1
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
------------------------
FORM 10-Q/A
------------------------
(AMENDMENT NO. 1)
(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, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .
COMMISSION FILE NUMBER 0-25984
------------------------
SUPERIOR NATIONAL
INSURANCE GROUP, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-4610936
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
26601 AGOURA ROAD
CALABASAS, CA 91302
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(818) 880-1600
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
------------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Number of shares of Common Stock, $0.01 par value per share, outstanding as
of close of business on August 12, 1998: 5,877,567 shares.
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2
SUPERIOR NATIONAL INSURANCE GROUP, INC.
INDEX TO FORM 10-Q
PART I. FINANCIAL INFORMATION
PAGE
----
Item 1. Financial Statements........................................ 3
Condensed consolidated balance sheets as of June 30, 1998 3
(unaudited) and December 31, 1997.........................
Condensed consolidated statements of income for the three 4
and six months ended June 30, 1998 (unaudited) and June
30, 1997 (unaudited) (restated)...........................
Condensed consolidated statement of changes in stockholders' 5
equity for the six months ended June 30, 1998 (unaudited)
and for the twelve months ended December 31, 1997.........
Condensed consolidated statements of cash flows as restated 6
for the six months ended June 30, 1998 (unaudited) and
June 30, 1997 (unaudited).................................
Notes to condensed consolidated financial statements 7
(unaudited)...............................................
Item 2. Management's Discussion and Analysis of Consolidated 13
Financial Condition and Results of Operations.............
PART II. OTHER INFORMATION
Item 5. Other Information........................................... 21
Item 6. Exhibits and Reports on Form 8-K............................ 22
SIGNATURE............................................................ 23
2
3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
ASSETS
JUNE 30, DECEMBER 31,
1998 1997
----------- ------------
(UNAUDITED) *
INVESTMENTS
Bonds and notes:
Available-for-sale, at market (cost: 1998, $179,057; 1997,
$203,373)............................................... $180,830 $205,214
Equity securities, at market (cost: 1998, $5,179; 1997,
$1,356)................................................... 5,263 1,526
Short-term investments, at cost............................. 650 6,634
-------- --------
TOTAL INVESTMENTS.................................. 186,743 213,374
Cash and cash equivalents (Restricted cash: 1998, $449;
1997, $651)............................................... 4,421 28,742
Reinsurance recoverable..................................... 55,474 53,082
Premiums receivable (less allowance for doubtful accounts:
1998 and 1997, $800)...................................... 34,518 36,888
Deferred income taxes (less valuation allowance of $8,129,
1998 and 1997)............................................ 22,592 25,104
Prepaid reinsurance premiums................................ 25,822 1,598
Goodwill.................................................... 35,248 35,887
Prepaid and other........................................... 31,218 34,798
-------- --------
TOTAL ASSETS....................................... $396,036 $429,473
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Claims and claim adjustment expenses........................ $154,843 $201,255
Unearned premiums........................................... 16,198 12,913
Reinsurance payable......................................... 17,964 3,412
Discontinued operations liability........................... 10,861 12,904
Accounts payable and other liabilities...................... 36,424 37,894
-------- --------
TOTAL LIABILITIES.................................. 236,290 268,378
COMPANY-OBLIGATED TRUST PREFERRED SECURITIES OF
SUBSIDIARY TRUST HOLDING SOLELY SENIOR SUBORDINATED
NOTES OF SNIG; $1,000 face per share; issued and
outstanding 105,000 shares in 1997 and 1998............ 101,051 101,277
STOCKHOLDERS' EQUITY
Common stock, $0.01 par value; authorized 25,000,000 shares:
issued 5,876,399 shares in 1998 and 5,871,279 shares in
1997...................................................... 59 59
Paid-in capital excess of par............................. 34,274 34,242
Paid-in capital -- warrants................................. 2,206 2,206
Accumulated other comprehensive income; Unrealized gain on
investments, net of taxes................................. 1,225 1,327
Retained earnings........................................... 26,076 21,984
Less: 245,000 shares of treasury stock at cost.............. (5,145) --
-------- --------
TOTAL STOCKHOLDERS' EQUITY......................... 58,695 59,818
======== ========
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY......... $396,036 $429,473
======== ========
- ---------------
* Derived from audited financial statements.
See Notes to Condensed Consolidated Financial Statements.
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4
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
THREE AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------- --------------------------
1998 1997 1998 1997
----------- ----------- ----------- -----------
(UNAUDITED) (UNAUDITED) (UNAUDITED) (UNAUDITED)
(RESTATED) (RESTATED)
REVENUES:
Premiums written, net of reinsurance ceded....... $13,579 $ 43,703 $42,080 $ 63,706
Net change in unearned premiums.................. 6,040 1,707 8,126 682
------- -------- ------- --------
Net premiums earned.............................. 19,619 45,410 50,206 64,388
Net investment income............................ 3,761 3,435 8,014 5,521
------- -------- ------- --------
TOTAL REVENUES.......................... 23,380 48,845 58,220 69,909
EXPENSES:
Claims and claim adjustment expenses, net of
reinsurance recoveries......................... 8,031 34,724 26,319 44,995
Commissions, net of reinsurance ceding
commissions.................................... (1,497) 4,687 1,467 6,888
Interest expense................................. -- 2,417 -- 4,144
General and administrative expenses
Underwriting................................... 9,912 6,158 16,939 10,961
Loss on termination of financing transaction
with a related party reinsurer............... -- 15,699 -- 15,699
Other.......................................... 196 340 375 521
Goodwill....................................... 335 137 639 137
------- -------- ------- --------
TOTAL EXPENSES.......................... 16,977 64,162 45,739 83,345
------- -------- ------- --------
INCOME BEFORE INCOME TAXES, PREFERRED SECURITIES
DIVIDENDS AND ACCRETION........................ 6,403 (15,317) 12,481 (13,436)
Income tax expense............................... 2,354 (5,240) 4,665 (4,569)
------- -------- ------- --------
INCOME BEFORE PREFERRED SECURITIES DIVIDENDS AND
ACCRETION...................................... 4,049 (10,077) 7,816 (8,867)
Preferred Securities dividends and accretion, net
of income tax.................................. -- (453) -- (907)
Trust Preferred Securities dividends and
accretion, net of income tax................... (1,852) -- (3,724) --
------- -------- ------- --------
NET INCOME....................................... $ 2,197 $(10,530) $ 4,092 $ (9,774)
======= ======== ======= ========
BASIC EARNINGS PER SHARE:
INCOME BEFORE PREFERRED SECURITIES DIVIDENDS AND
ACCRETION...................................... $ 0.69 $ (1.72) $ 1.34 $ (1.91)
Preferred securities dividends and accretion..... (0.32) (0.08) (0.64) (0.20)
------- -------- ------- --------
NET INCOME....................................... $ 0.37 $ (1.80) $ 0.70 $ (2.11)
======= ======== ======= ========
DILUTED EARNINGS PER SHARE:
INCOME BEFORE PREFERRED SECURITIES DIVIDENDS AND
ACCRETION...................................... $ 0.50 $ (1.33) $ 0.99 $ (1.38)
Preferred securities dividends and accretion..... (0.23) (0.06) (0.47) (0.14)
------- -------- ------- --------
NET INCOME....................................... $ 0.27 $ (1.39) $ 0.52 $ (1.52)
======= ======== ======= ========
See Notes to Condensed Consolidated Financial Statements.
4
5
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
ACCUMULATED
OTHER
COMPREHENSIVE
INCOME
------------- UNREALIZED
NUMBER OF GAIN (LOSS) PAID-IN
SHARES COMMON TREASURY ON CAPITAL- COMPREHENSIVE RETAINED
OUTSTANDING STOCK STOCK INVESTMENTS WARRANTS INCOME EARNINGS
----------- ------- -------- ------------- ---------- ------------- --------
Balance at December 31,
1996...................... 3,446,492 $16,022 $ -- $ (162) $2,206 $ 27,125
Comprehensive income
Net income................ -- -- -- -- -- (5,141) (5,141)
-------
Other comprehensive
income, net of tax
Change in unrealized
gain (loss) on
investments........... -- -- -- 1,489 -- 1,489 --
-------
Other comprehensive
income.................. 1,489
-------
Comprehensive income........ $(3,652)
=======
Common stock issued......... 2,390,438 18,000 -- -- -- --
Stock issued under stock
option plan............... 22,127 105 -- -- -- --
Common stock issued under
stock incentive plan...... 12,222 174 -- -- -- --
---------- ------- ------- ------ ------ --------
Balance at December 31,
1997...................... 5,871,279 34,301 -- 1,327 2,206 21,984
---------- ------- ------- ------ ------ --------
Comprehensive income
Net income................ -- -- -- -- -- 4,092 4,092
-------
Other comprehensive
income, net of tax
Change in unrealized
gain (loss) on
investments........... -- -- -- (102) -- (102) --
-------
Other comprehensive
income.................. (102)
-------
Comprehensive income........ $ 3,990
=======
Common stock issued......... -- -- -- -- -- --
Stock issued under stock
option plan............... 5,120 32 -- -- -- --
Common stock issued under
stock incentive plan...... -- -- -- -- -- --
Treasury stock.............. (245,000) -- (5,145) -- -- --
========== ======= ======= ====== ====== ========
Balance at June 30, 1998.... 5,631,399 $34,333 $(5,145) $1,225 $2,206 $ 26,076
========== ======= ======= ====== ====== ========
TOTAL
STOCKHOLDERS'
EQUITY
-------------
Balance at December 31,
1996...................... $ 45,191
Comprehensive income
Net income................ (5,141)
Other comprehensive
income, net of tax
Change in unrealized
gain (loss) on
investments........... 1,489
Other comprehensive
income..................
Comprehensive income........
Common stock issued......... 18,000
Stock issued under stock
option plan............... 105
Common stock issued under
stock incentive plan...... 174
--------
Balance at December 31,
1997...................... 59,818
--------
Comprehensive income
Net income................ 4,092
Other comprehensive
income, net of tax
Change in unrealized
gain (loss) on
investments........... (102)
Other comprehensive
income..................
Comprehensive income........
Common stock issued......... --
Stock issued under stock
option plan............... 32
Common stock issued under
stock incentive plan...... --
Treasury stock.............. (5,145)
========
Balance at June 30, 1998.... $ 58,695
========
See Notes to Condensed Consolidated Financial Statements.
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6
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS AS RESTATED
(IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
--------------------
1998 1997
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income........................................... $ 4,092 $ (9,774)
-------- --------
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Amortization of bonds and preferred stock................. 30 (803)
Amortization of capital lease obligation.................. (666) --
(Gain) loss on sale of investments........................ (1,028) 123
Loss on termination of financing transaction with a
related party reinsurer................................. -- 15,699
Amortization of goodwill.................................. 639 136
Interest expense on long-term debt........................ -- 3,146
Preferred securities dividends and accretion.............. 3,724 907
Increase in reinsurance receivables....................... (2,392) (4,216)
Decrease in premiums receivable........................... 2,370 2,004
Increase in other assets.................................. (4,420) (3,149)
Decrease in deferred income taxes......................... 4,485 (4,569)
(Decrease) increase in claims and claim adjustment expense
reserves................................................ (46,413) 2,714
Increase (decrease) in unearned premium reserves.......... 3,286 (909)
Decrease in accounts payable and other liabilities........ (3,692) (13,238)
-------- --------
Total adjustments.................................. (44,077) (2,155)
-------- --------
Net cash used in operating activities.............. (39,985) (11,929)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Paid-in-capital -- restricted stock....................... 31 3
Proceeds from issuance of common stock.................... -- 18,000
Long-term debt -- Chase Manhattan Bank.................... -- 44,000
Retirement of long-term debt -- Imperial Bank............. -- (7,250)
Reinsurance deposit....................................... (12,654) --
Purchase of treasury stock................................ (5,145) --
-------- --------
Net cash (used in) provided by financing activities..... (17,768) 54,753
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of bonds and notes:
Investments available-for-sale.......................... (108,103) (90,283)
Purchase of equity security............................... (64,536) (145)
Investments and cash for discontinued operations.......... (2,043) (17,125)
Purchase of Pac Rim Holding Corporation................... -- (41,170)
Sale of property, plant and equipment..................... 8,000 --
Sales of bonds and notes: Investments
available-for-sale...................................... 114,120 13,540
Maturities of bonds and notes: Investments
available-for-sale...................................... 19,121 6,968
Sale of equity securities................................. 60,745 517
Net decrease in invested cash............................. 6,128 76,753
-------- --------
Net cash provided by (used in) investing activities..... 33,432 (50,945)
-------- --------
Net decrease in cash.................................... (24,321) (8,121)
Cash and cash equivalents at beginning of period............ 28,742 34,423
-------- --------
Cash and cash equivalents at end of period.................. $ 4,421 $ 26,302
======== ========
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes.................. $ 181 $ 4
======== ========
Cash paid during the year for interest...................... $ 5,614 $ 191
======== ========
See Notes to Condensed Consolidated Financial Statements.
6
7
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 1998
(UNAUDITED)
NOTE A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A.1 BASIS OF PRESENTATION
Superior National Insurance Group, Inc. ("SNIG") is a holding company that
through its wholly-owned subsidiaries, Superior National Insurance Company
("SNIC") and Superior Pacific Casualty Company ("SPCC"), is engaged in writing
workers' compensation insurance principally in the States of California and
Arizona, and until September 30, 1993, was engaged in writing commercial
property and casualty insurance. SNIC and SPCC conduct business under the
"Superior Pacific" trade name. Unless the context indicates otherwise, "Superior
Pacific," as used herein, refers to SNIC and SPCC and their combined operations
from April 1997 to the present, and refers only to SNIC and its operations for
all prior periods. The "Company" refers to SNIG and its subsidiaries.
The accompanying unaudited condensed consolidated financial statements of
the Company have been prepared in accordance with generally accepted accounting
principles for interim financial information and with the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management, all
adjustments, including normally occurring accruals, considered necessary for a
fair presentation have been included. Certain reclassifications of prior year
amounts have been made to conform with the 1998 presentation. Operating results
for the six months ended June 30, 1998 are not necessarily indicative of the
results to be expected for the year ending December 31, 1998. These consolidated
financial statements should be read in conjunction with the consolidated
financial statements and footnotes thereto contained in the Company's Annual
Report on Form 10-K for the year ended December 31, 1997.
A.2 ACQUISITION OF PAC RIM HOLDING CORPORATION
On April 11, 1997, the Company completed its acquisition of Pac Rim Holding
Corporation ("Pac Rim") and its wholly-owned subsidiary, The Pacific Rim
Assurance Company, for total consideration of approximately $42.0 million in
cash. This consideration resulted in payments of approximately $20.0 million to
Pac Rim stockholders; $20.0 million to Pac Rim's convertible debenture holders;
and $2.0 million to Pac Rim's warrant and option holders. In addition, the
Company incurred $2.0 million in transaction fees and related expenses. The
Pacific Rim Assurance Company was renamed Superior Pacific Casualty Company upon
its acquisition by the Company. The Company financed the acquisition of Pac Rim
through a $44.0 million term loan and the sale of $18.0 million in newly issued
shares of common stock in a private transaction. Approximately $6.6 million of
the loan proceeds was used to prepay SNIG's previously outstanding long-term
debt, and approximately $10.0 million was contributed by SNIG to the capital of
SPCC. The $44.0 million term loan was subsequently retired from funds raised
from the sale of $105.0 million of 10 3/4% Trust Preferred Securities by a
subsidiary of SNIG. See Note A.5.
The purchase of Pac Rim resulted in $36.9 million of goodwill that is being
amortized on a straight line basis over 27.5 years. The transaction was
accounted for using the purchase method and the results of operations since the
date of acquisition have been included in operations. The designated accounting
date of the purchase of Pac Rim is April 1, 1997.
The balance sheet of Pac Rim at the acquisition date included the following
assets: investments of $105.9 million, cash of $2.6 million, receivables of
$17.3 million, and other assets of $22.3 million. Liabilities assumed in the
acquisition included unearned premiums of $6.9 million, claim and claim
adjustment expense reserves of $107.7 million and other liabilities of $32.3
million.
7
8
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE SIX MONTHS ENDED JUNE 30, 1998
(UNAUDITED)
A.3 EARNINGS PER SHARE ("EPS"); COMPREHENSIVE INCOME
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard No. 128 ("FAS No. 128"), "Earnings Per Share,"
which requires presentation of basic and diluted earnings per share for all
publicly traded companies effective for fiscal years ending after December 15,
1997.
The following is an illustration of the reconciliation of the numerators
and denominators of the basic and diluted earnings per share (EPS) computations
for the six months ended June 30, 1998 and June 30, 1997:
SIX MONTHS ENDED JUNE 30, 1998 SIX MONTHS ENDED JUNE 30, 1997
------------------------------------------ ------------------------------------------
INCOME SHARES PER SHARE INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT
-------------- ------------- --------- -------------- ------------- ---------
(IN THOUSANDS) (IN THOUSANDS)
BASIC EPS
Income before items
below............. $ 7,816 5,853,713 $ 1.34 $ (8,867) 4,641,954 $(1.91)
Preferred
Securities........ (3,724) (0.64) (907) (0.20)
------- ------ -------- ------
Net Income........... $ 4,092 $ 0.70 $ (9,774) $(2.11)
======= ====== ======== ======
EFFECT OF DILUTIVE
SECURITIES
Options.............. 386,280 336,603
Warrants............. 1,672,234 1,432,309
DILUTED EPS
Income before items
below............. $ 7,816 7,912,227 $ 0.99 $ (8,867) 6,410,866 $(1.38)
Preferred
Securities........ (3,724) (0.47) (907) (0.14)
------- ------ -------- ------
Net Income........... $ 4,092 $ 0.52 $ (9,774) $(1.52)
======= ====== ======== ======
8
9
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE SIX MONTHS ENDED JUNE 30, 1998
(UNAUDITED)
The following is an illustration of the reconciliation of the numerators
and denominators of the basic and diluted earnings per share (EPS) computations
for the three months ended June 30, 1998 and June 30, 1997:
THREE MONTHS ENDED JUNE 30, 1998 THREE MONTHS ENDED JUNE 30, 1997
------------------------------------------ ------------------------------------------
INCOME SHARES PER SHARE INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT
-------------- ------------- --------- -------------- ------------- ---------
(IN THOUSANDS) (IN THOUSANDS)
BASIC EPS
Income before items
below............. $ 4,049 5,834,347 $ 0.69 $(10,077) 5,837,173 $(1.72)
Preferred
Securities........ (1,852) (0.32) (453) (0.08)
------- ------ -------- ------
Net Income........... $ 2,197 $ 0.37 $(10,530) $(1.80)
======= ====== ======== ======
EFFECT OF DILUTIVE
SECURITIES
Options.............. 417,582 321,992
Warrants............. 1,732,524 1,387,215
DILUTED EPS
Income before items
below............. $ 4,049 7,984,453 $ 0.50 $(10,077) 7,546,380 $(1.33)
Preferred
Securities........ (1,852) (0.23) (453) (0.06)
------- ------ -------- ------
Net Income........... $ 2,197 $ 0.27 $(10,530) $(1.39)
======= ====== ======== ======
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS
No. 130"). SFAS 130 is effective for periods ending after December 15, 1997,
including interim periods. SFAS No. 130 requires companies to report
comprehensive income and its components in a financial statement and display the
accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in-capital. Comprehensive income includes all
changes in equity during a period except those resulting from investments by
stockholders and distributions to stockholders. The Company has included the
required disclosure of SFAS No. 130 in this filing.
A.4 CLAIM AND CLAIM ADJUSTMENT EXPENSE RESERVES
The liability for unpaid claim and claim adjustment expenses is based on an
evaluation of reported losses and on estimates of incurred but unreported
losses. The reserve liabilities are determined using adjusters' individual case
estimates and statistical projections, which can be affected by many external
factors that are difficult to predict, including changes in the economy, trends
in medical treatments and litigation, changes in regulatory environment, medical
services, and employment rights. The liability is reported net of estimated
salvage and subrogation recoverables. Adjustments to the liability resulting
from subsequent developments or revisions to the estimate are reflected in
results of operations in the period in which such adjustments become known.
While there can be no assurance that reserves at any given date are adequate to
meet the Company's obligations, the amounts reported on the balance sheet are
management's best estimate of that amount.
A.5 TRUST PREFERRED SECURITIES
In December 1997, SNIG formed Superior National Capital Trust I, a
statutory business trust (the "Trust"), whose sole purpose was to issue 10 3/4%
Trust Preferred Securities (the "Trust Preferred Securities"), having an
aggregate liquidation amount of $105 million, and to invest the proceeds thereof
in an
9
10
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE SIX MONTHS ENDED JUNE 30, 1998
(UNAUDITED)
equivalent amount of 10 3/4% Senior Subordinated Notes due 2017 of the Company
(the "Senior Subordinated Notes"). The Company owns directly all of the common
securities issued by the Trust, which it purchased for an aggregate
consideration of $3.25 million. The proceeds from the sale of the Trust
Preferred Securities were used solely to purchase SNIG's Senior Subordinated
Notes in the aggregate principal amount of $108.25 million, which are the sole
assets of the Trust. In addition, the Company entered into several contractual
undertakings which, the Company believes, when taken together, guarantee to the
holders of the Trust Preferred Securities an unconditional right to enforce the
payment of the distributions with respect to such securities.
A.6 LARGE ACCOUNT QUOTA-SHARE ARRANGEMENT
Effective February 1, 1998, Superior Pacific entered into a Quota-Share
Arrangement with United States Life Insurance Company, rated "A+" by A.M. Best
Company, Inc., under which Superior Pacific ceded 100% of premiums and claim and
claim adjustment expenses associated with policies having $100,000 or more of
estimated annual premium. Superior Pacific received a 35.0% ceding commission on
premiums ceded under this contract. Effective May 1, 1998, the Quota-Share
Arrangement was amended so that the ceding level was reduced to $25,000 in
estimated annual premium at inception, and the ceding commission was adjusted to
33.5%. The term of the amended agreement is three years, with two one-year
extensions.
NOTE B. DISCONTINUED OPERATIONS
Outstanding discontinued operations claim and claim adjustment expense
reserves were $15.7 million at June 30, 1998, which was consistent with
management's expectations. Offsetting these liabilities are $5.0 million of
reinsurance recoverable on paid and unpaid claim and claim adjustment expenses.
10
11
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE SIX MONTHS ENDED JUNE 30, 1998
(UNAUDITED)
NOTE C. RECONCILIATION WITH PREVIOUSLY REPORTED AMOUNTS
The amounts shown in the Condensed Consolidated Statement of Cash Flows
differ from those previously reported as a result of reclassifications made to
the Condensed Consolidated Balance Sheet. A reconciliation of amounts restated
are as follows:
SIX MONTHS ENDED JUNE 30,
------------------------------
1998 1997
------------- -------------
Net cash (used in) provided by operating activities
As previously reported.................................... $(37,800) $(11,929)
Reclass of investments withheld from reinsurer............ (2,185) --
-------- --------
As restated............................................ $(39,985) $(11,929)
======== ========
Net cash provided by (used in) financing activities
As previously reported.................................... $(19,811) $ 37,628
Reclass of investments and cash for discontinued
operations............................................. 2,043 17,125
-------- --------
As restated............................................ $(17,768) $ 54,753
======== ========
Net cash (used in) provided by investing activities
As previously reported.................................... $ 27,306 $(55,209)
Reclass of investments withheld from reinsurer............ 2,185 --
Reclass of investments and cash for discontinued
operations............................................. (2,043) (17,125)
Reclass of invested cash from cash and cash equivalents to
short-term investments................................. 5,984 21,389
-------- --------
As restated............................................ $ 33,432 $(50,945)
======== ========
Cash and cash equivalents at the end of the period
As previously reported.................................... $ 5,071 $ 72,427
Reclass of invested cash from cash and cash equivalents to
short-term investments................................. (650) (46,125)
-------- --------
As restated............................................ $ 4,421 $ 26,302
======== ========
11
12
SUPERIOR NATIONAL INSURANCE GROUP, INC.
AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE SIX MONTHS ENDED JUNE 30, 1998
(UNAUDITED)
Additionally, in 1997 the Company previously reported a $10.4 million
extraordinary loss on retirement of long-term debt, net of income tax benefit.
Subsequently, this amount was reclassified to an operating expense separately
disclosed as loss on termination of financing transaction with related party
reinsurer. This reclass resulted in no change to net income or stockholders'
equity. A reconciliation of amounts restated are as follows:
THREE MONTHS SIX MONTHS
ENDED ENDED
JUNE 30, 1997 JUNE 30, 1997
------------- -------------
Total Expenses
As previously reported.................................... $ 48,463 $ 67,646
Reclass of loss on termination of financing transaction
with related party reinsurer........................... 15,699 15,699
-------- --------
As restated............................................ $ 64,162 $ 83,345
======== ========
Income tax expense (benefit)
As previously reported.................................... $ 98 $ 769
Reclass on tax effect of loss on termination of financing
transaction with related party reinsurer............... (5,338) (5,338)
-------- --------
As restated............................................ $ (5,240) $ (4,569)
======== ========
Income before preferred securities dividends and accretion,
discontinued operations, and extraordinary items
As previously reported.................................... $ 284 $ 1,494
Reclass of extraordinary loss on retirement on long-term
debt, net of tax....................................... (10,361) (10,361)
-------- --------
As restated............................................ $(10,077) $ (8,867)
======== ========
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 1997 JUNE 30, 1997
------------------------------- -------------------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
REPORTED RECLASS RESTATED REPORTED RECLASS RESTATED
---------- ------- -------- ---------- ------- --------
BASIC EARNINGS PER SHARE
Income before preferred securities
dividends and accretion, and
extraordinary items.................... $ 0.05 $(1.77) $(1.72) $ 0.32 $(2.23) $(1.91)
Preferred Securities...................... (0.08) -- (0.08) (0.20) -- (0.20)
Extraordinary Items....................... (1.77) 1.77 -- (2.23) 2.23 --
------ ------ ------ ------ ------ ------
Net loss.................................. $(1.80) $ -- $(1.80) (2.11) $ -- $(2.11)
====== ====== ====== ====== ====== ======
DILUTED EARNINGS PER SHARE
Income before preferred securities
dividends and accretion, and
extraordinary items.................... $ 0.04 $(1.37) $(1.33) $ 0.23 $(1.61) $(1.38)
Preferred Securities...................... (0.06) -- (0.06) (0.14) -- (0.14)
Extraordinary Items....................... (1.37) 1.37 -- (1.61) 1.61 --
------ ------ ------ ------ ------ ------
Net loss.................................. $(1.39) $ -- $(1.39) $(1.52) $ -- $(1.52)
====== ====== ====== ====== ====== ======
12
13
ITEM 2.MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
References to "SNIG" and "the Company" in this quarterly report include the
results of operations of the recently acquired subsidiary Superior Pacific
Casualty Company ("SPCC"), formerly known as The Pacific Rim Assurance Company,
for the period beginning April 1, 1997. References to "SNIC" in this quarterly
report refer to Superior National Insurance Company, the primary operating
subsidiary of SNIG.
This discussion and analysis contains statements that constitute
"forward-looking" statements within the meaning of the Private Securities
Litigation Reform Act of 1995. Such forward-looking statements relate to future
events or the future financial performance of the Company and involve known and
unknown risks, uncertainties and other factors that may cause the actual
results, performance or achievements of the Company to be materially different
from any future results, performance or achievements expressed or implied by
such forward-looking statements. Such factors include, among other things,
inherent uncertainties related to the effect of the acquisitions, the Company's
leverage, and general conditions in the economy and in the workers' compensation
insurance market in particular, and such factors could cause actual results to
differ materially from those indicated by such forward-looking statements.
OVERVIEW
The Company recorded an underwriting profit from continuing operations of
$5.5 million in the six month period ended June 30, 1998, versus an underwriting
profit of $1.5 million, excluding a loss on the termination of a financing
transaction with a related party reinsurer (namely, Centre Reinsurance Limited
("Centre Re") in the corresponding period in the prior year. The increase in
underwriting profit from continuing operations was primarily the result of an
increase in premiums as a result of the April 11, 1997 acquisition of SPCC.
During the six months ended June 30, 1998, the Company realized net income of
$4.1 million or $0.52 per share on a diluted basis as compared to a loss of $9.8
million or $1.52 per share on a diluted basis for the six months ended June 30,
1997. In addition to improved underwriting profit, net income increased due to a
$2.5 million increase in investment income, which resulted from the increase in
invested assets. Invested assets increased due to the SPCC acquisition and the
net proceeds of the issuance of the Trust Preferred Securities discussed below.
The increase in underwriting profit and investment income was offset in part by
dividends and accretion on the Trust Preferred Securities and amortization of
goodwill. The loss in the prior year relates to a $15.7 million charge due to
the termination of a financing transaction with a related party reinsurer.
GENERAL FINANCIAL CONDITION
Total assets decreased by $33.4 million or 7.8% to $396.0 million for the
six months ended June 30, 1998. The decrease is due to a $50.9 million reduction
of cash and investments used primarily to fund operations, which is partially
offset by a $24.2 million increase to prepaid reinsurance premiums.
Total liabilities decreased by $32.3 million or 8.7% to $337.3 million for
the six months ended June 30, 1998. The decrease is principally due to a $46.4
million reduction in claim and claim adjustment expense reserves, which is
partially offset by a $14.6 million increase in reinsurance payables associated
with the Large Account Quota-Share as discussed below in "Results of
Operations."
Total equity decreased by $1.1 million or 1.9% to $58.7 million for the six
months ended June 30, 1998. This decrease primarily consists of $5.1 million
paid by SNIC to purchase 245,000 shares of SNIG's common stock ("Common Stock"),
which are held by SNIC as treasury stock on a GAAP basis, offset by $4.1 million
in net income.
RESULTS OF OPERATIONS
Effective February 1, 1998, the Company entered into a Quota-Share
Arrangement (the "Quota-Share Arrangement") with United States Life Insurance
Company, rated "A+" by A.M. Best Company, Inc. ("A.M. Best"), an independent
insurance rating agency, under which the Company ceded 100% of premiums and
claim and claim adjustment expenses associated with policies having $100,000 or
more of estimated annual
13
14
premium. The Company received a 35.0% ceding commission on premiums ceded under
this contract. Effective May 1, 1998, the Quota-Share Arrangement was amended so
that the ceding level was reduced to $25,000 in estimated annual premium at
inception, and the ceding commission was adjusted to 33.5%. The term of the
amended agreement is three years, with two one-year extensions.
Effective June 30, 1998, the Company and Zurich Reinsurance (North
America), Inc. ("ZRNA") entered an agreement to settle and commute (the "ZRNA
Commutation") all obligations and liabilities known and unknown associated with
the ZRNA Quota-Share contract and its related Assumption of Liability
Endorsement facility for the contract years incepting January 1, 1994, 1995,
1996, and 1997. The commutation was negotiated in accordance with the
commutation provision from the original ZRNA Quota-Share contract, which
resulted in a $1.8 million loss to the Company.
The following selected financial data and analysis provide an assessment of
the Company's financial results for the three months ended June 30, 1998, as
compared to the three months ended June 30, 1997. Certain prior period amounts
have been reclassified to conform to the current period presentation.
THREE MONTHS ENDED
JUNE 30,
----------------------
1998 1997
--------- ---------
(DOLLARS IN THOUSANDS)
Gross written premium....................................... $40,898 $48,310
Net written premium......................................... $13,579 $43,703
Net premium earned.......................................... $19,619 $45,410
Net claim and claim adjustment expenses..................... 8,031 34,724
Net underwriting and general and administrative expenses.... 8,415 10,845
------- -------
Underwriting profit (loss).................................. $ 3,173 $ (159)
Net investment income....................................... 3,761 3,435
Underwriting ratios (GAAP Basis)
Claims and claim adjustment expense ratio................... 40.9% 76.5%
Underwriting expense ratio.................................. 42.9% 23.9%
Policyholder dividends ratio................................ 0.0% 0.0%
------- -------
Combined ratio.............................................. 83.8% 100.4%
======= =======
Gross written premium decreased $7.4 million or 15.3% to $40.9 million in
the second quarter of 1998 as compared to the same period in 1997. This decrease
can be attributed to non-renewal of policies written by SPCC prior to the
acquisition and which expired in March 1998. Net written premium decreased $30.1
million or 68.9% to $13.6 million in the second quarter of 1998 as compared to
the same period in 1997. Along with the decrease in gross written premium,
essentially all of the decrease in net written premium is due to $23.7 million
of reinsurance premiums ceded under the Quota-Share Arrangement. Net premium
earned decreased $25.8 million or 56.8% to $19.6 million in the second quarter
of 1998 as compared to the same period in 1997, reflecting the decrease in net
written premium.
Net claim and claim adjustment expenses decreased $26.7 million or 76.9% to
$8.0 million in the second quarter of 1998 as compared to the same period in
1997. This decrease consists of a $9.8 million reduction in net claim and claim
adjustment expense and a $16.9 million increase in ceded claim and claim
adjustment expense related to the Quota-Share Arrangement. The $9.8 million
reduction in net claim and claim adjustment expense is primarily due to a $9.8
million decrease in net premiums earned, excluding the decrease reflected in net
premium written associated with the Quota-Share Arrangement as discussed above.
The reduction is also partially due to the re-underwriting of the policies that
expired related to the SPCC acquisition, which resulted in a decrease in net
claim and claim adjustment expense for the three months ended June 30, 1998 as
compared to the same period in 1997. The net claim and claim adjustment expense
ratio decreased to 40.9% in the second quarter of 1998 from 76.5% in the same
period of 1997. This decrease in the net claim and claim adjustment expense
ratio is due to an increase, during the second quarter of 1997, in claim and
claim adjustment expenses relative to the related premium level from activity
related to the SPCC acquisition.
14
15
Underwriting and general and administrative expenses, excluding the loss on
termination of a financing transaction with a related party reinsurer, increased
$3.8 million or 61.0% to $9.9 million in the second quarter of 1998, as compared
to the same period in 1997. This increase is primarily due to the acquisition of
SPCC and partially due to a $1.8 million expense related to the ZRNA
Commutation. Net commission expense decreased $6.2 million or 131.9% to $(1.5)
million in the second quarter of 1998, as compared to the same period in 1997.
The decrease in net commission expense is mainly due to $4.6 million in ceded
commission related to the Quota-Share Arrangement and partially due to a
decrease in gross commission expense related to the decrease in gross written
premium. Net underwriting and general and administrative expenses decreased to
22.4% to $8.4 million in the second quarter of 1998 from $10.8 million in the
same period of 1997, reflecting the changes discussed above. The Company's
underwriting expense ratio increased 19.0 percentage points to 42.9% for the
second quarter of 1998 from 23.9% for the same period in 1997, due primarily to
a reduction in the related net premium level from premiums ceded under the
Quota-Share Arrangement.
The Company recorded an underwriting profit, excluding the loss on
termination of a financing transaction with a related party reinsurer, from
continuing operations of $3.2 million in the second quarter of 1998, versus an
underwriting loss of $0.2 million for the same period in 1997. The increase in
underwriting profit from continuing operations was primarily the result of the
decrease in claim and claim adjustment expense discussed above, along with a
decrease in underwriting and general and administrative expenses.
Net investment income, excluding realized investment gains/losses,
decreased $0.3 million or 8.6% to $3.1 million in the second quarter of 1998
compared to the same period in 1997. This 8.6% decrease was due to a decrease in
average investable assets of $33.5 million as compared to the same period in
1997.
No interest expense was incurred in the second quarter of 1998 as compared
to $2.4 million for the same period in 1997, due to the repayment in the fourth
quarter of 1997 of all long term debt with funds obtained through the sale of
the Trust Preferred Securities.
Distributions and accretion on preferred securities increased by $2.1
million to $2.8 million in the second quarter of 1998, as compared to the same
period in 1997, as a result of the issuance of the Trust Preferred Securities
and by the redemption of preferred securities issued by an affiliate in December
1997.
In June 1997, the Company recorded a $15.7 million charge related to the
termination of a financing transaction with a related party reinsurer. The
termination of the financing transaction transferred $110.5 million in
receivables from the related party reinsurer in exchange for the cancellation of
$94.9 million in indebtedness to The Chase Manhattan Bank ("Chase"). No such
charges were incurred in the 1998 period.
The following selected financial data and analysis provide an assessment of
the Company's financial results for the six months ended June 30, 1998, as
compared to the six months ended June 30, 1997. Certain prior period amounts
have been reclassified to conform to the current period presentation.
SIX MONTHS ENDED
JUNE 30,
----------------------
1998 1997
--------- ---------
(DOLLARS IN THOUSANDS)
Gross written premium....................................... $81,951 $71,090
Net written premium......................................... $42,080 $63,706
Net premium earned.......................................... $50,206 $64,388
Net claim and claim adjustment expenses..................... 26,319 44,995
Net underwriting and general and administrative expenses.... 18,406 17,849
------- -------
Underwriting profit (loss).................................. $ 5,481 $ 1,544
Net investment income....................................... 8,014 5,521
Underwriting ratios (GAAP Basis)
Claims and claim adjustment expense ratio................... 52.4% 69.9%
Underwriting expense ratio.................................. 36.7% 27.7%
Policyholder dividends ratio................................ 0.0% 0.0%
------- -------
Combined ratio.............................................. 89.1% 97.6%
======= =======
15
16
Gross written premium increased $10.9 million or 15.3% to $82.0 million in
the first six months of 1998 as compared to the same period in 1997.
Substantially all of this increase can be attributed to the addition of business
written by SPCC. Net written premium decreased $21.6 million or 33.9% to $42.1
million in the first six months of 1998 as compared to the same period in 1997.
This decrease is primarily due to $31.6 million in premiums ceded under the
Quota-Share Arrangement, which is partially offset by a $10.9 million increase
to gross written premiums. Net premium earned decreased $14.2 million or 22.0%
to $50.2 million in the first six months of 1998 as compared to the same period
in 1997, reflecting the decrease in net written premium.
Net claim and claim adjustment expenses decreased $18.7 million or 41.5% to
$26.3 million in the first six months of 1998 as compared to the same period in
1997. This decrease primarily reflects a $17.7 million increase in ceded claim
and claim adjustment expense related to the Quota-Share Arrangement. The net
claim and claim adjustment expense ratio decreased to 52.4% in the first six
months of 1998 from 69.9% in the same period of 1997. This decrease in the net
claim and claim adjustment expense ratio is due to an increase, during the
second quarter of 1997, in claim and claim adjustment expenses relative to the
related premium level from activity related to the SPCC acquisition.
Underwriting and general and administrative expenses, excluding the loss on
the termination of a financing transaction with a related party reinsurer
(namely, Centre Re), increased $6.0 million or 54.5% to $16.9 million in the
first six months of 1998, as compared to the same period in 1997. This increase
is primarily due to the acquisition of SPCC and partially due to a $1.8 million
expense related to the ZRNA Commutation. Net commission expense decreased $5.4
million or 78.7% to $1.5 million in the first six months of 1998, as compared to
the same period in 1997. The decrease in net commission expense is mainly due to
$6.6 million in ceded commission related to the Quota-Share Arrangement, which
is partially offset by an increase in gross commission expense related to the
increase in gross written premium. Net underwriting and general and
administrative expenses increased 3.1% to $18.4 million in the first six months
of 1998 from $17.8 million in the same period of 1997, reflecting the changes
discussed above. The Company's underwriting expense ratio increased 9.0
percentage points to 36.7% for the first six months of 1998 from 27.7% for the
same period in 1997, due primarily to a reduction in the related net premium
level from premiums ceded under the Quota-Share Arrangement.
The Company recorded an underwriting profit, excluding the loss on the
termination of a financing transaction with a related party reinsurer, from
continuing operations of $5.5 million in the first six months of 1998, versus
$1.5 million for the same period in 1997. The increase in underwriting profit
from continuing operations was primarily the result of the decrease in claim and
claim adjustment expense discussed above, along with a decrease in underwriting
and general and administrative expenses.
Net investment income, excluding realized investment gains/losses,
increased $1.5 million or 27.0% to $7.0 million in the first six months of 1998
compared to the same period in 1997. The improvement was due to the increase in
assets available for investment resulting from the SPCC acquisition and the
availability of $30.0 million in invested assets as a result of the issuance of
the Trust Preferred Securities. Excluding the assets acquired in the SPCC
acquisition and the increase in invested assets due to the issuance of the Trust
Preferred Securities, net investment income decreased $2.6 million or 46.4% to
$2.9 million in the first six months of 1998 as compared to the same period in
1997. This 46.4% decrease was due to a decrease in the average investable asset
of $10.9 million as compared to the same period in 1997.
No interest expense was incurred in the first six months of 1998 as
compared to $4.1 million for the same period in 1997, due to the repayment in
the fourth quarter of 1997 of all long term debt with funds obtained through the
sale of the Trust Preferred Securities.
In June 1997, the Company recorded a $15.7 million charge related to the
termination of a financing transaction with a related party reinsurer. The
termination of the financing transaction transferred $110.5 million in
receivables from the related party reinsurer in exchange for the cancellation of
$94.9 million in indebtedness to Chase. No such charges were incurred in the
1998 period.
16
17
Distributions and accretion on preferred securities increased by $4.3
million to $5.6 million in the first six months of 1998 as compared to the same
period in 1997, as a result of the issuance of the Trust Preferred Securities
and by the redemption of preferred securities issued by an affiliate in December
1997.
A summary of net investment income, excluding capital gains (losses), for
the three and six months ended June 30, 1998 and 1997 is as follows (in
thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ----------------
1998 1997 1998 1997
------- ------- ------ ------
Interest on bonds and notes..................... $3,042 $1,940 $6,685 $2,798
Interest on invested cash....................... 200 1,706 518 3,052
Other........................................... 67 -- 143 --
------ ------ ------ ------
Total investment income......................... 3,309 3,646 7,346 5,850
Capital gains................................... 629 10 1,029 19
Investment expense.............................. 177 221 361 348
------ ------ ------ ------
Net investment income........................... $3,761 $3,435 $8,014 $5,521
====== ====== ====== ======
The Company's management monitors the matching of assets and liabilities
and attempts to maintain the Company's portfolio's investment duration at the
mid-point of the length of its net claim and claim adjustment expenses payout
pattern. Investment duration is the weighted average measurement of the current
maturity of a fixed income security, in terms of time, of the present value of
the future payments to be received from that security. However, in selecting
assets to purchase for its investment portfolio, the Company considers each
security's modified duration and the effect of that security's modified duration
on the portfolio's overall modified duration. Modified duration is a measurement
that estimates the percentage change in market value of an investment for a
small change in interest rates. The modified duration of fixed maturities at
June 30, 1998 was 2.94 years compared to 2.90 years at December 31, 1997. At
June 30, 1998, 99.5% of the carrying values of investments in the fixed
maturities portfolio were rated as investment grade by the Securities Valuation
Office of the National Association of Insurance Commissioners.
DISCONTINUED OPERATIONS
Discontinued operations had claim and claim adjustment expense reserves of
$11.3 million as of June 30, 1998, which was consistent with management's
expectations. The Company has significant exposure to construction defect
liabilities on property and casualty insurance policies underwritten from 1986
to 1993. Management continues to closely monitor the Company's potential
exposure to construction defect claims and has not changed its estimates of
ultimate claim and claim adjustment expenses on discontinued operations since
1995. Management believes its current reserves are adequate to cover the
Company's claims activity. There can be no assurance, however, that further
upward development of ultimate loss costs associated with construction defect
claims will not occur. The Company will continue to closely monitor the adequacy
of its claim and claim adjustment expense reserves in the discontinued
operations. Offsetting these liabilities are $0.5 million in reinsurance
recoverable on paid and unpaid claim and claim adjustment expenses.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is a measure of an entity's ability to secure sufficient cash to
meet its contractual obligations and operating needs. The Company's cash inflows
are generated from cash collected for policies sold, investment income on the
existing portfolio and sales and maturities of investments. The Company's cash
outflows consist primarily of payments for policyholders' claims, operating
expenses, and debt service. For their insurance operations, the Company's
subsidiaries must have available sufficient cash and liquid assets to meet their
obligations to policyholders and claimants in accordance with contractual
obligations in addition to meeting their ordinary operating costs. Absent
adverse material changes in the workers' compensation insurance market, and
based on the expectation that the financing transactions in connection with the
previously announced Acquisition of Business Insurance Group, Inc. will be
completed, management believes
17
18
that the Company's present cash resources are sufficient to meet the needs of
the Company for the foreseeable future.
During the first six months of 1998, the Company used $40.0 million of cash
in its operations versus cash used of $11.9 million during the same period in
1997. This $28.1 million increase in cash used is primarily due to the addition
of SPCC's operations beginning April 1, 1997. The Company's continued negative
cash flow is the result of the Company's historical in force premium bases being
significantly higher than its current level and higher than expected payments of
claim and claim adjustment expenses in the 1995 and 1996 accident years. The
Company anticipates it will continue to experience negative cash flow from
operations until the claims related to the historically higher premium base have
been paid out. In addition, the reduction in net written premium arising out of
the Quota-Share Arrangement for large accounts will increase negative cash flow
substantially. Although the Company has implemented its Claim Severity
Management Program to control cash outflows related to the 1995 and 1996
accident years at acceptable levels, there can be no assurance that it will be
successful. In any event, the Company believes that it has adequate short-term
investments and readily marketable investment-grade securities to cover both
claim payments and expenses. As of June 30, 1998, the Company had total cash,
cash equivalents, investments and investments held from reinsurers of $193.3
million and had 97.3% of its investment portfolio invested in cash, cash
equivalents, and fixed maturities. In addition, 97.1% of the Company's
fixed-income portfolio had ratings of "AA" or equivalent or better and 99.5% had
ratings of "BBB" or equivalent or better.
The Company used $17.8 million in cash from financing activities for the
six months ended June 30, 1998, and generated $54.8 million for the
corresponding period in 1997. During the six months ended June 30, 1998, funds
used for financing activities consisted of $12.7 million in reinsurance deposits
to ZRNA associated with a reinsurance contract, and $5.1 million to purchase
245,000 shares of Common Stock, which are held by SNIC as treasury stock on a
GAAP basis. The Common Stock acquired by SNIC was purchased in a single
transaction from Thomas J. Jamieson, a director of the Company, and Jaco Oil
Company, an entity controlled by Mr. Jamieson. The purchase price of $21.00 per
share represented a discount from the market price of the Common Stock at the
time of the transaction. The Company's Board of Directors, with disclosure of
the conflicts of interest, unanimously approved SNIC's purchase of Common Stock.
The cash generated by financing activities in the first six months of 1997 was
primarily associated with the Company's acquisition of SPCC. The Company
generated the necessary cash to acquire SPCC from the proceeds of a $44.0
million term loan and the sale of approximately $18.0 million in Common Stock.
Of the approximately $62.0 million raised in those financing transactions,
approximately $42.0 million was used to fund the acquisition of SPCC,
approximately $6.6 million was used to repay an existing bank loan, $10.0
million was contributed as capital to SPCC, and the remaining funds were used
for general corporate purposes, including the payment of related transaction
costs.
On December 3, 1997, Superior National Capital Trust I (the "Trust"), a
wholly owned subsidiary of the Company, issued its 10 3/4% Trust Preferred
Securities (the "Trust Preferred Securities"), having an aggregate liquidation
amount of $105.0 million, in a private placement, and also issued to the
Company, for an aggregate consideration of approximately $3.25 million, all of
the Trust's common securities. The proceeds from the sale of these securities
were used by the Trust to purchase the Company's 10 3/4% Senior Subordinated
Notes due 2017 (the "Senior Subordinated Notes"), all of which were issued in
connection with such transaction. In addition, the Company entered into several
contractual undertakings which, the Company believes, when taken together,
guarantee (the "Company Guarantee") to the holders of the Trust Preferred
Securities a full and unconditional right to enforce the payment of the
distributions with respect to such securities. On January 16, 1998, the Company
and the Trust completed the registration with the Securities and Exchange
Commission of an exchange offer for the outstanding Trust Preferred Securities,
Senior Subordinated Notes and Company Guarantee, pursuant to which substantially
all of such securities were exchanged for substantially similar securities. The
Company used the proceeds it received from the issuance of the Senior
Subordinated Notes to repay the $40.3 million outstanding balance on the term
loan used to acquire SPCC, to redeem approximately $27.7 million in preferred
stock issued by a Company affiliate to Centre Reinsurance (Bermuda) Ltd., to pay
approximately $4.0 million in related transaction costs, and for general
corporate purposes, including a $15.0 million contribution to the surplus of
SNIC.
18
19
Distributions on the Trust Preferred Securities (and interest on the
related Senior Subordinated Notes) are payable semi-annually, in arrears, on
June 1 and December 1 of each year, and commenced June 1, 1998. Subject to
certain conditions, set forth in the Indenture pursuant to which the Senior
Subordinated Notes were issued (the "Subordinated Notes Indenture"), on or after
December 1, 2005, the Company has the right to redeem the Senior Subordinated
Notes at any time, in whole or in part, at call prices (expressed as a
percentage of principal amount) ranging from 105.375% at December 1, 2005 to
101.792% at December 1, 2007, and 100% thereafter. The proceeds from any
redemption will be immediately applied by the Trust to redeem Trust Preferred
Securities and the Trust's common securities at such redemption prices. In
addition, the Company has the right, at any time, subject to certain conditions,
to defer payments of interest on the Senior Subordinated Notes for Extension
Periods (as defined in the Subordinated Notes Indenture), each not exceeding 10
consecutive semi-annual periods; provided that no Extension Period may extend
beyond the maturity date of the Senior Subordinated Notes. As a consequence of
any such extension by the Company of the interest payment period, distributions
on the Trust Preferred Securities would be deferred (though such distributions
would continue to accrue interest at a rate of 10.75% per annum compounded
semi-annually). Upon the termination of any Extension Period and the payment of
all amounts then due, the Company may commence a new Extension Period, subject
to certain requirements.
In addition, during 1997 the Company repaid approximately $0.6 million of
an existing bank loan and at the time due $3.7 million of the principal of the
term loan used to acquire SPCC.
In November 1996, the Company entered into a financing transaction
involving Centre Re and Chase pursuant to which Chase extended a $93.1 million
term loan, net of transaction costs. The Company used the proceeds from the
transaction to purchase from SNIC reinsurance receivables due from Centre Re. As
a result, the Company's investable assets increased $93.1 million. The
additional investments contributed to the increase in investment income in 1997.
In June 1997, the term loan was retired when $110.5 million of receivables
from Centre Re were transferred to Chase in exchange for cancellation of the
Company's $94.9 million debt due to Chase under the term loan. The retirement of
the term loan resulted in the Company recognizing a $15.7 million charge.
The Company has a reverse repurchase facility with a national securities
brokerage firm that allows it to engage in up to $20.0 million in reverse
repurchase transactions secured either by U.S. Treasury instruments, U.S. Agency
debt, or corporate debt. This arrangement provides the Company with additional
short-term liquidity. Reverse repurchase transactions may be rolled over from
one period to the next, at which time the transaction is repriced. This type of
financing allows the Company a great deal of flexibility to manage short-term
investments, avoiding the unnecessary realization of losses to satisfy
short-term cash needs. Further, this method of financing is less expensive than
bank debt. As of June 30, 1998, the Company had no obligation outstanding under
this facility.
The Company, as a holding company, depends on dividends and intercompany
tax allocation payments from its insurance subsidiaries, SNIC and SPCC, for its
net cash flow requirements, which consist primarily of periodic payments on its
outstanding debt obligations, principally the Senior Subordinated Notes
underlying the Trust Preferred Securities. Absent other sources of cash flow,
the Company cannot expend funds materially in excess of the amount of dividends
or tax allocation payments that could be paid to it by SNIC and SPCC. Further,
insurance companies are subject to restrictions affecting the amount of
shareholder dividends and advances that may be paid within any year without the
prior approval of the California Department of Insurance (the "DOI"). The
California Insurance Code provides that amounts may be paid as dividends on an
annual noncumulative basis (generally based up to the greater of (i) net income
for the preceding year and (ii) 10% of statutory surplus as regards
policyholders as of the preceding December 31) without prior notice to, or
approval by, the DOI. Dividends may only be paid out of "earned surplus" as
defined in the California Insurance Code. No dividends were paid by SPCC or SNIC
during 1997; however, SNIC paid $2.9 million to the Company for its current
income taxes. No dividends were paid during the six months ended June 30, 1998.
Insurance holding company regulations, in ordinary circumstances, place a two-
year moratorium on payments of dividends by a subsidiary that has undergone a
change of control. The Company has requested of the DOI, and expects to receive,
a waiver from the moratorium in connection with
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the Company's proposed acquisition of Business Insurance Group, Inc. ("BIG"). If
dividends are available for payment as expected, the Company believes it will
have adequate cash to service its debt.
The Company is a party to several leases principally associated with the
Company's home and branch office space, as well as its fixed assets. Such leases
contain provisions for scheduled lease charges and escalations in base rent over
the lease term. The Company's minimum lease commitment with respect to these
leases in 1998, is approximately $7.0 million. These leases expire from 2000 to
2003.
With the exception of the approximately $285.0 million in cash outlays
necessary to complete the Company's proposed acquisition of BIG, together with
fees and costs related thereto, the Company does not foresee any material
expenditures during the next twelve months other than those arising in the
ordinary course of business. See Part II -- Item 5 -- Other Information.
The effect of inflation on the Company's revenues and net income during the
six months ended June 30, 1998 was not significant.
TAXES
As of June 30, 1998, the Company had available approximately $128.0 million
in net operating loss carryforwards ("NOLs") to offset taxable income recognized
by the Company in periods after June 30, 1998. For federal income tax purposes,
these NOLs will expire in material amounts beginning in the year 2006. Any 5%
shift in the current ownership of the Company may result in a "change of
ownership" under Section 382 of the Internal Revenue Code of 1986, as amended,
and limit and defer the Company's ability to utilize NOLs. In an effort to
protect these NOLs, the Company's charter documents contain provisions
prohibiting 5% owners of the Common Stock (including holders of options and
warrants) from acquiring additional stock and prohibiting any additional person
or entity from becoming a 5% holder of Common Stock. The prohibition against
changes of ownership by the 5% holders of Common Stock expires in April 2000.
The Company believes that it is very likely that the equity financings it will
conduct to help fund the Company's proposed acquisition of BIG will result in a
"change of ownership," but has concluded that the cost of the limitation of use
of the NOLs in relation to the benefits derived from the acquisition of BIG is
acceptable. See Part II -- Item 5 -- Other Information. The Company is seeking
stockholder approval of a proposal to eliminate these restrictive charter
provisions at the Company's 1998 Annual Meeting of Stockholders.
YEAR 2000 STRATEGY
A significant percentage of the software that runs most of the computers in
the United States and the rest of the world relies on two-digit date codes to
perform computations and decision making functions. Commencing January 1, 2000,
these computer programs may fail from an inability to interpret date codes
properly, misinterpreting "00" as the year 1900 rather than 2000. The Company is
in the process of identifying all necessary software and hardware changes to
ensure that it does not experience any loss of critical business functionality
due to the Year 2000 issue. The Company has appointed an internal Year 2000
project manager and adopted a three phase approach of assessment, correction,
and testing. The scope of the project includes all internal software, hardware,
and operating systems, and assessment of risk to the business from producers,
vendors, and other partners in Year 2000 issues. The Company believes that this
formal assessment of risk (including the prioritization of business risk),
correction (including conversions to new software), and testing of necessary
changes will minimize the business risk of Year 2000 from internal systems. The
Company plans to complete its Year 2000 conversion not later than December 31,
1998. Although the Company has not completed its Year 2000 project, the Company
does not believe the Year 2000 issue will cause any system problems that could
have a material adverse effect on the operations of the Company. The Company
does not expect the cost associated with its Year 2000 project to be material.
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PART II. OTHER INFORMATION
ITEM 5. OTHER INFORMATION
On May 5, 1998, the Company and Foundation Health Corporation ("FHC"), a
wholly owned subsidiary of Foundation Health Systems, Inc., entered into a
Purchase Agreement under which the Company agreed to purchase for approximately
$256.5 million in cash ($285.0 million less the cost of a Loss Reserves
Guarantee (described below) provided through reinsurance) (the "Acquisition")
all outstanding shares of the capital stock of BIG, an insurance holding company
that, through its wholly owned insurance subsidiaries, California Compensation
Insurance Company, a California stock insurance company, Business Insurance
Company, a Delaware stock insurance company, Combined Benefits Insurance
Company, a California stock insurance company, and Commercial Compensation
Insurance Company, a New York stock insurance company, writes workers'
compensation and group health insurance, principally in California, with branch
operations throughout the continental United States. The Company will offset the
reduction in BIG's surplus resulting from the cost of reinsurance for the Loss
Reserves Guarantee with a capital contribution to BIG, so the total cash outlays
by the Company in connection with the Acquisition will be $285.0 million,
excluding transaction expenses.
In connection with the Acquisition, FHC will provide a "Loss Reserve
Guarantee" through the purchase of reinsurance, which will provide $175 million
of adverse development protection on BIG's loss and loss adjustment expense
reserves. The Loss Reserve Guarantee will be obtained by FHC at FHC's cost. The
reinsurance policy will be procured by BIG's insurance subsidiaries and its cost
will be deducted from the purchase price payable to FHC. The Company anticipates
contributing to the capital of the BIG insurance subsidiaries an amount equal to
the cost of the reinsurance policy. The Company will also enter into a three-
year quota share reinsurance agreement with a reinsurer rated "A+" by A.M. Best,
under which the Company and BIG will reinsure accounts with premiums in excess
of $25,000. See "Part I -- Item 2 -- Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations -- Results of
Operations." The Company has also agreed to enter into long-term contracts with
affiliates of FHC under which such affiliates will continue to provide bill
review and other claims control services to BIG and following the Acquisition,
to the Company.
The Acquisition will be financed by the Company with a combination of
equity and debt. The debt portion of the financing will be provided by the
proceeds from the issuance and sale in a public offering of approximately $110
million in aggregate principal amount of the Company's senior notes (the "Senior
Notes Offering"). The equity portion consists of the issuance and sale of
approximately $109.7 million of Common Stock (the "Stock Offering"), which
consists of the offering of rights to purchase Common Stock to existing
stockholders (other than IP Delaware and IP Bermuda) and warrant holders
(excluding certain warrant holders exercising preemptive rights) and the
offering of rights to holders of options and grants of restricted stock.
Additionally, Insurance Partners, L.P. ("IP Delaware"), Insurance Partners
Offshore (Bermuda), L.P. ("IP Bermuda"), and Insurance Partners II, L.P. and/or
Insurance Partners II Private Fund, L.P. (collectively with IP Delaware and IP
Bermuda, "IP") will purchase $94 million in Common Stock in a private
transaction (the "IP Stock Issuance"). IP has also agreed to provide a standby
commitment of up to $106 million to purchase an amount of shares of Common Stock
not subscribed for in the Stock Offering (the "Standby Commitment") sufficient
to assure the Company of $200 million in total equity financing. In addition, in
connection with its investment, IP has agreed to certain restrictions protecting
minority stockholders. The amounts obtained from all of these financings in
excess of $285 million will be used for transaction costs in connection with the
Acquisition and the related financing transactions, for capital for the
Company's insurance subsidiaries, and for general corporate purposes. The Stock
Offering, the Standby Commitment, the IP Stock Issuance, and the Senior Notes
Offering are each conditioned on the completion of the other and the completion
of the Acquisition.
All of the Common Stock to be issued in connection with these financing
transactions will be sold at a purchase price of $16.75 per share. The $16.75
price and other terms of the Stock Offering were determined on behalf of the
Company by two independent directors of the Company, in consultation with the
Company's financial advisors and in negotiations with IP, and will be materially
the same as the terms of the IP Stock
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Issuance and Standby Commitment, subject to adjustments determined by the
Company's board of directors to be reasonable and appropriate. This description
does not constitute an offer of any securities. Any offering of securities in
the transactions described above, other than pursuant to the IP Stock Issuance,
will be made only by means of a prospectus. Stockholders are cautioned, however,
that the mere decision to undertake a transaction does not change the
contingencies that apply to these prospective transactions, or the likelihood
that an offering will, in fact, occur. Registration statements have been filed
with the Securities and Exchange Commission relating to the Stock Offering and
the Senior Notes Offering, and none of these securities may be sold before the
registration statements are declared effective.
The Acquisition is subject to the now-expired waiting period under the
Hart-Scott-Rodino Anti-Trust Improvements Act of 1976, as amended, and approval
by several state insurance regulatory authorities. In addition, the Stock
Offering and the IP Stock Issuance are each subject to stockholder approval,
which the Company intends to solicit at its 1998 Annual Meeting of Stockholders,
presently scheduled to occur in late September 1998. Furthermore, the holders of
the Trust Preferred Securities are being requested to consent to the Senior
Notes Offering. Assuming the preceding approvals are obtained and that no
unforeseen impediments arise, the Company anticipates that the Acquisition will
be consummated in late October to early November of 1998.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
10.64 Commutation and Settlement Agreement, effective as of June
30, 1998, by and between the Company and ZRNA.+
11 Summary of the calculation of EPS.*
27 Financial Data Schedule.*
(b) Reports on Form 8-K: No reports were filed on Form 8-K during the second
quarter of 1998.
--------------------
+ Filed with original 10-Q filing.
* Filed with this 10-Q/A.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Dated: October 16, 1998 SUPERIOR NATIONAL INSURANCE
GROUP, INC.
By: /s/ J. CHRIS SEAMAN
------------------------------------
J. Chris Seaman
Executive Vice President and
Chief Financial Officer
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EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
10.64 Commutation and Settlement Agreement, effective as of June
30, 1998, by and between the Company and ZRNA.+
11 Summary of the calculation of EPS.*
27 Financial Data Schedule.*
- ---------------
+ Filed with original 10-Q filing.
* Filed with this 10-Q/A.