SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2001
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to ________
HIGHLANDS INSURANCE GROUP, INC.
(Exact Name of Registrant as Specified in its Charter)
1-14028
(Commission File Number)
DELAWARE 75-2370945
(State or Other Jurisdiction (I.R.S. Employer
Of Incorporation Or Organization) Identification Number)
1000 LENOX DRIVE,
Lawrenceville, New Jersey 08648
(Address of Principal Executive Offices) (Zip Code)
(609) 896-1921
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
The number of shares of the Registrant's Common Stock, par value $.01 per
share, outstanding at June 30, 2001 was 13,229,211.
1
HIGHLANDS INSURANCE GROUP, INC.
TABLE OF CONTENTS
PART I - Financial Information
Item Page
- ---- ----
1. Financial Statements:
Consolidated Balance Sheets
June 30, 2001 (Unaudited) and
December 31, 2000 3
Consolidated Statements of Operations
(Unaudited) - Three and Six Months Ended
June 30, 2001 and 2000 5
Consolidated Statements of Stockholders' Equity
Six Months Ended June 30, 2001 (Unaudited)
and Year Ended December 31, 2000 6
Consolidated Statements of Comprehensive Income (Loss)
(Unaudited) - Three and Six Months Ended
June 30, 2001 and 2000 7
Consolidated Statements of Cash Flows
(Unaudited) - Six Months Ended June 30,
2001 and 2000 8
Condensed Notes to Unaudited Consolidated
Financial Statements 9
2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 12
3. Quantitative and Qualitative Disclosures About
Market Risk 16
PART II - Other Information
1. Legal Proceedings 16
4. Submission of Matters to a Vote of Security Holders 17
6. Exhibits and Reports on Form 8-K 17
Signatures 17
2
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
June 30, December 31,
ASSETS 2001 2000
- ------ ---------- -----------
(Unaudited)
Investments:
Fixed maturity securities - available-for-sale, at fair
value (amortized cost of $785,528 at 6/30/01 and
$797,092 at 12/31/00) $ 773,275 776,453
Equity securities, at fair value (cost of $30,686 at
6/30/01 and $30,686 at 12/31/00) 31,799 32,091
Other investments, at cost 675 1,952
---------- ---------
Total investments 805,749 810,496
Cash and cash equivalents 99,056 109,763
Premiums in course of collection, net 153,601 126,719
Premiums due under retrospectively rated policies 138,541 138,119
Receivable from reinsurers 710,434 683,439
Prepaid reinsurance premiums 7,966 8,576
Funds on deposit with reinsurers 9,589 9,019
Net deferred tax asset 3,897 6,732
Accrued investment income 10,879 11,084
Deferred policy acquisition costs 51,765 49,622
Other assets 48,351 47,581
---------- ---------
Total assets $2,039,828 2,001,150
========== =========
See Condensed Notes to Unaudited Consolidated Financial Statements.
3
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS, (Continued)
(dollars in thousands)
June 30, December 31,
LIABILITIES AND STOCKHOLDERS' EQUITY 2001 2000
- ------------------------------------ ---------- -----------
(Unaudited)
Loss and loss adjustment expense reserves $1,425,856 1,392,497
Unearned premiums 243,440 224,120
Senior bank debt 49,004 49,004
Convertible subordinated debentures 61,892 58,626
Accounts payable and accrued liabilities 109,222 97,424
---------- ---------
Total liabilities 1,889,414 1,821,671
---------- ---------
Mandatorily redeemable preferred stock 5,082 4,930
---------- ---------
Commitments and contingent liabilities
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized;
13,229,211 and 13,225,411 issued and outstanding in 2001 and in 2000,
respectively 140 140
Additional paid-in capital 231,621 231,566
Accumulated other comprehensive loss (7,372) (12,572)
Treasury stock, at cost (739,400 shares in 2001 and 2000, including
445,900 shares held by subsidiaries in 2001 and 2000) (9,459) (9,459)
Deferred compensation on restricted stock (3,065) (3,097)
Retained loss (66,533) (32,029)
---------- ---------
Total stockholders' equity 145,332 174,549
---------- ---------
Total liabilities and stockholders' equity $2,039,828 2,001,150
========== =========
See Condensed Notes to Unaudited Consolidated Financial Statements.
4
HIGHLANDS INSURANCE GROUP, INC
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(dollars in thousands, except per share data)
Three Months Six Months
Ended June 30, Ended June 30,
---------------------- ---------------------
2001 2000 2001 2000
-------- ------- -------- -------
Revenues:
Net premiums earned $144,646 90,510 271,699 171,908
Net investment income 14,318 15,678 30,605 31,082
Net realized investment gains 495 162 1,065 958
-------- ------- -------- -------
Total revenues 159,459 106,350 303,369 203,948
-------- ------- -------- -------
Expenses:
Loss and loss adjustment expense incurred 124,025 65,385 238,055 126,736
Underwriting expenses 51,730 32,894 92,940 63,210
Debt interest and amortization expense 3,187 3,053 5,940 6,120
Other expenses, net 139 375 660 649
-------- ------- -------- -------
Total expenses 179,081 101,707 337,595 196,715
-------- ------- -------- -------
Income (loss) before income tax (19,622) 4,643 (34,226) 7,233
Income tax expense 119 1,006 126 1,560
-------- ------- -------- -------
Net income (loss) (19,741) 3,637 (34,352) 5,673
Dividends on mandatorily redeemable preferred stock 78 71 152 141
-------- ------- -------- -------
Net income (loss) attributable to common
stockholders $(19,819) 3,566 $(34,504) 5,532
======== ======= ======== =======
Earnings (loss) per common share:
Basic $(1.50) .27 $(2.61) .42
Diluted $(1.50) .27 $(2.61) .42
======== ======= ======== =======
Weighted average number of common shares
outstanding:
Basic 13,229 13,216 13,228 13,217
Diluted 13,229 13,218 13,228 13,219
======== ======= ======== =======
See Condensed Notes to Unaudited Consolidated Financial Statements.
5
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(dollars in thousands)
For the Six For the Year
Months Ended Ended
June 30, December 31,
2001 2000
-------- --------
(Unaudited)
Common stock:
Balance, beginning of year $ 140 140
Issuance of common stock, par value -- --
-------- --------
Balance, end of period 140 140
-------- --------
Additional paid-in capital:
Balance, beginning of year 231,566 231,515
Issuance of common stock, net 55 51
-------- --------
Balance, end of period 231,621 231,566
-------- --------
Accumulated other comprehensive income (loss):
Balance, beginning of year (12,572) (29,184)
Changes in net unrealized gain (losses), net of tax 5,261 16,682
Other (61) (70)
-------- --------
Balance, end of period (7,372) (12,572)
-------- --------
Treasury stock, at cost:
Balance, beginning of year (9,459) (9,459)
Acquisition of treasury stock -- --
-------- --------
Balance, end of period (9,459) (9,459)
-------- --------
Deferred compensation on restricted stock:
Balance, beginning of year (3,097) (3,147)
Net retirement of restricted stock 32 50
-------- --------
Balance, end of period (3,065) (3,097)
-------- --------
Retained (loss) earnings:
Balance, beginning of period (32,029) 74,536
Net income (loss) attributable to common stockholders (34,504) (106,565)
-------- --------
Balance, end of period (66,533) (32,029)
-------- --------
Total stockholders' equity $145,332 174,549
======== ========
See Condensed Notes to Unaudited Consolidated Financial Statements.
6
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(dollars in thousands)
Three Months Six Months
Ended June 30, Ended June 30,
------------------------- ----------------------
2001 2000 2001 2000
-------- ------ -------- -----
Net income (loss) attributable to common stockholders $(19,819) 3,566 $(34,504) 5,532
-------- ------ -------- -----
Other comprehensive income (loss), net of taxes:
Increase (decrease) in unrealized gain or loss on
investments, net of taxes of ($1,913) and
($1,752) for the three months and $3,205 and
$278 for the six months ended June 30, 2001
and 2000, respectively (3,552) (3,254) 5,953 516
Reclassification adjustments for realized gains in
net income, net of taxes of $174 and $57 for the
three months and $373 and $335 for the six months
ended June 30, 2001 and 2000, respectively (321) (105) (692) (623)
Other 56 -- (61) --
-------- ------ -------- -----
Other comprehensive income (loss), net of
taxes (3,817) (3,359) 5,200 (107)
-------- ------ -------- -----
Comprehensive income (loss) $(23,636) 207 $(29,304) 5,425
======== ====== ======== =====
See Condensed Notes to Unaudited Consolidated Financial Statements.
7
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(dollars in thousands)
Six Months Ended
June 30,
----------------------------
2001 2000
-------- -------
Cash flows (used in) provided by operating activities:
Net income (loss) $(34,352) 5,673
-------- -------
Adjustments to reconcile net income to net cash (used in) provided by operating
activities:
Depreciation and amortization 3,079 2,750
Net realized investment gains (1,065) (958)
Deferred tax expense -- 1,504
Change in:
Premiums in course of collection (26,882) (14,944)
Premiums due under retrospectively rated policies (422) 1,146
Receivables from reinsurers (26,995) 35,666
Prepaid reinsurance premiums 610 (6,496)
Funds on deposit with reinsurers (570) 787
Deferred policy acquisition costs (2,143) (8,734)
Loss and loss adjustment expense reserves 33,359 (50,072)
Unearned premiums 19,320 43,067
Other operating assets and liabilities 13,135 1,275
-------- -------
Total adjustments 11,426 4,991
-------- -------
Net cash (used in) provided by operating activities (22,926) 10,664
-------- -------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale 8,350 41,467
Other invested assets 2,018 815
Maturities or calls:
Fixed maturity securities available-for-sale 85,798 24,581
Investment purchases:
Fixed maturity securities available-for-sale (82,435) (58,415)
Equity securities -- (1,000)
Net additions to property and equipment (1,512) (934)
-------- -------
Net cash provided by investing activities 12,219 6,514
-------- -------
Cash flows from financing activities:
Repayment of senior bank debt -- (5,000)
-------- -------
Net cash used in financing activities -- (5,000)
-------- -------
Net (decrease) increase in cash and cash equivalents (10,707) 12,178
Cash and cash equivalents at beginning of period 109,763 78,283
-------- -------
Cash and cash equivalents at end of period $ 99,056 90,461
======== =======
Supplemental disclosure of cash flow information:
Interest paid $ 2,244 5,316
======== =======
See Condensed Notes to Unaudited Consolidated Financial Statements.
8
HIGHLANDS INSURANCE GROUP, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2001
1. Basis of Presentation
The accompanying consolidated financial statements as of June 30, 2001 and for
the three and six months ended June 30, 2001 and 2000 are unaudited and include
the accounts of Highlands Insurance Group, Inc., ("Highlands Group") and its
subsidiaries (the "Company"). In the opinion of management, all adjustments,
consisting of normal recurring adjustments necessary for a fair presentation,
have been reflected. The results for the period are not necessarily indicative
of the results to be expected for the entire year. The accompanying
consolidated financial statements should be read in conjunction with the
consolidated financial statements and related notes included in the Company's
Form 10-K for the year ended December 31, 2000.
Highlands Group is an insurance holding company for Highlands Holding Company,
Inc. and its subsidiaries ("Highlands"), American Reliance, Inc. and its
subsidiaries ("American Reliance"), and Highlands Holdings (U.K.) Limited and
its subsidiary ("Highlands UK") (a foreign reinsurance company located in the
United Kingdom), and certain other immaterial companies. For reporting
purposes, the Company considers all of its property and casualty insurance
operations as one segment. All material intercompany accounts and transactions
have been eliminated.
Certain financial information that is normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
but is not required for interim reporting purposes has been condensed or
omitted. Certain reclassifications have been made to the prior year's financial
statements to conform to the current year's presentation.
2. Impact of Recently Issued Standards
In July 2001, the FASB issued Statement No. 141, Business Combinations and
Statement No. 142, Goodwill and Other Intangible Assets. Statement 141 requires
that the purchase method of accounting be used for all business combinations
initiated after June 30, 2001, as well as all purchase method business
combinations completed after June 30, 2001. Statement 141 also specifies the
criteria that intangible assets acquired in a purchase method business
combination must meet to be recognized and reported apart from goodwill, noting
that any purchase price allocable to an assembled workforce may not be accounted
for separately. Statement 142 is effective January 1, 2002 and will require that
goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead tested for impairment at least annually in accordance
with the provisions of Statement 142. Statement 142 will also require that
intangible assets with estimable useful lives be amortized over their respective
estimated useful lives to their estimated residual values, and reviewed for
impairment in accordance with FAS Statement No. 121, Accounting for the
Impairment of Long Lived Assets and for Long-Lived Assets to be Disposed Of. As
of June 30, 2001, the Company has recorded negative goodwill in the amount of
$2.4 million. Upon adoption of Statement 142, the remaining balance of negative
goodwill will be recognized as an extraordinary item.
3. Debt Outstanding
Effective December 31, 2000, the Company and its lenders entered into an
Amendment and Waiver Agreement which amended the Credit Agreement thereby
eliminating the defaults of certain covenants, including financial covenants, in
the Credit Agreement. As of June 30, 2001, the Company was in compliance with
the Amended Credit Agreement. Although the Company is currently in compliance
with the terms of the Credit Agreement, the financial tests for the third
quarter are more difficult to meet than those for the second quarter. Given the
Company's results for the first six months, there can be no assurance that the
Company will be able to continue to comply with the amended covenants in the
Credit Agreement. In the event the Company is not able to
9
comply in the third quarter of 2001 with the amended covenants in the Credit
Agreement, it will seek to enter into a Waiver Agreement with the lenders. A
default under the Credit Agreement which is not cured or waived gives the
lenders the right to declare the entire loan under the Credit Agreement, $49
million at June 30, 2001, in default, accelerate the maturity of the loan and
seek repayment, including seeking to execute on the collateral for the loan,
i.e., the stock of the Company's principal insurance subsidiaries. The 10%
convertible subordinated debentures ("Debentures") in the principal amount of
$60.1 million are due December 31, 2005; however, by virtue of the cross-default
provisions of the Debentures, if the loan under the Credit Agreement is in
default and the payment of the debt is accelerated, the holders of the
Debentures have the right to declare the Debentures in default and accelerate
their maturity. Also, at the end of 1999, the Company was in default under
certain financial covenants in the Credit Agreement. Effective December 31,
1999, the Company and its lenders amended the Credit Agreement to revise those
financial covenants and to provide for the payment of $10.0 million in principal
during 2000.
As required under the December 31, 2000 Amendment and Waiver to the Credit
Agreement, the terms of the Debentures have been amended so that only payment in
kind ("PIK") interest may be made under the Debentures until the Credit
Agreement is paid. New 12.5% convertible subordinated debentures ("New
Debentures") in the amount of $5.9 million have been issued. The New Debentures
are in the same form and have the same terms as the Debentures, except that
interest is at the rate of 12.5% per annum on the New Debentures beginning July
1, 2001 and are convertible into Common Stock at a conversion price of $6.00 per
share.
In 1996, the Company received individual promissory notes ("Notes")
aggregating $2.85 million from certain members of the Company's then management
team ("Management Investors") for the purpose of investing in the Debentures.
The notes were without personal liability and were secured by a pledge of
Debentures. These Debentures were issued in exchange for the Management
Investors Notes and were issued pursuant to a Purchase, Redemption and Bonus
Agreement. In a non cash transaction, Management Investor Notes of $2.76
million which are due and payable on January 23, 2001, but which were not paid,
have been offset against $2.76 million of Management Investor Debentures.
4. Earnings Per Share
The following tables set forth the computation of basic and diluted earnings
per share (in thousands, except per share data):
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- ----------------------
2001 2000 2001 2000
-------- ------ ------- ------
NUMERATOR:
Net income (loss) attributable to common
stockholders as reported and for basic
earnings per share $(19,819) 3,566 (34,504) 5,532
======== ====== ======= ======
DENOMINATOR:
Denominator for basic earnings (loss) per share -
weighted average shares outstanding 13,229 13,216 13,228 13,217
Effect of dilutive securities:
Common stock warrants and outstanding stock
options (based on treasury stock method) -- 2 -- 2
-------- ------ ------- ------
Denominator for diluted earnings per share -
adjusted weighted average shares and assumed 13,229 13,218 13,228 13,219
conversions ======== ====== ======= ======
Basic earnings (loss) per share $ (1.50) .27 (2.61) .42
Diluted earnings (loss) per share $ (1.50) .27 (2.61) .42
======== ====== ======= ======
10
The Debentures, which are convertible into approximately 3.7 million shares,
were outstanding during the six months ended June 30, 2001 and 2000, but were
not included in the computation of diluted earnings per share because the
assumed conversion would be antidilutive. The New Debentures, which are
convertible into approximately 1 million shares, were outstanding during the
three and six months ended June 30, 2001, but were not included in the
computation of diluted earnings per share because the assumed conversion would
be antidilutive. Common stock warrants attached to the Debentures for
approximately 3.8 million shares for 2001 and 5 million shares for 2000,
respectively, were not included in the earnings per share calculation as they
were antidilutive.
Stock options for approximately 1.1 million and .9 million shares for 2001 and
2000, respectively, were not included in earnings per share calculations as they
were antidilutive.
5. Dividends from Subsidiaries and Statutory Information
The Company's insurance subsidiaries are restricted by law as to the amount of
dividends they may pay without the approval of regulatory authorities. Due to
the Company's operating losses, dividend payments to Highlands Group from its
insurance subsidiaries are currently limited to approximately $1.0 million in
2001 without prior regulatory approval.
Combined net income (loss) and policyholders' surplus of the Company's
combined insurance subsidiaries, as determined in accordance with statutory
accounting practices, follows for the three and six months ended June 30, 2001
and 2000 (in millions):
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ---------------------
2001 2000 2001 2000
----- ----- ----- -----
Net income (loss) $(15.8) 4.1 (33.4) 2.3
====== ===== ===== =====
Policyholders surplus $180.1 268.8 180.1 268.8
====== ===== ===== =====
6. Contingent Liabilities:
The information set forth in Item 1 of Part II of this report is incorporated
herein by reference.
The Company is a party to various claims and legal actions arising in the
ordinary course of its insurance business which, in the opinion of management,
will not have a material effect on the Company's financial position or results
of operations.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
The results of the Company's consolidated operations for the periods indicated
are set forth below:
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------- ---------------------------
2001 2000 2001 2000
--------- -------- -------- --------
(dollars in thousands) (dollars in thousands)
Consolidated Results:
Gross premiums written $ 159,775 116,241 322,305 231,913
Net premiums written $ 141,282 107,687 291,628 208,479
========= ======= ======== ========
Net premiums earned $ 144,646 90,510 271,699 171,908
Loss and loss adjustment expense incurred (124,025) (65,385) (238,055) (126,736)
Underwriting expenses (51,730) (32,894) (92,940) (63,210)
--------- ------- -------- --------
Underwriting loss (31,109) (7,769) (59,296) (18,038)
Net investment income 14,318 15,678 30,605 31,082
Net realized investment gains 495 162 1,065 958
Debt interest and amortization expense (3,187) (3,053) (5,940) (6,120)
Other (expenses) income, net (139) (375) (660) (649)
--------- ------- -------- --------
Income (loss) before taxes (19,622) 4,643 (34,226) 7,233
Income tax expense 119 1,006 126 1,560
--------- ------- -------- --------
Net income (loss) $ (19,741) 3,637 (34,352) 5,673
Dividends paid on mandatorily redeemable
preferred stock 78 71 152 141
--------- ------- -------- --------
Net income (loss) attributable to common
stockholders $ (19,819) 3,566 (34,504) 5,532
========= ======= ======== ========
Earnings (loss) per common share:
Basic $(1.50) .27 (2.61) .42
========= ======= ======== ========
Diluted $(1.50) .27 (2.61) .42
========= ======= ======== ========
Ratios:
Loss 85.7% 72.2% 87.6% 73.7%
Expense 35.8% 36.3% 34.2% 36.8%
--------- ------- -------- --------
Combined 121.5% 108.5% 121.8% 110.5%
========= ======= ======== ========
PERIOD TO PERIOD COMPARISONS
Gross Premiums Written. Gross premiums written for the three months and six
months ended June 30, 2001 and 2000 were $159.8 million $116.2 million, $322.3
million and $231.9 million, respectively. The $43.6 million and $90.4 million
or 37.5% and 39.0% increase for the three months and six months ended June 30,
2001, respectively is due primarily to growth in the core commercial and
personal lines from new and renewal business produced by the Company's regional
offices.
12
The Company estimates ultimate losses for retrospectively rated policies and
then adjusts gross premiums written and premiums due from policyholders for
changes in estimated ultimate losses and loss adjustment expenses from the date
of the prior valuation. These adjustments may cause gross premiums written, net
premiums written and net premiums earned to fluctuate significantly from period
to period. Gross premiums written in both periods did not include any
significant adjustment for either period. Experience rated contracts, such as
retrospectively rated policies, reduce but do not eliminate risk to the insurer.
On April 18, 2001, A.M. Best announced that it downgraded the Company's
rating from B++ (very good) to B (good). This rating downgrade is expected to
limit the future premium production of the Company.
Net Premiums Written. Net premiums written for the three months and six months
ended June 30, 2001 and 2000 were $141.3 million, $107.7 million, $291.6 million
and $208.5 million, respectively. The increase of $33.6 million and $83.1
million or 31.2% and 39.9% in 2001 compared to 2000 is related to the growth
affecting gross premiums written.
Net Premiums Earned. Net premiums earned for the three months and six months
ended June 30, 2001 and 2000 were $144.6 million, $90.5 million, $271.7 million,
and $171.9 million, respectively. The increase of $54.1 million and $99.8
million or 59.8% and 58.1% in 2001 compared to 2000 is related to the earnings
pattern of net premiums written. Net premiums written are initially deferred
and earned based upon the terms of the underlying policies which causes earning
trends to lag behind written premium trends during periods of increasing or
decreasing net premiums written.
Loss and Loss Adjustment Expense Incurred. Loss and loss and adjustment
expenses incurred for the three months and six months ended June 30, 2001 and
2000 were $124.0 million, $65.4 million, $238.1 million, and $126.7 million,
respectively. The loss and loss adjustment expense ratio for the three months
and six months ended June 30, 2001 and 2000 was 85.7%, 72.2%, 87.6%, and 73.7%,
respectively. The second quarter reported loss and loss adjustment expense ratio
of 85.7% includes approximately 10.0 points, or approximately $14.5 million, of
upward development on 2000 and prior years loss reserves. Approximately $10.0
million of additional reserves were added for the workers' compensation line of
business. Therefore, the accident year loss ratio for the second quarter of 2001
was approximately 75.7% compared to 72.2% in 2000. For the six months ended June
30, 2001, approximately $25.8 million of upward development on 2000 and prior
years loss reserves increased the reported loss ratio of 87.6% by 9.3 points.
The reserve increases have been in the workers' compensation ($16 million),
commercial automobile liability ($5.3 million) and other liability ($4.5
million) lines of business. The workers' compensation and commercial automobile
liability lines of business had significant growth during 2000. The Company is
focusing on underwriting standards and adequate pricing to address the
increasing loss ratio.
Underwriting Expenses. Underwriting expenses for the three months and six
months ended June 30, 2001 and 2000 were $51.7 million, $32.8 million, $92.9
million and $63.2 million, respectively. The expense ratio for the three months
and six months ended June 30, 2001 and 2000 was 35.8%, 36.3%, 34.2% and 36.8%,
respectively. The decreases primarily relate to the increase in earned premium
compared to the Company's internal expenses offset by the expense for
uncollectible premium of $2.6 million for a commercial automobile program.
The Company is reorganizing its operations by reducing the processing of
commercial renewal policies from eight to two locations and will reduce its
workforce by approximately 115 positions. This reorganization resulted in a
second quarter charge of approximately $.7 million but will reduce expenses on
an annual basis by approximately $5.2 million, of which approximately $2.1
million is expected to reduce the third and fourth quarter 2001 expenses.
Investment Results. Net investment income for the three months and six months
ended June 30, 2001 and 2000 was $14.3 million, $15.7 million, $30.6 million,
and $31.1 million, respectively. Net investment income decreased $1.4 million
and $.5 compared to 2000. Interest rates on the short end of the yield curve
have decreased significantly in 2001 compared to 2000. Net realized investment
gains for the Company were $.5 million, $.2 million, $1.1 million, and $1.0
million for the three months and six months ended June 30, 2001 and 2000,
respectively.
Debt Interest and Amortization Expense. Debt interest and amortization
expense for the three months and six months ended June 30, 2001 and 2000 was
$3.2 million, $3.1 million, $5.9 million, and $6.1 million, respectively. The
reduction for the six months ended June 30, 2001 compared to 2000 reflects the
paydowns of the Company's senior bank debt offset by a higher variable interest
rate including the variable performance add-ons.
Other Expenses. Other expenses consist of parent company expenses and
miscellaneous expenses from the insurance subsidiaries offset by miscellaneous
income.
13
Income Taxes. The Company provides for income taxes on its statements of
operations pursuant to Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes" (SFAS 109). The total tax expense which includes
state taxes for the three months and six months ended June 30, 2001 and 2000 was
$119 thousand, $1.0 million, $126 thousand, and $1.6 million, respectively.
LIQUIDITY AND CAPITAL RESOURCES
Highlands Group is a holding company, the principal assets of which at June
30, 2001 are all of the capital stock of Highlands Holding Company, Inc. and
American Reliance, Inc. The Company's property and casualty insurance business
is conducted by its wholly-owned insurance subsidiaries. The liquidity and
capital resource considerations for the Highlands Group are different than those
of the Company's insurance operations.
Holding Company
As a holding company, Highlands Group's principal requirements for funds are
to pay operating expenses, franchise and other taxes and debt service.
Operating expenses and other taxes imposed on the Company are not material. The
annual cash interest requirements relating to the Company's outstanding 10%
convertible subordinated debentures (the "Debentures") and the loan under the
Credit Agreement are approximately $4.0 million for 2001. Effective December
31, 2000, the Company and its lenders entered into an Amendment and Waiver
Agreement which amended the Credit Agreement thereby eliminating the defaults of
certain covenants, including financial covenants, in the Credit Agreement. As
of June 30, 2001, the Company was in compliance with the Amended Credit
Agreement. Although the Company is currently in compliance with the terms of
the Credit Agreement, the financial tests for the third quarter are more
difficult to meet than those for the second quarter. Given the Company's
results for the first six months, there can be no assurance that the Company
will be able to continue to comply with the amended covenants in the Credit
Agreement. In the event the Company is not able to comply in the third quarter
of 2001 with the amended covenants in the Credit Agreement, it will seek to
enter into a Waiver Agreement with the lenders. A default under the Credit
Agreement which is not cured or waived gives the lenders the right to declare
the entire loan under the Credit Agreement, $49 million at June 30, 2001, in
default, accelerate the maturity of the loan and seek repayment, including
seeking to execute on the collateral for the loan, i.e., the stock of the
Company's principal insurance subsidiaries. The Debentures in the principal
amount of $60.1 million are due December 31, 2005; however, by virtue of the
cross-default provisions of the Debentures, if the loan under the Credit
Agreement is in default and the payment of the debt is accelerated, the holders
of the Debentures have the right to declare the Debentures in default and
accelerate their maturity. Also, at the end of 1999, the Company was in default
under certain financial covenants in the Credit Agreement. Effective December
31, 1999, the Company and its lenders amended the Credit Agreement to revise
those financial covenants and to provide for the payment of $10.0 million in
principal during 2000.
Highlands Group's principal sources of funds are dividends and tax sharing
payments from its subsidiaries, if any, and funds that may be raised from time
to time from the issuance of additional debt or equity securities. The payment
of dividends by the insurance subsidiaries is subject to restrictions and
limitations imposed by the insurance regulatory authorities. Due to the
Company's operating losses, dividend payments to Highlands Group from it
insurance subsidiaries are currently limited to approximately $1.0 million in
2001 without prior regulatory approval. Both the issuance of additional debt
and the issuance of additional equity securities at a price less than current
market price would require the consent of the holders of a majority in interest
of the Debentures pursuant to the covenants contained in the Debentures.
As stated above, annual cash interest payments under the Credit Agreement and
the Debentures approximate $4 million for 2001. Furthermore, even in the
absence of defaults, the loan under the Credit Agreement is due and payable on
April 30, 2002. The Company is taking a number of steps to deal with these
requirements.
First, as required under the December 31, 2000 Amendment and Waiver to the
Credit Agreement, the terms of the Debentures have been amended so that only
payment in kind ("PIK") interest may be made under the Debentures until the loan
under the Credit Agreement is paid. The PIK interest will be paid in the form
of a new 12.5% convertible subordinated debenture due December 31, 2005 (the
"New Debentures"). The New Debentures are in the same form and have the same
terms as the Debentures, except that interest is at the rate of 12.5% per
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annum and the New Debenture are convertible into Common Stock at a conversion
price of $6.00 per share. Cash interest on the New Debentures may not be paid
until the loan under the Credit Agreement is paid. The New Debentures were
issued in April 2001. Secondly, the Company has retained two investment advisors
to explore strategic and other alternatives available to the Company, and to
advise the Special Committee described below on proposed transactions. There can
be no assurance that the Company will be successful in pursuing any of these
alternatives. If the Company is not successful, it will need to pay or refinance
the loan under the Credit Agreement by April 2002. There is no assurance that
the Company will have the resources to pay the loan or that it will be able to
find a source of refinancing.
A Special Committee was formed by the Board of Directors of the Company on
March 29, 2001 in connection with the Company's exploration of engaging in one
or more transactions, including without limitation one or more of the following:
a merger, consolidation or sale of all or a portion of its business or assets;
an acquisition of another company or business; obtaining an investment in the
Company; a joint venture or other joint endeavor (including creating a new
entity to effect any such venture or endeavor); a strategic or other transaction
(a "Transaction"). The Special Committee was formed to avoid potential
conflicts of interest. The Company may not take any action with respect to a
proposed Transaction unless such proposed Transaction is recommended for
approval to the full Board of Directors of the Company by the Special Committee
evidenced by a resolution duly adopted by the Special Committee. The powers and
authorities of the Special Committee include to retain independent legal,
accounting, actuarial or other advisors to advise the Special Committee in
connection with any proposed Transaction; to obtain reports (including without
limitation one or more fairness opinions) concerning proposals for one or more
Transaction; to cause its financial advisors to solicit indications of interest
from one or more persons or entities with respect to engaging in a Transaction;
to negotiate the form, terms and provisions of any proposed Transaction; to
consider and approve or disapprove any and all agreements (subject to the
ultimate authority of the full Board of Directors of the Company, upon
recommendation of the Special Committee, to approve any definitive agreement in
connection with any Transaction) related to the proposed Transaction; and to
recommend to the full Board of Directors of the Company the approval or
disapproval of any proposed Transaction. The Company has retained two
independent investment advisors to advise the Special Committee in connection
with any proposed Transaction.
Insurance Subsidiaries
Insurance Operations. The principal sources of funds for the insurance
subsidiaries are premiums and amounts earned from the investment of such
premiums. The principal uses of funds by these subsidiaries are loss payments
and related expenses, underwriting expenses, other operating expenses and
dividends and tax sharing payments to Highlands Group.
In the insurance industry, liquidity refers to the ability of an enterprise to
generate adequate amounts of cash from its operations, including its investment
portfolio, in order to meet its financial commitments, which are principally
obligations under the insurance policies it has written. Liquidity requirements
of insurance companies are influenced significantly by product mix. Future
catastrophe claims, the timing and amount of which are inherently unpredictable,
may create increased liquidity requirements for the insurance subsidiaries. The
liquidity requirements of the insurance subsidiaries are met by that portion of
the investment portfolio that is held in cash and highly liquid securities.
Forward Looking Information
The statements included in this Form 10-Q for the quarter end June 30, 2001,
regarding future financial performance and results and other statements that are
not historical facts are forward-looking statements. The words "expect,"
"project," "estimate," "predict," anticipate," "believes" and similar
expressions are also intended to identify forward-looking statements. Such
statements are subject to numerous risks, uncertainties and assumptions,
including but not limited to, the uncertainties relating to industry and market
conditions, natural disasters and other catastrophes, and other risks and
uncertainties described in the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 2000 and in the Company's other filings with the
Securities and Exchange Commission. Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual outcomes may vary materially from those indicated.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in the Company's investment strategies,
types of financial instruments held or the risks associated with such
instruments which would materially alter the market risk disclosures made in the
Company's Annual statement on Form 10-K for the year ended December 31, 2000.
PART II Other Information
ITEM 1. LEGAL PROCEEDINGS
From 1958 to 1986, the Company issued fixed premium, guaranteed cost (not
retrospectively rated) insurance policies to Brown & Root Company ("Brown &
Root"), a subsidiary of Halliburton Company. Beginning in 1987, the Company's
insurance policies with Halliburton (including Brown & Root) were written on a
retrospectively rated or high-deductible basis. Since the mid-1990's, over
20,000 third party asbestos claims have been made against Halliburton. Through
June 30, 2001, the Company paid $1.2 million on behalf of Halliburton under the
fixed premium policies on asbestos claims, and billed Halliburton $8.5 million
under the retrospectively rated and high-deductible policies on asbestos claims.
Halliburton has not paid this billed amount and has questioned the proper
allocation of the asbestos claims between the fixed premium and the
retrospectively rated and high-deductible policies.
On April 5, 2000, the Company filed an action in the Delaware Court of
Chancery ("Delaware Action") asserting that indemnification obligations exist
pursuant to the Distribution Agreement dated October 10, 1995 between the
Company and Halliburton, which was executed as part of the distribution by
Halliburton of the shares of the Company's common stock to Halliburton's
stockholders and the public. The action is seeking a declaratory judgment that
Halliburton is responsible for indemnifying the Company for losses and expenses
incurred on the Halliburton/Brown & Root policies; (ii) an injunction ordering
Halliburton to assume responsibility for such losses and expenses; (iii) a
judgment against Halliburton for non-payment of the amounts billed under the
retrospectively rated and high-deductible policies; and (iv) a declaration
estopping Brown & Root from invoking insurance under the fixed premium policies.
On July 13, 2000, the Company amended its complaint in the Delaware Action,
adding a count seeking a declaratory judgment that the Company is not liable
under the fixed premium policies because those policies were terminated pursuant
to the Investment Agreement dated October 10, 1995 among the Company,
Halliburton, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda)
L.P. The Company also filed a motion for a preliminary injunction enjoining
Halliburton from instituting, continuing or prosecuting any action in any other
jurisdiction arising out of or related to the subject matter of the Delaware
Action. On July 26, 2000, Halliburton filed motions to dismiss the Delaware
Action on the grounds of forum non conveniens and failure to state a claim upon
which relief can be granted. On September 8, 2000, the Company filed a motion
for judgment on the pleadings in the Delaware Action. Oral argument on
Halliburton's motions to dismiss and the Company's motion for judgment on the
pleadings in the Delaware Action was held on November 30, 2000. On March 21,
2001, the Chancery Court in the Delaware Action issued its decision in favor of
the Company, finding that the fixed premium policies had been terminated
pursuant to the Investment Agreement. An order was issued to that effect on
April 3, 2001. Halliburton filed an appeal of the order to the Delaware Supreme
Court on April 18, 2001. Oral argument before the Delaware Supreme Court is
scheduled for September 17, 2001.
On April 24, 2000, Halliburton filed an action in the District Court of Harris
County, Texas ("Texas Action") seeking (i) a declaratory judgment that the
Company is liable for costs and expenses under the fixed premium policies; (ii)
a declaratory judgment that Halliburton has the right to select the policy under
which such coverage is to be paid; and (iii) damages. The Company filed its
answer in the Texas Action on July 26, 2000 denying the allegations in
Halliburton's complaint. On July 27, 2000, Halliburton filed an amended
petition in the Texas Action adding Brown & Root as plaintiff. On November 6,
2000, Halliburton filed a second amended petition in the Texas Action adding
Highlands Group as a defendant. Proceedings in the Texas Action have largely
been held in abeyance by the parties pending the resolution of the Delaware
Action,
16
although there is no assurance that Halliburton will not attempt to activate the
Texas Action in the future.
If the Company is not ultimately successful in the litigation described above,
it could have a material adverse impact on the Company. The Company believes,
however, that the positions it has taken in the Delaware Action and Texas Action
are meritorious, and that, ultimately, the Company will not be responsible for a
material amount, if any, of Halliburton's asbestos liability.
ITEM 4. Submission of Matters to a Vote of Security Holders
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
None.
(b) Reports on Form 8-K
The Company filed a Form 8-K on March 16, 2001
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HIGHLANDS INSURANCE GROUP, INC.
(Registrant)
Date: August 14, 2001 By /s/ Willis T. King, Jr.
-----------------------
Willis T. King, Jr.
Chairman and Chief
Executive Officer
(Authorized Signatory)
Date: August 14, 2001 By /s/ Charles J. Bachand
----------------------
Charles J. Bachand
Vice President, Treasurer and
Principal Accounting Officer
(Authorized Signatory)
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