into an Aggregate Excess of
Loss Agreement with ZRNA.
- Effective June 30, 1998, SNIC entered into an agreement with ZRNA to
settle and commute 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 through 1997. ZRNA paid SNIC $5.6 million and SNIC reassumed from
ZRNA all of its workers' compensation claim and allocated claim adjustment
expense reserves previously ceded to ZRNA for contract years 1994-1997.
F-41
<PAGE>
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1998
(AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
(16) RELATED PARTY TRANSACTIONS (CONTINUED)
- In December 1998, as a condition to the sale of BICO, CalComp entered into
a 100% Quota Share Reinsurance agreement with CIC (formerly BICO) under
which CIC will provide Superior National with a "fronting" facility.
- SNIC entered into a reinsurance contract with ZRNA effective June 30,
1997, under which ZRNA assumed $10 million of reserves associated with
open claims for future medical payments from SNIC in consideration of $1
million in cash. Effective December 31, 1998, this contract was commuted
and ZRNA paid SNIC $250,000 to commute and settle all obligations and
liabilities associated with this contract.
- The 1991 Contract with Centre Re was commuted in June 1997. In 1997, the
Company paid Centre Re $5.3 million related to the cancellation of the
1993 Contract. In June 1997, the entire amount of reinsurance receivable
balance due from Centre Re associated with the 1991 Contract was used to
pay the $93.1 million Chase term loan, as discussed in Note 9. In December
1997, the Company redeemed from an affiliate of Zurich $27.7 million of
the 1994 Preferred Securities, as described in Note 10.
Effective October 1, 1998, SNIC received cash of $28.9 million from Centre
Re. On December 15, 1998, SNIC repaid Centre Re $30.5 million and recorded a
loss of $1.6 million related to this transaction.
On December 18, 1998, SNIG completed the sale of BICO to Centre Solutions
Holdings (Delaware) Limited pursuant to the BICO Purchase Agreement for a
purchase price of approximately $11.7 million, as described in Note 2.
Beginning December 31, 1997 the Company entered into agreements with Risk
Enterprise Management Limited ("REM") and an affiliate of REM to provide the
Claim Severity Management Program. In 1998, we paid an aggregate of $8.3 million
to REM and its affiliate under the terms of this program.
In December 1997, Centre Solutions purchased $10.0 million of the Trust
Preferred Securities.
F-42
<PAGE>
SCHEDULE I.1
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
SUPERIOR NATIONAL INSURANCE GROUP, INC.
BALANCE SHEET
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
--------- ---------
(AMOUNTS IN
THOUSANDS, EXCEPT
SHARE DATA)
<S> <C> <C>
ASSETS
INVESTMENTS
Bonds and Notes:
Available-for-sale, at market (cost: 1998, $381; 1997, $7,539)........ $ 389 $ 7,533
Other Investments....................................................... 50 --
--------- ---------
TOTAL INVESTMENTS................................................... 439 7,533
Cash and cash equivalents............................................. 7,067 5,404
Accrued investment income............................................. 47 38
Receivable from a related party reinsurer............................. -- --
Investment in subsidiaries............................................ 432,255 168,856
Intercompany receivable............................................... 113 91
Deferred income taxes................................................. -- 1,884
Other................................................................. 257 174
--------- ---------
TOTAL ASSETS........................................................ $ 440,178 $ 183,980
--------- ---------
--------- ---------
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Long-term debt.......................................................... $ 105,820 $ 30
Intercompany liability.................................................. 1,335 21,462
Deferred tax liability.................................................. 6,607 --
Accounts payable and other liabilities.................................. 1,370 1,393
--------- ---------
TOTAL LIABILITIES................................................... 115,132 22,885
1997 PREFERRED SECURITIES ISSUED BY AFFILIATE;
$1,000 face per share; issued & outstanding 105,000 shares in 1997 &
1998.................................................................. 101,084 101,277
STOCKHOLDERS' EQUITY
Common stock, $0.01 par value; authorized 40,000,000 shares in 1998,
25,000,000 shares in 1997: issued and outstanding 17,907,314 shares in
1998 and 5,871,279 shares in 1997..................................... 177 59
Paid-in capital excess of par........................................... 228,512 34,242
Paid in capital--warrants............................................... 2,206 2,206
Unrealized gain on equity securities, net of taxes...................... (58) 112
Unrealized gain (loss) on available-for-sale investments, net of
taxes................................................................. 1,378 1,215
Retained earnings....................................................... 8,382 21,984
Less: Unearned Compensation............................................. (1,107) --
Less: Notes receivable from subscribed stock............................ (10,385) --
Less: 245,000 shares of treasury stock.................................. (5,143) --
--------- ---------
TOTAL STOCKHOLDERS' EQUITY.......................................... 223,962 59,818
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.......................... $ 440,178 $ 183,980
--------- ---------
--------- ---------
</TABLE>
See notes to condensed financial information
F-43
<PAGE>
SCHEDULE I.2
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
SUPERIOR NATIONAL INSURANCE GROUP, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
DECEMBER 31,
---------------------------------
1998 1997 1996
---------- ---------- ---------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C>
REVENUES:
Net investment income (loss).................................................. $ 728 $ (112) $ 89
---------- ---------- ---------
TOTAL REVENUES.............................................................. 728 (112) 89
EXPENSES:
Interest expense.............................................................. 600 5,965 1,465
Loss on termination of financing transaction with a related party reinsurer... -- 15,699 --
Other operating expenses...................................................... 472 518 (446)
---------- ---------- ---------
TOTAL EXPENSES.............................................................. 1,072 22,182 1,019
---------- ---------- ---------
LOSS BEFORE INCOME TAXES, PREFERRED SECURITIES DIVIDENDS AND ACCRETION, AND
EXTRAORDINARY ITEMS........................................................... (344) (22,294) (930)
Income tax expense.............................................................. 4,217 2,908 858
---------- ---------- ---------
LOSS BEFORE PREFERRED SECURITIES DIVIDENDS AND ACCRETION, AND EXTRAORDINARY
ITEMS......................................................................... (4,561) (25,202) (1,788)
Equity in net (loss) income of subsidiaries..................................... (1,684) 25,709 5,418
1994 Preferred securities dividends and accretion, net of income tax benefit of
$1,260 and $858 in 1997 and 1996, respectively................................ -- (2,445) (1,667)
1997 Preferred securities dividends and accretion, net of income tax benefit of
$3,962 and $321 in 1998 and 1997, respectively................................ (7,357) (624) --
Extraordinary loss on retirement of long-term debt, net of income tax benefit of
$785 in 1997.................................................................. -- (1,524) --
Extraordinary loss on redemption of Pac Rim's outstanding debentures, net of
income tax benefit of $327 in 1997............................................ -- (635) --
Extraordinary loss on retirement of preferred securities, net of income tax
benefit of $134 in 1997....................................................... -- (259) --
Extraordinary loss on early retirement of Imperial Bank Loan net of income tax
benefit of $83 in 1997........................................................ -- (161) --
---------- ---------- ---------
NET (LOSS) INCOME........................................................... $ (13,602) $ (5,141) $ 1,963
---------- ---------- ---------
---------- ---------- ---------
</TABLE>
See notes to condensed financial information
F-44
<PAGE>
SCHEDULE I.3
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
SUPERIOR NATIONAL INSURANCE GROUP, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
DECEMBER 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income............................................................... $ (13,602) $ (5,141) $ 1,963
--------- --------- ---------
Adjustments to reconcile net (loss) income to net cash used in operating
activities:
Amortization of bonds and preferred stock..................................... 4 -- --
(Gain) loss on sale of investment............................................. (278) 7 5
Loss (income) from subsidiaries............................................... 1,684 (25,709) (5,418)
Loss on termination of financing transaction with a related party reinsurer... -- 15,699 --
Extraordinary loss--early retirement of long-term debt........................ -- 2,579 --
Interest expense on long-term debt............................................ 596 3,581 --
Preferred securities dividends and accretion.................................. 7,360 3,069 2,525
(Increase) decrease in accrued investment income.............................. (9) (37) 8
Decrease in deferred income taxes............................................. 3,962 2,909 --
(Increase) decrease in other assets........................................... (106) 2,209 (994)
Increase in receivable from a related party reinsurer......................... -- -- (110,527)
(Decrease) increase in accounts payable and other liabilities................. (33,498) 446 19,334
--------- ---------
Total adjustments........................................................... (20,285) 4,753 (95,067)
--------- --------- ---------
Net cash used in operating activities....................................... (33,887) (388) (93,104)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Paid-in-capital--restricted stock............................................... 276 279 78
Proceeds from issuance of common stock.......................................... 193,007 18,000 --
Proceeds from 1997 Trust Preferred Securities................................... -- 101,272 --
Long-term debt--Chase Manhattan Bank............................................ 105,194 41,257 --
Retirement of long-term debt--Chase Manhattan Bank.............................. -- (44,000) --
Retirement of 1994 Preferred Securities......................................... -- (27,668) --
Retirement of long-term debt--Imperial Bank..................................... -- (7,250) (1,250)
Prepayment penalty on long-term debt............................................ -- (244) --
Proceeds from Chase Financing................................................... -- -- 93,091
Retirement of long-term debt--Chase financing................................... -- -- (1,410)
--------- --------- ---------
Net cash provided by financing activities................................... 298,477 81,646 90,509
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of bonds and notes:
Investments available-for-sale................................................ (4,890) (7,539) --
Purchase of common and preferred stock.......................................... (68,384) -- --
Purchase of Pacific Rim Holding Company......................................... -- (44,016) --
Purchase of Business Insurance Group, Inc....................................... (287,851) -- --
Investment in subsidiary........................................................ -- (1,175) --
Investment in partnership....................................................... (50) -- --
Sales of bonds and notes: Investments available for sale........................ -- -- 1,493
Sales and maturities of fixed maturities........................................ 12,075 -- --
Sales of common and preferred stock............................................. 68,432 -- --
Dividend received from subsidiary............................................... 46,756 -- --
Capital contribution made to subsidiary......................................... (29,015) (25,000) --
Net decrease in invested cash................................................... -- 89 --
--------- --------- ---------
Net cash (used in) provided by investing activities......................... (262,927) (77,641) 1,493
--------- --------- ---------
Net increase (decrease) in cash............................................. 1,663 3,617 (1,102)
Cash and invested cash at beginning of period................................... 5,404 1,787 2,889
--------- --------- ---------
Cash and invested cash at end of period......................................... $ 7,067 $ 5,404 $ 1,787
--------- --------- ---------
--------- --------- ---------
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes.................................... $ 255 $ 1 $ 1
--------- --------- ---------
--------- --------- ---------
Cash paid during the year for interest........................................ $ 11,228 $ 2,433 $ 641
--------- --------- ---------
--------- --------- ---------
</TABLE>
See notes to condensed financial information
F-45
<PAGE>
SCHEDULE I.4
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
SUPERIOR NATIONAL INSURANCE GROUP, INC.
NOTES TO CONDENSED FINANCIAL INFORMATION
1. BASIS OF PRESENTATION
In accordance with the requirements of Regulation S-X of the Securities and
Exchange Commission, the financial statements of the registrant are condensed
and omit many disclosures presented in the consolidated financial statements and
the notes thereto.
2. DIVIDENDS FROM SUBSIDIARIES
During 1998, BIG paid $46.8 million in dividends to SNIG. No dividends were
paid to SNIG by its consolidated subsidiaries in 1997 and 1996. However, SNIC
paid SNIG $8.2 million and $2.9 million for its current income taxes in 1998 and
1997, respectively. In addition, SPCC paid SNIG $0.3 million for its current
income taxes in 1998.
F-46
<PAGE>
SCHEDULE II
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
<TABLE>
<CAPTION>
COLUMN C
-----------------------------
COLUMN E
COLUMN B ADDITIONS -----------
------------- ----------------------------- BALANCE
BALANCE AT CHARGED TO CHARGED TO COLUMN D AT END
BEGINNING COSTS AND OTHER ----------- OF
COLUMN A OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS PERIOD
- -------------------------------------------------- ------------- ------------ --------------- ----------- -----------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1998
Allowance for possible losses on premiums
receivable.................................... $ 800 $ 21,311(a) -- $ (3,170) $ 18,941
--
--
----- ------------ ----------- -----------
----- ------------ ----------- -----------
Allowance for possible losses on reinsurance
recoverable................................... -- -- -- -- --
--
--
----- ------------ ----------- -----------
----- ------------ ----------- -----------
Year ended December 31, 1997
Allowance for possible losses on premiums
receivable.................................... $ 300 $ 2,311 -- $ (1,811) $ 800
--
--
----- ------------ ----------- -----------
----- ------------ ----------- -----------
Allowance for possible losses on reinsurance
recoverable................................... -- -- -- -- --
--
--
----- ------------ ----------- -----------
----- ------------ ----------- -----------
Year ended December 31, 1996
Allowance for possible losses on premiums
receivable.................................... $ 500 $ 1,369 -- $ (1,569) $ 300
--
--
----- ------------ ----------- -----------
----- ------------ ----------- -----------
Allowance for possible losses on reinsurance
recoverable................................... -- -- -- -- --
--
--
----- ------------ ----------- -----------
----- ------------ ----------- -----------
</TABLE>
- ------------------------
(a) $17,841 is due to the acquisition of Business Insurance Group.
F-47
<PAGE>
SCHEDULE V.1
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
SUPPLEMENTAL INSURANCE INFORMATION
<TABLE>
<CAPTION>
COLUMN C COLUMN H COLUMN I
COLUMN B -------------- COLUMN E ----------- -------------
----------- FUTURE POLICY --------------- COLUMN G BENEFITS, AMORTIZATION
DEFERRED BENEFITS, COLUMN D OTHER POLICY COLUMN F ----------- CLAIMS, OF DEFERRED
POLICY LOSSES, CLAIMS ----------- CLAIMS AND ----------- NET LOSSES AND POLICY
ACQUISITION AND LOSS UNEARNED BENEFITS PREMIUM INVESTMENT SETTLEMENT ACQUISITION
COLUMN A COSTS EXPENSES PREMIUM PAYABLE REVENUE INCOME EXPENSES COSTS
- ------------------- ----------- -------------- ----------- --------------- ----------- ----------- ----------- -------------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1998
Workers'
Compensation... $ 17,136 $1,076,206 $ 52,928 $ -- $ 87,089 $ 16,236 $ 243,342 $ 9,761
----------- -------------- ----------- --- ----------- ----------- ----------- -------------
----------- -------------- ----------- --- ----------- ----------- ----------- -------------
1997
Workers'
Compensation... $ 5,879 $ 201,255 $ 12,913 $ -- $ 140,920 $ 12,674 $ 90,447 $ 19,977
----------- -------------- ----------- --- ----------- ----------- ----------- -------------
----------- -------------- ----------- --- ----------- ----------- ----------- -------------
1996
Workers'
Compensation... $ 3,042 $ 115,529 $ 9,702 $ -- $ 88,648 $ 7,769 $ 55,638 $ 16,870
----------- -------------- ----------- --- ----------- ----------- ----------- -------------
----------- -------------- ----------- --- ----------- ----------- ----------- -------------
<CAPTION>
COLUMN J
----------- COLUMN K
OTHER -----------
OPERATING PREMIUMS
COLUMN A EXPENSES WRITTEN
- ------------------- ----------- -----------
<S> <C> <C>
1998
Workers'
Compensation... $ 32,966 $ 79,695
----------- -----------
----------- -----------
1997
Workers'
Compensation... $ 41,608 $ 136,929
----------- -----------
----------- -----------
1996
Workers'
Compensation... $ 24,609 $ 87,715
----------- -----------
----------- -----------
</TABLE>
F-48
<PAGE>
SCHEDULE V.2
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
REINSURANCE
<TABLE>
<CAPTION>
COLUMN F
COLUMN C COLUMN D ---------------
COLUMN B ----------- -------------- COLUMN E PERCENTAGE OF
---------- CEDED TO ASSUMED FROM ---------- AMOUNT
GROSS OTHER OTHER NET ASSUMED
COLUMN A AMOUNT COMPANIES COMPANIES AMOUNT TO NET
- ---------------------------------------------- ---------- ----------- -------------- ---------- ---------------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1998
Premiums:
Workers' compensation insurance............. $ 185,094 $ 110,051 $ 12,046 $ 87,089 13.8%
---------- ----------- ------- ---------- ---
Total premiums............................ $ 185,094 $ 110,051 $ 12,046 $ 87,089 13.8%
---------- ----------- ------- ---------- ---
---------- ----------- ------- ---------- ---
Year ended December 31, 1997
Premiums:
Workers' compensation insurance............. $ 152,253 $ 22,081 $ 10,748 $ 140,920 7.6%
---------- ----------- ------- ---------- ---
Total premiums............................ $ 152,253 $ 22,081 $ 10,748 $ 140,920 7.6%
---------- ----------- ------- ---------- ---
---------- ----------- ------- ---------- ---
Year ended December 31, 1996
Premiums:
Workers' compensation insurance............. $ 97,270 $ 11,280 $ 2,658 $ 88,648 3.0%
---------- ----------- ------- ---------- ---
Total Premiums............................ $ 97,270 $ 11,280 $ 2,658 $ 88,648 3.0%
---------- ----------- ------- ---------- ---
---------- ----------- ------- ---------- ---
</TABLE>
F-49
<PAGE>
SCHEDULE V.3
SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES
SUPPLEMENTAL PROPERTY AND CASUALTY INSURANCE INFORMATION
<TABLE>
<CAPTION>
COLUMN H
COLUMN D ---------
---------------
DISCOUNT CLAIM AND
IF ANY, CLAIM
COLUMN C DEDUCTED ADJUSTMENT
------------ IN EXPENSES
COLUMN B RESERVES RESERVES INCURRED
----------- FOR UNPAID FOR UNPAID COLUMN G RELATED
DEFERRED CLAIM AND CLAIM AND COLUMN E COLUMN F ----------- TO:
POLICY CLAIMS CLAIM ----------- ---------- NET ---------
ACQUISITION ADJUSTMENT ADJUSTMENT UNEARNED EARNED INVESTMENT CURRENT
COLUMN A COSTS EXPENSES EXPENSES PREMIUM PREMIUM INCOME YEAR
- -------------------------------- ----------- ------------ --------------- ----------- ---------- ----------- ---------
(AMOUNTS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
1998
Workers' Compensation......... $ 17,136 $ 1,076,206 $ -- $ 52,928 $ 87,089 $ 16,236 $ 36,650
----------- ------------ --- ----------- ---------- ----------- ---------
----------- ------------ --- ----------- ---------- ----------- ---------
1997
Workers' Compensation......... $ 5,879 $ 201,255 $ -- $ 12,913 $ 140,920 $ 12,674 $ 95,826
----------- ------------ --- ----------- ---------- ----------- ---------
----------- ------------ --- ----------- ---------- ----------- ---------
1996
Workers' Compensation......... $ 3,042 $ 115,529 $ -- $ 9,702 $ 88,648 $ 7,769 $ 57,614
----------- ------------ --- ----------- ---------- ----------- ---------
----------- ------------ --- ----------- ---------- ----------- ---------
<CAPTION>
PRIOR
COLUMN A YEAR
- -------------------------------- ----------
<S> <C>
1998
Workers' Compensation......... $ 206,692(a)
----------
----------
1997
Workers' Compensation......... $ (5,379)
----------
----------
1996
Workers' Compensation......... $ (1,976)
----------
----------
</TABLE>
- ------------------------
(a) $206,692 includes $175,000 of claim and claim adjustment expenses existing
on BIG at acquisition.
F-50
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ----------- --------------------------------------------------------------------------------------------------------
<C> <S>
2.1 Purchase Agreement dated as of May 5, 1998 by and between FHC and Superior National(8)
2.2 Purchase Agreement dated as of December 7, 1998 between Centre Solutions Holdings (Delaware) Limited and
Superior National(11)
3.1 Amended and Restated Certificate of Incorporation of Superior National, as currently in effect(11)
3.2 Bylaws of Superior National, as currently in effect
4.1 Amended and Restated Declaration of Trust of the Trust, dated as of December 3, 1997, including the
Trust's Certificate of Trust and the forms of Trust Common Securities, Trust Preferred Securities, and
Exchange Trust Preferred Securities(6)
4.3 Senior Subordinated Indenture, including forms of the Senior Subordinated Notes and Exchange Senior
Subordinated Notes, dated as of December 3, 1997, between Superior National and Wilmington Trust
Company, as trustee, providing for the sale by Superior National to the Trust of the Senior
Subordinated Notes(6)
4.4 Guarantee Agreement, dated as of December 3, 1997, between Superior National and Wilmington Trust
Company, as trustee, with respect to the Trust Preferred Securities(6)
4.5 Guarantee Agreement with Respect to Common Securities, dated as of December 3, 1997, by Superior
National(6)
4.6 Form of Exchange Guarantee Agreement between Superior National and Wilmington Trust Company, as trustee,
with respect to the Exchange Trust Preferred Securities(6)
4.7 First Supplemental Indenture dated as of November 17, 1998 between Superior National and Wilmington
Trust Company, as trustee(11)
EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS
10.1 Employment Agreement, dated June 1, 1997, by and between Mr. William L. Gentz, President and Chief
Executive Officer, and Superior National(5)
10.2 Employment Agreement, dated February 17, 1997, by and between Mr. Arnold J. Senter, Executive Vice
President and Chief Operating Officer, and Superior National(3)
10.3 Employment Agreement, dated June 1, 1997, by and between Mr. J. Chris Seaman, Executive Vice President
and Chief Financial Officer, and Superior National(5)
10.4 Letter Agreement dated September 8, 1997 governing the terms of employment of Edward C. Shoop, Senior
Vice President and Chief Actuary
10.5 Letter Agreement dated July 13, 1998 governing the terms of employment of Doris K.T. Lai, Vice
President--Finance and Treasurer
10.6 1986 Non-Statutory Stock Option and 1986 Non-Statutory Stock Purchase Plan(2)
10.7 1995 Stock Incentive Plan(2)
OTHER MATERIAL CONTRACTS
10.8 Lease, dated 27th day of October 1988, by and between Corporate Center at Malibu Canyon, a California
Limited Partnership and Superior National, relating to the lease of our home office and Calabasas
Branch Facilities(1)
10.9 Purchase warrant, dated as of the 30th of June 1994, entitling Centreline Reinsurance Limited to
purchase 579,356 shares of Common Stock(1)
10.10 Form of Common Stock Purchase Warrant, held by those members of Superior National's management and other
parties set forth on the schedule attached thereto, to purchase an aggregate of 1,566,465 shares of
our common stock(6)
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ----------- --------------------------------------------------------------------------------------------------------
<C> <S>
10.11 Registration Rights Agreement, dated as of December 3, 1997, among Superior National, the Trust, and the
Initial Purchasers named therein(6)
10.12 Agreement with Prime Advisors regarding Investment Management Services provided to Superior National
dated April 12, 1997(4)
10.13 Agreement for Services between REM and SNIC, relating to the Claim Severity Management Program(7)
10.14 Average Existing Claim Severity Agreement, effective December 31, 1997, between ZRNA and Superior
Pacific(7)
10.15 Stock Purchase Agreement, dated as of May 5, 1998, among Superior National, IP Delaware, IP Bermuda, and
Capital Z Partners Ltd.(8)
10.16 Form of Common Stock Purchase Warrant dated as of December 10, 1998 held by those parties set forth on
the schedule attached thereto, to purchase an aggregate of 734,000 shares of our common stock(8)
10.17 Amended and Restated Registration Rights Agreement dated December 10, 1998 among Superior National, IP
Delaware, IP Bermuda, and IP II(8)
10.18 Retainer and Consulting Agreement dated as of December 31, 1997 between Superior National, SNIC, SPCC,
and REM(10)
10.19 Workers' Compensation Quota Share Large Account Business Reinsurance Contract, effective February 1,
1998, issued to Superior National(10)
10.20 Credit Agreement dated as of December 10, 1998 (the "Credit Agreement") among Superior National, various
lending institutions and The Chase Manhattan Bank(11)
10.21 Subsidiary Guaranty dated as of December 10, 1998 made by certain subsidiaries of Superior National in
connection with the Credit Agreement(11)
10.22 Pledge Agreement dated as of December 10, 1998 made by Superior National and certain subsidiaries of
Superior National in connection with the Credit Agreement(11)
10.23 Receivables Purchase and Sale Agreement dated as of December 9, 1998 among CalComp, CBIC, CCIC, BICO and
Insurance Funding LLC(11)
10.24 Support Agreement dated as of December 9, 1998 by Superior National in favor of Insurance Funding LLC,
EagleFunding Capital Corporation and BancBoston Robertson Stephens, Inc.(11)
10.251 Receivables Purchase Agreement dated as of December 9, 1998 among Insurance Funding LLC, EagleFunding
Capital Corporation, BancBoston Robertson Stephens, Inc. and Superior National(11)
10.26 Loss Portfolio Transfer and 100% Quota Share Reinsurance Contract between BICO and CalComp(11)
10.27 Aggregate Excess of Loss Reinsurance Agreement, dated as of September 3, 1998, between Inter-Ocean
Reinsurance Company Ltd. and BIG acting solely on behalf of the following subsidiaries: CalComp, BICO,
CBIC and CCIC(11)
10.28 Master Lease Finance Agreement dated as of December 1, 1998 by and between BancBoston Leasing Inc. and
BIG and its subsidiaries
10.29 Commutation and Settlement Agreement, effective as of June 30, 1998, by and between Superior National
and ZRNA(10)
11 Computation of Earnings per Share
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ----------- --------------------------------------------------------------------------------------------------------
<C> <S>
21 Subsidiaries of Superior National
27 Financial Data Schedule
</TABLE>
- ------------------------
(1) Previously filed as an exhibit to Superior National's Registration
Statement on Form 10, as filed with the SEC on May 1, 1995 (File No.
0-25984).
(2) Previously filed as an exhibit to Superior National's Annual Report on Form
10-K for the fiscal year ended December 31, 1995, as filed with the SEC on
March 29, 1996.
(3) Previously filed as an exhibit to Superior National's Annual Report on Form
10-K for the fiscal year ended December 31, 1996, as filed with the SEC on
March 10, 1997.
(4) Previously filed as an exhibit to Superior National's Quarterly Report on
Form 10-Q for the quarter ended March 31, 1997, as filed with the SEC on
May 15, 1997.
(5) Previously filed as an exhibit to Superior National's Quarterly Report on
Form 10-Q for the quarter ended September 30, 1997, as filed with the SEC
on November 13, 1997.
(6) Previously filed as an exhibit to Superior National's and the Trust's
Registration Statement on Form S-4 (Registration No. 333-43505) on December
30, 1997.
(7) Previously filed as an exhibit to Superior National's Annual Report on Form
10-K for the fiscal year ended December 31, 1997, as filed with the SEC on
March 31, 1998.
(8) Previously filed as an exhibit to Superior National's Quarterly Report on
Form 10-Q for the quarter ended March 31, 1998, as filed with the SEC on
May 15, 1998.
(9) Previously filed as an exhibit to Superior National's Quarterly Report on
Form 10-Q for the quarter ended June 30, 1998, as filed with the SEC on
August 14, 1998.
(10) Previously filed as an exhibit to Superior National's Registration
Statement on Form S-1 (Registration No. 333-58579) on July 7, 1998.
(11) Previously filed as an exhibit to Superior National's Current Report on
Form 8-K, as filed with the SEC on December 24, 1998.
(a)(4)
(1) Current Report on Form 8-K, filed with the SEC on December 24, 1998,
related to the acquisition of BIG.
(2) Current Report on Form 8-K/A, as filed with the SEC on January 27, 1999,
related to the acquisition of BIG.
<PAGE>
BY-LAWS
OF
SUPERIOR NATIONAL INSURANCE GROUP, INC.
-----------------------------------------------------------
ARTICLE I
STOCKHOLDERS
Section 1.1. ANNUAL MEETINGS. An annual meeting of stockholders shall
be held for the election of directors at such date, time and place, either
within or without the State of Delaware, as may be designated by resolution
of the Board of Directors from time to time. Any other proper business may
be transacted at the annual meeting.
Section 1.2. SPECIAL MEETINGS. Special meetings of stockholders for
any purpose or purposes may be called at any time by the Board of Directors,
any officer of the Corporation or by ten percent (10%) of the stockholders.
Section 1.3. NOTICE OF MEETINGS. Whenever stockholders are required or
permitted to take any action at a meeting, a written notice of the meeting
shall be given that shall state the place, date and hour of the meeting and,
in the case of a special meeting, the purpose or purposes for which the
meeting is called. Unless otherwise provided by law, the certificate of
incorporation or these by-laws, the written notice of any meeting shall be
given not less than ten nor more than sixty days before the date of the
meeting to each stockholder entitled to vote at such meeting. If mailed,
such notice shall be deemed to be given when deposited in the United States
mail, postage prepaid, directed to the stockholder at his address as it
appears on the records of the corporation.
Section 1.4. ADJOURNMENTS. Any meeting of stockholders, annual or
special, may adjourn from time to time to reconvene at the same or some other
place, and notice need not be given of any such adjourned meeting if the time
and place thereof are announced at the meeting at which the adjournment is
taken. At the adjourned meeting the corporation may transact any business
which might have been transacted at the original meeting. If the adjournment
is for more than thirty days, or if after the adjournment a new record date
is fixed for the adjourned meeting, notice of the adjourned meeting shall be
given to each stockholder of record entitled to vote at the meeting.
Section 1.5. QUORUM. Except as otherwise provided by law, the
certificate of incorporation or these by-laws, at each meeting of
stockholders the presence in person or by proxy of the holders of a majority
in voting power of the outstanding shares of stock entitled to vote at the
meeting shall be necessary and sufficient to constitute a quorum. In the
absence of a quorum, the stockholders so present may, by a majority in voting
power
<PAGE>
thereof, adjourn the meeting from time to time in the manner provided in
Section 1.4 of these by-laws until a quorum shall attend. Shares of its own
stock belonging to the corporation or to another corporation, if a majority
of the shares entitled to vote in the election of directors of such other
corporation is held, directly or indirectly, by the corporation, shall
neither be entitled to vote nor be counted for quorum purposes; provided,
however, that the foregoing shall not limit the right of the corporation or
any subsidiary of the corporation to vote stock, including but not limited to
its own stock, held by it in a fiduciary capacity.
Section 1.6. ORGANIZATION. Meetings of stockholders shall be presided
over by the Chairman of the Board, if any, or in his absence by the Vice
Chairman of the Board, if any, or in his absence by the President, or in his
absence by a Vice President, or in the absence of the foregoing persons by a
chairman designated by the Board of Directors, or in the absence of such
designation by a chairman chosen at the meeting. The Secretary shall act as
secretary of the meeting, but in his absence the chairman of the meeting may
appoint any person to act as secretary of the meeting.
Section 1.7. VOTING; PROXIES. Except as otherwise provided by the
certificate of incorporation, each stockholder entitled to vote at any
meeting of stockholders shall be entitled to one vote for each share of stock
held by him which has voting power upon the matter in question. Each
stockholder entitled to vote at a meeting of stockholders or to express
consent or dissent to corporate action in writing without a meeting may
authorize another person or persons to act for him by proxy, but no such
proxy shall be voted or acted upon after three years from its date, unless
the proxy provides for a longer period. A proxy shall be irrevocable if it
states that it is irrevocable and if, and only as long as, it is coupled with
an interest sufficient in law to support an irrevocable power. A stockholder
may revoke any proxy which is not irrevocable by attending the meeting and
voting in person or by filing an instrument in writing revoking the proxy or
by delivering a proxy in accordance with applicable law bearing a later date
to the Secretary of the corporation. Voting at meetings of stockholders need
not be by written ballot. At all meetings of stockholders for the election
of directors a plurality of the votes cast shall be sufficient to elect. All
other elections and questions shall, unless otherwise provided by law, the
certificate of incorporation or these by-laws, be decided by the affirmative
vote of the holders of a majority in voting power of the shares of stock
which are present in person or by proxy and entitled to vote thereon.
Section 1.8. NOTICE OF STOCKHOLDER BUSINESS AND NOMINATIONS.
(A) ANNUAL MEETINGS OF STOCKHOLDERS. (1) Nominations of persons
for election to the Board of Directors of the Corporation and the proposal of
business to be considered by the stockholders may be made at an annual
meeting of stockholders (a) pursuant to the Corporation's notice of meeting
delivered pursuant to Section 1.3 of these By-laws, (b) by or at the
direction of the Chairman of the Board of Directors or (c) by any stockholder
of the Corporation who is entitled to vote at the meeting, who complied with
the notice procedures set forth in clauses (2) and (3) of this
2.
<PAGE>
paragraph (A) of this By-law and who was a stockholder of record at the time
such notice is delivered to the Secretary of the Corporation.
(2) For nominations or other business to be properly brought
before an annual meeting by a stockholder pursuant to clause (c) of paragraph
(A)(1) of this By-law, the stockholder must have given timely notice thereof
in writing to the Secretary of the Corporation. To be timely, a
stockholder's notice shall be delivered to the Secretary at the principal
executive offices of the Corporation not less than seventy days nor more than
ninety days prior to the first anniversary of the preceding year's annual
meeting; PROVIDED, HOWEVER, that in the event that the date of the annual
meeting is advanced by more than twenty days, or delayed by more than seventy
days, from such anniversary date, notice by the stockholder to be timely must
be so delivered not earlier than the ninetieth day prior to such annual
meeting and not later than the close of business on the later of the
seventieth day prior to such annual meeting or the tenth day following the
day on which public announcement of the date of such meetings if first made.
Such stockholder's notice shall set forth (a) as to each person whom the
stockholder proposes to nominate for election or re-election as a director
all information relating to such person that is required to be disclosed in
solicitations of proxies for election of directors, or is otherwise required,
in each case pursuant to Regulation 14A under the Securities Exchange Act of
1934, as amended (the "Exchange Act"), including such person's written
consent to being named in the proxy statement as a nominee and to serving as
a director if elected; (b) as to any other business desired to be brought
before the meeting, the reasons for conducting such business at the meeting
and any material interest in such business of such stockholder and the
beneficial owner, if any, on whose behalf the proposal is made; and (c) as to
the stockholder giving the notice and the beneficial owner, if any, on whose
behalf the nomination or proposal is made (i) the name and address of such
stockholder, as they appear on the Corporation's books, and of such
beneficial owner and (ii) the class and number of shares of the Corporation
which are owned beneficially and or record by such stockholder and such
beneficial owner.
(3) Notwithstanding anything in the second sentence of
paragraph (A)(2) of this By-law to the contrary, in the event that the number
of directors to be elected to the Board of Directors of the Corporation is
increased and there is no public announcement naming all of the nominees for
director or specifying the size of the increased Board of Directors made by
the Corporation at least eighty days prior to the first anniversary of the
preceding year's annual meeting, a stockholder's notice required by this
By-law shall also be considered timely, but only with respect to nominees for
any new positions created by such increase, if it shall be delivered to the
Secretary at the principal executive offices of the Corporation not later
than the close of business on the tenth day following the day on which such
public announcement is first made by the Corporation.
(B) SPECIAL MEETINGS OF STOCKHOLDERS. Only such business shall be
conducted at a special meeting of stockholders as shall have been brought before
the meeting pursuant to the Corporation's notice of meeting pursuant to Section
1.3 of these By-laws. Nominations of persons for election to the Board of
Directors may be made at a
3.
<PAGE>
special meeting of stockholders at which directors are to be elected pursuant
to the Corporation's notice of meeting (a) by or at the direction of the
Board of Directors or (b) by any stockholder of the Corporation who is
entitled to vote at the meeting, who complies with the notice procedures set
forth in this By-law and who is a stockholder of record at the time such
notice is delivered to the Secretary of the Corporation. Nominations by
stockholders of persons for election to the Board of Directors may be made at
such a special meeting of stockholders if the stockholder's notice as
required by paragraph (A)(2) of this By-law shall be delivered to the
Secretary at the principal executive offices of the Corporation not earlier
than the ninetieth day prior to such special meeting and not later than the
close of business on the later of the seventieth day prior to such special
meeting or the tenth day following the day on which public announcement is
first made of the date of the special meeting and of the nominees proposed by
the Board of Directors to be elected at such meeting. In no event shall the
public announcement of an adjournment of a special meeting commence a new
time period for the giving of a stockholder's notice as described above.
(C) GENERAL.
(1) Only persons who are nominated in accordance with the
procedures set forth in this By-law shall be eligible to serve as director and
only such business shall be conducted at a meeting of stockholders as shall have
been brought before the meeting in accordance with the procedures set forth in
this By-law. Except as otherwise provided by law, the Certificate of
Incorporation or these By-laws, the chairman of the meeting shall have the power
and duty to determine whether a nomination or any business proposed to be
brought before the meeting was made in accordance with the procedures set forth
in this By-law and, if any proposed nomination or business is not compliance
with this By-law, to declare that such defective proposal or nomination shall
disregarded.
(2) For purposes of this By-law, "public announcement" shall
mean disclosure in a press release reported by the Dow Jones News Service,
Associated Press or comparable national news service or in a document publicly
filed by the Corporation with the Securities and Exchange Commission pursuant to
Section 13, 14 or 15(d) of the Exchange Act.
(3) Notwithstanding the foregoing provisions of this By-law, a
stockholder shall also comply with all applicable requirements of the Exchange
Act and the rules and regulations thereunder with respect to the matters set
forth in this By-law. Nothing in this By-law shall be deemed to affect any
rights of stockholders to request inclusion of proposals in the Corporation's
proxy statement pursuant to Rule 14a-8 under the Exchange Act.
Section 1.9. FIXING DATE FOR DETERMINATION OF STOCKHOLDERS OF RECORD. In
order that the corporation may determine the stockholders entitled to notice of
or to vote at any meeting of stockholders or any adjournment thereof, or to
express consent to corporate action in writing without a meeting, or entitled to
receive payment of any dividend or other
4.
<PAGE>
distribution or allotment of any rights, or entitled to exercise any rights
in respect of any change, conversion or exchange of stock or for the purpose
of any other lawful action, the Board of Directors may fix a record date,
which record date shall not precede the date upon which the resolution fixing
the record date is adopted by the Board of Directors, and which record date:
(1) in the case of determination of stockholders entitled to vote at any
meeting of stockholders or adjournment thereof, shall, unless otherwise
required by law, not be more than sixty nor less than ten days before the
date of such meeting; (2) in the case of determination of stockholders
entitled to express consent to corporate action in writing without a meeting,
shall not be more than ten days from the date upon which the resolution
fixing the record date is adopted by the Board of Directors; and (3) in the
case of any other action, shall not be more than sixty days prior to such
other action. If no record date is fixed: (1) the record date for
determining stockholders entitled to notice of or to vote at a meeting of
stockholders shall be at the close of business on the day next preceding the
day on which notice is given, or, if notice is waived, at the close of
business on the day next preceding the day on which the meeting is held; (2)
the record date for determining stockholders entitled to express consent to
corporate action in writing without a meeting, when no prior action of the
Board of Directors is required by law, shall be the first date on which a
signed written consent setting forth the action taken or proposed to be taken
is delivered to the corporation in accordance with applicable law, or, if
prior action by the Board of Directors is required by law, shall be at the
close of business on the day on which the Board of Directors adopts the
resolution taking such prior action; and (3) the record date for determining
stockholders for any other purpose shall be at the close of business on the
day on which the Board of Directors adopts the resolution relating thereto.
A determination of stockholders of record entitled to notice of or to vote at
a meeting of stockholders shall apply to any adjournment of the meeting;
provided, however, that the Board of Directors may fix a new record date for
the adjourned meeting.
Section 1.10. LIST OF STOCKHOLDERS ENTITLED TO VOTE. The Secretary shall
prepare and make, at least ten days before every meeting of stockholders, a
complete list of the stockholders entitled to vote at the meeting, arranged in
alphabetical order, and showing the address of each stockholder and the number
of shares registered in the name of each stockholder. Such list shall be open
to the examination of any stockholder, for any purpose germane to the meeting,
during ordinary business hours, for a period of at least ten days prior to the
meeting, either at a place within the city where the meeting is to be held,
which place shall be specified in the notice of the meeting, or if not so
specified, at the place where the meeting is to be held. The list shall also be
produced and kept at the time and place of the meeting during the whole time
thereof and may be inspected by any stockholder who is present. Upon the
willful neglect or refusal of the directors to produce such a list at any
meeting for the election of directors, they shall be ineligible for election to
any office at such meeting. Except as otherwise provided by law, the stock
ledger shall be the only evidence as to who are the stockholders entitled to
examine the stock ledger, the list of stockholders or the books of the
corporation, or to vote in person or by proxy at any meeting of stockholders.
Section 1.11. CONSENT OF STOCKHOLDERS IN LIEU OF MEETING.
5.
<PAGE>
(a) Any action required to be taken at any annual or special meeting
of stockholders of the Corporation, or any action which may be taken at any
annual or special meeting of the stockholders, may be taken without a meeting,
without prior notice and without a vote, if a consent or consents in writing,
setting for the action so taken, shall be signed by the holders of outstanding
stock having not less than the minimum number of votes that would be necessary
to authorize or take such action at a meeting at which all shares entitled to
vote thereon were present and voted and shall be delivered to the Corporation by
delivery to its registered office in Delaware, its principal place of business,
or an officer or agent of the Corporation having custody of the book in which
proceedings of meetings of stockholders are recorded. Delivery made to the
Corporation's registered office shall be made by hand or by certified or
registered mail, return receipt request.
(b) Every written consent shall bear the date of signature of each
stockholder who signs the consent and no written consent shall be effective to
take the corporate action referred to therein unless, within sixty (60) days of
the date the earliest dated consent is delivered to the Corporation, a written
consent or consents signed by a sufficient number of holders to take action are
delivered to the Corporation in the manner prescribed in paragraph (c) of this
Section.
(c) In order that the Corporation may determine the stockholders
entitled to consent to corporate action in writing without a meeting, the Board
of Directors may fix a record date, which record date shall not precede the date
upon which the resolution fixing the record date is adopted by the Board of
Directors, and which date shall not be more than ten (10) days after the date
upon which the resolution fixing the record date is adopted by the Board of
Directors. Any stockholder of record seeking to have the stockholders authorize
or take corporate action by written consent shall, by written notice to the
Secretary, request the Board of Directors to fix a record date. The Board of
Directors shall promptly, but in all events within ten (10) days after the date
on which such a request is received, adopt a resolution fixing the record date.
If no record date has been fixed by the Board of Directors within ten (10) days
of the date on which such a request is received, the record date for determining
stockholders entitled to consent to corporate action in writing without a
meeting, when no prior action by the Board of Directors is required by
applicable law, shall be the first date on which a signed written consent
setting forth the action taken or proposed to be taken is delivered to the
Corporation in accordance with paragraphs (a) and (b) of this Section. If no
record date has been fixed by the Board of Directors and prior action by the
Board of Directors is required by applicable law, the record date for
determining stockholders entitled to consent to corporate action in writing
without a meeting shall be at the close of business on the date on which the
Board of Directors adopts the resolution taking such prior action.
(d) Within five (5) business days after receipt of the earliest dated
consent delivered to the Corporation in the manner provided in this Section, the
Corporation, shall retain nationally recognized independent inspectors of
elections for the purposes of
6.
<PAGE>
performing a ministerial review of the validity of consents and any
revocations thereof. The cost of retaining inspectors of election shall be
borne by the Corporation.
(e) At any time that stockholders soliciting consents in writing to
corporate action have a good faith belief that the requisite number of valid and
unrevoked consents to authorize or take the action specified has been received
by them, the consents shall be delivered by the soliciting stockholders of the
Corporation's registered office in the State of Delaware or principal place of
business or to the Secretary of the Corporation, together with a certificate
stating their belief that the requisite number of valid and unrevoked consents
has been received as of a specific date, which date shall be identified in the
certificate. In the event that delivery shall be made to the Corporation's
registered office in Delaware, such delivery shall be made by hand or by
certified or registered mail, return receipt requested. Upon receipt of such
consents, the Corporation shall cause the consents to be delivered promptly to
the inspectors of election. The Corporation also shall deliver promptly to the
inspectors of election any revocations of consents in its possession, custody or
control as of the time of receipt of the consents.
(f) As promptly as practicable after the consents and revocations are
received by them, the inspectors of election shall issue a preliminary report to
the Corporation stating: (i) the number of shares represented by valid and
unrevoked consents; (ii) the number of shares represented by invalid consents;
(iii) the number of shares represented by invalid revocations; and (iv) the
number of shares entitled to submit consents as of the record date. Unless the
Corporation and the soliciting stockholders agree to a shorter or longer period,
the Corporation and the soliciting stockholders shall have five (5) days to
review the consents and revocations and to advise the inspectors and the
opposing party in writing as to whether they intend to challenge the preliminary
report. If no timely written notice of an intention to challenge the
preliminary report is received, the inspectors shall certify the preliminary
report (as corrected or modified by virtue or the detection by the inspectors of
clerical errors) as their final report and deliver it to the Corporation. If
the Corporation or the soliciting stockholders give timely written notice of an
intention to challenge the preliminary report, a challenge session shall be
scheduled by the inspectors as promptly as practicable. A transcript of the
challenge session shall be recorded by a certified court reporter. Following
completion of the challenge session, the inspectors shall issue as promptly as
practicable their final report and deliver it to the Corporation. A copy of the
final report shall be included in the book in which the proceedings of meetings
of stockholders are required.
(g) The Corporation shall give prompt notice to the stockholders of
the results of any consent solicitation or the taking of corporate action
without a meeting by less than unanimous written consent.
(h) This Section shall in no way impair or diminish the right of any
stockholder or director, or any officer whose title to office is contested, to
contest the validity of any consent or revocation thereof, or to take any other
action with respect thereto.
7.
<PAGE>
Section 1.12. INSPECTORS OF ELECTION. The corporation may, and shall if
required by law, in advance of any meeting of stockholders, appoint one or more
inspectors of election, who may be employees of the corporation, to act at the
meeting or any adjournment thereof and to make a written report thereof. The
corporation may designate one or more persons as alternate inspectors to replace
any inspector who fails to act. In the event that no inspector so appointed or
designated is able to act at a meeting of stockholders, the person presiding at
the meeting shall appoint one or more inspectors to act at the meeting. Each
inspector, before entering upon the discharge of his or her duties, shall take
and sign an oath to execute faithfully the duties of inspector with strict
impartiality and according to the best of his or her ability. The inspector or
inspectors so appointed or designated shall (i) ascertain the number of shares
of capital stock of the corporation outstanding and the voting power of each
such share, (ii) determine the shares of capital stock of the corporation
represented at the meeting and the validity of proxies and ballots, (iii) count
all votes and ballots, (iv) determine and retain for a reasonable period a
record of the disposition of any challenges made to any determination by the
inspectors, and (v) certify their determination of the number of shares of
capital stock of the corporation represented at the meeting and such inspectors'
count of all votes and ballots. Such certification and report shall specify such
other information as may be required by law. In determining the validity and
counting of proxies and ballots cast at any meeting of stockholders of the
corporation, the inspectors may consider such information as is permitted by
applicable law. No person who is a candidate for an office at an election may
serve as an inspector at such election.
Section 1.13. CONDUCT OF MEETINGS. The date and time of the opening and
the closing of the polls for each matter upon which the stockholders will vote
at a meeting shall be announced at the meeting by the person presiding over the
meeting. The Board of Directors of the corporation may adopt by resolution such
rules and regulations for the conduct of the meeting of stockholders as it shall
deem appropriate. Except to the extent inconsistent with such rules and
regulations as adopted by the Board of Directors, the chairman of any meeting of
stockholders shall have the right and authority to prescribe such rules,
regulations and procedures and to do all such acts as, in the judgment of such
chairman, are appropriate for the proper conduct of the meeting. Such rules,
regulations or procedures, whether adopted by the Board of Directors or
prescribed by the chairman of the meeting, may include, without limitation, the
following: (i) the establishment of an agenda or order of business for the
meeting; (ii) rules and procedures for maintaining order at the meeting and the
safety of those present; (iii) limitations on attendance at or participation in
the meeting to stockholders of record of the corporation, their duly authorized
and constituted proxies or such other persons as the chairman of the meeting
shall determine; (iv) restrictions on entry to the meeting after the time fixed
for the commencement thereof; and (v) limitations on the time allotted to
questions or comments by participants. Unless and to the extent determined by
the Board of Directors or the chairman of the meeting, meetings of stockholders
shall not be required to be held in accordance with the rules of parliamentary
procedure.
8.
<PAGE>
ARTICLE II
BOARD OF DIRECTORS
Section 2.1. NUMBER; QUALIFICATIONS. The Board of Directors shall consist
of eleven (11) members unless changed by an amendment to the certificate of
incorporation. Directors need not be stockholders.
Section 2.2. ELECTION; RESIGNATION; VACANCIES. The Board of Directors
shall initially consist of the persons named as directors in the certificate of
incorporation, and each director so elected shall hold office until the first
annual meeting of stockholders or until his successor is elected and qualified.
At the first annual meeting of stockholders and at each annual meeting
thereafter, the stockholders shall elect directors each of whom shall hold
office for a term of one year or until his successor is elected and qualified.
Any director may resign at any time upon written notice to the corporation. Any
newly created directorship or any vacancy occurring in the Board of Directors by
reason of death or resignation may be filled by a majority of the remaining
members of the Board of Directors, although such majority is less than a quorum,
or by a plurality of the votes cast at a meeting of stockholders. Any vacancy
occurring in the Board of Directors by reason of removal of a director by the
vote or written consent of the stockholders may be filled only by a majority of
the shares entitled to vote represented at a duly held meeting at which a quorum
is present, or by the written consent of the holders of the outstanding shares
entitled to vote. Each director elected in accordance with either of the two
preceding sentences shall hold office until the expiration of the term of office
of the director whom he has replaced or until his successor is elected and
qualified.
Section 2.3. REGULAR MEETINGS. Regular meetings of the Board of Directors
may be held at such places within or without the State of Delaware and at such
times as the Board of Directors may from time to time determine, and if so
determined notices thereof need not be given.
Section 2.4. SPECIAL MEETINGS. Special meetings of the Board of Directors
may be held at any time or place within or without the State of Delaware
whenever called by the President, any Vice President, the Secretary, or by any
member of the Board of Directors. Notice of a special meeting of the Board of
Directors shall be given by the person or persons calling the meeting at least
twenty-four hours before the special meeting.
Section 2.5. TELEPHONIC MEETINGS PERMITTED. Members of the Board of
Directors, or any committee designated by the Board of Directors, may
participate in a meeting thereof by means of conference telephone or similar
communications equipment by means of which all persons participating in the
meeting can hear each other, and participation in a meeting pursuant to this
by-law shall constitute presence in person at such meeting.
Section 2.6. QUORUM; VOTE REQUIRED FOR ACTION. At all meetings of the
Board of Directors a majority of the whole Board of Directors shall constitute a
quorum for the
9.
<PAGE>
transaction of business. Except in cases in which the certificate of
incorporation, these by-laws or applicable law otherwise provides, the vote
of a majority of the directors present at a meeting at which a quorum is
present shall be the act of the Board of Directors.
Section 2.7. ORGANIZATION. Meetings of the Board of Directors shall be
presided over by the Chairman of the Board, if any, or in his absence by the
Vice Chairman of the Board, if any, or in his absence by the President, or in
their absence by a chairman chosen at the meeting. The Secretary shall act as
secretary of the meeting, but in his absence the chairman of the meeting may
appoint any person to act as secretary of the meeting.
Section 2.8. ACTION BY WRITTEN CONSENT OF DIRECTORS. Unless otherwise
restricted by the certificate of incorporation or these by-laws, any action
required or permitted to be taken at any meeting of the Board of Directors, or
of any committee thereof, may be taken without a meeting if all members of the
Board of Directors or such committee, as the case may be, consent thereto in
writing, and the writing or writings are filed with the minutes of proceedings
of the Board of Directors or such committee.
10.
<PAGE>
ARTICLE III
COMMITTEES
Section 3.1. COMMITTEES. The Board of Directors may designate one or more
committees, each committee to consist of one or more of the directors of the
corporation. The Board of Directors may designate one or more directors as
alternate members of any committee, who may replace any absent or disqualified
member at any meeting of the committee. In the absence or disqualification of a
member of the committee, the member or members thereof present at any meeting
and not disqualified from voting, whether or not he or they constitute a quorum,
may unanimously appoint another member of the Board of Directors to act at the
meeting in place of any such absent or disqualified member. Any such committee,
to the extent permitted by law and to the extent provided in the resolution of
the Board of Directors, shall have and may exercise all the powers and authority
of the Board of Directors in the management of the business and affairs of the
corporation, and may authorize the seal of the corporation to be affixed to all
papers which may require it.
Section 3.2. COMMITTEE RULES. Unless the Board of Directors otherwise
provides, each committee designated by the Board of Directors may make, alter
and repeal rules for the conduct of its business. In the absence of such rules
each committee shall conduct its business in the same manner as the Board of
Directors conducts its business pursuant to Article II of these by-laws.
ARTICLE IV
OFFICERS
Section 4.1. EXECUTIVE OFFICERS; ELECTION; QUALIFICATIONS; TERM OF OFFICE;
RESIGNATION; REMOVAL; VACANCIES. The Board of Directors shall elect a President
and Secretary, and it may, if it so determines, choose a Chairman of the Board
and a Vice Chairman of the Board from among its members. The Board of Directors
may also choose one or more Vice Presidents, one or more Assistant Secretaries,
a Chief Financial Officer or a Treasurer and one or more Assistant Treasurers.
Each such officer shall hold office until the first meeting of the Board of
Directors after the annual meeting of stockholders next succeeding his election,
and until his successor is elected and qualified or until his earlier
resignation or removal. Any officer may resign at any time upon written notice
to the corporation. The Board of Directors may remove any officer with or
without cause at any time, but such removal shall be without prejudice to the
contractual rights of such officer, if any, with the corporation. Any number of
offices may be held by the same person. Any vacancy occurring in any office of
the corporation by death, resignation, removal or otherwise may be filled for
the unexpired portion of the term by the Board of Directors at any regular or
special meeting.
Section 4.2. POWERS AND DUTIES OF EXECUTIVE OFFICERS. The officers of the
corporation shall have such powers and duties in the management of the
corporation as may
11.
<PAGE>
be prescribed in a resolution by the Board of Directors and, to the extent
not so provided, as generally pertain to their respective offices, subject to
the control of the Board of Directors. The Board of Directors may require
any officer, agent or employee to give security for the faithful performance
of his duties.
ARTICLE V
STOCK
Section 5.1. CERTIFICATES. Every holder of stock shall be entitled to
have a certificate signed by or in the name of the corporation by the Chairman
or Vice Chairman of the Board of Directors, if any, or the President or a Vice
President, and by the Chief Financial Officer or Treasurer or an Assistant
Treasurer, or the Secretary or an Assistant Secretary, of the corporation
certifying the number of shares owned by him in the corporation. Any of or all
the signatures on the certificate may be a facsimile. In case any officer,
transfer agent or registrar who has signed or whose facsimile signature has been
placed upon a certificate shall have ceased to be such officer, transfer agent,
or registrar before such certificate is issued, it may be issued by the
corporation with the same effect as if he were such officer, transfer agent, or
registrar at the date of issue.
Section 5.2. LOST, STOLEN OR DESTROYED STOCK CERTIFICATES; ISSUANCE OF NEW
CERTIFICATES. The corporation may issue a new certificate of stock in the place
of any certificate theretofore issued by it, alleged to have been lost, stolen
or destroyed, and the corporation may require the owner of the lost, stolen or
destroyed certificate, or his legal representative, to give the corporation a
bond sufficient to indemnify it against any claim that may be made against it on
account of the alleged loss, theft or destruction of any such certificate or the
issuance of such new certificate.
ARTICLE VI
INDEMNIFICATION
Section 6.1. RIGHT TO INDEMNIFICATION. The corporation shall indemnify
and hold harmless, to the fullest extent permitted by applicable law as it
presently exists or may hereafter be amended, any person (an "Indemnitee") who
was or is made or is threatened to be made a party or is otherwise involved in
any action, suit or proceeding, whether civil, criminal, administrative or
investigative (a "proceeding"), by reason of the fact that he, or a person for
whom he is the legal representative, is or was a director or officer of the
corporation or, while a director or officer of the corporation, is or was
serving at the request of the corporation as a director, officer, employee or
agent of another corporation or of a partnership, joint venture, trust,
enterprise or nonprofit entity, including service with respect to employee
benefit plans, against all liability and loss suffered and expenses (including
attorneys' fees) reasonably incurred by such Indemnitee. Notwithstanding the
preceding sentence, except as otherwise provided in Section 6.3, the corporation
shall be required to indemnify an Indemnitee in connection with a proceeding (or
part thereof)
12.
<PAGE>
commenced by such Indemnitee only if the commencement of such proceeding (or
part thereof) by the Indemnitee was authorized by the Board of Directors of
the corporation.
Section 6.2. PREPAYMENT OF EXPENSES. The corporation shall pay the
expenses (including attorneys' fees) incurred by an Indemnitee in defending any
proceeding in advance of its final disposition, PROVIDED, HOWEVER, that, to the
extent required by law, such payment of expenses in advance of the final
disposition of the proceeding shall be made only upon receipt of an undertaking
by the Indemnitee to repay all amounts advanced if it should be ultimately
determined that the Indemnitee is not entitled to be indemnified under this
Article VI or otherwise.
Section 6.3. CLAIMS. If a claim for indemnification or payment of
expenses under this Article VI is not paid in full within sixty days after a
written claim therefor by the Indemnitee has been received by the corporation,
the Indemnitee may file suit to recover the unpaid amount of such claim and, if
successful in whole or in part, shall be entitled to be paid the expense of
prosecuting such claim. In any such action the corporation shall have the
burden of proving that the Indemnitee is not entitled to the requested
indemnification or payment of expenses under applicable law.
Section 6.4. NONEXCLUSIVITY OF RIGHTS. The rights conferred on any
Indemnitee by this Article VI shall not be exclusive of any other rights which
such Indemnitee may have or hereafter acquire under any statute, provision of
the certificate of incorporation, these by-laws, agreement, vote of stockholders
or disinterested directors or otherwise.
Section 6.5. OTHER SOURCES. The corporation's obligation, if any, to
indemnify or to advance expenses to any Indemnitee who was or is serving at its
request as a director, officer, employee or agent of another corporation,
partnership, joint venture, trust, enterprise or nonprofit entity shall be
reduced by any amount such Indemnitee may collect as indemnification or
advancement of expenses from such other corporation, partnership, joint venture,
trust, enterprise or non-profit enterprise.
Section 6.6. AMENDMENT OR REPEAL. Any repeal or modification of the
foregoing provisions of this Article VI shall not adversely affect any right or
protection hereunder of any Indemnitee in respect of any act or omission
occurring prior to the time of such repeal or modification.
Section 6.7. OTHER INDEMNIFICATION AND PREPAYMENT OF EXPENSES. This
Article VI shall not limit the right of the corporation, to the extent and in
the manner permitted by law, to indemnify and to advance expenses to persons
other than Indemnitees when and as authorized by appropriate corporate action.
13.
<PAGE>
ARTICLE VII
MISCELLANEOUS
Section 7.1. FISCAL YEAR. The fiscal year of the corporation shall be
determined by resolution of the Board of Directors.
Section 7.2. SEAL. The corporate seal shall have the name of the
corporation inscribed thereon and shall be in such form as may be approved from
time to time by the Board of Directors.
Section 7.3. WAIVER OF NOTICE OF MEETINGS OF STOCKHOLDERS, DIRECTORS AND
COMMITTEES. Any written waiver of notice, signed by the person entitled to
notice, whether before or after the time stated therein, shall be deemed
equivalent to notice. Attendance of a person at a meeting shall constitute a
waiver of notice of such meeting, except when the person attends a meeting for
the express purpose of objecting, at the beginning of the meeting, to the
transaction of any business because the meeting is not lawfully called or
convened. Neither the business to be transacted at nor the purpose of any
regular or special meeting of the stockholders, directors, or members of a
committee of directors need be specified in any written waiver of notice.
Section 7.4. INTERESTED DIRECTORS; QUORUM. No contract or transaction
between the corporation and one or more of its directors or officers, or between
the corporation and any other corporation, partnership, association, or other
organization in which one or more of its directors or officers are directors or
officers, or have a financial interest, shall be void or voidable solely for
this reason, or solely because the director or officer is present at or
participates in the meeting of the Board of Directors or committee thereof which
authorizes the contract or transaction, or solely because his or their votes are
counted for such purpose, if: (1) the material facts as to his relationship or
interest and as to the contract or transaction are disclosed or are known to the
Board of Directors or the committee, and the Board of Directors or committee in
good faith authorizes the contract or transaction by the affirmative votes of a
majority of the disinterested directors, even though the disinterested directors
be less than a quorum; or (2) the material facts as to his relationship or
interest and as to the contract or transaction are disclosed or are known to the
stockholders entitled to vote thereon, and the contract or transaction is
specifically approved in good faith by vote of the stockholders; or (3) the
contract or transaction is fair as to the corporation as of the time it is
authorized, approved or ratified, by the Board of Directors, a committee
thereof, or the stockholders. Common or interested directors may be counted in
determining the presence of a quorum at a meeting of the Board of Directors or
of a committee which authorizes the contract or transaction.
Section 7.5. FORM OF RECORDS. Any records maintained by the corporation
in the regular course of its business, including its stock ledger, books of
account, and minute books, may be kept on, or be in the form of, punch cards,
magnetic tape, photographs,
14.
<PAGE>
microphotographs, or any other information storage device, provided that the
records so kept can be converted into clearly legible form within a
reasonable time.
Section 7.6. AMENDMENT OF BY-LAWS. These by-laws may be altered or
repealed, and new by-laws made, by the Board of Directors, but the stockholders
may make additional by-laws and may alter and repeal any by-laws whether adopted
by them or otherwise.
15.
<PAGE>
[LETTERHEAD]
September 8, 1997
Mr. Ed Shoup, FCAS
5677 Heatherton Drive
Somis, CA 93066
Dear Ed:
This letter will document our conversation of September 5, 1997. Superior
National Insurance Company will offer you the position of Senior Vice
President and Chief Actuary on the following terms and conditions:
1. Your affirmative response by the close of business on Friday, September 12,
1997.
2. A satisfactory check by Superior on your background and employment history.
3. Your agreement to commence employment no later than October 1, 1997.
4. An annual salary of $130,000, payable twice monthly.
5. An annual cash car allowance of $10,000, payable twice monthly, which is
paid in lieu of all mileage reimbursement and other business auto expenses.
6. Four weeks of vacation annually, subject to Superior's standard
carryover and cash-out policies.
7. Standard benefits package, including:
a. Medical, dental, and disability insurance.
b. Participation in Superior's 401K plan.
c. All other benefit plans enjoyed by executives of comparable rank.
8. A one year change in control agreement, under which, if you are
terminated from employment at Superior as a result of a change in control
of the Company only, you will receive your salary and benefits for a
period of one year from the date of your termination. The agreement will
expire after two years.
9. Attendance at a reasonable number of Society of Actuary, WCIRB, and
other meetings associated with your duties at Superior, the expenses of
which will be borne by Superior.
10. You understand that you will be reporting to me for administrative
purposes, but salary and employment issues will be decided jointly by
Bill Gentz and me.
We're excited about the prospects of having you join the Company, and look
forward to your early response.
Very truly yours,
J. Chris Seaman
Copy to Bill Gentz
Arnold Senter
<PAGE>
[LETTERHEAD]
July 13, 1998
Ms. Doris Lai
3285 Midvale Ave.
Los Angeles, CA 90034
Via Fax (310) 470-9384
Dear Doris:
This letter will confirm our offer to you to accept the position of Vice
President - Finance at Superior National Insurance Group, Inc. effective
August 3, 1998 under the following terms:
1. Salary of $125,000.
2. 5,000 options at the current market value.
3. One year "evergreen" employment contract. If you are terminated by the
Company for any reason other than "for cause" at any time the contract
is in force, you will continue to receive compensation for one year from
the date of termination.
4. You will be credited with the time of your prior employment for all
benefit purposes, except where prohibited by law.
5. You will be allowed full participation in the management purchase of
SNTL shares associated with the upcoming rights offering, including the
financing to be provided to management by the company.
6. Your duties will involve management of the Accounting Department, and
Alex Corbett and Stuart Levine will report directly to you, and you in
turn will report directly to me. Premium Audit and Collections will in
future report directly to me as well, as opposed to reporting through
the Vice President - Finance.
I trust you will find this proposal satisfactory, and I want to assure you
that we are delighted at the prospect of your return to Superior National.
Very truly yours,
/s/ J. Chris Seaman
J. Chris Seaman
Copy to Brad Cooper
Bill Gentz
<PAGE>
[LOGO] BANCBOSTON LEASING
a BANK OF BOSTON company
MASTER LEASE FINANCE AGREEMENT
This MASTER LEASE FINANCE AGREEMENT, dated as of the 1st day of
December, 1998, ("Lease Agreement") is made at Boston, Massachusetts by and
between BancBoston Leasing Inc. ("Lessor"), a Massachusetts corporation with
its principal place of business at 100 Federal Street, Boston, Massachusetts
02110 and Business Insurance Group, Inc. and Subsidiaries ("Lessee"), a
Delaware corporation with its principal place of business at 11171 Sun Center
Drive, Rancho Cordova, California 95670.
IN CONSIDERATION OF the mutual promises and covenants contained herein,
Lessor and Lessee hereby agree as follows:
1. PROPERTY LEASED. At the request of Lessee and subject to the terms
and conditions of this Lease Agreement, Lessor shall lease to Lessee and
Lessee shall lease from Lessor such personal property ("Equipment") as may be
mutually agreed upon by Lessor and Lessee. The Equipment shall be selected
by or ordered at the request of Lessee, identified in one or more equipment
schedules substantially in the form of Exhibit A attached hereto ("Equipment
Schedule") and accepted by Lessee in one or more certificates of acceptance
("Certificate of Acceptance") in the form of Exhibit B attached hereto. Each
Equipment Schedule executed by Lessor and Lessee and each Certificate of
Acceptance executed by Lessee shall constitute a part of this Lease Agreement.
2. CERTAIN DEFINITIONS.
2.1 The "Commencement Date" shall mean the date on which the Equipment
identified in the applicable Equipment Schedule is accepted by Lessee under
this Lease Agreement. Each Commencement Date shall be evidenced by the
Certificate of Acceptance applicable to such Equipment Schedule.
2.2 The "Rent Start Date" shall mean either (i) the first day of the
month following the month in which the Commencement Date occurs or (ii) the
Commencement Date, if the Commencement Date occurs on the first day of the
month.
2.3 The "Monthly Rent" shall mean the amount set forth in the
applicable Equipment Schedule as Monthly Rent for the Equipment identified on
such Equipment Schedule.
2.4 The "Daily Rent" shall mean one-thirtieth (1/30) of the Monthly
Rent.
2.5 The words "herein", "hereof", and "hereunder" shall refer to this
Lease Agreement as a whole and not to any particular section. All other
capitalized terms defined in this Lease Agreement shall have the meanings
assigned thereto.
3. TERM OF LEASE; PAYMENT OF RENT.
3.1 The term of lease for the Equipment ("Lease Term") shall begin on
the Commencement Date set forth in the applicable Certificate of Acceptance
and shall continue during and until the expiration of the number of full
calendar months set forth in the applicable Equipment Schedule, measured from
the Rent Start Date. The Lease Term may not be cancelled or terminated
except as set forth in Section 10.2 below.
3.2 Aggregate Daily Rent shall be due and payable by Lessee on the Rent
Start Date in an amount equal to the Daily Rent multiplied by the actual
number of days elapsed from, and including, the Commencement Date to, but
excluding, the Rent State Date. The Monthly Rent shall be due and payable on
the Rent State Date and, thereafter on the first day of each month of the
Lease Term. All Daily Rents and Monthly Rents shall be paid to Lessor at its
office in Boston, Massachusetts.
4. ACCEPTANCE OF EQUIPMENT; EXCLUSION OF WARRANTIES.
4.1 Lessee shall signify its acceptance of the Equipment identified in
the applicable Equipment Schedule by promptly executing and delivering to
Lessor a Certificate of Acceptance. Lessee acknowledges that its execution
and delivery of the Certificate of Acceptance shall conclusively establish,
as between Lessor and Lessee, that the Equipment has been inspected by
Lessee, is in good repair and working order, is of the design, manufacture
and capacity selected by Lessee, and is accepted by Lessee under this Lease
Agreement.
4.2 In the event the Equipment is ordered by Lessor from a manufacturer
or supplier at the request of Lessee, Lessor shall not be required to pay the
purchase price for such Equipment unless and until the applicable Certificate
of Acceptance has been received by Lessor. Lessee hereby agrees to
indemnify, defend and hold harmless from any liability to any manufacturer or
supplier arising from the failure of Lessee to lease any Equipment which is
ordered by Lessor at the request of Lessee or for which Lessor has assumed an
obligation to purchase.
4.3 Lessor leases the Equipment to Lessee and Lessee leases the
equipment from Lessor "AS IS" and "WITH ALL FAULTS". Lessee hereby
acknowledges that (i) Lessor is not a manufacturer, supplier or dealer of
such Equipment nor an agent thereof; and (ii) LESSOR HAS NOT MADE, DOES NOT
MAKE, AND HEREBY DISCLAIMS ANY REPRESENTATION OR WARRANTY WHATSOEVER, EXPRESS
OR IMPLIED, WITH RESPECT TO THE EQUIPMENT INCLUDING, BUT NOT LIMITED TO, ITS
DESIGN, CAPACITY, CONDITION, MERCHANTABILITY, OR FITNESS FOR USE OR FOR ANY
PARTICULAR PURPOSE. Lessee further acknowledges that Lessor is not
responsible for any repairs, maintenance, service, latent or other defects in
the Equipment or in the operation thereof, or for compliance of any Equipment
with requirements of any laws, ordinances, governmental rules or regulations
including, but not limited to, laws with respect to environmental matters,
patent, trademark, copyright or trade secret infringement, or for any direct
or consequential damages arising out of the use of or inability to use the
Equipment.
4.4 Provided no Event of Default, as defined in Section 15 below, has
occurred and is continuing, Lessor agrees to cooperate with Lessee, at
<PAGE>
the sole cost and expense of Lessee, in making any claim against a
manufacturer or supplier of the Equipment arising from a defect in such
Equipment. At the request of Lessee, Lessor shall assign to Lessee all
warranties on the Equipment available from any manufacturer or supplier to
the full extent permitted by the terms of such warranties and by applicable
law.
5. OWNERSHIP; INSPECTION; MAINTENANCE AND USE.
5.1 Title to the equipment shall at all times be in the name of Lessor.
Any Equipment subject to titling and registration laws shall be titled and
registered by Lessee on behalf of and in the name of Lessor at the sole cost
and expense of Lessee. Lessee shall cooperate with and provide Lessor with
any information or documents necessary for titling and registration of the
Equipment. Upon the request of Lessor, Lessee shall execute and documents or
instruments which may be necessary or appropriate to confirm, to record or to
give notice of the interest of Lessor in the Equipment, including, but not
limited to, financing statements under the Uniform Commercial Code. Lessee,
at the request of Lessor, shall affix to the Equipment, in a conspicuous
place, any label, plaque or other insignia supplied by Lessor designating the
interest of Lessor in the Equipment.
5.2 The Equipment shall be located at the address specified in the
applicable Equipment Schedule and shall not be removed therefrom without the
prior written consent of Lessor. Lessor, its agents or employes shall have
the right to enter the premises of Lessee, upon reasonable notice and during
normal business hours, for the purpose of inspecting the Equipment.
5.3 Lessee shall pay all costs, expenses, fees and charges whatsoever
incurred in connection with the use and operation of the Equipment. Lessee
shall, at all times and at its own expense, keep the Equipment in good repair
and working order, reasonable wear and tear excepted. Any maintenance
contract required by a manufacturer or supplier for the care and upkeep of
the Equipment shall be entered into by Lessee at its sole cost and expense.
Lessee shall permit the use and operation of the Equipment only by personnel
authorized by Lessee and shall comply with all laws, ordinances or
governmental rules and regulations relating to the use and operation of the
Equipment.
6. ALTERATIONS AND MODIFICATIONS. Lessee may make, or cause to be made
on its behalf, any improvement, modification or addition to the Equipment
with the prior written consent of Lessor, provided, however, that such
improvement, modification or addition is readily removable without causing
damage to the impairment of the functional effectiveness of the Equipment.
To the extent that such improvement, modification or addition is not so
removable, it shall immediately become the property of Lessor and thereupon
shall be considered Equipment for all purposes of this Lease Agreement.
7. EQUIPMENT USE; NO DEFENSE, SET-OFFS OR COUNTERCLAIMS.
7.1 Provided no Event of Default, as defined in Section 15 below, has
occurred and is continuing, Lessee shall have the use of the Equipment in the
ordinary course of its business during the Lease Term without interruption by
Lessor or any person or entity claiming through or under Lessor.
7.2 Lessee acknowledges and agrees that ANY DAMAGE TO OR LOSS,
DESTRUCTION, OR UNFITNESS OF, OR DEFECT IN THE EQUIPMENT, OR THE INABILITY OF
LESSEE TO USE THE EQUIPMENT FOR ANY REASON WHATSOEVER, SHALL NOT (i) GIVE
RISE TO ANY DEFENSE, COUNTERCLAIM, OR RIGHT OF SET-OFF AGAINST LESSOR, OR
(ii) PERMIT ANY ABATEMENT OR RECOUPMENT OF, OR REDUCTION IN DAILY OR MONTHLY
RENT, OR (iii) RELIEVE LESSEE OF THE PERFORMANCE OF ITS OBLIGATIONS UNDER
THIS LEASE AGREEMENT INCLUDING, BUT NOT LIMITED TO, ITS OBLIGATION TO PAY THE
FULL AMOUNT OF DAILY RENT AND MONTHLY RENT, WHICH OBLIGATIONS ARE ABSOLUTE
AND UNCONDITIONAL, unless and until this Lease Agreement is terminated with
respect to such Equipment in accordance with the provisions of Section 10.2
below. Any claim that Lessee may have which arises from a defect in or
deficiency of the Equipment shall be brought solely against the manufacturer
or supplier of the Equipment and Lessee shall, notwithstanding any such
claim, continue to pay Lessor all amounts due and to become due under this
Lease Agreement.
8. ADVERSE CLAIMS AND INTERESTS.
8.1 Except for any liens, claims, mortgages, pledges, encumbrances or
security interests created by Lessor, Lessee shall keep the Equipment, at all
times, free and clear from all liens, claims, mortgages, pledges,
encumbrances and security interests and from all levies, seizures and
attachments. Without limitation of the covenants and obligations of Lessee
set forth in the preceding sentence, Lessee shall immediately notify Lessor
in writing of the imposition of any prohibited lien, claim, levy or
attachment on or seizure of the Equipment at which time Lessee shall provide
Lessor with all relevant information in connection therewith.
8.2 Lessee agrees that the Equipment shall be and at all times shall
remain personal property. Accordingly, Lessee shall take such steps as may
be necessary to prevent any person from acquiring, having or retaining any
rights in or to the Equipment by reason of its being affixed or attached to
real property.
9. INDEMNITIES; PAYMENT OF TAXES.
9.1 Lessee hereby agrees to indemnify, defend and hold harmless Lessor,
its agents, employees, successors and assigns from and against any and all
claims, actions, suits, proceedings, costs, expenses, damages and liabilities
whatsoever arising out of or in connection with the manufacture, ordering,
selection, specifications, availability, delivery, titling, registration,
rejection, installation, possession, maintenance, ownership, use, leasing,
operation or return of the Equipment including, but not limited to, any claim
or demand based upon any STRICT OR ABSOLUTE LIABILITY IN TORT and upon any
infringement or alleged infringement of any patent, trademark, trade secret,
license, copyright or otherwise. All costs and expenses incurred by Lessor
in connection with any of the foregoing including, but not limited to,
reasonable legal fees, shall be paid by Lessee on demand.
9.2 Lessee hereby agrees to indemnify, defend and hold Lessor harmless
against all Federal, state and local taxes, assessments, licenses,
withholdings, levies, imposts, duties, assessments, excise taxes,
registration fees and other governmental fees and charges whatsoever, which
are imposed, assessed or levied on or with respect to the Equipment or its
use or related in any way to this Lease Agreement ("Tax Assessments"), except
for taxes on or measured by the net income of Lessor determined substantially
in the same manner as under the Internal Revenue Code of 1986, as amended.
Lessee shall file all returns, reports or other such documents required in
connection with the Tax Assessments and shall provide Lessor with copies
thereof. If, under local law or custom, Lessee is not authorized to make the
filings required by a taxing authority, Lessee shall notify Lessor in writing
and Lessor shall thereupon undertake to file such returns, reports or
documents. Without limiting any of the foregoing, Lessee shall indemnify,
defend and hold Lessor harmless from all penalties, fines, interest payments,
claims and expenses including, but not limited to, reasonable legal fees,
arising from any failure of Lessee to comply with the requirements of this
Section 9.2.
9.3 The obligations and indemnities of Lessee under this Section 9 for
events occurring or arising during the Lease Term shall continue in full
force and effect, notwithstanding the expiration or other termination of this
Lease Agreement.
<PAGE>
10. RISK OF LOSS; LOSS OF EQUIPMENT.
10.1 Lessee hereby assumes and shall bear the entire risk of loss for
theft, damage, seizure, condemnation, destruction or other injury whatsoever
to the Equipment from any and every cause whatsoever. Such risk of loss
shall be deemed to have been assumed by Lessee from and after such risk
passes from the manufacturer or supplier by agreement or pursuant to
applicable law.
10.2 In the event of any loss, seizure, condemnation or destruction of
the Equipment or damage to the Equipment which cannot be repaired by Lessee,
Lessee shall immediately notify Lessor in writing. Within thirty (30) days
of such notice, during which time Lessee shall continue to pay Monthly Rent,
Lessee shall, at the option of Lessor, either (i) replace the Equipment with
equipment of the same type and manufacture and in good repair, condition and
working order, transfer title to such equipment to Lessor free and clear of
all liens, claims and encumbrances, whereupon such equipment shall be deemed
Equipment for all purposes of this Lease Agreement, or (ii) pay to Lessor an
amount equal to the present value of the aggregate of the remaining unpaid
Monthly Rents plus any other costs actually incurred by Lessor. The present
value shall be determined by discounting the aggregate of the remaining
unpaid Monthly Rents to the date of payment by Lessee at the rate of five (5)
percent per annum. Any insurance or condemnation proceeds received by Lessor
shall be credited to the obligation of Lessee under this Section 10.2 and the
remainder of such proceeds, if any, shall be paid to Lessee by Lessor in full
compensation for the loss of the leasehold interest in the Equipment by
Lessee.
10.3 Upon any replacement of or payment for the Equipment as provided
in Section 10.2 above, this Lease Agreement shall terminate only with respect
to the Equipment so replaced or paid for, and Lessor shall transfer to Lessee
title only to such Equipment "AS IS", "WITH ALL FAULTS", and WITH NO
WARRANTIES WHATSOEVER, EITHER EXPRESS OR IMPLIED, INCLUDING, WITHOUT
LIMITATION, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR USE OR FOR ANY
PARTICULAR PURPOSE. Lessee shall pay any sales or use taxes due on such
transfer.
11. INSURANCE.
11.1 Lessee shall keep the Equipment insured against all risks of loss
or damage from every cause whatsoever occurring during the Lease Term, for an
amount not less than the higher of the full replacement value of the
Equipment or the aggregate of unpaid Daily Rent and Monthly Rent for the
balance of the Lease Term. Lessee shall also carry public liability
insurance, both personal injury and property damage, covering the Equipment,
and Lessee shall be liable for any deductable portions of all required
insurance.
11.2 All insurance required under this Section 11 shall name Lessor as
additional insured and loss payee. Such insurance shall also be with such
insurers and shall be in such forms and amounts as are satisfactory to
Lessor. All applicable policies shall provide that no act, omission or
breach of warranty by Lessee shall give rise to any defense against payment
of the insurance proceeds to Lessor. Lessee shall pay the premiums for such
insurance and, at the request of Lessor, deliver to Lessor duplicates of such
policies or other evidence satisfactory to Lessor of such insurance coverage.
In any event, Lessee shall provide Lessor with endorsements upon the policies
issued by the insurers which evidence the existence of insurance coverage
required by this Section 11 and by which the insurers agree to give Lessor
written notice at least twenty (20) days prior to the effective date of any
expiration, modification, reduction, termination or cancellation of any such
policies.
11.3 The proceeds of insurance required under this Section 11 and
payable as a result of loss or damage to the Equipment shall be applied as
set forth in Section 10.2 above. Upon the occurrence of an Event of Default
as defined in Section 15 below, Lessee hereby irrevocably appoints Lessor as
its attorney-in-fact, which power shall be deemed coupled with an interest,
to make claim for, receive payment of, execute and endorse all documents,
checks or drafts received in payment for loss or damage under any insurance
policies required by this Section 11.
11.4 Notwithstanding anything herein, Lessor shall not be under any
duty to examine any evidence of insurance furnished hereunder, or to
ascertain the existence of any policy or coverage, or to advise Lessee of any
failure to comply with the provisions of this Section 11.
12. SURRENDER TO LESSEE. Upon the expiration of the Lease Term and
provided that no Event of Default, as defined in Section 15 below, has
occurred and is continuing, Lessor shall transfer title to the Equipment to
Lessee "AS IS", "WITH ALL FAULTS", and WITH NO WARRANTIES WHATSOEVER, EITHER
EXPRESS OR IMPLIED, INCLUDING, WITHOUT LIMITATION, ANY WARRANTIES OF
MERCHANTABILITY OR FITNESS FOR USE OR FOR PARTICULAR PURPOSE.
13. FINANCIAL STATEMENTS. Lessee shall annually, within ninety (90)
days after the close of the fiscal year for Lessee, furnish to Lessor
financial statements of Lessee, including a balance sheet as of the close of
such year and statements of income and retained earnings for such year,
prepared in accordance with generally accepted accounting principles,
consistently applied from year to year, and certified by independent public
accountants for Lessee, if requested by Lessor, Lessee shall also provide
quarterly financial statements of Lessee, similarly for each of the first
three quarters of each fiscal year, certified (subject to normal year-end
audit adjustments) by the chief financial officer of Lessee and furnished to
Lessor within sixty (60) days following the end of the quarter, and such
other financial information as may be reasonably requested by Lessor.
14. DELAYED PAYMENT CHANGE. Lessee shall pay to Lessor interest upon
the amount of any Daily Rent, Monthly Rent or other sums not paid by Lessee
when due and owing under this Lease Agreement, from the due date thereof
until paid, at the rate of one and one half (1 1/2) percent per month, but if
such rate violates applicable law, then the maximum rate of interest allowed
by such law.
15. DEFAULT.
15.1 The occurrence of any of the following events shall constitute an
event of default ("Event of Default") under this Lease Agreement.
(a) Lessee fails to pay any Daily Rent or any Monthly Rent when due
and such failure to pay continues for ten (10) consecutive days; or
(b) Lessee fails to pay any other sum required hereunder, and such
failure continues for a period of ten (10) days following written notice from
Lessor; or
(c) Lessee fails to maintain the insurance as required by Section 11
above and such failure continues for ten (10) days after written notice from
Lessor; or
(d) Lessee violates or fails to perform any other term, covenant or
condition of this Lease Agreement or any other document, agreement to
instrument executed pursuant hereto or in connection herewith, which failure
is not cured within (30) days after notice from Lessor; or
(e) Lessee ceases to exist or terminates its independent operations by
reason of any discontinuance, dissolution, liquidation, merger, sale of
substantially all of its assets, or otherwise ceases doing business as a
going concern; or
<PAGE>
(f) Lessee (i) applies for or consents to the appointment of, or the
taking of possession by, a receiver, custodian, trustee, liquidator or similar
official for itself or for all or a substantial part of its property, (ii) is
generally not paying its debts as such debts become due, (iii) makes a
general assignment for the benefit of its creditors, (iv) commences a
voluntary case under the United States Bankruptcy Code, as now or hereafter
in effect, seeking liquidation, reorganization or other relief with respect
to itself or its debts, (v) files a petition seeking to take advantage of any
other law providing for the relief of debtors, (vi) takes any action under
the laws of its jurisdiction of incorporation or organization similar to any
of the foregoing, or (vii) takes any corporate action for the purpose of
effecting any of the foregoing; or
(g) A proceeding or case is commenced, without the application or
consent of Lessee, in any court of competent jurisdiction, seeking (i) the
liquidation, reorganization, dissolution, winding up of Lessee or composition
or readjustment of the debts of Lessee, (ii) the appointment of a trustee,
receiver, custodian, liquidator or similar official for Lessee or for all or
any substantial part of its assets, or (iii) similar relief with respect to
Lessee, under any law providing for the relief of debtors; or an order for
relief is entered with respect to Lessee in an involuntary case under the
United States Bankruptcy Code, as now or hereafter in effect; or an action
under the laws of the jurisdiction of incorporation or organization of
Lessee, similar to any of the foregoing, is taken with respect to Lessee
without its application or consent; or
(h) Lessee makes any representation or warranty herein or in any
statement or certificate at any time given in writing pursuant to or in
connection with this Lease Agreement, which is false or misleading in any
material respect; or
(i) Lessee* defaults under any promissory note, credit agreement, loan
agreement, conditional sales contract, guaranty, lease, indenture, bond,
debenture or other material obligation whatsoever, and a party thereto or a
holder thereof is entitled to accelerate the obligations of Lessee*
thereunder; or Lessee* defaults in meeting any of its trade, tax or other
current obligations as they mature, unless such obligations are being
contested diligently and in good faith; or
(j) Any party to any guaranty, letter of credit, subordination or
credit agreement or other undertaking, given for the benefit of Lessor and
obtained in connection with this Lease Agreement, breaches, fails to
continue, contests, or purports to terminate or to disclaim such guaranty,
letter of credit, subordination or credit agreement or other undertaking; or
such guaranty, letter of credit, subordination agreement or other undertaking
becomes unenforceable; or a guarantor of this Lease Agreement shall die, cease
to exist or terminate its independent operations.
15.2 No waiver by Lessor of any Event of Default shall constitute a
waiver of any other Event of Default or of the same Event of Default at any
other time.
16. REMEDIES.
16.1 Upon the occurrence of an Event of Default and while such Event of
Default is continuing, Lessor, at its sole option, upon its declaration, and
to the extent not inconsistent with applicable law, may exercise any one or
more of the following remedies:
(a) Lessor may terminate this Lease Agreement whereupon all rights of
Lessee to the use of the Equipment shall cease;
(b) Whether or not this Lease Agreement is terminated, Lessor may
cause Lessee, at the sole cost and expense of Lessee, to return any or all of
the Equipment promptly to the possession of Lessor in good repair and working
order, reasonable wear and tear excepted. Lessor, at its sole option and
through its employees, agents or contractors, may peaceably enter upon the
premises where the Equipment is located and take immediate possession of and
remove the Equipment, all without liability to Lessor, its employees, agents
or contractors for such entry. LESSEE HEREBY WAIVES, TO THE EXTENT PERMITTED
BY APPLICABLE LAW, ANY AND ALL RIGHTS TO NOTICE AND/OR HEARING PRIOR TO THE
REPOSSESSION OR REPLEVIN OF THE EQUIPMENT BY LESSOR, ITS EMPLOYEES, AGENTS OR
CONTRACTORS;
(c) Lessor may proceed by court action to enforce performance by
Lessee of this Lease Agreement or pursue any other remedy Lessor may have
hereunder, at law, in equity or under any applicable statute including,
without limitation, the rights and remedies of a secured party under the
Uniform Commercial Code of The Commonwealth of Massachusetts or of any other
jurisdiction, and recover such other actual damages as may be incurred by
Lessor;
(d) Lessor may recover from Lessee damages, not as a penalty but as
liquidation for all purposes and without limitation of any other amounts due
from Lessee under this Lease Agreement, in an amount equal to the sum of (i)
any unpaid Daily Rents and/or Monthly Rents due and payable for periods prior
to the repossession of the Equipment by Lessor plus any interest due thereon
pursuant to Section 14 above, (ii) the present value of all future Monthly
Rents required to be paid over the remaining Lease Term after repossession of
the Equipment by Lessor, determined by discounting such future Monthly Rents
to the date of payment by Lessee at a rate of five (5) percent per annum, and
(iii) all costs and expenses incurred in searching for, taking, removing,
storing, repairing, refurbishing and leasing or selling such Equipment; or
(e) Lessor may sell, lease or otherwise dispose of any or all of the
Equipment, whether or not in the possession of Lessor, at public or private
sale and with or without notice Lessee, which notice is hereby expressly
waived by Lessee, to the extent permitted by and not inconsistent with
applicable law. Lessor may sell, lease or dispose of the Equipment in such
order and manner as Lessor may determine. Lessor shall then apply against
the obligations of Lessee hereunder the net proceeds of such sale, lease or
other disposition, after deducting all costs incurred by Lessor in connection
with such sale, lease or other disposition including, but not limited to,
costs of transportation, repossession, storage, refurbishing, advertising or
other fees and Lessee shall remain liable for any deficiency. Lessor shall
account for any excess of such proceeds over the total obligations owed by
Lessee, which excess shall be immediately paid over to Lessee. Unless the
Equipment threatens to decline speedily in value or is of the type
customarily sold on a recognized market, Lessor shall give to Lessee at least
(5) days prior written notice of the time and place of any public sale of the
Equipment or of the time after which any private sale or other disposition of
the Equipment is to be made.
16.2 No failure on the part of Lessor to exercise, and no delay in
exercising, any right or remedy hereunder shall operate as a waiver thereof.
No single or partial exercise of any right or remedy hereunder shall preclude
any other or further exercise thereof of the exercise of any other right or
remedy. Each right and remedy hereunder is cumulative and not exclusive of
any other right or remedy including, without limitation, any right or remedy
available to Lessor at law, by statute or in equity.
16.3 Lessee shall pay all costs and expenses including, but not limited
to, reasonable legal fees incurred by Lessor arising out of or in connection
with any Event of Default or this Lease Agreement. Lessee shall also be
liable for any amounts due and payable to Lessor under any other provision of
this Lease Agreement.
<PAGE>
17. ASSIGNMENT; SUBLEASE.
17.1 Lessor may sell, assign or otherwise transfer all or any part of
its right, title and interest in and to the Equipment and/or this Lease
Agreement to a third-party assignee, subject to the terms and conditions of
this Lease Agreement including, but not limited to, the right to the use of
the Equipment by Lessee as set forth in Section 7.1 above. Such assignee
shall assume all of the rights and obligations of Lessor under this Lease
Agreement and shall relieve Lessor therefrom. Thereafter, all references to
Lessor herein shall mean such assignee. Notwithstanding any such sale,
assignment or transfer, the obligations of Lessee hereunder shall remain
absolute and unconditional as set forth in Section 7.2 above.
17.2 Lessor may also, to the extent if its interest therein, pledge,
mortgage or grant a security interest in the Equipment and assign this Lease
Agreement as collateral. Each such pledgee, mortgagee, lienholder or
assignee shall have any and all rights as may be assigned by Lessor but none
of the obligations of Lessor hereunder. Any pledge, mortgage or grant of
security interest in the Equipment or assignment of this Lease Agreement
shall be subject to the terms and conditions hereof including, but not
limited to, the right to the use of the Equipment by Lessee as set forth in
Section 7.1 above. Lessor, by reason of such pledge, mortgage, grant of
security interest or collateral assignment, shall not be relieved of any of
its obligations hereunder which shall remain absolute and unconditional as
set forth in Section 7.2 above. Upon the written request of Lessor, Lessee
shall acknowledge such obligations to the pledgee, mortgagee, lienholder or
assignee.
17.3 LESSEE SHALL NOT SELL, TRANSFER, SUBLEASE, CONVEY OR PLEDGE ANY OF
ITS INTEREST IN THIS LEASE AGREEMENT OR ANY OF THE EQUIPMENT WITHOUT THE
PRIOR WRITTEN CONSENT OF LESSOR. Any such sale, transfer, assignment,
sublease, conveyance or pledge, whether by operation of law or otherwise,
without the prior written consent of Lessor, shall be void.
18. COMPLIANCE AND APPROVALS. Lessee warrants and agrees that this
Lease Agreement and the performance by Lessee of all of its obligations
hereunder have been duly authorized, do not and will not conflict with any
provision of the charter or bylaws of Lessee or of any agreement, indenture,
lease or other instrument to which Lessee is a party of by which Lessee or
any of its property is or may be bound. Lessee warrants and agrees that this
Lease Agreement does not and will not require any governmental authorization,
approvals, license or consent except those which have been duly obtained and
will remain in effect during the entire Lease Term.
19. MISCELLANEOUS.
19.1 The section headings are inserted herein for convenience of
reference and are not a part of and shall not affect the meaning or
interpretation of this Lease Agreement.
19.2 Any provision of this Lease Agreement which is unenforceable in
whole or in part in any jurisdiction shall, as to such jurisdiction, be
ineffective only to the extent of such unenforceability without invalidating
any remaining part or other provision hereof and shall not be affected in any
manner by reason of such enforceability in any other jurisdiction. The
validity and interpretation of this Lease Agreement and the rights and
obligations of the parties hereto shall be governed in all respects by the
laws of The Commonwealth of Massachusetts without giving effect to the
conflicts of laws provisions thereof.
19.3 This Lease Agreement, including all Equipment Schedules and
Certificates of Acceptance, constitutes the entire agreement between Lessor
and Lessee. Lessor and Lessee agree that this Lease Agreement shall not be
amended, altered or changed except by a written agreement signed by the
parties hereto. LESSEE ACKNOWLEDGES THAT THERE HAVE BEEN NO REPRESENTATIONS,
EXPRESS OR IMPLIED, BY LESSOR OTHER THAN AS SET FORTH AND LESSEE EXPRESSLY
CONFIRMS THAT IT HAS NOT RELIED UPON ANY REPRESENTATIONS BY LESSOR, EXCEPT
THOSE SET FORTH HEREIN, AS A BASIS FOR ENTERING INTO THIS LEASE AGREEMENT.
19.4 Any notice required to be given by Lessee or Lessor hereunder
shall be deemed adequately given if sent by registered or certified mail,
return receipt requested, to the other party at their respective addresses
stated herein or at such other place as either party may designate in writing
to the other.
19.5 Lessee agrees to execute and deliver such additional documents and
to perform such further acts as may be reasonably requested by Lessor in
order to carry out and effectuate the purposes of this Lease Agreement. Upon
the written request of Lessor, Lessee further agrees to execute any
instrument necessary for filing or recording this Lease Agreement or to
confirm the interest of Lessor in the Equipment. Lessor is hereby authorized
to insert in any Equipment Schedule the serial numbers of the Equipment and
other identifying marks or similar information and to sign, on behalf of
Lessee, any Uniform Commercial Code financing statements.
19.6 This Lease Agreement cannot be cancelled or terminated except as
expressly provided herein.
19.7 Whenever the context of this Lease Agreement requires, the
singular includes the plural and the plural includes the singular. Whenever
the word Lessor is used herein, it includes all assignees and successors in
interest of Lessor. If more that one Lessee are named in this Lease
Agreement, the liability of each shall be joint and several.
19.8 All agreements, indemnities, representations and warranties of
Lessee made herein and all rights and remedies of Lessor shall survive the
expiration or other termination of this Lease Agreement, whether or not
expressly provided herein.
19.9 Any waiver of any power, right, remedy or privilege of Lessor
hereunder shall not be effective unless in writing signed by Lessor.
19.10 This Lease Agreement may be executed in one or more counterparts,
each of which shall be deemed an original, but all of which together shall
constitute one and the same instrument.
IN WITNESS WHEREOF, Lessor and Lessee, each by its duly authorized
officer or agent, have duly executed and delivered this Lease Agreement,
which is intended to take effect as sealed instrument, as of the day and year
first written above.
Business Insurance Group, Inc. and Subsidiaries
By: J. Chris Seamon
---------------------------------------------
Title: V.P
---------------------------------------------
Accepted at Boston, Massachusetts
BANCBOSTON LEASING INC.
By: [Illegible]
-------------------------------
Title: Assistant Vice President
-------------------------------
<PAGE>
RIDER NO. 1
TO
MASTER LEASE FINANCE AGREEMENT
This Rider No. 1 (the "Rider") is entered into between BancBoston
Leasing Inc. ("Lessor") and the undersigned signatories (collectively, the
"Lessee"), and is contemporaneous with and amends the Master Lease Finance
Agreement dated as of December 1, 1998 (the "Lease Agreement"), between
Lessor and Lessee. It is the intention of Lessor and Lessee that, upon
execution, this Rider shall constitute a part of the Lease Agreement.
IN CONSIDERATION OF the mutual covenants and promises as hereinafter set
forth, Lessor and Lessee hereby agree as follows:
1. All capitalized terms used in this Rider shall, unless otherwise
defined, have the meanings set forth in the Lease Agreement.
2. Add the following to the end of Section 15.1(g) after the words
"application of consent;": "and the same is not dismissed within (60) days."
3. Add the following as Sections 20 and 21 of the Lease Agreement:
"20. Relationship of Co-Lessees. Joint and Several Obligations;
Defaults of Co-Lessees. The undersigned Co-Lessees are all engaged in
interrelated businesses and increasing the availability of capital equipment
to Superior National Insurance Group, Inc. and other Co-Lessees will benefit,
directly and indirectly, the business of all Co-Lessees in furtherance of
their respective corporate purposes. In light of the foregoing, the Co-Lessees
covenant and agree the the obligations, representations and warranties
hereunder of the Lessee are the joint and several obligations of the
Co-Lessees and that any reference to an Event of Default involving the Lessee
shall mean an Event of Default involving any Co-Lessee."
"21. Appointment of Agent. For convenience of the Co-Lessees
and in order to facilitate the administration of various actions required
under this Lease Agreement, each of the Co-Lessees hereby designates Superior
National Insurance Group, Inc. (the "Agent") as its agent in connection with
the Lease Agreement, and grants the Agent an irrevocable power of attorney to
take all actions and execute all such documents in the place and stead of
each Co-Lessee as may now or hereinafter be necessary to carry out the duties
of the Lessee hereunder; including (a) the execution and delivery on behalf
of the Co-Lessees of any and all Equipment Schedules, Riders, notices,
consents and requests required or permitted to be given under this Lease
Agreement (b) the receipt on behalf of Co-Lessees of all notices required or
permitted to be given to Lessee under this Lease Agreement, (c) the
selection, inspection, and acceptance of any item of Equipment, (d) the
negotiation, resolution and settlement of any disputes arising under this
Lease Agreement and (e) the taking of all such actions and execution of all
such documents as may be necessary or appropriate in connection with the
exercise of any purchase or renewal option. Notwithstanding the foregoing,
each Co-Lessee may act on its own behalf hereunder. Lessor shall
nevertheless be entitled to rely on all acts taken by Agent with respect to
any Co-Lessee hereunder, and each Co-Lessee (i) agrees that Lessor or any
assignee, lender or secured party shall be entitled to rely on such acts to
the same extent if they were performed by such Co-Lessee, (ii) waives the
right to require Lessor to (a) proceed against any other party, (b) proceed
against or exhaust any security held from any other party, and (c) pursue any
other remedy in Lessor's power whatsoever; (iii) waives diligence, demand,
presentment, protest and notice; (iv) consents to the alteration or release
in any manner of any other obligor, including without limitation the renewal,
extension, acceleration, changes in time for payment, and increases or
decreases in any Monthly Rent, rate of interest or other amounts owing, all
without in any way altering the liability of such Co-Lessee, and (v) waives
any circumstances which might otherwise constitute a legal or equitable
discharge of a surety or guarantor and, without limitation, any right of
subrogation, contribution, indemnification, setoff or other recourse in
respect of sums paid to Lessor by any other Co-Lessee."
<PAGE>
The terms and conditions of this Rider shall prevail where there may be
conflicts or inconsistencies with the terms and conditions of the Lease
Agreement.
IN WITNESS WHEREOF, Lessor and Lessee, each by its duly authorized
officer or agent, have duly executed and delivered this Rider which is
intended to take effect as a sealed instrument as of the date of the Lease
Agreement.
BUSINESS INSURANCE GROUP, INC.,
A DELAWARE CORPORATION,
in its individual capacity as a Co-Lessee, and
as Agent for the Co-Lessees under this Lease
Agreement
By: /s/ J. Chris Seaman
------------------------------------------
Title: V.P.
------------------------------------------
BUSINESS INSURANCE COMPANY
A DELAWARE CORPORATION, Co-Lessee
By: /s/ J. Chris Seaman
------------------------------------------
Title: V.P.
------------------------------------------
CALIFORNIA COMPENSATION
INSURANCE COMPANY,
A CALIFORNIA CORPORATION, Co-Lessee
By: /s/ J. Chris Seaman
------------------------------------------
Title: V.P.
------------------------------------------
COMMERCIAL COMPENSATION
INSURANCE COMPANY
A NEW YORK CORPORATION, Co-Lessee
By: /s/ J. Chris Seaman
------------------------------------------
Title: V.P.
------------------------------------------
COMBINED BENEFITS INSURANCE COMPANY
A CALIFORNIA CORPORATION, Co-Lessee
By: /s/ J. Chris Seaman
------------------------------------------
Title: V.P.
------------------------------------------
Accepted at Boston, Massachusetts
BANCBOSTON LEASING INC.
By: [Illegible]
------------------------------
Title: [Illegible]
------------------------------
<PAGE>
AMENDMENT NO. 1 TO MASTER LEASE FINANCE AGREEMENT
THIS AMENDMENT NO. 1 TO MASTER LEASE FINANCE AGREEMENT (the "Amendment")
is made as of the 10th day of December, 1998, among BANCBOSTON LEASING INC.
("Lessor"), BUSINESS INSURANCE GROUP INC., individually and as agent for its
subsidiaries ("BIG"), and SUPERIOR NATIONAL INSURANCE GROUP, INC.,
individually and as agent for its subsidiaries ("Superior National"). BIG
and its subsidiaries (collectively, the "Original Lessees") and Lessor have
heretofore entered into that certain Master Lease Finance Agreement, together
with Rider No. 1 to Master Lease Finance Agreement, each dated as of December
1, 1998 (collectively, the "Lease Agreement"). Capitalized terms used herein
without definition shall have the meaning given them in the Lease Agreement.
In connection therewith, Superior National executed and delivered to Lessor
that Certain Unlimited Guaranty dated as of December 1, 1998 (the "Guaranty").
The Original Lessees have been acquired by Superior National and the
parties desire to add Superior National as an additional co-lessee, jointly
and severally liable under the Lease Agreement; and further desire to
terminate the Guaranty.
NOW, THEREFORE, in consideration of the mutual covenants and promises as
hereinafter set forth, the parties agree as follows:
1. From and after the date hereof, the Lease Agreement is amended to
include Superior National as a co-lessee thereunder; to change the Agent from
BIG to Superior National; and BIG grants to Superior National an irrevocable
power of attorney to take all actions and execute all documents in the place
and stead of BIG, as agent, as may now or hereafter be necessary to carry out
the duties of the "Lessee" thereunder, all in accordance with the provisions
of Section 21 of the Lease Agreement.
2. Superior National acknowledges and agrees that, from and after the
date hereof, Superior National shall be a co-lessee, jointly and severally
liable for the obligations of the Lessee pursuant to the Lease Agreement; and
Superior National acknowledges that increasing the availability of equipment
to the co-lessees will benefit, directly and indirectly, the business of
Superior National in furtherance of its corporate purposes; all pursuant to
Section 20 of the Lease Agreement.
3. Except as expressly set forth herein, the terms and conditions of
the Lease Agreement remain unmodified and in full force and effect.
4. Subject to the effectiveness of this Agreement, the Guaranty is
terminated and all obligations of Superior National pursuant to the Guaranty
are released.
5. This Amendment, together with the Lease Agreement, constitutes the
entire agreement among the parties with respect to the subject matter hereof.
6. THE VALIDITY AND INTERPRETATION OF THIS AMENDMENT AND THE RIGHTS AND
OBLIGATIONS OF THE PARTIES HERETO SHALL BE GOVERNED IN ALL RESPECTS BY THE
LAWS OF THE COMMONWEALTH OF MASSACHUSETTS, WITHOUT
<PAGE>
GIVING EFFECT TO THE CONFLICT OF LAWS PROVISIONS THEREOF.
7. This Amendment may be executed in one or more counterparts, each of
which shall be deemed an original, but all of which together shall constitute
one and the same instrument.
IN WITNESS WHEREOF, the parties, each by its duly authorized officer or
agent, have duly executed and delivered this Amendment No. 1 to Master Lease
Finance Agreement, which is intended to take effect as a sealed instrument,
as of the day and year first above written.
BUSINESS INSURANCE GROUP INC.,
individually and as Agent
By: /s/ J. Chris Seaman
----------------------------
Name: J. Chris Seaman
----------------------------
Title: VP
----------------------------
SUPERIOR NATIONAL INSURANCE GROUP,
INC., INDIVIDUALLY AND AS AGENT FOR ITS
SUBSIDIARIES
By: /s/ J. Chris Seaman
----------------------------
Name: J. Chris Seaman
----------------------------
Title: VP
----------------------------
BANCBOSTON LEASING INC.
By: [Illegible]
-----------------------------
Name:
-----------------------------
Title:
-----------------------------
2
<PAGE>
AMENDMENT NO. 2 TO MASTER LEASE FINANCE AGREEMENT
THIS AMENDMENT NO. 2 TO MASTER LEASE FINANCE AGREEMENT (this "Amendment")
is made as of this 18th day of December, 1998, by and among BANCBOSTON
LEASING INC. ("Lessor") and SUPERIOR NATIONAL INSURANCE GROUP, INC.,
individually and as agent ("Lessee") for its subsidiaries (collectively,
together with Lessee, the "Co-Lessees" and sometimes hereinafter individually
referred to as a "Co-Lessee"). Lessee and Lessor have heretofore entered into
that certain Master Lease Finance Agreement, dated as of December 1, 1998
(collectively with Rider No. 1 dated December 1, 1998, to Master Lease
Finance Agreement, Amendment No. 1 dated as of December 10, 1998, to Master
Lease Finance Agreement, and any and all Equipment Schedules thereunder, the
"Lease Agreement"). Capitalized terms used herein without definition shall
have the meaning given them in the Lease Agreement.
WHEREAS, in connection with the sale by Lessee of its indirect 100%
stock ownership of Business Insurance Company ("BICO"), Lessee has requested
that Lessor agree to remove BICO as a Co-Lessee, and Lessor shall agree so to
remove BICO and to amend the Lease Agreement accordingly, all upon the terms
and conditions hereof.
NOW, THEREFORE, in consideration of the mutual covenants and promises as
hereinafter set forth, the parties agree as follows:
1. The Lease Agreement is hereby amended by the deletion of Business
Insurance Company as a Co-Lessee, wherever its name appears therein,
effective as of the date hereof.
2. Except as expressly set forth herein, the terms and conditions of
the Lease Agreement remain unmodified and in full force and effect.
3. This Amendment, together with the Lease Agreement, constitutes the
entire agreement among the parties with respect to the subject matter hereof.
4. The validity and interpretation of this Amendment and the rights
and obligations of the parties hereto shall be governed in all respects by
the laws of The Commonwealth of Massachusetts, without giving effect to the
conflict of laws provisions thereof.
5. This Amendment may be executed in one or more counterparts, each
of which shall be deemed an original, but all of which together shall
constitute one and the same instrument.
IN WITNESS WHEREOF, the parties, each by its duly authorized officer or
agent, have duly executed and delivered this Amendment No. 2 to Master Lease
Finance Agreement, which is intended to take effect as a sealed instrument,
as of the day and year first above written.
SUPERIOR NATIONAL INSURANCE BANCBOSTON LEASING INC.
GROUP,INC., individually and as agent
By:/s/ J. Chris Seaman By: [Illegible]
---------------------------------- ------------------------------
Name: J. Chris Seaman Name:
---------------------------------- ------------------------------
Title: CFO Title
---------------------------------- ------------------------------
<PAGE>
EXHIBIT 11
The following is an illustration of the reconciliation of the numerators
and denominators of the basic and diluted earnings per share (EPS)
computations:
<TABLE>
<CAPTION>
1998 1997 1996
-------------------------------------- -------------------------------------- ------------------------------------
INCOME SHARES PER SHARE INCOME SHARES PER SHARE INCOME PER SHARE AMOUNT
(NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) AMOUNT (DENOMINATOR)
-------------- ------------- --------- -------------- ------------- --------- ------------- -------- -------------
(IN THOUSANDS) (IN THOUSANDS) (IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BASIC EPS
Income before
items Below.... $ (6,245) 6,759,598 $(0.92) $ 463 5,249,736 $ 0.09 $ 3,630 3,432,679 $ 1.06
Preferred
Securities..... (7,357) (1.09) (3,069) (0.58) (1,667) (0.49)
Discontinued
Operations..... -- -- -- -- -- --
Extraordinary
Items.......... -- -- (2,535) (0.49) -- --
-------- ------ ------- ------ ------- ------
Net Income...... $(13,602) $(2.01) $(5,141) $(0.98) $ 1,963 $ 0.57
-------- ------ ------- ------ ------- ------
-------- ------ ------- ------ ------- ------
EFFECT OF DILUTIVE
Securities
Options..... N/A 295,065 226,183
Warrants.... N/A 1,471,364 1,167,178
DILUTED EPS
Income before
items Below.. $ (6,245) 6,759,598 $(0.92) $ 463 7,016,165 $ 0.07 $ 3,630 4,826,040 $ 0.75
Preferred
Securities... (7,357) (1.09) (3,069) (0.44) (1,667) (0.34)
Discontinued
Operations... -- -- -- -- -- --
Extraordinary
Items........ -- -- (2,535) (0.37) -- --
-------- ------ ------- ------ ------- ------
Net Income.... $(13,602) $(2.01) $(5,141) $(0.74) $ 1,963 $ 0.41
-------- ------ ------- ------ ------- ------
-------- ------ ------- ------ ------- ------
</TABLE>
Options to purchase 1,250 shares at $14.81, 12,500 shares at $14.875,
7,250 shares at $14.25, and 1,250 shares at $14.31 were outstanding during
the last quarter of 1997 but were not included in the computation of diluted
EPS because the options' exercise price was greater than the average market
price of the common shares. The options, which expire in 2002, were still
outstanding at the end of year 1998.
<PAGE>
EXHIBIT 21
LIST OF SUBSIDIARIES
WHOLLY OWNED SUBSIDIARIES OF SUPERIOR NATIONAL INSURANCE GROUP, INC.
("SNIG"), A DELAWARE CORPORATION
Business Insurance Group, Inc. ("BIG"), a Delaware corporation
Superior National Capital Holding Corporation ("SNCHC"), a Nevada corporation
Superior National Capital Trust I, a Delaware statutory trust
SUPERIOR NATIONAL CAPITAL, L.P., A BERMUDA LIMITED PARTNERSHIP
SNIG and SNCHC are the two general partners
WHOLLY OWNED SUBSIDIARIES OF BIG
Pacific Insurance Brokerage, Inc., a California corporation
InfoNet Management Systems, Inc. a California corporation
SN Insurance Services, Inc., a California corporation
Superior (Bermuda) Ltd., a Bermuda corporation
Superior Pacific Casually Company ("SPCC"), a California corporation
Superior National Insurance Company ("SNIC"), a California corporation
SN Insurance Administrators, Inc., a California corporation
California Compensation Insurance Company, a California corporation
Combined Benefits Insurance Company, a California corporation
Commercial Compensation Insurance Company, a New York corporation
WHOLLY OWNED SUBSIDIARY OF SPCC
Regional Benefits Insurance Services, Inc., a California corporation
WHOLLY OWNED SUBSIDIARY OF SNIC
Western Select Service Corp., a California corporation
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<DEBT-HELD-FOR-SALE> 541,678
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 1,544
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 550,615
<CASH> 316,786
<RECOVER-REINSURE> 14,429
<DEFERRED-ACQUISITION> 17,136
<TOTAL-ASSETS> 1,719,642
<POLICY-LOSSES> 1,076,206
<UNEARNED-PREMIUMS> 52,928
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 9,635
<NOTES-PAYABLE> 105,820
101,084
0
<COMMON> 228,691
<OTHER-SE> 223,962
<TOTAL-LIABILITY-AND-EQUITY> 1,719,642
87,089
<INVESTMENT-INCOME> 14,382
<INVESTMENT-GAINS> 1,854
<OTHER-INCOME> 0
<BENEFITS> 68,342<F3>
<UNDERWRITING-AMORTIZATION> 9,761
<UNDERWRITING-OTHER> 28,419
<INCOME-PRETAX> (7,744)
<INCOME-TAX> (1,499)
<INCOME-CONTINUING> (6,245)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (13,602)
<EPS-PRIMARY> (2.01)
<EPS-DILUTED> (2.01)
<RESERVE-OPEN> 761,035<F1>
<PROVISION-CURRENT> 36,650
<PROVISION-PRIOR> 31,692<F2>
<PAYMENTS-CURRENT> 76,823
<PAYMENTS-PRIOR> 108,807
<RESERVE-CLOSE> 1,706,206
<CUMULATIVE-DEFICIENCY> 31,692
<FN>
<F1>Includes BIG reserves at acquisition of $608,935
<F2>Includes $175,000 of existing claims on BIG net of $175,000 of Reinsurance
recovery on loss reserve guarantee.
<F3>Includes $(175,000) Reinsurance recovery on loss reserve guarantee.
</FN>
</TABLE>
