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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, 2002
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, 2002 was 12,978,533.
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1
HIGHLANDS INSURANCE GROUP, INC.
TABLE OF CONTENTS
PART I - Financial Information
Item Page
1. Financial Statements:
Consolidated Balance Sheets
June 30, 2002 (Unaudited) and
December 31, 2001 3
Consolidated Statements of Operations
(Unaudited) - Three Months and Six
Months Ended June 30, 2002 and 2001 5
Consolidated Statements of Stockholders' Equity
Six Months Ended June 30, 2002 (Unaudited)
and Year Ended December 31, 2001 6
Consolidated Statements of Comprehensive Income
(Loss) (Unaudited) - Three Months and Six
Months Ended June 30, 2002 and 2001 7
Consolidated Statements of Cash Flows
(Unaudited) - Six Months Ended June 30,
2002 and 2001 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 15
PART II - Other Information
1. Legal Proceedings 16
4. Submission of Matters to a Vote of Security Holders 18
6. Exhibits and Reports on Form 8-K 18
Signatures 19
2
HIGHLANDS INSURANCE GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
June 30, December 31,
ASSETS 2002 2001
------ ----------- ------------
(Unaudited)
Investments:
Fixed maturity securities - available-for-sale, at fair
value (amortized cost of $641,754 at 6/30/02 and
$723,410 at 12/31/01) $ 636,700 714,243
Equity securities, at fair value (cost of $24,049 at 6/30/02
and $28,940 at 12/31/01) 24,153 29,665
Other investments, at cost 2 54
---------- ---------
Total investments 660,855 743,962
Cash and cash equivalents 104,564 109,634
Premiums in course of collection, net 38,701 85,838
Premiums due under retrospectively rated policies 91,773 108,952
Receivable from reinsurers 679,550 691,938
Prepaid reinsurance premiums 3,108 7,523
Funds on deposit with reinsurers 20,035 20,035
Accrued investment income 8,797 9,723
Other assets 36,586 43,007
---------- ---------
Total assets $1,643,969 1,820,612
========== =========
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 2002 2001
------------------------------------ ----------- -------------
(Unaudited)
Loss and loss adjustment expense reserves $1,571,691 1,599,127
Unearned premiums 52,999 168,480
Senior bank debt 47,504 49,004
Convertible subordinated debentures 62,702 62,297
Accounts payable and accrued liabilities 70,965 99,751
---------- ---------
Total liabilities 1,805,861 1,978,659
---------- ---------
Mandatorily redeemable preferred stock 5,235 5,235
---------- ---------
Commitments and contingent liabilities
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized;
12,978,533 issued and outstanding in 2002 and in 2001 137 137
Additional paid-in capital 228,872 228,872
Accumulated other comprehensive loss (3,209) (8,582)
Treasury stock, at cost (739,400 shares in 2002 and 2001, including 445,900
shares held by subsidiaries in 2002 and 2001) (9,459) (9,459)
Deferred compensation on restricted stock (313) (313)
Retained loss (383,155) (373,937)
---------- ---------
Total stockholders' equity (deficit) (167,127) (163,282)
---------- ---------
Total liabilities and stockholders' equity $1,643,969 1,820,612
========== =========
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,
------------------------------------ ---------------------------------
2002 2001 2002 2001
------------ ------------- ------------ -------------
Revenues:
Net premiums earned $ 60,325 144,646 144,691 271,699
Net investment income 11,724 14,318 24,216 30,605
Net realized investment gains (losses) (2,307) 495 (1,754) 1,065
----------- ------------ ------------ ------------
Total revenues 69,742 159,459 167,153 303,369
----------- ------------ ------------ ------------
Expenses:
Loss and loss adjustment expense incurred 61,441 124,025 140,833 238,055
Underwriting expenses 12,083 51,730 31,794 92,940
Debt interest and amortization expense 2,944 3,187 5,169 5,940
Other expenses (income), net (556) 139 683 660
----------- ------------ ------------ ------------
Total expenses 75,912 179,081 178,479 337,595
----------- ------------ ------------ ------------
Loss before income tax (6,170) (19,622) (11,326) (34,226)
Income tax expense (benefit) 2 119 (6) 126
----------- ------------ ------------ ------------
Net loss before extraordinary item (6,172) (19,741) (11,320) (34,352)
Extraordinary item - write-off of negative goodwill -- -- 2,259 --
----------- ------------ ------------ -----------
Net loss (6,172) (19,741) (9,061) (34,352)
Dividends on mandatorily redeemable preferred 79 78 156 152
----------- ------------ ------------ ------------
Net loss attributable to common stockholders $ (6,251) (19,819) (9,218) (34,504)
=========== ============ ============ ============
Earnings per common share:
Loss before extraordinary items $ (0.48) (1.50) (0.88) (2.61)
Extraordinary item -- -- 17 --
----------- ------------ ------------ -----------
Net loss attributable to common stockholders $ (0.48) (1.50) (0.71) (2.61)
=========== ============ ============ ============
Weighted average number of common shares
outstanding 12,979 13,229 12,979 13,228
=========== ============ ============ ============
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,
2002 2001
------------ ------------
(Unaudited)
Common stock:
Balance, beginning of year $ 137 140
Issuance (cancellation) of common stock, par value -- (3)
------------ ------------
Balance, end of period 137 137
------------ ------------
Additional paid-in capital:
Balance, beginning of year 228,872 231,566
Issuance (cancellation) of common stock, net -- (2,694)
------------ ------------
Balance, end of period 228,872 228,872
------------ ------------
Accumulated other comprehensive income (loss):
Balance, beginning of year (8,582) (12,572)
Changes in net unrealized gain (losses), net of tax 3,492 7,015
Change in valuation allowance for deferred taxes on unrealized investment
gains and losses 1,866 (2,955)
Other 15 (70)
------------ ------------
Balance, end of period (3,209) (8,582)
------------ ------------
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 (313) (3,097)
Net retirement (issuance) of restricted stock -- 2,784
------------ ------------
Balance, end of period (313) (313)
------------ ------------
Retained (loss) earnings:
Balance, beginning of year (373,937) (32,029)
Net income (loss) attributable to common stockholders (9,218) (341,908)
------------ ------------
Balance, end of period (383,155) (373,937)
------------ ------------
Total stockholders' equity (deficit) $ (167,127) (163,282)
============ ============
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,
--------------------------- ----------------------------
2002 2001 2002 2001
------------ ------------ ------------ -------
Net income (loss) attributable to common stockholders $ (6,251) (19,819) (9,218) (34,504)
---------- ---------- ---------- ----------
Other comprehensive income (loss), net of taxes:
Increase (decrease) in unrealized gain or loss on investments,
net of taxes of $5,199 and $(1,913) for the three months and
$1,266 and $3,205 for the six months ended June 30, 2002
and 2001, respectively 9,655 (3,552) 2,352 5,953
Reclassification adjustments for realized gains in net income,
net of taxes of $808 and $(174) for the three months and
$614 and $(373) for the six months ended June 30, 2002 and
2001, respectively 1,499 (321) 1,140 (692)
Change in valuation allowance for deferred taxes on unrealized
investment gains and losses 5,992 -- 1,866 --
Other 24 56 15 (61)
---------- ---------- ---------- ----------
Other comprehensive income (loss), net of taxes 17,170 (3,817) 5,373 5,200
---------- ---------- ---------- ----------
Comprehensive income (loss) $ 10,919 (23,636) (3,845) (29,304)
========== ========== ========== ==========
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,
-------------------------------
2002 2001
--------------- -------------
Cash flows used in operating activities:
Net income (loss) $ (9,061) (34,352)
-------------- ---------------
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization 3,389 3,079
Net realized investment gains 1,754 (1,065)
Deferred tax expense -- --
Extraordinary item - write-off of negative goodwill (2,259) --
Change in:
Premiums in course of collection 47,137 (26,882)
Premiums due under retrospectively rated policies 17,179 (422)
Receivables from reinsurers 12,388 (26,995)
Prepaid reinsurance premiums 4,415 610
Funds on deposit with reinsurers -- (570)
Deferred policy acquisition costs -- (2,143)
Loss and loss adjustment expense reserves (27,436) 33,359
Unearned premiums (115,481) 19,320
Other operating assets and liabilities (26,269) 13,135
--------------- ---------------
Total adjustments (85,183) 11,426
--------------- ---------------
Net cash used in operating activities (94,244) (22,926)
-------------- --------------
Cash flows from investing activities:
Proceeds from sales:
Fixed maturity securities available-for-sale 135,295 8,350
Equity securities 5,594 --
Other invested assets 80 2,018
Maturities or calls:
Fixed maturity securities available-for-sale 23,861 85,798
Investment purchases:
Fixed maturity securities available-for-sale (73,869) (82,435)
Equity securities -- --
Net additions to property and equipment (287) (1,512)
-------------- --------------
Net cash provided by investing activities 90,674 12,219
-------------- --------------
Cash flows from financing activities:
Repayment of senior bank debt (1,500) --
-------------- --------------
Net cash used in financing activities (1,500) --
-------------- -------------
Net (decrease) increase in cash and cash equivalents (5,070) (10,707)
Cash and cash equivalents at beginning of period 109,634 109,763
-------------- --------------
Cash and cash equivalents at end of period $ 104,564 99,056
============== ===============
Supplemental disclosure of cash flow information:
Interest paid $ -- 2,244
============== ===============
See Condensed Notes to Unaudited Consolidated Financial Statements.
8
HIGHLANDS INSURANCE GROUP, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2002
1. Basis of Presentation
The accompanying consolidated financial statements as of June 30, 2002 and
for the three and six months ended June 30, 2002 and 2001 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, 2001. The independent auditors report on the
Company's 2001 consolidated financial statements reflects a disclaimer of
opinion due to the significant uncertainty regarding the Company's ability to
continue as a going concern.
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. The Company has been in
default under the terms of its bank debt for noncompliance with certain
financial ratios. The Company does not have sufficient funds to satisfy the
$47.5 million principal which was due on April 30, 2002. The Company is
currently negotiating a forebearance agreement with its senior debt lenders in
anticipation of filing a plan under Chapter 11 of the Bankruptcy Code.
The California Department of Insurance is conducting an examination of the
financial statements of Pacific National Insurance Company and its subsidiary,
Pacific Automobile Insurance Company (collectively, "Pacific") as of December
31, 2001. The California Department has received a report from an independent
consultant indicating that the loss and expense reserves of those two companies
may be materially understated at December 31, 2001. Pacific and its external
actuaries have notified the California Department of their disagreement with the
conclusions in the report. Discussions between Pacific and the California
Department are continuing. On May 16, 2002, the Indiana Insurance Department
issued Orders of Supervision covering two of the Company's subsidiaries
domiciled in Indiana, Statesman Insurance Company and American Professionals
Insurance Company. In February 2002, the Texas Department of Insurance issued
Supervisory Orders to the Company's Texas insurance subsidiaries, including
Highlands Insurance Company, the Company's principal insurance subsidiary. By
their terms, the orders are also binding on all the companies' affiliates. A
Supervisory Order for another of the insurance subsidiaries, State Capital
Insurance Company, was issued by the North Carolina Department of Insurance in
December 2001, and in October 2001, the Wisconsin Commissioner of Insurance
issued a Stipulation and Order covering Northwestern National Casualty Company,
the Company's second largest insurance subsidiary, and NN Insurance Company,
another of the Company's insurance subsidiaries. In addition to these orders,
the Company's insurance subsidiaries have had their licenses to transact
business suspended, amended to permit servicing of existing business, or revoked
in numerous states. Except where prohibited by law, the Company is not renewing
any business upon policy term expiration. These matters raise substantial doubt
regarding the Company's ability to continue as a going concern.
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
9
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. Extraordinary Item
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 became effective January 1, 2002 and requires 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 also requires 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 December 31,
2001, the Company had recorded negative goodwill in the amount of $2.3 million.
Upon adoption of Statement 142 on January 1, 2002, the remaining balance of
negative goodwill was recognized as an extraordinary item.
3. 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,
------------------------------- -------------------------------
2002 2001 2002 2001
----------- ----------- ----------- ------
NUMERATOR:
Net income (loss) attributable to common stockholders
as reported and for basic earnings per share $ (6,251) (19,819) (9,218) (34,504)
Effect of dilutive securities - after tax debt
expense applicable -- -- -- --
----------- ----------- ----------- -----------
Numerator for diluted earnings (loss) per common
share - income available to common stockholders
after assumed conversions, if appropriate $ (6,251) (19,819) (9,218) (34,504)
=========== =========== =========== ===========
DENOMINATOR:
Denominator for basic earnings (loss) per share -
weighted average shares outstanding 12,979 13,229 12,979 13,228
Effect of dilutive securities:
Common stock warrants and outstanding stock
options (based on treasury stock method) -- -- -- --
Convertible subordinated debentures, if appropriate -- -- -- --
----------- ----------- ----------- ----------
Denominator for diluted earnings per share - adjusted
weighted average shares and assumed conversions 12,979 13,229 12,979 13,228
=========== =========== =========== ===========
Basic earnings (loss) per share $ (0.48) (1.50) (0.71) (2.61)
Diluted earnings (loss) per share $ (0.48) (1.50) (0.71) (2.61)
=========== =========== =========== ===========
The convertible subordinated debentures ("Debentures"), which are
convertible into approximately 3.7 million shares, were outstanding during the
six months ended June 30, 2002 and 2001, but were not included in the
computation of diluted earnings per share because the assumed conversion
would be antidilutive. Common
10
stock warrants attached to the Debentures for approximately 3.8 million shares
for 2002 and 5 million shares for 2001 were not included in the earnings per
share calculation as they were antidilutive.
Stock options for 654,492 and 1,150,266 shares for 2002 and 2001,
respectively, were not included in earnings per share calculations as they were
antidilutive.
4. 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,
----------------------------- -----------------------------
2002 2001 2002 2001
------------ ------------ ------------ ---------
(dollars in thousands)
Consolidated Results:
Gross premiums written $ 15,735 159,775 45,660 322,305
Net premiums written $ 9,738 141,282 33,624 291,628
============ ============ ============ ============
Net premiums earned $ 60,325 144,646 144,691 271,699
Loss and loss adjustment expense incurred (61,441) (124,025) (140,833) (238,055)
Underwriting expenses (12,083) (51,730) (31,794) (92,940)
------------ ------------ ------------ ------------
Underwriting loss (13,199) (31,109) (27,936) (59,296)
Net investment income 11,724 14,318 24,216 30,605
Net realized investment gains (2,307) 495 (1,754) 1,065
Debt interest and amortization expense (2,944) (3,187) (5,169) (5,940)
Other (expenses) income, net 556 (139) (660) (660)
------------ ------------ ------------ ------------
Loss before taxes (6,170) (19,622) (11,326) (34,226)
Income tax expense 2 119 (6) 126
------------ ------------ ------------ ------------
Net loss $ (6,172) (19,741) (11,320) (34,352)
Dividends on mandatorily redeemable preferred stock 79 78 156 152
------------ ------------ ------------ ------------
Net loss attributable to common
stockholders before extraordinary gains (6,251) (19,819) (11,476) (34,504)
Extraordinary item - write-off of negative
goodwill -- -- 2,259 --
------------ ------------ ------------ ------------
Net loss attributable to common
stockholders $ (6,251) (19,819) (9,218) (34,504)
============ ============ ============ ============
Earnings (loss) per common share:
Loss before extraordinary items $ (0.48) (1.50) (0.88) (2.61)
Extraordinary item -- -- .17 --
----------- ----------- ------------ ------------
(0.48) (1.50) (0.71) (2.61)
============ ============ ============ ============
Ratios:
Loss 101.8% 85.7% 97.3% 87.6%
Expense 20.0% 35.8% 22.0% 34.2%
----------- ----------- ----------- -----------
Combined 121.8% 121.5% 119.3% 121.8%
=========== =========== =========== ===========
Period to Period Comparisons
Gross Premiums Written. Gross premiums written for the three months and six
months ended June 30, 2002 and 2001 were $15.7 million, $159.8 million, $45.7
million and $322.3 million, respectively. The $144.1 million
12
and $276.6 or 90.2% and 85.8% decrease in 2002 compared to 2001 is due primarily
to the Company's implementation of its plan to not renew any business upon
policy term expiration, except where prohibited by law.
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 for these items for the three months and six months
ended June 30, 2002 were $22.5 million and $25.5 million, respectively. Due to a
policy backlog in 2001, an immaterial amount of such premium was included in the
first half of that year. 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 six
months ended June 30, 2002 and 2001 were $9.7 million, $141.3 million, $33.6
million and $291.6 million, respectively. The decrease of $131.6 million and
$258 million or 93.1% and 88.5% in 2002 compared to 2001 is due to the same
issues affecting gross premiums written. Included in these amounts for the three
months and six months ended June 30, 2002 were $22.5 million and $25.5 million
of retrospectively rated policies, respectively.
Net Premiums Earned. Net premiums earned for the three months six months
ended June 30, 2002 and 2001 were $60.3 million, $144.6 million, $144.7 million
and $271.7 million, respectively. The decrease of $84.3 million and $127 million
or 58.3% and 46.7% in 2002 compared to 2001 is due to the same reasons affecting
net premiums written, but the effect is less due 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. Included in these amounts for the three months and six months
ended June 30, 2002 were $11.6 million and $9.6 million of retrospectively rated
policies, respectively.
Loss and Loss Adjustment Expense Incurred. Loss and loss and adjustment
expenses incurred for the three months and six months ended June 30, 2002 and
2001 were $61.4 million, $124.0 million, $140.8 million and $238.1 million,
respectively. The loss and loss adjustment expense ratio for the three months
and six months ended June 30, 2002 and 2001 was 101.8%, 85.7%, 97.3%, and 87.6%,
respectively. The difference in the loss ratio is due to prior year reserve
development of $5.0 million, settlements of disputed items of $6.0 million in
the current period and higher loss ratios being applied to 2002 premiums versus
same periods in 2001.
Underwriting Expenses. Underwriting expenses for the three months and six
months ended June 30, 2002 and 2001 were $12.1 million, $51.7 million, $31.8
million and $92.9 million, respectively. The underwriting expense ratio for the
three months and six months ended June 30, 2002 and 2001 was 20%, 35.8%, 22% and
34.2%, respectively. The decline in the 2002 underwriting expense ratio,
compared to the 2001 expense ratio, of 12.2 points is primarily related to the
non-recognition in 2002 of deferred acquisition costs of $49.6 million that
would have been amortized in 2002 that were written off at December 31, 2001.
Investment Results. Net investment income for the three months and six
months ended June 30, 2002 and 2001 was $11.7 million, $14.3 million, $24.2
million and $30.6 million, respectively. Net investment income decreased $2.6
million and $6.4 from 2001 primarily due to reductions in the investment
portfolio's average amortized cost and lower interest rates. Net realized
investment gains (losses) for the Company were $(2.3) million, $.5 million,
$(1.7) million and $1.1 million for the three months and six months ended June
30, 2002 and 2001, respectively. Included in both the three month and six month
realized loss in 2002 are losses relating to $3.0 million of bonds with other
than temporary impairment.
Debt Interest and Amortization Expense. Debt interest and amortization
expense for the three months and six months ended June 30, 2002 and 2001 was
$2.9 million, $3.2 million, $5.2 million and $5.9 million, respectively. The
reduction in 2002 compared to 2001 reflects the paydowns of the Company's senior
bank debt as well as lower interest rates in 2002.
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 for the three
months and six months ended June 30, 2002 and 2001 was $2 thousand, $119
thousand, $(6) thousand and $126 thousand, respectively.
Extraordinary Item. 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 became effective January 1, 2002
and requires 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 also requires
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 December 31, 2001, the Company had recorded negative goodwill in the
amount of $2.3 million. Upon adoption of Statement 142 on January 1, 2002, the
remaining balance of negative goodwill was recognized as an extraordinary item.
Liquidity and Capital Resources
Highlands Group is a holding company, the principal assets of which at June
30, 2002 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. As described more fully below, due to the
Company's current financial condition, the Highlands Group is currently
negotiating a forebearance agreement with its senior debt lenders in
anticipation of filing a plan under Chapter 11 of the Bankruptcy Code.
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 franchise and other taxes imposed on the Company are not
material. The Company has outstanding $47.5 million in outstanding senior bank
debt and $62.7 million principal amount of convertible subordinated debentures.
The bank debt, which is collaterized by a first lien on the stock of the
Company's principal insurance subsidiaries, matured on April 30, 2002 and has
not been paid. The Company and the lender banks executed the Eighth Amendment
and Waiver to the Credit Agreement dated as of May 1, 2002 which waived certain
events of default and extended the maturity of the senior bank debt to June 30,
2002. The convertible subordinated debentures are due December 31, 2005;
however, by virtue of the cross default provisions of the debentures, if the
senior bank debt becomes due and is not paid, the holders of the debentures have
the right to declare the debentures in default and accelerate their maturity.
Highlands Group's only significant sources of funds are dividends and tax
sharing payments from its subsidiaries. As a result of orders issued by state
insurance regulators and losses incurred by the Company's insurance
subsidiaries, no further payments from the insurance subsidiaries are likely to
be made. As a result, the Highlands Group is currently negotiating a
forebearance agreement with its senior debt lenders in anticipation of filing a
plan under Chapter 11 of the Bankruptcy Code.
As a result of the losses incurred by the Company's insurance subsidiaries,
one or more state insurance commissioners could seek to place the Company's
insurance subsidiaries that are under their jurisdiction in rehabilitation or
liquidation. If an insurance subsidiary were placed in rehabilitation or
liquidation, the Company would lose control of that insurance subsidiary. See
Part II, Item 1 - Legal Proceedings for a
14
discussion of Regulatory Proceedings.
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. As a result of the
insurance subsidiaries ceasing to write any new business and not renewing
existing business, premium income to the Company has been materially reduced.
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
and the profitability of the products. Continuing operating losses, including
those from future catastrophe claims, the timing and amount of which are
inherently unpredictable, may create increased liquidity requirements for the
insurance subsidiaries. The Company's insurance subsidiaries have not purchased
any catastrophe reinsurance for the current period due to the decreasing
exposures of the companies and the prohibitive cost of such reinsurance. 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 ended June 30,
2002, 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, 2001 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, 2001.
15
PART II Other Information
ITEM 1. Legal Proceedings
Halliburton. 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, a large number of third party asbestos claims have been made against
Halliburton. Through December 31, 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 (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. 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 and on March 13, 2002, the Delaware Supreme Court issued an order
affirming the decision of the Chancery Court. On March 28, 2002, Halliburton
filed a motion with the Delaware Supreme Court requesting reargument. On July
11, 2002, the Delaware Supreme Court denied Halliburton's motion. On July 19,
2002, the Company filed a motion for summary judgment with Delaware Chancery
Court requesting reimbursement of approximately $10 million paid by the Company
on behalf of Halliburton, principally for asbestos claims, and litigation
expenses.
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.
16
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.
Liquidator of LMI Insurance Company. On February 26, 2002, the Liquidator
of LMI Insurance Company ("LMI"), a former subsidiary of the Company now in
liquidation, filed an action against Pacific National Insurance Company, a
subsidiary of the Company, in the Court of Common Pleas, Franklin County, Ohio.
The complaint alleges that a voidable transfer or fraudulent payment in the
amount of $7 million was made by LMI to Pacific National. On March 29, 2002, the
Liquidator of LMI filed an action in the Court of Common Pleas, Franklin County,
Ohio against the Registrant and its present and former officers and directors,
certain of the Registrant's subsidiaries, and current and former officers and
directors of the named subsidiaries. The complaint alleges the following: (i)
breach of representations and warranties contained in the Form A filed in 1996
and the amended and restated Form A filed in 1997 with the Ohio Department of
Insurance when the Registrant acquired control of LMI; (ii) waste of the assets
of LMI by failing to maintain adequate records of LMI; (iii) breach of a group
services agreement among LMI and other subsidiaries of the Registrant; (iv)
failure of the officers and directors of the Registrant and the named
subsidiaries to implement controls to ensure performance of the subsidiaries
under the group services agreement; and (v) breach of fiduciary duty by the
officers and directors of the Registrant by failing to maintain and preserve the
assets of LMI and negligently permitting the Registrant's subsidiaries to waste
LMI's assets. The Liquidator is seeking damages in excess of $25,000 to be
determined at trial on each of claims in the complaint plus interest, costs and
attorney's fees. The Registrant and the other defendants filed answers to both
complaints on June 2, 2002. The Company believes that these complaints are
completely without merit and the defendants are vigorously defending them.
Regulatory Proceedings. The California Department of Insurance is
conducting an examination of the financial statements of Pacific National
Insurance Company and its subsidiary, Pacific Automobile Insurance Company
(collectively, "Pacific") as of December 31, 2001. The California Department has
received a report from an independent consultant indicating that the loss and
expense reserves of those two companies may be materially understated at
December 31, 2001. Pacific and its external actuaries have notified the
California Department of their disagreement with the conclusions in the report.
Discussions between Pacific and the California Department are continuing. On May
16, 2002, the Indiana Insurance Department issued Orders of Supervision covering
two of the Company's subsidiaries domiciled in Indiana, Statesman Insurance
Company and American Professionals Insurance Company. In February 2002, the
Texas Department of Insurance issued Supervisory Orders to the Company's Texas
insurance subsidiaries, including Highlands Insurance Company, the Company's
principal insurance subsidiary. By their terms, the orders are also binding on
all the companies' affiliates. A Supervisory Order for another of the insurance
subsidiaries, State Capital Insurance Company, was issued by the North Carolina
Department of Insurance in December 2001, and in October 2001, the Wisconsin
Commissioner of Insurance issued a Stipulation and Order covering Northwestern
National Casualty Company, the Company's second largest insurance subsidiary,
and NN Insurance Company, another of the Company's insurance subsidiaries. In
addition to these orders, the Company's insurance subsidiaries have had their
licenses to transact business suspended, amended to permit servicing of existing
business or revoked in numerous states.
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ITEM 4. Submission of Matters to a Vote of Security Holders
None.
ITEM 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10.22 - Eighth Amendment and waiver to Credit Agreement dated as
of May 1, 2002 among Registrant, Various Lending
Institutions and the JP Morgan Chase Bank, as
Administrative Agent.
10.23 - Employment Agreement between Company and Stephen L.
Kibblehouse pursuant to Section 1350 of Title 18 of the
United States Code
99.1 - Statement of Chief Executive Officer pursuant to Section
1350 of Title 18 of the United States Code
99.2 - Statement of Chief Financial Officer pursuant to
Section 1350 of Title 18 of the United States Code
(b) Reports on Form 8-K
None
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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, 2002 By /s/ Stephen L. Kibblehouse
------------------------------------------
Stephen L. Kibblehouse
Chief Executive Officer
(Authorized Signatory)
Date: August 14, 2002 By /s/ Albert J. Marino
------------------------------------------
Albert J. Marino
Chief Financial Officer and Treasurer
(Authorized Signatory)
19