SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
X OF THE SECURITIES EXCHANGE ACT OF 1934
-----
For the quarterly period ended September 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 September 30, 2001 was 13,228,688.
1
HIGHLANDS INSURANCE GROUP, INC.
TABLE OF CONTENTS
PART I - Financial Information
Item Page
- ---- ----
1. Financial Statements:
Consolidated Balance Sheets
September 30, 2001 (Unaudited) and
December 31, 2000 3
Consolidated Statements of Operations
(Unaudited) - Three and Nine Months Ended
September 30, 2001 and 2000 5
Consolidated Statements of Stockholders' Equity
Nine Months Ended September 30, 2001 (Unaudited)
and Year Ended December 31, 2000 6
Consolidated Statements of Comprehensive Income (Loss)
(Unaudited) - Three and Nine Months Ended
September 30, 2001 and 2000 7
Consolidated Statements of Cash Flows
(Unaudited) - Nine Months Ended September 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 14
3. Quantitative and Qualitative Disclosures About
Market Risk 18
PART II - Other Information
1. Legal Proceedings 18
3. Defaults upon Senior Securities 20
4. Submission of Matters to a Vote of Security Holders 20
6. Exhibits and Reports on Form 8-K 20
Signatures 21
2
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
September 30, December 31,
ASSETS 2001 2000
------ ---------- ---------
(Unaudited)
Investments:
Fixed maturity securities - available-for-sale, at fair
value (amortized cost of $712,171 at 9/30/01 and $797,092
at 12/31/00) $ 716,648 776,453
Equity securities, at fair value (cost of $30,686 at
9/30/01 and $30,686 at 12/31/00) 33,320 32,091
Other investments, at cost 152 1,952
---------- ---------
Total investments 750,120 810,496
Cash and cash equivalents 95,616 109,763
Premiums in course of collection, net 117,380 126,719
Premiums due under retrospectively rated policies 138,541 138,119
Receivable from reinsurers 709,995 683,439
Prepaid reinsurance premiums 10,267 8,576
Funds on deposit with reinsurers 10,403 9,019
Net deferred tax asset -- 6,732
Accrued investment income 10,915 11,084
Deferred policy acquisition costs 44,452 49,622
Other assets 98,650 47,581
---------- ---------
Total assets $1,986,339 2,001,150
========== =========
See Condensed Notes to Unaudited Consolidated Financial Statements.
3
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS, (Continued)
(dollars in thousands)
September 30, December 31,
LIABILITIES AND STOCKHOLDERS' EQUITY 2001 2000
------------------------------------ ---------- ---------
(Unaudited)
Loss and loss adjustment expense reserves $1,431,062 1,392,497
Unearned premiums 212,939 224,120
Senior bank debt 49,004 49,004
Convertible subordinated debentures 62,095 58,626
Net deferred tax liability 2,489 --
Accounts payable and accrued liabilities 96,975 97,424
---------- ---------
Total liabilities 1,854,564 1,821,671
---------- ---------
Mandatorily redeemable preferred stock 5,159 4,930
---------- ---------
Commitments and contingent liabilities
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized;
13,968,088 and 13,958,343 issued in 2001 and 2000, respectively;
13,228,688 and 13,218,943 outstanding in 2001 and in 2000,
respectively 140 140
Additional paid-in capital 231,621 231,566
Accumulated other comprehensive income (loss) 4,452 (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 (97,073) (32,029)
---------- ---------
Total stockholders' equity 126,616 174,549
---------- ---------
Total liabilities and stockholders' equity $1,986,339 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 Nine Months
Ended September 30, Ended September 30,
---------------------- ---------------------
2001 2000 2001 2000
-------- ------- ------- -------
Revenues:
Net premiums earned $131,666 102,912 403,365 274,820
Net investment income 14,854 15,639 45,459 46,721
Net realized investment gains (losses) 2,821 (132) 3,886 826
-------- ------- ------- -------
Total revenues 149,341 118,419 452,710 322,367
-------- ------- ------- -------
Expenses:
Loss and loss adjustment expense incurred 124,925 77,869 362,980 204,605
Underwriting expenses 51,492 33,129 144,432 96,339
Debt interest and amortization expense 2,743 3,056 8,683 9,176
Other expenses, net 642 320 1,302 969
-------- ------- ------- -------
Total expenses 179,802 114,374 517,397 311,089
-------- ------- ------- -------
Income (loss) before income tax (30,461) 4,045 (64,687) 11,278
Income tax expense 2 980 128 2,540
-------- ------- ------- -------
Net income (loss) (30,463) 3,065 (64,815) 8,738
Dividends on mandatorily redeemable preferred stock 77 71 229 212
-------- ------- ------- -------
Net income (loss) attributable to common
stockholders $(30,540) 2,994 (65,044) 8,526
======== ======= ======= =======
Earnings (loss) per common share:
Basic $ (2.31) .23 (4.92) .65
Diluted $ (2.31) .23 (4.92) .65
======== ======= ======= =======
Weighted average number of common shares
outstanding:
Basic 13,229 13,219 13,228 13,217
Diluted 13,229 13,239 13,228 13,225
======== ======= ======= =======
See Condensed Notes to Unaudited Consolidated Financial Statements.
5
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(dollars in thousands)
For the Nine For the Year
Months Ended Ended
September 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 17,124 16,682
Other (100) (70)
-------- --------
Balance, end of period 4,452 (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 (65,044) (106,565)
-------- --------
Balance, end of period (97,073) (32,029)
-------- --------
Total stockholders' equity $126,616 174,549
======== ========
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 Nine Months
Ended September 30, Ended September 30,
-------------------------- -----------------------
2001 2000 2001 2000
-------- ------- ------ ------
Net income (loss) attributable to common stockholders $(30,540) 2,994 (65,044) 8,526
-------- ----- ------- ------
Other comprehensive income (loss), net of taxes:
Increase (decrease) in unrealized gain or loss on
investments, net of taxes of $7,376 and $3,207
for the three months and $10,581 and $3,485 for the
nine months ended September 30, 2001 and 2000,
respectively 13,697 5,956 19,650 6,472
Reclassification adjustments for realized gains in
net income, net of taxes of $(987) and $46 for the
three months and $(1,360) and ($289) for the nine
months ended September 30, 2001 and 2000, respectively (1,834) 86 (2,526) (537)
Other (39) -- (100) --
-------- ----- ------- ------
Other comprehensive income (loss), net of 11,824 6,042 17,024 5,935
taxes -------- ----- ------- ------
Comprehensive income (loss) $(18,716) 9,036 (48,020) 14,461
======== ===== ======= ======
See Condensed Notes to Unaudited Consolidated Financial Statements.
7
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(dollars in thousands)
Nine Months Ended
September 30,
-----------------------------
2001 2000
--------- --------
Cash flows (used in) provided by operating activities:
Net income (loss) $ (64,815) 8,738
--------- --------
Adjustments to reconcile net income to net cash (used in) provided by operating
activities:
Depreciation and amortization 4,809 3,831
Net realized investment gains (3,886) (826)
Deferred tax expense -- 2,416
Change in:
Premiums in course of collection 9,339 (24,156)
Premiums due under retrospectively rated policies (422) 2,434
Receivables from reinsurers (26,556) 32,738
Prepaid reinsurance premiums (1,691) (6,842)
Funds on deposit with reinsurers (1,384) 3,281
Deferred policy acquisition costs 5,170 (12,528)
Loss and loss adjustment expense reserves 38,565 (49,344)
Unearned premiums (11,181) 61,851
Other operating assets and liabilities 3,597 1,012
--------- --------
Total adjustments 16,360 13,867
--------- --------
Net cash (used in) provided by operating activities (48,455) 22,605
--------- --------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale 35,727 81,591
Equity securities -- 1,721
Other invested assets 2,920 1,258
Maturities or calls:
Fixed maturity securities available-for-sale 140,564 38,973
Investment purchases:
Fixed maturity securities available-for-sale (142,773) (117,870)
Equity securities -- (1,000)
Net additions to property and equipment (2,130) (1,487)
--------- --------
Net cash provided by investing activities 34,308 3,186
--------- --------
Cash flows from financing activities:
Repayment of senior bank debt -- (10,000)
--------- --------
Net cash used in financing activities -- (10,000)
--------- --------
Net (decrease) increase in cash and cash equivalents (14,147) 15,791
Cash and cash equivalents at beginning of period 109,763 78,283
--------- --------
Cash and cash equivalents at end of period $ 95,616 94,074
========= ========
Supplemental disclosure of cash flow information and non-cash investing activity:
Interest paid $ 3,019 6,478
========= ========
Receivable for securities sold, included in other assets $ 53,980 --
========= ========
See Condensed Notes to Unaudited Consolidated Financial Statements.
8
HIGHLANDS INSURANCE GROUP, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2001
1. Basis of Presentation
---------------------
The accompanying consolidated financial statements as of September 30, 2001
and for the three and nine months ended September 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.
The accompanying consolidated financial statements have been prepared as
though the Company will continue as a going concern. As described in Note 3,
the Company obtained waivers for failure to comply with certain financial
covenants at September 30, 2001 pertaining to its bank debt. As described in
Note 5, the Company's primary insurance subsidiaries have been required to
obtain insurance regulatory approval prior to entering into certain business
transactions and have been required to submit a financial plan to the Texas
Department of Insurance regarding the Company's plans in regard to increasing
regulatory capital and surplus for these insurance subsidiaries. Furthermore,
the Company's ability to continue to write desired business is dependent, in
part, on ratings assigned by insurance rating agencies. To the extent the
Company is unable to either: obtain additional capital in the near term, obtain
additional waivers or alternative financing of debt, continue to operate without
additional restrictive regulatory oversight of its insurance subsidiaries, or to
maintain its insurance rating, such matters raise substantial doubt about the
Company's ability to continue as a going concern. On November 19, 2001, A.M.
Best notified the Company that its rating was being reduced from "B" (Fair) to
"C-" (Weak).
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.
During the three months and nine months ended September 30, 2001, the Company
has recorded adverse development on losses incurred for accident years 2000 and
prior of $13.3 million and $38.5 million, respectively. The recovery of
deferred acquisition costs is based on management's best estimates of operating
results, including loss and loss adjustment expense, underwriting expenses, and
the timing of these payments. In addition, during the three months ended
September 30, 2001, the Company established an allowance of $1.0 million for
deferred acquisition costs determined to be unrecoverable. Should these
estimated operating results develop unfavorably, the recoverability of deferred
acquisition costs could be negatively impacted.
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. 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
9
Lived Assets and for Long-Lived Assets to be Disposed Of. As of September 30,
2001, the Company has recorded negative goodwill in the amount of $2.3 million.
Upon adoption of Statement 142, the remaining balance of negative goodwill will
be recognized as an extraordinary item.
In August 2001, the FASB issued Statement No. 143, Accounting for Asset
Retirement Obligations. Statement 143 requires entities to record the fair
value of a liability for an asset retirement obligation in the period in which
it is incurred and a corresponding increase in the carrying amount of the
related long-lived asset and is effective for fiscal years beginning after June
15, 2002. The Company is currently assessing the impact of Statement 143 on its
financial condition and results of operations.
In October 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Statement 144 provides that long-
lived assets to be disposed of by sale be measured at the lower of carrying
amount or fair value less cost to sell, whether reported in continuing
operations or in discontinued operations, and broadens the reporting of
discontinued operations to include all components of an entity with operations
that can be distinguished from the rest of the entity and that will be
eliminated from the ongoing operations of the entity in a disposal transaction.
Statement 144 is effective for fiscal years beginning after December 15, 2001.
The Company is currently assessing the impact of Statement 144 on its financial
condition and results of operations.
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. The loan under the Credit Agreement is due and payable on
April 30, 2002, and is secured by a lien on the Company's principal insurance
subsidiaries. As of September 30, 2001, the Company was not in compliance with
the Credit Agreement. On November 13, 2001, the Company and the lenders entered
into a Waiver to Credit Agreement in which the lenders agreed to waive the
breaches of the financial covenants until December 31, 2001. If the Credit
Agreement is not refinanced or amended, or if additional waivers are not
obtained from the lenders, the Company will be in default of the Credit
Agreement on December 31, 2001. 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 September 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 Company's 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 as PIK interest.
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 the New Debentures 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 were due and payable on January 23, 2001, but which were not paid,
have been offset against $2.76 million of Management Investor Debentures.
10
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 Nine Months Ended
September 30, September 30,
----------------------- ------------------------
2001 2000 2001 2000
-------- ------ ------- ------
NUMERATOR:
Net income (loss) attributable to common
stockholders as reported and for basic
earnings per
share $(30,540) 2,994 (65,044) 8,526
======== ====== ======
DENOMINATOR:
Denominator for basic earnings (loss) per share -
weighted average shares outstanding 13,229 13,219 13,228 13,217
Effect of dilutive securities:
Common stock warrants and outstanding stock
options (based on treasury stock method) -- 20 -- 8
-------- ------ ------- ------
Denominator for diluted earnings per share -
adjusted weighted average shares and assumed
conversions 13,229 13,239 13,288 13,225
======== ====== ======= ======
Basic earnings (loss) per share $ (2.31) .23 (4.92) .65
Diluted earnings (loss) per share $ (2.31) .23 (4.92) .65
======== ====== ======= ======
The Debentures, which are convertible into approximately 3.7 million shares,
were outstanding during the nine months ended September 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 nine months ended September 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.
Two of the Company's insurance subsidiaries, Northwestern National Casualty
Company ("NNCC") and NN Insurance Company ("NNI") a subsidiary of NNCC, and the
Wisconsin Insurance Commissioner entered into a stipulation and order in October
2001 requiring prior approval of transactions with affiliates, including the
payment of dividends and tax sharing payments, and of any transaction involving
the transfer of a material portion of NNCC's or NNI's business or other similar
transaction other than in the ordinary course of business. The foregoing
requirement does not apply to existing contracts. The Company has agreed to
obtain prior approval from the Texas Department of Insurance ("Texas
Department") for any affiliated transactions of $1,000,000 or more in any year.
This requirement does not apply to transactions under existing and previously
approved reinsurance,
11
management, tax allocation, investment or administrative agreements. The
Company also agreed to provide the Texas Department notice of any proposed
material transaction between the Company and any non-affiliated entity. On
October 9, 2001, the Texas Department requested that the Company submit a plan
to show how it intended to correct certain operational and financial issues. On
November 13, 2001, the Company submitted that plan which included the financial
plan set forth below.
The Company is implementing a comprehensive financial plan (the "Plan") to
restructure the Company in an effort to return it to profitability. This Plan
includes the ceasing to write personal lines by selling books of business,
nonrenewing policies and withdrawing from personal lines of business. The
Company is focusing its attention on its current commercial business which it is
re-underwriting and re-pricing as it leaves unprofitable lines and states. The
Company is re-evaluating its agents' profitability and plans to reduce its
ongoing agency force from approximately 2,200 to approximately 500. This Plan is
expected to result in a reduction of net written premiums from over $400 million
in 2001 to under $200 million in 2002. Accompanying this reduction in premiums,
the Company is taking actions to manage the expenses to appropriate levels. The
Company has eliminated five regional offices and established two field support
centers to process the remaining regional business. The Company announced the
elimination of 190 positions previously this year in connection with those
actions and expects to continue to reduce its workforce as appropriate. The
success of the Plan could be adversely affected by changes in the Company's A.M.
Best rating, change in the industry or market conditions, the occurrence of
catastrophes, or other uncertainties. On November 19, 2001, A.M. Best notified
the Company that its rating was being reduced from "B" ("Fair") to "C-" (Weak).
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"). There can be no assurance that the Company will be
successful in pursuing any of these alternatives. 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 Transactions; 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
any 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.
The States of domicile for the Company's insurance subsidiaries impose risk-
based capital (RBC) requirements on insurance enterprises, including the
Company's subsidiaries. The RBC Model serves as a benchmark for the regulation
of insurance companies by state insurance regulators. RBC provides for targeted
surplus levels based on formulas which specify various weighting factors that
are applied to financial balances or various levels of activity based on the
perceived degree of risk, and are set forth in the RBC requirements. Such
formulas focus on four general types of risk: (a) the risk with respect to the
company's assets (asset or default risk); (b) the risk of default on amounts due
from reinsurers, policyholders or other creditors (credit risk); (c) the risk of
under-estimating liabilities from business already written or inadequately
pricing business to be written in the coming year (underwriting risk); and, (d)
the risk associated with items such as excessive premium growth, contingent
liabilities and other items not reflected on the balance sheet (off-balance
sheet risk). The amount determined under such formulas is called the Authorized
Control Level RBC (ACLC).
The RBC guidelines define specific capital levels based on a company's ACLC
that are determined by the ratio of the company's total adjusted capital (TAC)
to its ACLC. TAC is equal to statutory capital, plus or minus certain other
specified adjustments. The specific capital levels, in declining order, and
applicable ratios are generally as follows: "Company Action Level" where TAC is
less than or equal to 2.0 times ACLC; "Regulatory Action Level" where TAC is
less than or equal to 1.5 times ACLC; "Authorized Control Level"
12
where TAC is less than or equal to 1.0 times ACLC; and, "Mandatory Control
Level" where TAC is less than or equal to 0.7 times ACLC. Companies at the
Company Action Level must submit a comprehensive financial plan to the insurance
commissioner of the state of domicile. Companies at the Regulatory Action Level
are subject to a mandatory examination or analysis by the commissioner and
possible required corrective actions. At the Authorized Control Level, a company
is subject to, among other things, the commissioner placing it under regulatory
control. At the Mandatory Control Level, the insurance commissioner is required
to place a company under regulatory control.
The Company's financial plan as submitted to the Texas Department of Insurance
on November 13, 2001 anticipates the Company may trigger an action level at
December 31, 2001 for Highlands Insurance Company. Failure to meet the capital
requirements and interim capital targets included in the Company's comprehensive
financial plan would expose the Company to regulatory sanctions that may include
restrictions on operations and growth, mandatory asset dispositions, and placing
the Company under regulatory control. The ultimate outcome of this situation
cannot presently be determined.
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 nine months ended September 30,
2001 and 2000 (in millions):
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
2001 2000 2001 2000
------ ----- ----- -----
Net income (loss) $(16.6) 2.3 (50.0) 4.6
====== ===== ===== =====
Policyholders surplus $142.8 262.1 142.8 262.1
====== ===== ===== =====
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.
13
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 Nine Months Ended
September 30, September 30,
------------------------------ ---------------------------
2001 2000 2001 2000
--------- -------- -------- --------
(dollars in thousands) (dollars in thousands)
Consolidated Results:
Gross premiums written $ 112,486 136,607 434,791 368,520
Net premiums written $ 98,865 121,349 390,493 329,828
========= ======= ======== ========
Net premiums earned $ 131,666 102,912 403,365 274,820
Loss and loss adjustment expense incurred (124,925) (77,869) (362,980) (204,605)
Underwriting expenses (51,492) (33,129) (144,432) (96,339)
--------- ------- -------- --------
Underwriting loss (44,751) (8,086) (104,047) (26,124)
Net investment income 14,854 15,639 45,459 46,721
Net realized investment gains (losses) 2,821 (132) 3,886 826
Debt interest and amortization expense (2,743) (3,056) (8,683) (9,176)
Other (expenses) income, net (642) (320) (1,302) (969)
--------- ------- -------- --------
Income (loss) before taxes (30,461) 4,045 (64,687) 11,278
Income tax expense 2 980 128 2,540
--------- ------- -------- --------
Net income (loss) $ (30,463) 3,065 (64,815) 8,738
Dividends paid on mandatorily redeemable
preferred stock 77 71 229 212
--------- ------- -------- --------
Net income (loss) attributable to common
stockholders $ (30,540) 2,994 (65,044) 8,526
========= ======= ======== ========
Earnings (loss) per common share:
Basic $(2.31) .23 (4.92) .65
========= ======= ======== ========
Diluted $(2.31) .23 (4.92) .65
========= ======= ======== ========
Ratios:
Loss 94.9% 75.7% 90.0% 74.5%
Expense 39.1% 32.2% 35.8% 35.1%
--------- ------- -------- --------
Combined 134.0% 107.9% 125.8% 109.6%
========= ======= ======== ========
PERIOD TO PERIOD COMPARISONS
Gross Premiums Written. Gross premiums written for the three months and nine
months ended September 30, 2001 and 2000 were $112.5 million, $136.6 million,
$434.8 million and $368.5 million, respectively. The $24.1 million or 17.6%
decrease for the quarter is due in part to the implementation of the Company's
financial plan to reduce premiums and operating expenses and to the downgrade in
the Company's A.M. Best Rating on April 18, 2001 from B++ (very good) to B. The
$66.3 million or 18% increase for the nine months, partially offset by the third
quarter decrease, is due primarily to growth in the core commercial and personal
lines from new and renewal business produced by the Company's regional offices
in the first two quarters.
14
The Company is implementing a financial plan aimed at actively managing the
reduction of its written premium to a level below $200 million for 2002 compared
to over $400 million estimated for 2001. This plan is designed to enable the
Company to focus on historically profitable lines of its business.
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 did not include any significant adjustment for
the nine months ended September 30, 2001 or 2000. Experience rated contracts,
such as retrospectively rated policies, reduce but do not eliminate, risk to the
insurer.
Net Premiums Written. Net premiums written for the three months and nine
months ended September 30, 2001 and 2000 were $98.9 million, $121.3 million,
$390.5 million and $329.8 million, respectively. The decrease of $22.4 million
or 18.5% and the increase of $60.7 million or 18.4% in 2001 compared to 2000 are
related to the factors affecting gross premiums written.
Net Premiums Earned. Net premiums earned for the three months and nine months
ended September 30, 2001 and 2000 were $131.7 million, $102.9 million, $403.4
million and $274.8 million, respectively. The increase of $28.8 million and
$128.6 million or 28.0% and 46.8% 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 adjustment
expenses incurred for the three months and nine months ended September 30, 2001
and 2000 were $124.9 million, $77.9 million, $363.0 million and $204.6 million,
respectively. The loss and loss adjustment expense ratio for the three months
and nine months ended September 30, 2001 and 2000 was 94.9%, 75.7%, 90.0% and
74.5%, respectively. The third quarter reported loss and loss adjustment
expense ratio of 94.9% includes approximately 21.0 points, or approximately
$27.6 million, of loss reserve strengthening ($13.3 million for 2000 and prior
accident years and $14.3 million for the current accident year). For the nine
months ended September 30, 2001, approximately $52.8 million ($38.5 million of
which was for prior accident years) of reserve strengthening increased the
reported loss ratio of 90.0% by 13.1 points. For the nine months ended September
30, 2001, the significant reserve increases were in the workers' compensation
($22.2 million) and commercial automobile liability ($12.1 million) lines of
business.
Underwriting Expenses. Underwriting expenses for the three months and nine
months ended September 30, 2001 and 2000 were $51.5 million, $33.1 million,
$144.4 million and $96.3 million, respectively. The expense ratio for the three
months and nine months ended September 30, 2001 and 2000 was 39.1%, 32.2%, 35.8%
and 35.1%, respectively. The increases primarily relate to the additional
acquisition costs associated with the increase for the nine months ended
September 30, 2001 in earned premium and expenses for uncollectible premiums of
$5.8 million ($3.1 million for the three months ended September 30, 2001) for a
commercial automobile program. In addition, during the three months ended
September 30, 2001, the Company established an allowance of $1.0 million for
deferred acquisition costs that were determined to be unrecoverable.
Investment Results. Net investment income for the three months and nine
months ended September 30, 2001 and 2000 was $14.9 million, $15.6 million, $45.5
million and $46.7 million, respectively. Net investment income decreased $.7
million and $1.2 million 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 (losses) for the Company were $2.8 million, $(.1)
million, $3.9 million and $.8 million for the three months and nine months ended
September 30, 2001 and 2000, respectively.
Debt Interest and Amortization Expense. Debt interest and amortization
expense for the three months and nine months ended September 30, 2001 and 2000
was $2.7 million, $3.1 million, $8.7 million and $9.2 million, respectively. The
reduction for the three months and nine months ended September 30, 2001 compared
to 2000 reflects the paydown of the Company's senior bank debt and a lower
variable interest rate in 2001.
15
Other Expenses. Other expenses consist of parent company expenses and
miscellaneous expenses from the insurance subsidiaries offset by miscellaneous
income.
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 nine months ended September 30, 2001 and
2000 was $2 thousand, $1.0 million, $.1 million and $2.5 million, respectively.
During the fourth quarter of 2000, the Company increased its valuation allowance
from approximately $12.2 million at September 30, 2000 to approximately $95.6
million at December 31, 2000 related to its $134.8 million of deferred tax
assets. During 2001, the Company increased its valuation allowance to
approximately $116.5 million related to its $144.3 million of deferred tax
assets.
LIQUIDITY AND CAPITAL RESOURCES
Highlands Group is a holding company, the principal assets of which at
September 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 loan under the
Credit Agreement is approximately $4.0 million for 2001. The loan under the
Credit Agreement is due and payable on April 30, 2002, and is secured by a lien
on the Company's principal insurance subsidiaries. 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
September 30, 2001, the Company was not in compliance with certain financial
covenants under the Credit Agreement. On November 13, 2001, the Company and the
lenders entered into a Waiver to Credit Agreement in which the lenders agreed to
waive the breaches of the financial covenants until December 31, 2001. If the
Credit Agreement is not refinanced or amended, or if additional waivers are not
obtained from the lenders, the Company will be in default of the Credit
Agreement on December 31, 2001. 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 September 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 outstanding 10% convertible subordinated debentures (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. Two of the
Company's insurance subsidiaries, Northwestern National Casualty Company
("NNCC") and NN Insurance Company ("NNI"), a subsidiary of NNCC, and the
Wisconsin Insurance Commissioner entered into a stipulation and order in October
2001 requiring prior approval of transactions with affiliates, including the
payment of dividends and any tax sharing payments, and of any transaction
involving the transfer of a material portion of NNCC's or NNI's business or
other similar transaction other than in the ordinary course of business. The
foregoing restrictions do not apply to existing contracts. The Company has
agreed to obtain prior approval from the Texas Department of Insurance ("Texas
Department") for any affiliated transactions of $1,000,000 or more in any year.
This requirement does not apply to transactions under existing and previously
approved reinsurance, management, tax allocation, investment or administrative
agreements. The Company also
16
agreed to provide the Texas Department notice of any proposed material
transaction between the Company and any non-affiliated entity. On October 9,
2001, the Texas Department requested that the Company submit a plan to show how
it intended to correct certain operational and financial issues. On November 13,
2001, the Company submitted that plan which included the financial plan
described below. (See Insurance Subsidiaries--Insurance Operations)
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
approximates $4 million for 2001 and, 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 annum
and the New Debentures 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. New Debentures in the amount of
$5.9 million were issued in April 2001 as PIK interest. 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
Transactions; 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 any 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.
The States of domicile for the Company's insurance subsidiaries impose risk-
based capital (RBC) requirements on insurance enterprises, including the
Company's subsidiaries. The RBC Model serves as a benchmark for the regulation
of insurance companies by state insurance regulators. RBC provides for targeted
surplus levels based on formulas which specify various weighting factors that
are applied to financial balances or various levels of activity based on the
perceived degree of risk, and are set forth in the RBC requirements. Such
formulas focus on four general types of risk: (a) the risk with respect to the
company's assets (asset or default risk); (b) the risk of default on amounts due
from reinsurers, policyholders or other creditors (credit risk); (c) the risk of
under-estimating liabilities from business already written or inadequately
pricing business to be written in the coming year (underwriting risk); and, (d)
the risk associated with items such as excessive premium growth, contingent
liabilities and other items not reflected on the balance sheet (off-balance
sheet risk). The amount determined under such formulas is called the Authorized
Control Level RBC (ACLC).
The RBC guidelines define specific capital levels based on a company's ACLC
that are determined by the ratio of the company's total adjusted capital (TAC)
to its ACLC. TAC is equal to statutory capital, plus or minus certain other
specified adjustments. The specific capital levels, in declining order, and
applicable ratios are generally as follows: "Company Action Level" where TAC is
less than or equal to 2.0 times ACLC; "Regulatory Action Level" where TAC is
less than or equal to 1.5 times ACLC; "Authorized Control Level" where TAC is
less than or equal to 1.0 times ACLC; and, "Mandatory Control Level" where TAC
is less than or equal to 0.7 times ACLC. Companies at the Company Action Level
must submit a comprehensive financial plan to the insurance commissioner of the
state of domicile. Companies at the Regulatory Action Level are subject to a
mandatory examination or analysis by the commissioner and possible required
corrective actions. At the Authorized Control Level, a company is subject to,
among other things, the commissioner placing it under regulatory control. At the
Mandatory Control Level, the insurance commissioner is required to place a
company under regulatory control.
The Company's financial plan as submitted to the Texas Department of Insurance
on November 13, 2001 anticipates the Company may trigger an action level at
December 31, 2001 for Highlands Insurance Company. Failure to meet the capital
requirements and interim capital targets included in the Company's comprehensive
financial plan would expose the Company to regulatory sanctions that may include
restrictions on operations and growth, mandatory asset dispositions, and placing
the Company under regulatory control. The ultimate outcome of this situation
cannot presently be determined.
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.
The Company is implementing a comprehensive financial plan (the "Plan") to
restructure the Company in an effort to return it to profitability. The Plan
(which has been submitted to the Texas Department) includes the
17
ceasing to write personal lines by selling books of business, nonrenewing
policies and withdrawing from personal lines of business. The Company is
focusing its attention on its current commercial business which it is re-
underwriting and re-pricing as it leaves unprofitable lines and states. The
Company is re-evaluating its agents' profitability and plans to reduce its
ongoing agency force from approximately 2,200 to approximately 500. The Plan is
expected to result in a reduction of net written premiums from over $400 million
in 2001 to under $200 million in 2002. Accompanying this reduction in premiums,
the Company is taking actions to manage its expenses to appropriate levels. The
Company has eliminated five regional offices and established two field support
centers to process the remaining regional business. The Company announced the
elimination of 190 positions previously this year in connection with those
actions and expects to continue to reduce its workforce as appropriate. The
success of the Plan could be adversely affected by changes in the
Company's rating by A.M. Best, changes in the industry or market conditions, the
occurrence of catastrophes, or other uncertainties. On November 19, 2001, A.M.
Best notified the Company that its rating was being reduced from "B" (Fair} to
"C-" (Weak).
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.
The Company attempts to match the duration of its investment portfolio against
the anticipated payout pattern of its loss and loss adjustment expenses. As the
Company anticipates a continued reduction in premium writings, the payment of
loss and loss adjustment expenses will result in negative cash flows from
operations. However, management believes that the negative cash flow from
operations will be appropriately matched by maturities and sales in the
investment portfolio.
Forward Looking Information
The statements included in this Form 10-Q for the quarter ended September 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 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.
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
September 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
18
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 (i) 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 was
held on September 17, 2001. To date, no decision has been issued by the
Delaware Supreme Court.
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, 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.
19
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
See discussion at Item 2, "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources."
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, August 27, 2001, and
November 8, 2001
20
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: November 19, 2001 By /s/ Stephen L. Kibblehouse
----------------------------------
Stephen L. Kibblehouse
Co-Chief Executive Officer
(Authorized Signatory)
Date: November 19, 2001 By /s/ James W. Hooker
---------------------------------
James W. Hooker
Controller and Principal Accounting Officer
(Authorized Signatory)
21