<PAGE>
 
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                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
 
                               ----------------
 
                                   FORM 10-K
 
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
    ACT OF 1934
 
                  For the Fiscal Year Ended December 31, 1998
                                      OR
 
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
    EXCHANGE ACT OF 1934
 
                               ----------------
 
                        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                     (Zip Code)
              Offices)
 
                                (609) 896-1921
             (Registrant's Telephone Number, Including Area Code)
 
          Securities registered pursuant to Section 12(b) of the Act:
 
           Title of each class            Name of each exchange on   which
      Common Stock $.01 Par Value                   registered
                                               New York Stock Exchange
 
          Securities registered pursuant to Section 12(g) of the Act:
 
                                     NONE.
 
  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
 
  The aggregate market value of the voting stock held by nonaffiliates of the
Registrant as of March 12, 1999, was $165,764,456 (based on $13.25 per share).
At March 12, 1999, the Registrant had outstanding 12,941,425 shares of its
Common Stock, par value $.01 per share.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  The registrant's definitive proxy statement to be filed with the Securities
and Exchange Commission within 120 days of December 31, 1998 is incorporated
by reference in Part III of this 10-K.
 
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<PAGE>
 
                               TABLE OF CONTENTS
 
<TABLE>
<CAPTION>
 Item                                                                      Page
 ----                                                                      ----
                                     PART I
 
 <C>  <S>                                                                  <C>
  1.  Business...........................................................    1
  2.  Properties.........................................................   15
  3.  Legal Proceedings..................................................   15
  4.  Submission of Matters to a Vote of Security Holders................   15
 
                                    PART II
 
  5.  Market for Company's Common Stock and Related Stockholder Matters..   15
  6.  Selected Financial Data............................................   16
  7.  Management's Discussion and Analysis of Financial Condition and
      Results of Operations..............................................   17
 7A.  Quantitative and Qualitative Disclosures about Market Risk.........   25
  8.  Financial Statements and Supplemental Data.........................   26
  9.  Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure...............................................   26
 
                                    PART III
 
 10.  Directors and Executive Officers of the Registrant.................   26
 11.  Executive Compensation.............................................   26
 12.  Security Ownership of Certain Beneficial Owners and Management.....   26
 13.  Certain Relationships and Related Transactions.....................   26
 
                                    PART IV
 
 14.  Financial Statements, Exhibits and Reports on Form 8-K.............   27
</TABLE>
<PAGE>
 
                                    PART I
 
ITEM 1: Business.
 
General
 
  Highlands Insurance Group, Inc. (the "Highlands Group") is an insurance
holding company that, through its subsidiaries (collectively, the "Company"),
is engaged in the property and casualty insurance business. Until January 23,
1996, the Highlands Group was a wholly-owned subsidiary of Halliburton Company
("Halliburton"). On that date, the shares of the Highlands Group's common
stock (the "Common Stock") were distributed to holders of common stock of
Halliburton in the form of a dividend (the "Distribution").
 
  On April 30, 1997, the Highlands Group acquired Vik Brothers Insurance, Inc.
and its subsidiaries ("VBI"). Immediately after the consummation of the
acquisition, VBI was renamed American Reliance, Inc. The acquisition was
accounted for as a purchase and, accordingly, the financial results of
American Reliance, Inc. and subsidiaries ("American Reliance") are included in
the consolidated financial statements effective April 30, 1997.
 
  The Company's home office is in Lawrenceville, New Jersey, where it has one
of its regional offices. It maintains seven other regional offices in Houston,
Texas; Raleigh, North Carolina; Columbus, Ohio; Brookfield, Wisconsin; Des
Moines, Iowa; Denver, Colorado; and Woodland Hills, California. Specialized
business units are located in Lawrenceville and Houston to service larger or
specialized (such as marine) accounts. The Company's principal subsidiaries,
Highlands Insurance Company, Northwestern National Casualty Company and
Pacific National Insurance Company, are rated "B++" (very good) by A.M. Best.
 
  The Company's principal product lines, shown as a percentage of gross
premiums written for 1998, are as follows:
 
<TABLE>
      <S>                                                                 <C>
      Commercial multiple-peril..........................................  25.6%
      Workers' compensation..............................................  23.8
      Commercial automobile..............................................  12.6
      Homeowners multiple peril and fire.................................  10.6
      Personal automobile................................................   7.3
      General liability..................................................   7.1
      Marine.............................................................   4.8
      Other..............................................................   8.2
                                                                          -----
                                                                          100.0%
                                                                          =====
</TABLE>
 
  The Company, which is licensed in all 50 states and the District of
Columbia, writes primarily property and casualty insurance for commercial
customers and certain personal lines. Its commercial policyholders consist of
small to medium-sized customers, such as retailers, wholesalers, contractors,
service businesses and customers in the habitational sector, located mainly on
the East Coast and in California and Texas. In addition, the Company writes
insurance at its Houston office for medium to large commercial accounts
headquartered in Texas and Louisiana. These customers are engaged in heavy
industries, including oil lease operations, construction, engineering,
manufacturing and certain service businesses. Its largest customer is
Halliburton, the Highlands Group's former parent, which represented 9.0% of
the Company's gross premiums written in 1998. The Company provides insurance
services to Halliburton pursuant to an agreement which expires on December 31,
1999. Halliburton has advised the Company that it does not intend to continue
the contract past its expiration date. The Company also writes ocean marine
insurance out of its Houston office, mainly along the Gulf of Mexico and on
the West Coast of the United States, including Hawaii and Alaska, and inland
marine insurance, mainly in Texas. Its personal lines focus on homeowners
multiple peril and fire coverages and automobile insurance located primarily
on the East Coast. At the end of 1998, the Company established specialized
business units at its Lawrenceville headquarters for the purpose of expanding
its large account and marine business throughout its organization.
 
                                       1
<PAGE>
 
  Between 1976 and 1996, the Company discontinued three of its product lines
(the "Discontinued Lines") which still generate claims that affect the
Company's results of operations: business originated by its London operations;
an umbrella/excess liability policy program; and assumed casualty and property
reinsurance contracts. The Discontinued Lines represented an immaterial amount
of the Company's gross premiums written in 1998 and 1997.
 
Products
 
  The Company writes commercial and personal property and casualty coverage.
The commercial lines include primarily commercial multiple peril, workers'
compensation, general liability and commercial automobile insurance.
Frequently, commercial policies are sold on an account basis, including a
combination of these policy coverages. Policies written for large commercial
accounts are generally underwritten on a high deductible or retrospectively
rated basis, with significant risk retention by the insured. Policies written
for small to medium-sized accounts are generally on a fixed premium basis
where the insured has little or no retained risk, although certain workers'
compensation policies provide for profit sharing participation to the insured
in the form of dividends. The personal lines consist of homeowners multiple
peril and dwelling fire and personal automobile insurance. Additionally, the
Company writes ocean and inland marine insurance which is generally unrelated
to the commercial or personal lines property and casualty products.
 
  The following table sets forth the Company's gross premiums written by
product line for the periods indicated.
 
<TABLE>
<CAPTION>
                                                                 Years Ended
                                                                 December 31,
                                                              ------------------
                                                               1998  1997  1996
                                                              ------ ----- -----
                                                                (in millions)
      <S>                                                     <C>    <C>   <C>
      Commercial multiple peril.............................. $ 96.6  80.0  16.4
      Workers' compensation..................................   90.0  69.6  60.5
      Commercial automobile..................................   47.5  40.1  23.3
      Homeowners multiple peril and fire.....................   40.2  29.5   0.9
      Personal automobile....................................   27.5  19.5   0.6
      General liability......................................   26.7  54.8  21.7
      Marine.................................................   18.1  28.2  20.1
      Other..................................................   30.5  22.6  11.8
      Discontinued lines.....................................    1.0   1.7   3.2
                                                              ------ ----- -----
        Total................................................ $378.1 346.0 158.5
                                                              ====== ===== =====
</TABLE>
 
  The following is a description of the types of insurance products sold by
the Company.
 
  Commercial Multiple Peril. Commercial multiple peril policies insure
businesses and commercial dwellings against property and third party liability
exposures.
 
  Workers' Compensation. Workers' compensation coverage insures employers
against medical and indemnity claims resulting from work related injuries.
 
  Commercial Automobile. Commercial automobile coverage insures businesses
against losses incurred from personal bodily injury, bodily injury to third
parties and property damage to an insured's vehicle, other vehicles and other
property. This product line is primarily offered in connection with the
Company's other primary insurance products.
 
  Homeowners Multiple Peril and Fire. Homeowners multiple peril coverage
insures individuals for losses to their residences and personal property and
against third party liability exposures.
 
  Personal Automobile. Personal automobile insurance insures individuals
against losses incurred from personal bodily injury, bodily injury to third
parties and property damage to the insured's vehicle, other vehicles and other
property.
 
                                       2
<PAGE>
 
  General Liability. General liability coverage insures businesses against
third-party liability from accidents occurring on their premises or arising
out of their operations, such as injuries sustained from products sold.
 
  Marine. Ocean marine coverage insures business against property and
liability losses related to the operation of waterborne vessels and their
cargo.
 
  Other. In addition to its primary product lines above, the Company also
underwrites inland marine, surety bonds and property coverage.
 
Types of Policies
 
  Approximately 88.0% of the Company's gross premiums written in 1998 related
to policies written on a traditional fixed premium basis whereby the customer
receives stated levels of coverage in return for a fixed premium over the
policy term, including certain workers' compensation policies which provide
for participating dividends. The balance of the Company's insurance premiums
are written on policies subject to retrospective rating or individually
negotiated, high deductible, fixed premium policies.
 
  Premiums for retrospectively rated policies may be adjusted up or down,
subject to certain limitations contained in the policy, based on the actual
loss experience of the insured during the policy period. Loss experience rated
policies reduce but do not eliminate risk to the insurer. The Company
estimates ultimate losses for the retrospectively rated policies and then
adjusts written and earned premiums and premiums due from policyholders for
changes in the estimated ultimate losses from the prior valuation.
 
  High deductible policies are similar to retrospectively rated policies in
terms of the level of risk retention by the insured. Under a high deductible
policy, the insured deposits an estimated deductible amount with the insurer,
which amount is generally adjusted quarterly to reflect loss payments under
the deductible. Amounts within the deductible limit are not recorded as
premiums or losses. Consequently, premiums on a high deductible policy
generally are significantly lower than on a retrospectively rated policy. In
addition, cash receipts to the Company on high deductible policies are
generally lower than for retrospectively rated policies and, thus, the
opportunity for investment income is reduced.
 
Geographic Distribution
 
  The following table sets forth the geographic distribution of the Company's
gross premiums written for the periods indicated.
 
<TABLE>
<CAPTION>
                                                                 Years Ended
                                                                 December 31,
                                                              ------------------
                                                               1998  1997  1996
                                                              ------ ----- -----
                                                                (in millions)
      <S>                                                     <C>    <C>   <C>
      Texas.................................................. $ 52.4  79.4  95.4
      New Jersey.............................................   51.3  44.6   0.3
      California.............................................   47.1  33.4   7.9
      Pennsylvania...........................................   31.4  27.2   1.1
      North Carolina.........................................   18.3  13.0   0.4
      Iowa...................................................   14.4  10.0    --
      New York...............................................   11.3  10.2   0.2
      Louisiana..............................................   10.8  10.4  16.4
      Other..................................................  141.1 117.8  36.8
                                                              ------ ----- -----
                                                              $378.1 346.0 158.5
                                                              ====== ===== =====
</TABLE>
 
                                       3
<PAGE>
 
Marketing
 
  The Company sells its insurance products in various regional markets through
a network of approximately 2,100 independent agents. Its ten largest agents
wrote 8.8% of the Company's gross premiums written in 1998.
 
  The Company markets small to medium-sized commercial and personal insurance
through eight regional offices in New Jersey, Texas, North Carolina, Ohio,
Wisconsin, Iowa, Colorado and California. Specialized business units are
located in Lawrenceville and Houston to service larger or specialized (such as
marine) accounts. At the end of 1998, the Company opened a sales office in
Atlanta, Georgia and is in the process of opening an office in Providence,
Rhode Island.
 
  The Company's small to medium-sized commercial customers (with premium on
policies ranging from $2,500 to $100,000) consist mainly of retailers,
wholesalers, service businesses, funeral homes, office buildings, religious
institutions, franchise and family style restaurants, municipalities, golf
courses, automobile dealers, customers in the habitational sector (such as
apartments, condominiums, motels and hotels), contractors, wholesale durable
goods producers, producers of retail building materials, machine shops and
tool manufacturers. Most of the premium is written on the East Coast and in
California and Texas.
 
  The personal lines unit, which is headquartered in Raleigh, North Carolina,
focuses on homeowners multiple peril and fire coverages and, to a lesser
extent, personal automobile coverage located primarily along the East Coast.
The Company is in the process of expanding its personal automobile business to
California, Georgia and Rhode Island.
 
  The Company sells insurance products, through its special accounts unit in
Houston, Texas, to a limited number of relatively large industrial clients,
headquartered in Texas and Louisiana, engaged in oil lease operations,
construction, engineering, manufacturing and service businesses where
insurance needs require specialized service capabilities and flexible
coverages. The Company, through its marine unit in Houston, markets its ocean
marine products along the Gulf of Mexico and the West Coast of the United
States, including Hawaii and Alaska and inland marine insurance, mainly in
Texas. Its ocean marine customers consist of commercial fishing, tug and
barge, and oil field support vessels. The insurance services unit provides
insurance coverages for Halliburton, comprised mostly of workers'
compensation, automobile liability and general liability insurance written on
a high deductible and retrospectively rated basis. The Company provides this
coverage as substantially service-based business, through an agreement which
expires on December 31, 1999. Halliburton has advised the Company that it does
not intend to continue the contract past its expiration date. The Company also
established special accounts and marine units in its Lawrenceville office at
the end of 1998 to expand its large account and marine business throughout the
organization.
 
  Because the Company's business (other than with Halliburton) is marketed
through independent insurance agents and brokers, it considers its
relationship with these agents and brokers to be critical to its success.
Accordingly, the Company seeks to establish long-term relationships with well-
established agencies and brokers with a proven track record. In selecting
agencies and brokers for appointment, the Company considers the following
criteria: a record of profitability and financial stability; an experienced
and professional staff; the existence of a marketing plan for future growth;
and a plan for succession in management. The Company's agents are primarily
medium-sized firms, generally with annual premium volume estimated at between
$2 million and $25 million. Agents are retained under agency agreements which
provide for the payment of commissions based on a percentage of premiums
written by line of business. Some agents are also eligible to earn contingent
commissions based on achieving specified levels of premium volume with
profitable underwriting experience. The Company continually monitors the
performance of its agents and brokers and terminates relationships in the case
of substandard performance.
 
  The success of the Company depends in large part on maintaining a strong
agency network. To increase its responsiveness to agents' needs, the Company
has instituted agency councils on a regional basis to deal with issues that
are important to agents. The Company has also established teams in its regions
which consolidate
 
                                       4
<PAGE>
 
underwriting, field marketing and agency services into single units. Specific
marketing programs have been established to provide agents with marketing
support, including an agency newsletter to communicate product marketing
information.
 
  In 1998, the Company introduced a stock purchase plan for its independent
agents to permit them to purchase the Company's Common Stock on favorable
terms in order to encourage them to become stockholders in the Company and
thereby increase their identity of interest with the Company.
 
Underwriting
 
  The underwriting and risk selection process is performed at each of the
regional offices and business units. Underwriting guidelines and criteria are
established for the regional offices by corporate underwriting, located in
Lawrenceville, New Jersey. Underwriting audits of the regional offices are
performed by the corporate underwriting staff on an annual basis to ensure
compliance with underwriting directives. The other business units establish
independent underwriting guidelines and criteria and monitoring procedures.
 
Claim
 
  Claims are processed in the regional office or the business unit where the
business is written. Home office claim support is located in Lawrenceville,
New Jersey, which establishes claim policies and procedures for the regional
claim offices. The home office also provides support on complex claims, such
as environmental, asbestos, and construction defect claims, fraud detection
and administration, and conducts an oversight audit function for each regional
claim office. In addition, a centralized salvage and subrogation unit is
located in Raleigh, North Carolina.
 
  The Company primarily uses its own adjusters to settle claims, but also uses
independent adjusters when necessary for claims in remote areas. On-site
adjusters are maintained for a few of the larger accounts. The Company uses
in-house counsel for a portion of its claims litigation.
 
Loss Control
 
  The Company maintains a loss control operation in all of its offices in the
field to provide loss prevention service to customers and to assist
underwriters in the risk selection and pricing process. Loss control services
include management consultation and recommendation, on-site inspection and
training using video, audio and written resources. Services provided to
underwriters include inspections, estimation of building replacement costs,
risk assessment and recommendations for improving the loss experience on a
risk.
 
Discontinued Lines
 
  Between 1976 and 1996, the Company discontinued three lines of business
which still generate claims that affect the Company's results of operations:
(i) business generated by the Company's London operations, which were
initially conducted as a branch office and subsequently by a UK subsidiary
(together "Highlands (UK)") and which were discontinued by 1993; (ii) certain
umbrella/excess liability policies which were discontinued in 1985; and (iii)
assumed casualty and property reinsurance, which was discontinued between 1976
and 1996. The Company has outsourced the claims handling and run-off
management of Highlands (UK) to a professional run-off company doing business
in the United Kingdom. The run-off of the other discontinued lines is being
managed directly by Company personnel in Houston, Texas.
 
Loss and Loss Adjustment Expense Reserves
 
  Significant periods of time often elapse between the occurrence of an
insured loss, the reporting of the loss to the insurer and the insurer's
payment of that loss. To recognize liabilities for unpaid losses, insurers
establish
 
                                       5
<PAGE>
 
reserves as balance sheet liabilities representing estimates of amounts needed
to pay reported and unreported losses and the related loss adjustment expense.
The Company's loss and loss adjustment expense reserves are reviewed quarterly
by the Company's internal actuaries and at year end by the Company's
independent actuaries. The Company's independent actuaries issued opinions on
the 1998 loss and loss adjustment expense reserves for the insurance
subsidiaries, as required for their statutory filings with the various
insurance departments.
 
  The process of estimating loss reserves is a difficult and complex exercise
involving many variables and subjective judgments. As part of the reserving
process, insurers review historical data and consider the impact of various
factors such as changes in the Company's operations (such as underwriting or
claims handling), trends in claim frequency and severity, emerging economic
and social trends, inflation and changes in the regulatory and litigation
environments. This process assumes that past experience, adjusted for the
effects of current developments and anticipated trends, is an appropriate
basis for predicting future events. There is no precise method, however, for
evaluating the impact of any specific factor on the adequacy of reserves,
because the eventual deficiency or redundancy of reserves is affected by many
factors.
 
  When a claim is reported to the Company, claim personnel establish a "case
reserve" for the estimated amount of the ultimate liability. This reflects the
informed judgment of such personnel based on general insurance reserving
practices and on the experience and knowledge of such personnel regarding the
nature and value of the specific types of claims. Case reserves are increased
or decreased as deemed necessary by the Company's claim department, after
evaluating, among other things, coverage, liability and the severity of
subsequent developments and periodic reviews of the claims.
 
  In accordance with industry practice, the Company maintains reserves for
estimated unreported losses and associated adjustment and litigation expenses.
These reserves are established to provide for claims which have been incurred
but not yet reported ("unreported losses") and to provide for adverse
development in case reserves. A significant portion of the Company's loss
reserve is the reserve relating to unreported losses. These reserves, by
definition, are not established for specific claims. In calculating reserves
for unreported losses, therefore, the Company estimates the ultimate net
liability for losses using various techniques. Such reserves are established
based on loss experience and are grouped both by class of business and by
accident year. Reserve adjustments relating to unreported losses are also made
to take into account changes in the volume of business written, claims
frequency and severity, the mix of business, claims processing and other items
that can be expected to affect the Company's liability for losses over time.
 
  During the loss adjustment period, additional facts regarding individual
claims may become known. As the Company becomes aware of additional facts, it
may become necessary for it to refine and adjust liability estimates, and even
after adjustment, the ultimate net liability for claims may be less than or
greater than the revised estimates.
 
                                       6
<PAGE>
 
  The following table presents a reconciliation of total beginning and ending
reserve balances of the Company for loss and loss adjustment expense for the
periods indicated.
 
<TABLE>
<CAPTION>
                                                    1998      1997      1996
                                                 ---------- --------- ---------
                                                         (in thousands)
<S>                                              <C>        <C>       <C>
Balance at January 1............................ $1,605,374 1,156,824 1,253,627
Acquisition of American Reliance................         --   520,719        --
  Less--Reinsurance recoverables................    692,668   652,449   599,558
                                                 ---------- --------- ---------
Net balance at January 1........................    912,706 1,025,094   654,069
                                                 ---------- --------- ---------
Incurred related to--
  Current year..................................    256,528   230,033   133,717
  Commutation of Aggregate Excess of Loss
   Reinsurance
   Agreement....................................     50,000        --        --
  Prior year--
    Asbestos and environmental..................     21,840     5,433     6,557
    All other...................................         32    11,013    16,315
                                                 ---------- --------- ---------
  Total prior year..............................     21,872    16,446    22,872
                                                 ---------- --------- ---------
    Total incurred..............................    328,400   246,479   156,589
                                                 ---------- --------- ---------
Paid related to--
  Current year..................................     90,635   120,705    37,020
  Prior year--
    Asbestos and environmental..................     13,373     6,812     7,855
    All other...................................    266,117   231,350   155,666
                                                 ---------- --------- ---------
  Total prior year..............................    279,490   238,162   163,521
                                                 ---------- --------- ---------
    Total paid..................................    370,125   358,867   200,541
                                                 ---------- --------- ---------
Net balance at December 31......................    870,981   912,706   610,117
  Add--Reinsurance recoverables.................    732,567   692,668   546,707
                                                 ---------- --------- ---------
Balance at December 31.......................... $1,603,548 1,605,374 1,156,824
                                                 ========== ========= =========
</TABLE>
 
  The loss reserve experience of the Company, as reflected on the basis of
generally accepted accounting principles, is shown in the following table,
which represents the development of balance sheet reserves (net of
reinsurance) for 1988 through 1998. The top three lines of the table reconcile
gross loss and loss adjustment expense reserves to net loss and loss
adjustment expense reserves for 1992 through 1998. The upper section of the
table shows the cumulative amount paid with respect to the previously recorded
net reserves as of the end of each succeeding period. The lower portion of the
table shows the re-estimated amount of the previously recorded net reserves
based on experience as of the end of each succeeding period. In addition, the
table also presents the gross re-estimated reserve liability as of the latest
re-estimation period. The Company did not restate data for years prior to 1992
in this table for presentation on a gross basis.
 
  The loss reserve estimate is increased or decreased as more information
becomes known about the frequency and severity of losses for individual years.
The cumulative (deficiency) redundancy represents the aggregate change in the
estimates over all prior periods. This table does not present accident or
policy year development data. Conditions and trends that have affected
development of the reserves in the past may not necessarily occur in the
future. Accordingly, it may not be appropriate to extrapolate deficiencies or
redundancies based on this table.
 
                                       7
<PAGE>
 
<TABLE>
<CAPTION>
                      1988      1989      1990       1991        1992       1993       1994       1995       1996       1997
                    --------  --------  ---------  ---------  ----------  ---------  ---------  ---------  ---------  ---------
                                                                   (in thousands)
 <S>                <C>       <C>       <C>        <C>        <C>         <C>        <C>        <C>        <C>        <C>
 Gross reserves
  for loss and
  loss adjustment
  expense........   $     --        --         --         --   1,393,352  1,225,242  1,149,173  1,253,627  1,156,824  1,605,374
 Deduct:
  reinsurance
  recoverable....         --        --         --         --     827,381    627,285    557,096    599,558    546,707    692,668
 Net reserves for
  loss and loss
  adjustment
  expense........    452,448   493,818    540,818    652,925     565,971    597,957    592,077    654,069    610,117    912,706
 Net paid
  (cumulative) as
  of:
 One year later..    165,380   207,948    236,070    263,755     268,072    184,586    198,415    163,521    135,747    279,490
 Two years
  later..........    283,703   344,994    419,791    420,876     395,244    333,366    323,737    266,093    231,409
 Three years
  later..........    353,811   448,667    510,739    518,442     513,135    426,022    404,287    348,713
 Four years
  later..........    419,100   516,833    573,504    608,865     587,726    488,676    473,059
 Five years
  later..........    468,899   555,134    638,963    668,889     639,647    548,333
 Six years
  later..........    497,568   605,691    685,578    714,843     692,851
 Seven years
  later..........    540,202   641,245    723,905    763,008
 Eight years
  later..........    569,297   670,661    764,543
 Nine years
  later..........    595,966   704,056
 Ten years later.    625,928
 Gross paid
  (cumulative) as
  of:
 One year later..                                                583,180    405,885    284,446    279,091    183,701    338,120
 Two years
  later..........                                                920,199    635,683    522,680    429,250    324,859
 Three years
  later..........                                              1,113,503    836,921    650,471    556,177
 Four years
  later..........                                              1,296,333    945,321    762,957
 Five years
  later..........                                              1,392,285  1,046,959
 Six years later.                                              1,485,306
 Net liability
  re-estimated as
  of:
 End of year.....    452,448   493,818    540,818    652,925     565,971    597,957    592,077    654,069    610,117    912,706
 One year later..    479,617   544,574    653,379    694,248     688,811    662,841    735,647    676,940    626,563    984,578
 Two years
  later..........    518,162   627,917    725,661    785,147     772,020    788,454    750,941    702,633    689,107
 Three years
  later..........    565,941   667,812    772,614    828,241     894,071    805,313    783,138    765,168
 Four years
  later..........    585,565   714,290    824,126    938,216     915,163    835,720    863,781
 Five years
  later..........    631,570   765,856    925,216    957,726     943,789    913,664
 Six years
  later..........    680,821   863,909    943,067    988,466   1,035,577
 Seven years
  later..........    772,322   872,101    971,193  1,084,762
 Eight years
  later..........    776,353   897,497  1,060,151
 Nine years
  later..........    799,829   976,982
 Ten years later.    879,250
 Net deficiency..   (426,802) (483,164)  (519,333)  (431,837)   (469,606)  (315,707)  (271,704)  (111,099)   (78,990)   (71,872)
 Impact of 1995
  Third Quarter
  Change.........     84,482    88,701     90,501     96,640     103,483    107,594    117,000         --         --         --
 Impact of
  Commutation of
  Stop Loss
  Agreement......     50,000    50,000     50,000     50,000      50,000     50,000     50,000     50,000     50,000     50,000
 Remaining net
  deficiency.....   (292,320) (344,463)  (378,832)  (285,197)   (316,123)  (158,113)  (104,704)   (61,099)   (28,990)   (21,872)
                    ========  ========  =========  =========  ==========  =========  =========  =========  =========  =========
 Gross re-
  estimated
  liability as
  of:
 End of year.....                                              1,393,352  1,225,242  1,149,173  1,253,627  1,156,824  1,605,374
 One year later..                                              1,636,022  1,413,673  1,445,913  1,324,315  1,285,772  1,746,580
 Two years
  later..........                                              1,811,827  1,693,009  1,492,471  1,468,762  1,457,924
 Three years
  later..........                                              2,102,378  1,741,108  1,644,068  1,644,068
 Four years
  later..........                                              2,157,078  1,895,541  1,921,075
 Five years
  later..........                                              2,307,982  2,070,956
 Six years.......                                              2,470,661
 Gross cumulative
  deficiency.....                                             (1,077,309)  (845,714)  (771,902)  (390,441)  (301,100)  (141,206)
                                                              ==========  =========  =========  =========  =========  =========
 Gross...........                                              2,470,661  2,070,956  1,921,075  1,644,068  1,457,924  1,746,580
 Less: re-
  estimated
  recoverable....                                              1,435,084  1,157,292  1,057,294    878,900    768,817    762,002
                                                              ----------  ---------  ---------  ---------  ---------  ---------
 Net re-estimated
  liability......                                             $1,035,577    913,664    863,781    765,168    689,107    984,578
                                                              ==========  =========  =========  =========  =========  =========
<CAPTION>
                      1998
                    ---------
 <S>                <C>
 Gross reserves
  for loss and
  loss adjustment
  expense........   1,603,548
 Deduct:
  reinsurance
  recoverable....     732,567
 Net reserves for
  loss and loss
  adjustment
  expense........     870,981
 Net paid
  (cumulative) as
  of:
 One year later..
 Two years
  later..........
 Three years
  later..........
 Four years
  later..........
 Five years
  later..........
 Six years
  later..........
 Seven years
  later..........
 Eight years
  later..........
 Nine years
  later..........
 Ten years later.
 Gross paid
  (cumulative) as
  of:
 One year later..
 Two years
  later..........
 Three years
  later..........
 Four years
  later..........
 Five years
  later..........
 Six years later.
 Net liability
  re-estimated as
  of:
 End of year.....     870,981
 One year later..
 Two years
  later..........
 Three years
  later..........
 Four years
  later..........
 Five years
  later..........
 Six years
  later..........
 Seven years
  later..........
 Eight years
  later..........
 Nine years
  later..........
 Ten years later.
 Net deficiency..
 Impact of 1995
  Third Quarter
  Change.........
 Impact of
  Commutation of
  Stop Loss
  Agreement......
 Remaining net
  deficiency.....
 Gross re-
  estimated
  liability as
  of:
 End of year.....   1,603,548
 One year later..
 Two years
  later..........
 Three years
  later..........
 Four years
  later..........
 Five years
  later..........
 Six years.......
 Gross cumulative
  deficiency.....
 Gross...........
 Less: re-
  estimated
  recoverable....
 Net re-estimated
  liability......
</TABLE>
 
  The four components which account for the substantial majority of the
indicated historical (1987-1994) reserve deficiencies are: (i) reserving
practices prior to 1991 for unreported losses associated with retrospectively
rated policies, (ii) environmental (including asbestos) claims, (iii)
Discontinued Lines business and (iv) inadequate individual claim reserves.
 
  As the table above illustrates, the Company's net reserves at the end of
1997 developed unfavorably in 1998 by $21.9 million. This increase is due
primarily to deficiencies on asbestos and environmental loss and loss
adjustment expense reserves. However, the deficiencies were primarily covered
by retrospectively rated policies which resulted in adjustments to gross
premiums written thus minimizing the impact on the Company's income statement.
For additional discussion regarding loss and loss adjustment expense reserves,
see Item 7: "Management's Discussion and Analysis of Financial Condition and
Results of Operations."
 
                                       8
<PAGE>
 
  In 1995, the Company and its independent actuary conducted a review of its
loss and loss adjustment expense reserves to assess the Company's reserve
position. As a result of such review, the Company recorded a $117 million
charge to loss and loss adjustment expense incurred which relate to items (ii)
and (iii) in the second preceding paragraph. Loss and loss adjustment expense
reserves were increased by $117 million (net of reinsurance) as follows: (i)
asbestos and environmental reserves were increased by $59.5 million relating
to exposures prior to 1986; (ii) assumed casualty reinsurance reserves were
increased by $13.1 million relating to risks reinsured in the early to mid-
1970's; and (iii) catastrophe loss reserves reinsured for Highlands (UK) were
increased by $12.0 million relating primarily to underwriting years 1988
through 1990. An additional $13.0 million was added to loss adjustment expense
reserves to reflect additional costs related to the settlement of claims and
run-off costs related to Highlands (UK). This reserve increase impacts the
reserve development for 1994 and all prior years. The remaining $19.4 million
reflects changes to reserves for unreported losses in order to reflect the
1995 evaluation of overall loss and loss adjustment expense reserves and
impacts development for 1994 and various other prior years.
 
  The Company and the property and casualty insurance industry in general have
experienced substantial adverse reserve development, particularly since 1988,
related to environmental claims. The areas of exposure for the Company are
discussed in "Management's Discussion and Analysis of Financial Condition and
Results of Operations." For 1998, 1997 and 1996, the amounts of adverse
reserve development related to environmental claims were $21.8 million, $5.4
million and $6.6 million, respectively. Prior to 1993, the Company did not
explicitly identify the amount of unreported loss reserve related to
environmental claims.
 
  Prior to the end of 1991, the Company did not establish a reserve for
unreported losses from retrospectively rated policies written for Halliburton
and its affiliated companies. The emergence of these losses was effectively
offset by collection of additional premiums under the policies and thus the
impact on the Company's income statement was minimal. For 1988 to 1990, the
total incurred loss emergence was equal to the adverse reserve development for
these policies and amounted to $181.0 million. 1991 also contained an
additional increase of $46.3 million related to the initial establishment of
unreported loss and allocated loss adjustment expense reserves for all
accident years prior to 1991.
 
  Although the majority of the assumed reinsurance contracts covering casualty
exposures relate to the 1969 through 1974 policy years, losses have continued
to emerge throughout the last ten years. For the calendar years 1998, 1997 and
1996, the amounts of assumed reinsurance losses recorded were $2.4 million,
$3.6 million and $3.4 million respectively. From 1985 to 1991, this line
contributed $51.0 million of adverse reserve development averaging
approximately $7.3 million per year. Included within these amounts are losses
related to environmental claims, although enough information to identify these
losses is not always provided by the ceding companies. To the extent
information provided by ceding companies permits, the environmental losses
have been segregated for the Company's reserve analysis.
 
  Loss and loss adjustment expense reserves for Highlands (UK) have
demonstrated reserve deficiencies in prior years. Net reserve re-estimates for
1998, 1997 and 1996 have produced increased liabilities of $64,200, $1.4
million and $1.5 million, respectively. There have been several factors
contributing to the adverse reserve development, including the large number of
catastrophic claims, and losses resulting from the exhaustion of certain
reinsurance coverage relating to the catastrophe claims.
 
Reinsurance
 
  The Company utilizes reinsurance arrangements to limit its maximum loss, to
provide greater diversification of risks and to minimize exposures on larger
risks. Reinsurance involves an insurance company transferring or ceding all or
a portion of its exposure on insurance policies to a reinsurer. The reinsurer
assumes the exposure in exchange for a portion of the premiums received by the
ceding insurance company. Generally, reinsurance coverage is on an excess of
loss basis, which means that reinsurance coverage commences after losses
exceed a specified dollar amount. Additionally, the Company has catastrophe
coverage for certain types of losses over stipulated aggregate amounts arising
from any one occurrence. Although reinsurance does not legally discharge an
insurer from its primary liability for the full amount of the policies, it
does make the assuming reinsurer liable to the reinsured to the extent of the
reinsurance ceded.
 
                                       9
<PAGE>
 
  The Company maintained excess of loss reinsurance treaties for each of its
main property, casualty and marine coverages during 1998. On casualty risks,
including workers' compensation, the retention level was $500,000 per
occurrence, with reinsurance coverage up to $30 million per occurrence.
Additional workers' compensation coverage was provided by a second catastrophe
excess of loss arrangement that provides $80 million above the $30 million for
total workers' compensation coverage of $109.5 million in excess of $500,000.
On property risks, reinsurers assume liability for 100% in excess of a
retention of $500,000 up to $25 million per risk and per occurrence. For
larger limits or whenever unusual exposures are present, the Company purchases
individual policy reinsurance which is referred to as facultative. In
addition, the Company purchased property catastrophe reinsurance to reduce its
exposure to losses resulting from any single catastrophic event. Under this
treaty, the Company retained $3 million of each loss occurrence and had
protection for 95% of all losses in excess thereof up to $60 million. On
marine business, reinsurers assumed liability on loss occurrences which exceed
$250,000 per occurrence up to $22 million.
 
  The Company monitors the financial condition of the reinsurance companies
with which it places significant reinsurance coverage and strives to place
reinsurance coverage with financially sound reinsurance companies. In the
past, the Company has placed coverage with several hundred reinsurance
companies. It monitors the financial condition of many of such companies only
on a periodic basis. A number of such companies are in run-off or have ceased
writing reinsurance and some have become insolvent. The Company's ability to
monitor the financial condition of some formerly used foreign reinsurance
companies is limited because of the difficulty of acquiring current financial
information.
 
  The following table sets forth by quality of reinsurer (for those domestic
companies rated by A.M. Best) the Company's reinsurance recoverable as of
December 31, 1998.
 
<TABLE>
<CAPTION>
                                                                    December 31,
      Category                                                          1998
      --------                                                      ------------
                                                                        (in
                                                                     millions)
      <S>                                                           <C>
      A.M. Best Rated:
        A- or better...............................................    $328.2
        B++ or less................................................     192.0
      Non A.M. Best Rated:
        Equitas/Lloyds.............................................     123.5
        Other foreign reinsurers...................................     132.0
        Pools and associations.....................................      11.6
                                                                       ------
          Total reinsurance recoverable............................    $787.3
                                                                       ======
</TABLE>
 
  Based upon its evaluations of reinsurers, the Company retains the ceded
reserves for potentially uncollectible reinsurance at such time as an
uncollectible amount is probable and the amount may be reasonably estimated.
Because of the difficulty of acquiring current financial information for
certain foreign reinsurers, including Lloyds syndicate members, the Company
believes that no meaningful range of potentially uncollectible reinsurance can
be established beyond recorded reserves. With respect to carriers that are not
authorized reinsurers as determined by an insurance subsidiary's domiciliary
department of insurance, the Company often receives collateral primarily in
the form of bank letters of credit generally securing the reinsurance
recoverable for reported losses and, in some instances, unreported losses. At
December 31, 1998, such collateral totaled approximately $45.4 million, of
which $16.0 million was received from other foreign reinsurers above. The
Company's three largest reinsurance recoverables at December 31, 1998 were
with the underwriting syndicates at Lloyds, amounting to approximately $123.5
million of which approximately $81.8 million is carried by Highlands (UK),
$113.7 million with American Re-Insurance Company and $70.1 million with
General Reinsurance Company. See Item 7: "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Liquidity and Capital
Resources--Reinsurance Receivables."
 
                                      10
<PAGE>
 
Investments
 
  The Company adheres to conservative investment practices and manages its
portfolio internally. The table below shows the carrying value and
classification of the Company's investments at the dates indicated.
 
<TABLE>
<CAPTION>
                                                              December 31,
                                                         ----------------------
                                                           1998    1997   1996
                                                         -------- ------- -----
                                                             (in millions)
      <S>                                                <C>      <C>     <C>
      Fixed maturities:
        United States Government and government
         agencies....................................... $  205.5   276.4 152.4
        States, municipalities and political
         subdivisions...................................     61.2   189.5 223.1
        Mortgage-backed securities......................    415.0   417.5 113.4
        Corporate securities............................    318.4   282.5 172.7
        Foreign governments.............................       .1      .1  12.9
        Sinking fund preferred stock....................      1.0      .5   5.8
      Equity securities.................................     21.1     1.6  27.0
      Other investments.................................      3.1     4.1   3.8
      Cash and cash equivalents.........................     70.7    60.7  49.5
                                                         -------- ------- -----
                                                         $1,096.1 1,232.9 760.6
                                                         ======== ======= =====
</TABLE>
 
  Fixed Maturities. Fixed maturities constituted 91.3% of the Company's
investments at December 31, 1998. The Company determines the mix of its
investment in taxable and tax-exempt securities based on its current and
projected tax position and the relationship between taxable and tax-exempt
investment yields. As of December 31, 1998, taxable bonds accounted for
approximately 93.9% of total fixed maturities. Beginning April 30, 1997, the
Company reclassified its entire fixed maturities portfolio as available-for-
sale. Fixed maturity investments classified as available-for-sale are carried
on the Company's balance sheet at estimated fair value, with unrealized gains
and losses (net of taxes) recorded in stockholders' equity. At December 31,
1998, the pre-tax unrealized gains on available-for-sale fixed maturities
totaled $25.4 million.
 
  The fixed maturities portfolio is managed conservatively to provide a
reasonable return while limiting exposure to risk. The following table sets
forth the composition of the Company's portfolio of fixed maturity investments
by National Association of Insurance Commissioners ("NAIC") rating and a
description of the equivalent ratings of Moody's Investor Services, Inc.
("Moody's") at the dates indicated.
 
<TABLE>
<CAPTION>
                               Moody's
                             Equivalent  December 31, December 31, December 31,
           NAIC Ratings      Description     1998         1997         1996
           ------------      ----------- ------------ ------------ ------------
      <S>                    <C>         <C>          <C>          <C>
      1..................... AAA/AA/A        91.1%        93.8%        95.7%
      2..................... BAA              8.2          5.0          4.3
      3..................... BA               0.5          0.9           --
      4..................... B                0.2          0.3           --
                                            -----        -----        -----
                                            100.0%       100.0%       100.0%
                                            =====        =====        =====
</TABLE>
 
  See Notes to Consolidated Financial Statements for a description of the
contractual maturities of the Company's fixed maturities portfolio at December
31, 1998 and 1997.
 
  Equities. Equity holdings comprised 1.9% of the Company's investments at
December 31, 1998, and consist of a diversified portfolio of unaffiliated
preferred stocks.
 
  Other Invested Assets. Other invested assets represent amounts invested in
limited partnerships and comprised 0.3% of total investments at December 31,
1998.
 
                                      11
<PAGE>
 
  Cash and Cash Equivalents. The Company's portfolio also includes short-term
securities and other miscellaneous investments, which in the aggregate
comprised 6.5% of total investments at December 31, 1998.
 
  The following table sets forth the Company's gross investment income and the
pre-tax yield of its investment portfolio (excluding investment income related
to premium notes receivable from insureds).
 
<TABLE>
<CAPTION>
                                         Years ended December 31,
                         ----------------------------------------------------------
                                1998                1997                1996
                         ------------------- ------------------  ------------------
                         Investment Pre-Tax  Investment Pre-Tax  Investment Pre-Tax
                           Income   Yield(1)   Income   Yield(1)   Income   Yield(1)
                         ---------- -------- ---------- -------  ---------- -------
                                          (dollars in thousands)
<S>                      <C>        <C>      <C>        <C>      <C>        <C>
Fixed maturity
 securities:
  Taxable...............  $66,939     6.95%   $53,666    6.97%    $26,815    7.06%
  Non-taxable(2)........    7,136     5.53     14,408    6.71      16,743    7.14
  Equity securities.....      517     5.68      2,073    9.64       2,180    7.84
  Short-term............    3,993     6.48      4,997    6.71       5,807    5.50
  Other invested assets.       57     2.82        372    9.48          54    1.35
                          -------     ----    -------    ----     -------    ----
    Total...............  $78,642     6.75%   $75,516    6.95%    $51,599    6.96%
                          =======     ====    =======    ====     =======    ====
</TABLE>
--------
(1) Calculated as gross investment income (including dividend income in the
    case of equity securities) divided by the average of the investment
    balances at the beginning and end of each quarter. Investment balances are
    at amortized cost, except in the case of equity securities for which cost
    is used.
(2) For purposes of comparing non-taxable yields to yields on taxable
    securities, these yields are equivalent to pre-tax yields of 8.5%, 10.3%,
    11.0% in 1998, 1997 and 1996, respectively, assuming a 35% tax rate. The
    disparity between the equivalents of pre-tax yields on non-taxable fixed
    maturity securities in comparison with the pre-tax yields on taxable fixed
    maturity securities is a function of the differing interest rate
    environments in which such securities were acquired.
 
Competition; Industry Conditions
 
  The property and casualty insurance business is highly competitive, mainly
on the basis of price and service. The Company estimates that there are more
than 3,000 property and casualty insurers nationwide. Many of the Company's
competitors are large national companies with greater financial and other
resources than the Company. In addition to independent insurance companies,
there is increasing competition for commercial business because of
alternatives to traditional insurance such as captive insurers and self-
insurance. Besides traditional insurance products, insurers writing commercial
lines of business now offer products for alternative forms of risk protection.
These products, including high deductible programs and other forms of self-
insurance which utilize captive insurance companies and risk retention groups,
have been instituted and marketed to attract additional business to these
companies. It is not possible to predict how continued growth in alternative
forms of risk protection will affect future operations. The Company competes
on the basis of underwriting expertise, pricing, service and product design.
Management believes its regional market knowledge, flexibility and quality
service to agents and insureds provide a competitive advantage.
 
Regulation
 
  The Company's insurance subsidiaries are subject to comprehensive regulation
throughout the United States, under statutes that delegate regulatory,
supervisory and administrative powers to state insurance commissioners. The
nature and extent of such regulation vary from jurisdiction to jurisdiction,
but typically involve (i) approval requirements for premium rates for certain
lines of insurance, (ii) standards of solvency and minimum capital and surplus
requirements, (iii) limitations on amounts and types of investments, (iv)
restrictions on the size of risks that may be insured by a single company, (v)
approval requirements for policy forms, methods of accounting and methods of
establishing loss and loss adjustment expense reserves, (vi) licensing of
insurers and agents, (vii) limitations on the exit of certain classes of
business, (viii) required participation in
 
                                      12
<PAGE>
 
frequently under-priced underwriting pools, and (ix) filing requirements for
annual and other reports with respect to financial condition and other
matters. Such regulations may impede, or impose burdensome conditions on, rate
increases or other actions that the Company might wish to take to enhance its
operating results. In addition, state regulatory examiners perform periodic
examinations of insurance companies. Such regulations are generally intended
for the protection of policyholders rather than investors.
 
  The Company also is subject to laws governing insurance holding companies in
states where its insurance subsidiaries are domiciled (Texas, Ohio, North
Carolina, California, Indiana and Wisconsin). These laws, among other things,
(i) require the Company to file periodic information with state regulatory
authorities including information concerning its capital structure, ownership,
financial condition and general business operations; (ii) regulate certain
transactions between the Company, its affiliates and the insurance
subsidiaries, including the amount of dividends and other distributions and
the terms of surplus notes; (iii) and restrict the ability of any one person
to acquire certain levels of the Company's voting securities without prior
regulatory approval.
 
  Highlands Insurance Company ("HIC") and its subsidiaries, Highlands
Underwriters Insurance Company, Highlands Casualty Company and Aberdeen
Insurance Company, are domiciled in Texas. Under current Texas law, any
dividend or distribution, together with any dividend or distribution made
within the preceding twelve months, is an "extraordinary dividend" if it
exceeds the greater of (a) 10.0% of the insurer's surplus as regards
policyholders as of the preceding December 31, or (b) the insurer's net income
for the preceding year. An extraordinary dividend may not be paid unless the
company reports the extraordinary dividend to the Texas Insurance Commissioner
at least 30 days before payment and the Texas Insurance Commissioner does not
disapprove the extraordinary dividend within that period. The maximum dividend
payable by HIC during 1999 without the prior approval of the Texas Insurance
Commissioner is approximately $29.2 million.
 
  Northwestern National Casualty Company ("NNCC") and its subsidiary, NN
Insurance Company ("NNI"), are domiciled in Wisconsin. Under current Wisconsin
law, any dividend or distribution of cash or other property, together with
that of other dividends paid or credited and distributions made within the
preceding twelve months, is an "extraordinary dividend" if it exceeds the
lesser of (a) 10.0% of the insurer's surplus as regards policyholders as of
the preceding December 31, or (b) the greater of: (i) the net income
(excluding realized capital gains) of the insurer for the calendar year
preceding the date of the dividend or distribution or (ii) the aggregate of
the net income of the insurer for the three calendar years preceding the date
of the dividend or distribution, minus realized capital gains for those
calendar years, and minus dividends paid or credited and distributions made
within the first two of the preceding three calendar years. An extraordinary
dividend may not be paid unless the company reports the extraordinary dividend
to the Wisconsin Insurance Commissioner at least 30 days before payment and
the Wisconsin Insurance Commissioner does not disapprove the extraordinary
dividend within that period. NNCC can pay dividends of $8.0 million during
1999 without the prior approval of the Wisconsin Insurance Department.
 
  Pacific National Insurance Company ("PNIC") and its subsidiary, Pacific
Automobile Insurance Company ("PAIC"), are domiciled in California. Under
current California law, any payment by an insurer of a dividend or
distribution of cash or other property, whose fair market value, together with
that of other dividends or distributions made within the preceding 12 months,
exceeds the greater of (i) 10.0% of the insurer's surplus as regards
policyholders as of the preceding December 31, or (ii) the net income of the
insurer for the 12-month period ending on the preceding December 31 is defined
as an "extraordinary dividend." California law permits an insurer to pay
dividends only from earned surplus. An extraordinary dividend may not be paid
unless it has been approved by the insurance department or the insurance
department has not disapproved the dividend or distribution within 30 days
after notice of the declaration to the department. PNIC can pay dividends of
$2.7 million during 1999 without prior approval of the California Insurance
Department.
 
  The dividend capability of LMI Insurance Company ("LMI") which is domiciled
in Ohio, State Capital Insurance Company, which is domiciled in North
Carolina, and American Professionals Insurance Company and Statesman Insurance
Company, which are domiciled in Indiana, are not material to the Company.
 
                                      13
<PAGE>
 
  Risk-Based Capital Requirement. In order to enhance the regulation of
insurer solvency, the NAIC adopted a formula and model law to implement risk-
based capital requirements for property and casualty insurance companies.
These risk-based capital requirements are designed to assess capital adequacy
and to raise the level of protection that statutory surplus provides for
policyholder obligations. The risk-based capital model for property and
casualty insurance companies measures three major areas of risk facing
property and casualty insurers: (i) underwriting, which encompasses the risk
of adverse loss developments and inadequate pricing; (ii) declines in asset
values arising from credit risk; and (iii) declines in asset values arising
from investment risks. Insurers having less statutory surplus than required by
the risk-based capital calculation are subject to varying degrees of
regulatory action, depending on the level of capital inadequacy.
 
  The risk-based capital model formula creates four levels of regulatory
action (as defined in the NAIC's model law). The extent of regulatory
intervention and action increases as the level of surplus to risk-based
capital falls. The first level, Company Action Level, requires an insurer to
submit a plan of corrective actions to the regulator if surplus falls below
200% of the Authorized Control Level. The Regulatory Action Level requires an
insurer to submit a plan containing corrective actions and permits the
domiciliary insurance regulator to perform an examination or other analysis
and issue a corrective order if surplus falls below 150% of the Authorized
Control Level. The Authorized Control Level allows the regulator to
rehabilitate or liquidate an insurer in addition to the aforementioned
actions. The fourth action level, Mandatory Control Level, requires the
regulator to rehabilitate or liquidate the insurer if surplus falls below 70%
of the Authorized Control Level.
 
  At December 31, 1998, all of the insurance subsidiaries of Highlands Group,
other than LMI, were above the Company Action Level. LMI's surplus was within
the Authorized Control Level at December 31, 1996. In connection with the
acquisition of American Reliance by the Highlands Group, LMI submitted a
corrective action plan to the Ohio Insurance Department, which accepted the
plan. The plan included, among other things, LMI ceasing to write insurance
and being put in run-off. At December 31, 1998, LMI's surplus was at the
Company Action Level. Management believes that the regulatory matters
concerning LMI will not have a material impact on the Company's results of
operations or financial position.
 
  The business of Highlands (UK) is subject to regulation under the laws of
the United Kingdom pursuant to the Insurance Companies Act of 1982. After
incurring unacceptable underwriting results in 1991 and 1992 and reviewing the
prospects for the future, Highlands (UK) voluntarily ceased writing new
business effective April 1993. The Company received a Notification of
Requirements from the Department of Trade and Industry ("DTI") in 1993, which
included: timely reporting of certain financial information; restrictions on
certain investment activities without prior approval of the DTI; restrictions
relating to transactions with connected persons; and a provision requiring
Highlands (UK) to cease to effect contracts of insurance except where it has a
legal obligation to do so. Capital infusions for Highlands (UK) were made in
1994 and 1995. During 1994, the DTI sent an additional requirements notice to
Highlands (UK) requesting a plan for restoration of a sound financial position
because of its failure to maintain a margin of solvency required by Section 32
of the Insurance Companies Act of 1982 for a company writing premiums.
Highlands (UK) has developed such a plan. Maintaining a license to write
business in the United Kingdom is not essential and the Highlands (UK) plan
does not anticipate any further capital contribution to Highlands (UK) beyond
the 1995 contribution of $10 million. Management believes that the regulatory
matters concerning Highlands (UK) will not have a material impact on the
Company's results of operations or financial position.
 
Employees
 
  The Company had 1,009 employees as of December 31, 1998. The Company
believes that its relations with its employees are satisfactory.
 
                                      14
<PAGE>
 
ITEM 2: Properties.
 
  The Company owns its principal executive offices in Lawrenceville, New
Jersey, which has 53,220 square feet of office space. In addition, it leases
its offices in Houston, Texas and has operating leases for its regional
offices. The Company believes that it has adequate space for its current
operations and to accommodate expansion.
 
ITEM 3: Legal Proceedings.
 
  None.
 
ITEM 4: Submission of Matters to a Vote of Security Holders.
 
  None.
 
                                    PART II
 
ITEM 5: Market for Company's Common Stock and Related Stockholder Matters.
 
  The Company's Common Stock is listed on the New York Stock Exchange ("NYSE")
under the trading symbol "HIC." As of March 12, 1999 approximately 12,941,425
shares of Common Stock were issued and outstanding. In addition, 1,200,000
shares of Common Stock are reserved for issuance pursuant to restricted stock
grants and options granted or to be granted pursuant to the 1995 Stock Option
Plan and the 1995 Directors' Stock Plan. See Item 11: "Executive
Compensation."
 
  The following table sets forth, for the calendar periods indicated, the high
and low per share sale prices of the Common Stock as reported in NYSE--
Composite Transactions.
 
<TABLE>
<CAPTION>
      Period                                                         High   Low
      ------                                                        ------ -----
      <S>                                                           <C>    <C>
      1997 First Quarter........................................... $24.00 18.50
      1997 Second Quarter.......................................... $21.38 17.50
      1997 Third Quarter........................................... $25.00 19.25
      1997 Fourth Quarter.......................................... $29.38 22.13
      1998 First Quarter........................................... $28.38 23.38
      1998 Second Quarter.......................................... $28.88 17.88
      1998 Third Quarter........................................... $18.88 11.81
      1998 Fourth Quarter.......................................... $13.19  9.75
</TABLE>
 
  The approximate number of stockholders of record of Common Stock as of March
12, 1999 was 6,379.
 
  Dividends. The Company has not previously paid any dividends and currently
does not intend to pay dividends on the Common Stock. This policy, however,
will be reconsidered from time to time by the Board of Directors of the
Company. The Company's ability to pay dividends in the future will depend upon
its financial performance and other factors that are not presently
determinable. The Credit Agreement with its lending banks prohibits the
payment of cash dividends by the Company and the Company's 10% Convertible
Subordinated Debentures due December 31, 2005 (the "Debentures") contain
covenants restricting the payment of dividends in excess of specified amounts.
As described above, the payment of dividends to the Company by the U.S.
insurance subsidiaries is subject to certain limitations under insurance laws.
 
                                      15
<PAGE>
 
ITEM 6: Selected Financial Data.
 
  The following table summarizes certain selected historical consolidated
financial data with respect to the Company and is based upon the historical
consolidated financial statements of the Company. The information set forth
below should be read in conjunction with "Management's Discussion and Analysis
of Financial Condition and Results of Operations," and the Consolidated
Financial Statements and related notes thereto included elsewhere herein.
 
<TABLE>
<CAPTION>
                                       Years Ended December 31,
                          ---------------------------------------------------------
                             1998       1997          1996      1995(1)     1994
                          ----------  ---------     ---------  ---------  ---------
                            (dollars in thousands, except per share date)
<S>                       <C>         <C>           <C>        <C>        <C>
Statement of Operations
 Data:
Revenues:
  Net premiums earned...  $  388,813    311,993       152,048    201,446    241,676
  Net investment income.      77,969     74,383        50,988     48,529     46,720
  Net realized
   investment gains.....      16,874      5,585         1,199      2,618      1,910
                          ----------  ---------     ---------  ---------  ---------
    Total revenues......     483,656    391,961       204,235    252,593    290,306
Expenses:
  Loss and loss
   adjustment expense
   incurred.............     328,400    246,479       156,589    300,253    224,315
  Underwriting expenses.     141,788    115,564        56,487     73,905     65,022
  Debt interest and
   amortization expense.      12,258     10,542         6,903         --         --
  Other expenses
   (income), net........       2,000        857         1,697       (823)    (1,314)
                          ----------  ---------     ---------  ---------  ---------
    Total expenses......     484,446    373,442       221,676    373,335    288,023
Income (loss) before
 income tax expense
 (benefits).............        (790)    18,519       (17,441)  (120,742)     2,283
Income tax expense
 (benefit)(2)...........      (3,887)     1,683       (12,098)        --         --
                          ----------  ---------     ---------  ---------  ---------
Net income (loss)(2)....  $    3,097     16,836        (5,343)  (120,742)     2,283
                          ==========  =========     =========  =========  =========
Earnings (loss) per
 common share(3):
  Basic.................  $      .24       1.34          (.47)    (10.55)       .20
  Diluted...............  $      .20       1.09          (.47)    (10.55)       .20
 
Balance Sheet Data (at
 end of period):
Investments, cash and
 cash equivalents.......  $1,096,147  1,232,917       760,618    720,746    683,020
Receivable from
 reinsurers.............  $  787,344    723,114       556,900    602,380    561,474
  Total assets..........  $2,265,043  2,366,656     1,566,031  1,636,091  1,539,418
Loss and loss adjustment
 expense reserves.......  $1,603,548  1,605,374     1,156,824  1,253,627  1,149,173
Stockholders' equity ...  $  318,554    329,293       263,475    267,110    295,808
Certain Financial Ratios
 and Other Data:
GAAP:
  Loss ratio............        84.4%      79.0%        103.0%     149.0%      92.8%
  Expense ratio.........        36.5       37.0          37.1       36.7       26.9
                          ----------  ---------     ---------  ---------  ---------
    Combined ratio......       120.9%     116.0%        140.1%     185.7%     119.7%
                          ==========  =========     =========  =========  =========
Statutory surplus.......  $  313,542    333,141       188,527    180,020    257,953
Net premiums written to
 policyholder surplus...         1.2x       1.2x(4)       0.8x       1.1x       0.9x
</TABLE>
 
--------
(1) The Company recorded a charge to pre-tax earnings during the year ended
    December 31, 1995 of $125 million for loss and loss adjustment expenses.
 
                                      16
<PAGE>
 
(2) The Company provides for income taxes in its statements of operations
    pursuant to Financial Accounting Standards Board Statement of Financial
    Accounting Standards No. ("SFAS") 109, "Accounting for Income Taxes." With
    respect to losses for periods preceding the Distribution, no tax benefits
    were recorded in the statements of operations pursuant to SFAS 109 due to
    the Company's tax-sharing agreement with its former parent, Halliburton.
    Tax receipts under its intercompany tax-sharing arrangements with
    Halliburton were recorded as additions to stockholders' equity for the
    periods preceding the Distribution. For further information regarding
    federal and foreign income taxes, see Note 7 to Consolidated Financial
    Statements.
(3) The earnings per share amounts prior to 1997 have been restated to comply
    with Statement of Financial Accounting Standards No. 128. Earnings Per
    Share. For further discussion of earnings per share and the impact of
    Statement No. 128, see the notes to the consolidated financial statements.
    Earnings (loss) per share for periods preceding the distribution have been
    computed based upon the 11,448,208 shares of Company Common Stock
    distributed on January 23, 1996.
(4)   Includes twelve months pro forma net premium written for American
      Reliance.
 
ITEM 7: Management's Discussion and Analysis of Financial Condition and
Results of Operations.
 
The Industry
 
  The property and casualty insurance industry's profitability may be affected
significantly by the availability of insurance coverage, which varies
according to levels of surplus in the industry, volatile and unpredictable
developments, including natural and man-made disasters (such as hurricanes,
windstorms, earthquakes, blizzards, fires and explosions), fluctuations in
interest rates and other changes in the investment environment that affect
market prices of insurance companies' investments and the income from those
investments, inflationary pressures that may tend to affect the size of losses
and judicial, legislative and regulatory decisions affecting insurers'
liabilities. The demand for property and casualty insurance can also vary
significantly, generally rising as the overall level of economic activity
increases and falling as such activity decreases. Price competition has also
been enhanced by a flight of commercial insureds to alternative risk
mechanisms, often including a degree of self insurance.
 
  The industry has experienced the effects of a number of well publicized
catastrophic events in recent years, some of which have affected the Company.
Growth in liabilities related to asbestos and environmental risks has also
adversely affected the industry and is of significance to the Company. See "--
Results of Operations--Loss and Loss Adjustment Expense Reserves" below.
 
  Property and casualty insurers are regulated by the various state insurance
departments that coordinate their efforts through the NAIC. See "Business--
Regulation." Regulation includes rate and policy form approval, licensing of
insurance agents and companies and solvency oversight.
 
                                      17
<PAGE>
 
Results of Operations
 
  As discussed in Note 2 to the Consolidated Financial Statements, on April
30, 1997, the Company completed the acquisition of Vik Brothers Insurance,
Inc., renamed American Reliance, Inc. ("American Reliance"). The acquisition
was accounted for under the purchase method of accounting and, accordingly,
the consolidated financial statements include the results of American
Reliance's operations only from date of acquisition. The results of the
Company's consolidated operations for the periods indicated are set forth
below:
 
<TABLE>
<CAPTION>
                                                             Years Ended
                                                            December 31,
                                                        -----------------------
                                                         1998     1997    1996
                                                        -------  ------  ------
                                                        (dollars in millions,
                                                          except per share
                                                                data)
      <S>                                               <C>      <C>     <C>
      Consolidated Results:
      Gross premiums written........................... $ 378.1   346.0   158.5
      Net premiums written............................. $ 374.8   277.7   135.1
                                                        =======  ======  ======
      Net premiums earned.............................. $ 388.8   312.0   152.1
      Loss and loss adjustment expense.................  (328.4) (246.5) (156.6)
      Underwriting expenses............................  (141.8) (115.6)  (56.5)
                                                        -------  ------  ------
      Underwriting loss................................   (81.4)  (50.1)  (61.0)
      Net investment income............................    78.0    74.4    51.0
      Net realized investment gains....................    16.9     5.6     1.2
      Debt interest and amortization expense...........   (12.3)  (10.5)   (6.9)
      Other (expenses) income, net.....................    (2.0)   (0.9)   (1.7)
                                                        -------  ------  ------
      Income (loss) before income taxes................    (0.8)   18.5   (17.4)
      Income tax expense (benefit).....................    (3.9)    1.7   (12.1)
                                                        -------  ------  ------
      Net income (loss)................................ $   3.1    16.8    (5.3)
                                                        =======  ======  ======
      Earnings (loss) per share:
        Basic.......................................... $   .24    1.34    (.47)
        Diluted........................................ $   .20    1.09    (.47)
      Ratios:
        Loss...........................................    84.4%   79.0%  103.0%
        Expense........................................    36.5    37.0    37.1
                                                        -------  ------  ------
        Combined.......................................   120.9%  116.0%  140.1%
                                                        =======  ======  ======
</TABLE>
 
Period to Period Comparisons
 
  Gross Premiums Written. Gross premiums written for 1998, 1997 and 1996 were
$378.1 million, $346.0 million and $158.5 million, respectively. The increase
in 1998 is attributable to the inclusion of American Reliance for the full
year 1998 ($278.2 million) compared to eight months in 1997 ($214.8 million)
because it was acquired on April 30, 1997. Using full year 1997 gross premiums
written for American Reliance produces a decline in 1998 of approximately
19.7% due primarily to three factors. First, the Company continues to focus on
stricter underwriting standards and adequate pricing. The current pricing
environment is highly competitive
 
                                      18
<PAGE>
 
as insurers compete to retain business. Second, service disruption in early
1998 associated with the implementation of a new policy issuance system at the
end of 1997 negatively impacted new and renewal policy processing and agents'
willingness to place business with the Company. Finally, the reduction in the
A.M. Best rating of Highlands Insurance Company to B++ from A-, announced by
A.M. Best in June 1998, caused a decline in premium production. The declines
have been partially offset by approximately $15.3 million of increases in
premiums under retrospectively rated policies.
 
  In 1998, the Company entered into agreements with insurance companies which
provide certain of the Company's customers access to A+ paper. These
agreements were entered into to limit the future loss of business due to A.M.
Best's downgrade of Highlands Insurance Company.
 
  Gross premiums written for retrospectively rated policies may be adjusted up
or down, subject to certain limitations contained in the policy, based on the
estimated loss experience of the insured during the policy period. 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 and net
premiums earned to fluctuate significantly from period to period. Experience
rated contracts reduce but do not eliminate risk to the insurer.
 
  Gross premiums written for 1997 increased $187.5 million compared to 1996
due to the inclusion of American Reliance for eight months in 1997 which
amounted to $214.8 million. Excluding the American Reliance business, gross
premiums written for 1997 declined $27.3 million or approximately 17.2% in
1997. The decline was due to stricter underwriting standards and increased
price competition.
 
  Net Premiums Written. Net premiums written for 1998, 1997 and 1996 were
$374.8 million, $277.7 million and $135.1 million, respectively. $62.5 million
of the increase in 1998 is related to the same issues affecting gross premiums
written. The remaining increase of $34.6 million resulted from the non-
recurring return premium associated with the Company's termination of an
Aggregate Excess of Loss Reinsurance Agreement ("Stop Loss Agreement") entered
into in 1992.
 
  Net premiums written for 1997 increased $142.6 million compared to 1996
primarily due to the inclusion of American Reliance for eight months in 1997
which amounted to $159.9 million. Excluding the American Reliance business,
net premiums written for 1997 declined 12.8% compared to 1996 for the same
reasons noted for gross premiums written.
 
  Net Premiums Earned. Net premiums earned for 1998, 1997 and 1996 were $388.8
million, $312.0 million and $152.1 million, respectively. The acquisition of
American Reliance increased net premiums earned by $67.4 million and $188.9
million for 1998 and 1997, respectively. Additionally, the termination of the
Stop Loss Agreement had the effect of increasing reported premiums in 1998 by
$34.6 million. The offsetting decreases for 1998 and 1997 of $25.2 million and
$29.0 million, respectively, relate to the same items affecting gross and net
premiums written.
 
  Loss and Loss Adjustment Expenses Incurred. Loss and loss and adjustment
expenses incurred for 1998, 1997 and 1996 were $328.4 million, $246.5 million
and $156.6 million, respectively. The increase in 1998 of $81.9 million
compared to 1997 was attributable to several factors. First, the termination
of the Stop Loss Agreement noted above had the effect of increasing loss and
loss adjustment expenses reported in 1998 by $50.0 million. Second, the
Company experienced catastrophe losses primarily in the second quarter of $5.2
million in 1998 compared to $17.3 million in 1997. The catastrophe losses
adversely impacted the entire industry in 1998 due to the high frequency of
catastrophes. Third, during 1998, the Company experienced an increase in loss
and loss adjustment expenses of $1.9 million ($8.0 million in 1998 compared to
$6.1 million in 1997) related to California construction defect claims.
Fourth, in 1998, there were higher incurred losses subject to retrospectively
rated policies. Finally, the inclusion of American Reliance for the full year
of 1998 compared to eight months in 1997 increased loss and loss adjustment
expenses in 1998.
 
                                      19
<PAGE>
 
  Loss and loss adjustment expenses incurred for 1997 increased $89.9 million
from 1996 primarily due to the acquisition of American Reliance. The increase
was partially offset by lower loss and loss adjustment expenses incurred due
to the declining premium volume excluding American Reliance.
 
  Underwriting Expenses. Underwriting expenses for 1998, 1997 and 1996 were
$141.8 million, $115.6 million and $56.5 million, respectively. The
underwriting expense ratio for 1998, 1997 and 1996 was 36.5%, 37.0% and 37.1%,
respectively. Elimination of the non-recurring premium related to the Stop
Loss Agreement and certain retrospectively rated policies resulted in an
expense ratio of 41.8% for 1998. The increase reflects the higher costs
associated with the problems implementing the policy issuance system and
resulting decrease in premium volume.
 
  Investment Results. Net investment income for 1998, 1997 and 1996 was $78.0
million, $74.4 million and $51.0 million, respectively. Net investment income
increased $3.6 million from 1997 due to the inclusion of American Reliance for
the full year in 1998. The 1998 investment income increase was partially
offset by lower interest rates in 1998 and a reduction in the size of the
investment portfolio. Net investment income for 1997 increased from 1996
primarily due to the acquisition and inclusion of American Reliance. Net
realized investment gains for the Company were $16.9 million, $5.6 million and
$1.2 million for 1998, 1997 and 1996, respectively.
 
  Debt Interest and Amortization Expense. Debt interest and amortization
expense for 1998 compared to the same period for 1997 increased $1.8 million
as a result of the $65 million loan under a Credit Agreement entered into in
April 1997 being outstanding for the full year in 1998 versus eight months in
1997. The loan was used to finance the purchase of American Reliance. The
increase in debt interest and amortization expense between 1996 and 1997 of
$3.6 million was also the result of the loan incurred under the Credit
Agreement.
 
  Other Expenses. Other expenses consist of parent company expenses and
miscellaneous expenses from the insurance subsidiaries offset by miscellaneous
income.
 
  Income Taxes. The Company provides for income taxes on its statements of
operations pursuant to Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes" (SFAS 109). The total tax benefit for 1998 was
$3.9 million. The Company's effective tax rate reflects the significant amount
of net investment income from tax advantaged fixed income securities and the
magnitude of the underwriting loss in relation to net taxable investment
income. The total tax expense for 1997 was $1.7 million and the 1997 effective
rate also reflects the relationship between net investment income from tax
advantaged fixed income securities and underwriting losses. For 1996, the
Company recognized the benefit of its net operating loss.
 
                                      20
<PAGE>
 
 Loss and Loss Adjustment Expense Reserves
 
  Underwriting results of the property and casualty industry are significantly
influenced by estimates of loss and loss adjustment expense reserves. (See
Note 11 to the Consolidated Financial Statements.) These reserves are an
accumulation of the estimated amounts necessary to settle and pay all
outstanding and unreported claims including loss adjustment expenses, net of
estimated claim recoveries. The case reserve estimates for reported claims are
based upon the facts of each case and the Company's experience with similar
cases. Consideration is given to historical trends regarding reserving
patterns, changes in the Company's operations (such as underwriting and claims
handling), loss payments, and the effects of court decisions, economic
conditions and public attitudes. The process of establishing reserves is
imprecise involving significant judgment and assumptions. As information
develops that varies from experience, provides additional data or, in some
cases, augments data that previously were not considered sufficient for use in
determining reserves, changes in the Company's estimate of ultimate
liabilities may be required. Changes in prior year reserve estimates (net of
reinsurance), which may be material, are reflected in the results of
operations in the period such changes are determined to be required.
 
  During the last several years, the Company has experienced significant
adverse development on prior years net ultimate loss estimates. The following
table sets forth the amount of the adverse development for the periods
indicated.
 
<TABLE>
<CAPTION>
                                                                   Years ended
                                                                  December 31,
                                                                 ---------------
                                                                 1998  1997 1996
                                                                 ----- ---- ----
                                                                   (dollars in
                                                                    millions)
      <S>                                                        <C>   <C>  <C>
      Net reserve re-estimates due to:
        Stop Loss Agreement..................................... $50.0   --   --
        Asbestos and environmental..............................  21.8  5.4  6.6
        All other...............................................    .1 11.0 16.3
                                                                 ----- ---- ----
          Net adverse development............................... $71.9 16.4 22.9
                                                                 ===== ==== ====
</TABLE>
 
  As a result of changes in estimates of insured events in prior years,
primarily asbestos and environmental claims, construction defect claims and
catastrophe claims, and the effects of the termination of the Stop Loss
Agreement in 1998, the provision for loss and loss adjustment expense incurred
(net of reinsurance recoveries of $69.3 million, $112.5 million and $47.8
million for 1998, 1997 and 1996, respectively) increased by $71.9 million in
1998, $16.4 million in 1997 and $22.9 million in 1996. The principal reason
for the loss reserve development in 1998 was the termination of the Stop Loss
Agreement. In addition, the emergence of environmental, asbestos and
construction defect claims over the last few years and the difficulty in
accurately estimating the necessary reserves have significantly contributed to
the Company's loss reserve development over the three year period.
 
  The Company's loss and loss adjustment expense reserves are reviewed at each
year end by the Company's actuaries and external independent actuaries in
connection with the process of establishing the Company's reserve position.
 
Liquidity and Capital Resources
 
  Highlands Group is a holding company, the principal assets of which at
December 31, 1998 are all of the capital stock of Highlands Insurance Company
and American Reliance, Inc. The Company's property and casualty insurance
business is conducted by its direct and indirect wholly-owned insurance
subsidiaries. The liquidity and capital resource considerations for the
Highlands Group are different than those of the Company's insurance
operations.
 
 Holding Company
 
  As a holding company, Highlands Group's principal requirements for funds are
to pay operating expenses, franchise and other taxes, debt service and
dividends. Operating expenses and franchise and other taxes imposed
 
                                      21
<PAGE>
 
on the Company are not expected to be material. The annual cash interest
requirements relating to the Company's outstanding 10% convertible
subordinated debentures (the "Debentures") and the loan under the Credit
Agreement are approximately $10.7 million. Highlands Group does not currently
intend to pay dividends on its Common Stock. In light of the Company's
corporate strategy, an additional use of funds may be to invest in other
insurance companies or other insurance operations. During 1998, Highlands
Group repurchased 293,500 shares of its Common Stock at an aggregate cost of
$4 million. Such repurchased shares are held in treasury.
 
  Highlands Group's principal sources of funds are dividends and tax sharing
payments from its subsidiaries, if any, and funds that may be raised from time
to time from the issuance of additional debt or equity securities. The payment
of dividends by the insurance subsidiaries is subject to restrictions and
limitations imposed by the insurance regulatory authorities. Dividend payments
to Highlands Group from its insurance subsidiaries are limited to $39.9
million in 1999 without prior regulatory approval. Both the issuance of
additional debt and the issuance of additional equity securities at a price
less than current market price would require the consent of the holders of a
majority in interest of the Debentures pursuant to the covenants contained in
the Debentures.
 
  Management believes that Highlands Group's liquid assets and access to the
capital markets enable it to meet its liquidity needs for the next year.
 
 Insurance Subsidiaries
 
  Insurance Operations. The principal sources of funds for the insurance
subsidiaries are premiums and amounts earned from the investment of such
premiums. The principal uses of funds by these subsidiaries are loss payments
and related expenses, underwriting expenses, other operating expenses and
dividends and tax sharing payments to Highlands Group.
 
  In the insurance industry, liquidity refers to the ability of an enterprise
to generate adequate amounts of cash from its operations, including its
investment portfolio, in order to meet its financial commitments, which are
principally obligations under the insurance policies it has written. Liquidity
requirements of insurance companies are influenced significantly by product
mix. Future catastrophe claims, the timing and amount of which are inherently
unpredictable, may create increased liquidity requirements for the insurance
subsidiaries. The liquidity requirements of the insurance subsidiaries are met
by that portion of the investment portfolio that is held in cash and highly
liquid securities.
 
  During the fourth quarter of 1998, the Board of Directors authorized a share
repurchase of up to $20 million of the Company's Common Stock to be conducted
by two of the Company's insurance subsidiaries, Highlands Insurance Company
and Northwestern National Casualty Company, through March 31, 1999. As of
December 31, 1998, those insurance subsidiaries purchased 430,900 shares of
Common Stock at an aggregate cost of $5.3 million.
 
  Statutory Surplus. Maintenance of appropriate levels of statutory surplus of
the Company's United States domiciled insurance subsidiaries is a primary
objective of the Company and is also important to regulatory authorities and
insurance rating agencies. In addition, increased public and regulatory
concerns regarding the financial stability of participants in the insurance
industry have caused greater emphasis to be placed by current and potential
customers upon the ratings assigned to property and casualty insurance
companies. The Company's principal insurance subsidiaries have been assigned
an A.M. Best secure rating of "B++" (Very Good). LMI, which has ceased current
operations, has been rated vulnerable--"D" (Poor).
 
  The following table sets forth certain information with respect to the
Company's combined statutory surplus ("U.S. Insurance Subsidiaries") at the
dates indicated.
<TABLE>
<CAPTION>
                               December 31,
                               -------------
                                1998   1997
                               ------  -----
                               (dollars in
                                millions)
      <S>                      <C>     <C>
      Statutory surplus....... $313.5  333.1
      Net premiums written to
       surplus ratio..........    1.2x   1.2x(1)
</TABLE>
--------
(1) Includes twelve months pro forma net premium written for American
    Reliance.
 
                                      22
<PAGE>
 
  Reinsurance Receivables. The Company monitors the financial condition of the
reinsurance companies with which it places significant reinsurance coverage
and strives to place current reinsurance coverages with financially sound
reinsurance companies. In the past, the Company has placed reinsurance
coverage with several hundred reinsurance companies. It monitors the financial
condition of many of such companies only on a periodic basis. A number of such
companies are in runoff or have ceased writing reinsurance and some have
become insolvent. The Company's ability to monitor the financial condition of
some reinsurance companies is limited because of the difficulty of acquiring
accurate and timely information.
 
  Based on the Company's evaluation of the financial condition of its
reinsurers, the Company has established reserves for potentially uncollectible
reinsurance of $1.7 million and $2.2 million as of December 31, 1998 and 1997,
respectively. Additionally, the Company has retained $22.3 million and $18.2
million of ceded reserves related to potentially uncollectible reinsurance at
December 31, 1998 and 1997. With respect to carriers that are not authorized
reinsurers as determined by the appropriate department of insurance, the
Company often receives collateral primarily in the form of bank letters of
credit generally securing the reinsurance recoverable regarding reported
losses and in some instances unreported losses. At December 31, 1998, such
collateral totaled approximately $18.9 million. The Company's three largest
reinsurance recoverable exposures at December 31, 1998 were approximately
$123.5 million with underwriting syndicates at Equitas/Lloyds (Highlands
(U.K.) $81.8 million and U.S. Insurance Subsidiaries $41.7 million), $113.7
million with American Re-Insurance Company and $70.1 million with General
Reinsurance Company. American Re-Insurance Company and General Reinsurance
Company are rated by A. M. Best "A+" and "A++", respectively.
 
Year 2000
 
  The Company is dependent on computers to process and report its business.
Information technology ("IT") systems are used for billing and collecting
premiums, issuing policies, processing claims, managing assets and reporting
financial results. A failure of the Company's IT systems to function properly
would have a material adverse effect on the Company's financial condition and
results of operations. The process of becoming ready for the Year 2000
consists of (i) identifying and assessing IT systems requiring renovation
(whether through modification or replacement); (ii) renovating systems; (iii)
validating or testing systems for Year 2000 compliance; and (iv) implementing
compliance solutions. The Company has identified and assessed its IT systems
which require renovation to properly process the Year 2000. As described
below, with respect to its most important IT systems, the Company is at
various stages of the process ranging from renovating the system to having
implemented a new system.
 
  The Company began installing a new financial and management reporting IT
system during 1998. Implementation is expected to be completed by July 1999.
 
  Because American Reliance was acquired in April 1997, it has a discrete
policy issuance and processing IT system from the rest of the Company, the
status of which is set forth separately. In 1994, American Reliance, working
with an outside vendor, began a project to create a single processing platform
for all of its business that, among other things, would be able to process its
Year 2000 business. In August 1997, Phase One of this project, covering new
and renewal business for a portion of the commercial multiple peril line and
the commercial automobile, general liability and personal lines, representing
approximately 70% of its business, began to be implemented. A combination of
internal and vendor related factors such as design errors, inadequate testing
and poor implementation led to problems with this Phase and contributed to
service problems. The Company has resolved a majority of the problems with
Phase One. Phase Two of the project, covering the balance of the commercial
multiple peril line and the workers' compensation and commercial umbrella
lines, representing the remainder of its business, was implemented with few
problems in November 1998. Although the claims processing system for policies
issued under the new American Reliance system is Year 2000 compliant, the
claims processing system for policies issued under the old system is not. The
Company is developing primary and contingent plans to address claims in the
old system. The plans are expected to be completed in April and implemented by
the end of the year.
 
                                      23
<PAGE>
 
  The Company is developing a new processing platform for its Texas business
that is Year 2000 compliant. The new platform is composed of policy
administration and claim administration subsystems. The policy administration
component, in part internally developed but substantially purchased, has been
partially implemented and commenced processing of business on a new and
renewal basis in May 1998. Conversion to the new system is expected to be
completed by July 1999. The claim administration component has been purchased
and is planned for completion in September 1999.
 
  The Company has spent approximately $2.1 million through December 31, 1998
to make its IT systems and non-IT systems Year 2000 compliant (excluding $16
million of costs associated with the development of the two processing
platforms). The Company expects to incur an additional $2 million in 1999 in
this process. The Company's insurance subsidiaries are expected to fund these
costs out of their operations. Although the Company's Year 2000 efforts have
caused it to defer certain other IT system projects, the Company does not
believe such deferral will have a material adverse effect on its financial
position and results of operations.
 
  The Company has begun identifying and assessing non-IT systems such as
telephones and other facility related systems. The assessment of these systems
will be completed in April 1999. The Company believes that it will be able to
modify, or, where appropriate, replace, these systems by September 1999. The
telephone system in Lawrenceville, New Jersey was replaced in February 1999
and the Raleigh, North Carolina system is scheduled to be replaced in July
1999.
 
  The Company relies on third party vendors for many services such as
communications, electricity and energy, banking and reinsurance. The Company
has identified the entities which are material to its operations and is
assessing whether they will be Year 2000 compliant through questionnaires and
affirmation of Year 2000 compliance. The Company expects to complete this
assessment in April 1999.
 
  The Company has made and will continue to make significant efforts to ensure
that it and its material third party vendors are Year 2000 compliant. The
effect, if any, on the Company's financial position and results of operations
from the failure of these efforts to become Year 2000 compliant cannot be
reasonably estimated.
 
  The Company's efforts have focused on renovating its IT systems, not on
preparing contingency plans if it fails in such renovation efforts. The
Company will develop contingency plans for those systems where renovation will
not be completed when required. Contingency plans for other systems and
material third party vendors which may not be Year 2000 compliant in time will
be made on a case-by-case basis as part of the assessment process for each
such system and vendor.
 
  In addition to the Company's systems, the Year 2000 issues may affect its
underlying business. The Company does not believe that Year 2000 occurrences
are covered under property and casualty policies that it issues. The Company's
insurance products are based on those developed by Insurance Services Office,
Inc. ("ISO"), which recently developed policy language that clarifies that
there is no coverage for Year 2000 occurrences. The Company has adopted the
ISO exclusionary language in states where it has been approved. In states not
accepting the ISO exclusionary language, the Company has filed its own
exclusionary language. The Company is attaching either the ISO or its own
exclusionary language to all policies with a rating classification the Company
believes could potentially have Year 2000 losses. The Company's exposure for
any such losses and expenses pursuant to policies it issues cannot be
reasonably estimated at this time.
 
  The estimated cost of the Company's Year 2000 efforts and the dates on which
it believes it will complete such efforts are based on management's best
estimates, which were derived using numerous assumptions regarding future
events, including the continued availability of certain resources, third party
remediation plans and other factors. There can be no assurance that these
estimates will prove accurate. Actual results could differ materially from
those currently anticipated. Specific factors that could cause such material
differences include: the availability and costs of personnel trained in Year
2000 issues; the ability to identify, assess, renovate and test all relevant
computer codes and embedded technology; the risk that reasonable testing will
not uncover all Year 2000 problems; and similar uncertainties.
 
                                      24
<PAGE>
 
Forward Looking Information
 
  The statements included in this 1998 Annual Report 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 this 1998 Annual Report 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 7A: Quantitative and Qualitative Disclosures about Market Risk.
 
Market Risk Disclosures for Financial Instruments
 
  Market risk is the risk of lower securities and portfolio values resulting
from adverse changes in interest rates and market prices. In addition to
market risk, the Company is exposed to other risks, including the credit risk
relating to its financial instruments and the underlying insurance risk
relating to its core business. The sensitivity analysis below summarizes only
the exposure to the market risk.
 
  The Company's investment strategy is to maximize income and total return by
investing in a diverse portfolio of high-quality investment grade securities.
As a result, the Company minimizes its credit risk.
 
  Interest Rate Risk -- The Company has exposure to market price declines
resulting from increases in interest rates. The Company attempts to mitigate
its exposure to interest rate risk through active portfolio management
including limiting average portfolio duration to approximately four years.
Market prices for all securities held are updated and reviewed monthly
including estimates of cash flows as well as the impact of interest rate
fluctuations relating to the Company's investment portfolio.
 
  Equity Price Risk -- The Company's exposure to common stock securities is
less than one-half of one percent of assets. The equity risk described in the
table below represents preferred stocks having fixed income like
characteristics.
 
  The following table illustrates the hypothetical effect of an increase in
interest rates of 100 basis points (1%) at December 31, 1998. Prior period
disclosures are not required in the initial year of disclosure. The changes in
market rates selected reflect the Company's view of changes which are
reasonably possible over a one-year period. The rates should not be considered
a prediction by the Company of future events. This analysis is not intended to
provide a precise forecast of the effect of changes in interest rates and
equity prices on the Company's income, cash flow and stockholders' equity. In
addition, the analysis does not take into account any actions the Company may
take to reduce its exposure in response to market fluctuations.
 
<TABLE>
<CAPTION>
                                                                       Adjusted
                                                                        Market
                                                                       Value as
                                                            Estimated  indicated
   December 31, 1998                                        Fair Value   above
   -----------------                                        ---------- ---------
                                                                (dollars in
                                                                 thousands)
   <S>                                                      <C>        <C>
   Interest Rate Risk:
     Fixed Maturities...................................... $1,001,236 $940,801
     Other.................................................      3,107    2,952
   Equity Price Risk:
     Equity Securities.....................................     21,057   19,237
                                                            ---------- --------
       Totals.............................................. $1,025,400 $962,990
                                                            ========== ========
</TABLE>
 
                                      25
<PAGE>
 
  In addition to the above scheduled investments, the Company's Credit
Agreement is also subject to interest rate fluctuations. An increase in
interest rates of 100 basis points (1%) would result in additional annual
interest expense of $650,000.
 
  Certain assumptions are inherent in the above analysis. The Company assumes
an instantaneous shift in interest rates and equity prices at December 31,
1998 and that the composition of its investment portfolio remains relatively
constant. Also, the Company assumes a change in interest rates is reflected
uniformly across all financial instruments even though interest rates on
certain types of instruments may fluctuate or lag behind other instruments.
 
ITEM 8: Financial Statements and Supplemental Data.
 
  The Consolidated Financial Statements are set forth herein beginning on page
F-1 of this Report.
 
ITEM 9: Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
 
  None.
 
                                   PART III
 
ITEM 10: Directors and Executive Officers of the Registrant.
 
  This item is omitted because a definitive proxy statement which involves the
election of directors and which contains the information required by this item
will be filed with the Securities and Exchange Commission not later than 120
days after the close of the fiscal year, and is incorporated herein by
reference.
 
ITEM 11: Executive Compensation.
 
  This item is omitted because a definitive proxy statement which involves the
election of directors and which contains the information required by this item
will be filed with the Securities and Exchange Commission not later than 120
days after the close of the fiscal year, and is incorporated herein by
reference.
 
ITEM 12: Security Ownership of Certain Beneficial Owners and Management.
 
  This item is omitted because a definitive proxy statement which involves the
election of directors and which contains the information required by this item
will be filed with the Securities and Exchange Commission not later than 120
days after the close of the fiscal year, and is incorporated herein by
reference.
 
ITEM 13: Certain Relationships and Related Transactions.
 
  This item is omitted because a definitive proxy statement which involves the
election of directors and which contains the information required by this item
will be filed with the Securities and Exchange Commission not later than 120
days after the close of the fiscal year, and is incorporated herein by
reference.
 
                                      26
<PAGE>
 
                                    PART IV
 
ITEM 14: Financial Statements, Exhibits and Reports on Form 8-K.
 
  (a) (1) and (2) Financial Statements. The Consolidated Financial Statements
and Schedules are listed in the Index to Financial Statements on page F-1 and
are filed as part of this Report.
 
  (a) (3) Exhibits.
 
<TABLE>
 <C>     <S>
   *2.1  Amended and Restated Agreement and Plan of Merger among Highlands
         Insurance Group, Inc., Highlands Acquisition Corp. and Vik Brothers
         Insurance, Inc. dated as of February 13, 1997
   *2.2  Amendment No. 1 to the Amended and Restated Plan of Merger dated March
         10, 1997
   +3.1  Amended and Restated Certificate of Incorporation of the Registrant
   +3.2  Form of Amended and Restated Bylaws of the Registrant
   +4.1  Form of Stock Certificate of Common Stock (See also Exhibits 3.1 and
         3.2)
   +4.2  Form of 10% Convertible Subordinated Debentures Due December 31, 2005
   +4.3  Form of Common Stock Subscription Warrant, Series A
   +4.4  Form of Common Stock Subscription Warrant, Series B
   +4.5  Form of 10% Convertible Subordinated Debentures Due December 31, 2005,
         Series 2
   +4.6  Form of Common Stock Subscription Warrant, Series A-2
   +4.7  Form of Common Stock Subscription Warrant, Series B-2
   *4.8  Stockholders Agreement among Highlands Insurance Group, Inc.,
         Insurance Partners, L.P., Insurance Partners Offshore (Bermuda) L.P.,
         The Scandinavia Company, Erik M. Vik and Manoeuvre Ltd.
   *4.9  Form of Amendment Number 1 to 10% Convertible Subordinated Debenture,
         Due December 31, 2005 of Highlands Insurance Group, Inc.
   *4.10 Form of Amendment Number 1 to 10% Convertible Subordinated Debenture,
         Series 2, Due December 31, 2005 of Highlands Insurance Group, Inc.
   *4.11 Form of Amendment Number 1 to Common Stock Subscription Warrant,
         Series A
   *4.12 Form of Amendment Number 1 to Common Stock Subscription Warrant,
         Series B
   *4.13 Form of Amendment Number 1 to Common Stock Subscription Warrant,
         Series A-2
   *4.14 Form of Amendment Number 1 to Common Stock Subscription Warrant,
         Series B-2
  +10.1  Distribution Agreement among Halliburton and the Registrant dated as
         of October 10, 1995 (exhibits omitted)
  +10.2  Investment Agreement among the Registrant, Halliburton and the
         Investors, dated as of October 10, 1995 (exhibits and schedules
         omitted)
  *10.3  Credit Agreement among Highlands Insurance Group, Inc., Various
         Lending Institutions and The Chase Manhattan Bank, as Administrative
         Agent, dated April 30, 1997
  +10.4  Form of Insurance Products and Services Agreement (schedules omitted)
  +10.5  Form of Employee Benefit Matters Agreement
  +10.6  Form of Transition Agreement
  +10.7  Form of Registration Rights Agreement to be entered into among
         Insurance Partners, L.P., Insurance Partners Offshore (Bermuda), L.P.
         and the Registrant
  +10.8  Form of 1995 Stock Option Plan
 **10.9  Restricted Stock Plan
  +10.10 Form of Employment Agreement to be entered into between the Registrant
         and Richard M. Haverland
  +10.11 Form of Indemnification Agreement to be entered into between the
         Registrant and each of its directors
  +10.12 Form of 1995 Directors' Stock Plan
  +10.13 Amendatory Agreement dated as of November 9, 1995 among the Company,
         Halliburton, the Investors, Robert A. Spass and Bradley E. Cooper
         (amending the Investment Agreement)
</TABLE>
 
 
                                       27
<PAGE>
 
<TABLE>
 <C>      <S>
   +10.14 Form of note to be issued in consideration for the issuance by the
          Registrant of 10% Convertible Subordinated Debentures Due December
          31, 2005, Series 2, Common Stock Subscription Warrants, Series A-2,
          and Common Stock Subscription Warrants, Series B-2
   +10.15 Form of pledge agreement to secure the note filed as Exhibit 10.14
   +10.16 Form of Purchase, Redemption and Bonus Agreement to be entered into
          between the Company and the Management Investors with respect to the
          Management Securities
   *10.17 Registration Rights Agreement between Highlands Insurance Group, Inc.
          and American Re-Insurance Company dated April 30, 1997
   *10.18 Registration Rights Agreement among Highlands Insurance Group, Inc.,
          the Scandinavia Company, Inc., Erik M. Vik, Manoeuvre Ltd. and
          Triumph-Connecticut Limited Partnership and Alexander M. Vik dated
          April 30, 1997
 ***10.20 Agency Stock Purchase Plan
  ++10.21 Employee Stock Purchase Plan
  ++10.22 Employees' Retirement And Savings Plan
    21.1  List of Subsidiaries
    23.1  Consent of Independent Auditors
    27    Financial Data Schedule (included only in the electronic data filing
          of this document)
</TABLE>
--------
  + Incorporated by reference to the Company's registration statement on Form
    10 as filed with the Commission on January 4, 1996.
 
  * Incorporated by reference to the Company's Report on Form 8-K, as amended,
    dated April 30, 1997 as filed with the Commission.
 
 ** Incorporated by reference to the Company's Report on Form 10-K, for the
    fiscal year ended December 31, 1998 as filed with the Commission.
 
*** Incorporated by reference to the Company's registration statement on Form
    S-3 as filed with the Commission on May 1, 1998.
 
 ++ Incorporated by reference to the Company's registration statement on Form
    S-8 as filed with the Commission on June 1, 1998
 
  (b) Reports on Form 8-K during the quarter ended December 31, 1998.
 
  None.
 
                                      28
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
 
                                                  Highlands Insurance Group,
                                                   Inc.
 
                                          By:   /s/ Richard M. Haverland
                                             ----------------------------------
                                              Richard M. Haverland,
                                              Chairman, President and Chief
                                              Executive Officer
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
 
<TABLE>
<S>  <C> <C>
</TABLE>
              Signature                      Title                   Date
 
   /s/ Richard M. Haverland          Chairman, President       March 31, 1999
-----------------------------------   and Chief Executive
       Richard M. Haverland           Officer
 
   /s/  Charles J. Bachand           Vice President,           March 31, 1999
-----------------------------------   Treasurer and
        Charles J. Bachand            Principal Financial
                                      and Accounting
                                      Officer
 
   /s/    Robert A. Spass            Director                  March 31, 1999
-----------------------------------
          Robert A. Spass
 
   /s/   Bradley E. Cooper           Director                  March 31, 1999
-----------------------------------
         Bradley E. Cooper
 
   /s/   W. Bernard Pieper           Director                  March 31, 1999
-----------------------------------
         W. Bernard Pieper
 
   /s/   Kenneth S. Crews            Director                  March 31, 1999
-----------------------------------
         Kenneth S. Crews
 
   /s/    Philip J. Hawk             Director                  March 31, 1999
-----------------------------------
          Philip J. Hawk
 
   /s/   Robert W. Shower            Director                  March 31, 1999
-----------------------------------
         Robert W. Shower
<PAGE>
 
                  INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
 
<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
<S>                                                                         <C>
Audited Financial Statements
  Report of Independent Public Accountants.................................  F-2
  Consolidated Balance Sheets as of December 31, 1998 and 1997.............  F-3
  Consolidated Statements of Operations for the Years Ended December 31,
   1998, 1997 and 1996.....................................................  F-4
  Consolidated Statements of Stockholders' Equity for the Years Ended
   December 31, 1998, 1997
   and 1996................................................................  F-5
  Consolidated Statements of Comprehensive Income for the Years Ended
   December 31, 1998, 1997
   and 1996................................................................  F-6
  Consolidated Statements of Cash Flows for the Years Ended December 31,
   1998, 1997 and 1996.....................................................  F-7
  Notes to Consolidated Financial Statements...............................  F-8
 
Financial Statement Schedules
  Schedule I--Summary of Investments Other Than Investments in Related
   Parties--
   December 31, 1998....................................................... F-28
  Schedule II--Condensed Financial Information of Registrant (Parent
   Company only):
    Balance Sheets--As of December 31, 1998 and 1997....................... F-29
    Statements of Operations--For the Years Ended December 31, 1998, 1997
     and 1996.............................................................. F-30
    Statements of Cash Flows--For the Years Ended December 31, 1998, 1997
     and 1996.............................................................. F-31
  Schedule III--Supplementary Insurance Information--As of and For the
   Years Ended
   December 31, 1998, 1997 and 1996........................................ F-32
  Schedule IV--Reinsurance--For the Years Ended December 31, 1998, 1997 and
   1996.................................................................... F-33
  Schedule V--Valuation and Qualifying Accounts--For the Years Ended
   December 31, 1998, 1997
   and 1996................................................................ F-34
  Schedule VI--Supplemental Information Concerning Consolidated
   Property/Casualty Insurance Operations--As of and For the Years Ended
   December 31, 1998, 1997 and 1996........................................ F-35
</TABLE>
 
                                      F-1
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
To the Board of Directors
Highlands Insurance Group, Inc.:
 
  We have audited the accompanying consolidated balance sheets of Highlands
Insurance Group, Inc. and subsidiaries (the Company) as of December 31, 1998
and 1997 and the related consolidated statements of operations, stockholders'
equity, comprehensive income, and cash flows for each of the years in the
three-year period ended December 31, 1998. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Highlands
Insurance Group, Inc. and subsidiaries as of December 31, 1998 and 1997 and
the results of their operations and their cash flows for each of the years in
the three-year period ended December 31, 1998 in conformity with generally
accepted accounting principles.
 
  Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedules listed in the Index to
Financial Statements and Schedules that pertain to December 31, 1998, 1997 and
1996 and for the years then ended are presented for the purpose of complying
with the Securities and Exchange Commission's rules and are not part of the
basic financial statements. These schedules have been subjected to the
auditing procedures applied in the audit of the basic financial statements
and, in our opinion, fairly state in all material respects the financial data
required to be set forth therein in relation to the basic financial statements
taken as a whole.
 
                                          KPMG LLP
 
Houston, Texas
March 26, 1999
 
                                      F-2
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
                           DECEMBER 31, 1998 AND 1997
                                 (in thousands)
 
<TABLE>
<CAPTION>
                         ASSETS                             1998       1997
                         ------                          ----------  ---------
<S>                                                      <C>         <C>
Investments:
  Fixed maturity securities available-for-sale, at fair
   value (amortized cost of $975,858 in 1998 and
   $1,132,249 in 1997).................................. $1,001,236  1,166,585
  Equity securities, at fair value (cost of $20,585 in
   1998 and $1,410 in 1997).............................     21,057      1,554
  Other investments, at cost............................      3,107      4,061
                                                         ----------  ---------
    Total investments...................................  1,025,400  1,172,200
Cash and cash equivalents...............................     70,747     60,717
Premiums in course of collection, net...................     51,138     84,977
Premiums due under retrospectively rated policies.......    144,613    130,150
Receivable from reinsurers..............................    787,344    723,114
Prepaid reinsurance premiums............................      2,523     24,451
Funds on deposit with reinsurers........................     17,873     20,172
Net deferred tax asset..................................     70,433     64,043
Accrued investment income...............................     13,916     16,459
Deferred policy acquisition costs.......................     31,537     32,313
Other assets............................................     49,519     38,060
                                                         ----------  ---------
    Total assets........................................ $2,265,043  2,366,656
                                                         ==========  =========
          LIABILITIES AND STOCKHOLDERS' EQUITY
          ------------------------------------
Loss and loss adjustment expense reserves............... $1,603,548  1,605,374
Unearned premiums.......................................    137,353    173,411
Senior bank debt........................................     65,000     65,000
Convertible subordinated debentures.....................     57,017     56,229
Funds held..............................................     14,049     24,023
Accounts payable and accrued liabilities................     69,522    113,326
                                                         ----------  ---------
    Total liabilities...................................  1,946,489  2,037,363
                                                         ----------  ---------
Commitments and contingent liabilities
 
Stockholders' equity:
  Common stock, $.01 par value; 50,000,000 shares
   authorized, 13,235,316 shares issued and outstanding
   in 1998, 13,187,273 shares issued and outstanding in
   1997.................................................        132        132
  Additional paid-in capital............................    223,976    223,460
  Accumulated other comprehensive income................     16,803     22,278
  Treasury stock, at cost (724,400 shares in 1998)......     (9,268)        --
  Deferred compensation on restricted stock.............     (1,074)    (1,465)
  Retained earnings.....................................     87,985     84,888
                                                         ----------  ---------
    Total stockholders' equity..........................    318,554    329,293
                                                         ----------  ---------
    Total liabilities and stockholders' equity.......... $2,265,043  2,366,656
                                                         ==========  =========
</TABLE>
 
The accompanying notes to the consolidated financial statements are an integral
                           part of these statements.
 
                                      F-3
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                  (in thousands, except per common share data)
 
<TABLE>
<CAPTION>
                                                      1998     1997    1996
                                                    --------  ------- -------
<S>                                                 <C>       <C>     <C>
Revenues:
  Net premiums earned.............................. $388,813  311,993 152,048
  Net investment income............................   77,969   74,383  50,988
  Net realized investment gains....................   16,874    5,585   1,199
                                                    --------  ------- -------
    Total revenues.................................  483,656  391,961 204,235
                                                    --------  ------- -------
Expenses:
  Loss and loss adjustment expense incurred........  328,400  246,479 156,589
  Underwriting expenses............................  141,788  115,564  56,487
  Debt interest and amortization expense...........   12,258   10,542   6,903
  Other expenses, net..............................    2,000      857   1,697
                                                    --------  ------- -------
    Total expenses.................................  484,446  373,442 221,676
                                                    --------  ------- -------
Income (loss) before income taxes..................     (790)  18,519 (17,441)
Income tax expense (benefit).......................   (3,887)   1,683 (12,098)
                                                    --------  ------- -------
    Net income (loss).............................. $  3,097   16,836  (5,343)
                                                    ========  ======= =======
Earnings (loss) per common share:
  Basic............................................ $    .24     1.34    (.47)
  Diluted.......................................... $    .20     1.09    (.47)
Weighted average number of common shares
 outstanding:
  Basic............................................   13,095   12,600  11,448
  Diluted..........................................   15,811   15,388  11,448
</TABLE>
 
 
The accompanying notes to the consolidated financial statements are an integral
                           part of these statements.
 
                                      F-4
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                      1998     1997     1996
                                                    --------  -------  -------
<S>                                                 <C>       <C>      <C>
Common Stock:
 Balance, beginning of year........................ $    132      114    1,000
  Change in par value of common stock..............       --       --     (886)
  Issuance of common stock, par value..............       --       18       --
                                                    --------  -------  -------
 Balance, end of year..............................      132      132      114
                                                    --------  -------  -------
Additional paid-in capital:
 Balance, beginning of year........................  223,460  192,273  184,168
  Addition resulting from issuance of convertible
   subordinated debentures.........................       --       --    7,439
  Change in par value of common stock..............       --       --      886
  Contribution from former parent:
   Net current tax asset...........................       --       --    7,723
   Net deferred tax asset..........................       --       --   (7,943)
  Issuance of common stock, paid in capital........      516   31,187       --
                                                    --------  -------  -------
 Balance, end of year..............................  223,976  223,460  192,273
                                                    --------  -------  -------
Accumulated other comprehensive income:
 Balance, beginning of year........................   22,278    3,036    8,547
  Changes in net unrealized gain, net of tax.......   (5,475)  19,242   (5,511)
                                                    --------  -------  -------
 Balance, end of year..............................   16,803   22,278    3,036
                                                    --------  -------  -------
Treasury stock, at cost:
 Balance, beginning of year........................       --       --       --
  Acquisition of treasury stock....................   (9,268)      --       --
                                                    --------  -------  -------
 Balance, end of period............................   (9,268)      --       --
                                                    --------  -------  -------
Deferred compensation on restricted stock:
 Balance, beginning of year........................   (1,465)      --       --
  Net forfeitures (issuance) of restricted stock...      391   (1,465)      --
                                                    --------  -------  -------
 Balance, end of year..............................   (1,074)  (1,465)      --
                                                    --------  -------  -------
Retained earnings:
 Balance, beginning of year........................   84,888   68,052   73,395
  Net income (loss)................................    3,097   16,836   (5,343)
                                                    --------  -------  -------
 Balance, end of period............................   87,985   84,888   68,052
                                                    --------  -------  -------
Total stockholders' equity......................... $318,554  329,293  263,475
                                                    ========  =======  =======
</TABLE>
 
The accompanying notes to the consolidated financial statements are an integral
                           part of these statements.
 
                                      F-5
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                             (dollars in thousands)
 
<TABLE>
<CAPTION>
                                                        1998     1997   1996
                                                       -------  ------ -------
<S>                                                    <C>      <C>    <C>
Net income (loss)..................................... $ 3,097  16,836  (5,343)
                                                       -------  ------ -------
Other comprehensive income, net of taxes:
  Increase (decrease) in unrealized gain on
   investments net of taxes of $6,138; $13,368; and
   $(2,322)...........................................  11,399  24,827  (4,312)
  Less: reclassification adjustments for gains in net
   income.............................................  16,874   5,585   1,199
                                                       -------  ------ -------
  Other comprehensive income, net of taxes............  (5,475) 19,242  (5,511)
                                                       -------  ------ -------
Comprehensive income (loss)........................... $(2,378) 36,078 (10,854)
                                                       =======  ====== =======
</TABLE>
 
 
 
The accompanying notes to the consolidated financial statements are an integral
                           part of these statements.
 
                                      F-6
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                    1998      1997      1996
                                                  --------  --------  --------
<S>                                               <C>       <C>       <C>
Cash flows from operating activities:
 Net income (loss)..............................  $  3,097    16,836    (5,343)
                                                  --------  --------  --------
 Adjustments to reconcile net income (loss) to
  net cash used in operating activities:
  Depreciation and amortization.................     3,453     2,054     1,112
  Net realized investment gains.................   (16,874)   (5,585)   (1,199)
  Change in:
  Premiums in course of collection..............    33,839    19,972    16,911
  Premiums due under retrospective policies.....   (14,463)   (8,874)   13,152
  Receivable from reinsurers....................   (64,230)     (303)   45,480
  Prepaid reinsurance premiums..................    21,928    19,634     4,100
  Funds on deposit with reinsurers..............     2,299    (5,716)      993
  Net deferred tax asset........................    (3,443)    1,516   (12,098)
  Deferred policy acquisition costs.............       776     3,623     5,308
  Loss and loss adjustment expense reserves.....    (1,826)  (72,170)  (96,803)
  Unearned premiums.............................   (36,058)  (36,019)  (21,097)
  Funds held....................................    (9,974)    7,548    (6,227)
  Other operating assets and liabilities........   (49,705)    2,513     3,070
                                                  --------  --------  --------
   Total adjustments............................  (134,278)  (71,807)  (47,298)
                                                  --------  --------  --------
   Net cash used in operating activities........  (131,181)  (54,971)  (52,641)
                                                  --------  --------  --------
Cash flows from investing activities:
 Proceeds from sales:
  Fixed maturity securities available-for-sale..   409,954   140,985        --
  Equity securities.............................       986    26,767     4,726
  Other investments.............................       842     1,559        --
 Maturities or calls:
  Fixed maturity securities available-for-sale..   155,698   163,907    27,168
  Fixed maturity securities held-to-maturity....        --     5,972    40,162
 Investment purchases:
  Fixed maturity securities available-for-sale..  (392,686) (306,180) (131,559)
  Fixed maturity securities held-to-maturity....        --        --   (20,220)
  Equity securities.............................   (18,337)       --    (2,282)
 Net purchases of property and equipment........    (6,134)   (6,793)   (1,337)
 Acquisition of subsidiary, net of cash
  acquired......................................        --     5,124        --
 Payment of acquisition expenses................        --    (3,730)       --
 Other proceeds.................................        --        92        --
 Proceeds from disposal of subsidiary, net......        --    10,000        22
 Cash returned by former affiliates, net........        --        --     3,800
                                                  --------  --------  --------
  Net cash provided by (used in) investing
   activities...................................   150,323    37,703   (79,520)
                                                  --------  --------  --------
Cash flows from financing activities:
  Proceeds from senior bank debt................        --    65,000        --
  Repayment of acquired bank debt...............        --   (35,638)       --
  Payment for debt issuance expense.............      (675)   (1,017)   (5,705)
  Issuance of common stock......................       831       156        --
  Acquisition of treasury stock.................    (9,268)       --        --
  Proceeds from convertible subordinated
   debentures...................................        --        --    60,000
  Contribution from former parent for net
   current tax asset............................        --        --    42,174
                                                  --------  --------  --------
  Net cash (used in) provided by financing
   activities...................................    (9,112)   28,501    96,469
                                                  --------  --------  --------
Net increase (decrease) in cash and cash
 equivalents....................................    10,030    11,233   (35,692)
Cash and cash equivalents at beginning of year..    60,717    49,484    85,176
                                                  --------  --------  --------
Cash and cash equivalents at end of year........  $ 70,747    60,717    49,484
                                                  ========  ========  ========
Supplemental disclosure of cash flow
 information:
  Interest paid.................................  $ 10,603     8,803     5,639
                                                  ========  ========  ========
  Reclassification of fixed income securities
   from held-to-maturity to available for sale..  $     --   348,130        --
                                                  ========  ========  ========
</TABLE>
The accompanying notes to the consolidated financial statements are an integral
                           part of these statements.
 
                                      F-7
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 
1. Summary of Significant Accounting Policies:
 
 Basis of Reporting and Operations
 
  The accompanying consolidated financial statements include the accounts of
Highlands Insurance Group, Inc., (Highlands Group) and its subsidiaries (the
Company). Highlands Group is an insurance holding company for Highlands
Insurance Company and its subsidiaries (Highlands), American Reliance, Inc.
and its subsidiaries (American Reliance) beginning April 30, 1997, 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 (collectively, the Insurance Subsidiaries). 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.
 
  Highlands Group was wholly-owned by Halliburton Company (Halliburton) until
January 23, 1996 when Halliburton distributed all of the outstanding shares of
common stock of Highlands Group (the Distribution) to holders of record of
common stock of Halliburton on January 4, 1996. Holders of record received one
share of common stock of Highlands Group for every ten shares of common stock
of Halliburton held on that date. Approximately 11.4 million common shares of
Highlands Group were issued in conjunction with the Distribution.
 
  The accompanying consolidated financial statements are presented in
accordance with generally accepted accounting principles. Certain items in the
December 31, 1997 and 1996 consolidated financial statements have been
reclassified to conform to the current years presentation. Such
reclassifications had no impact on stockholders' equity or operations as
previously reported.
 
 Net Premiums Earned
 
  Insurance premiums on property and casualty insurance contracts are earned
ratably over the terms of the policies after estimated adjustments for
retrospectively rated policies and a deduction for ceded insurance.
 
 Loss and Loss Adjustment Expense Reserves
 
  Loss and loss adjustment expense reserves are based on (a) case basis
estimates for claims reported on direct business, adjusted in the aggregate
for ultimate loss expectations, (b) estimates of incurred but not reported
(IBNR) claims based upon past experience, (c) estimates of assumed insurance
losses, (d) estimates of future expenses to be incurred in settlement of
claims and (e) estimates of claim recoveries. In establishing these estimates,
consideration is given to current conditions and trends as well as past
Company and industry experience.
 
  Loss and loss adjustment expense reserves are based on estimates, and the
ultimate liability may vary significantly from such estimates (see note 11).
Any adjustments that are made to the reserves are reflected in the
consolidated statements of operations in the year such adjustments are known.
 
 Deferred Acquisition Costs
 
  Costs of acquiring insurance business which vary with and are primarily
related to the production of such business are deferred. Such costs include
commissions, premium taxes and certain underwriting and policy issuance costs.
Deferred acquisition costs are amortized ratably over the period the related
premiums are earned. Anticipated investment income and product line
profitability are considered in the determination of the recoverability of
deferred acquisition costs. Amortization of deferred acquisition costs were
$71.5 million, $61.7 million and $28.8 million for the years ended December
31, 1998, 1997 and 1996, respectively.
 
                                      F-8
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 Investments
 
  In connection with the acquisition of Vik Brothers Insurance, Inc. (see note
2), the Company classified its entire investment portfolio as available-for-
sale effective April 30, 1997. At April 30, 1997, fixed maturity securities
with an amortized cost of $348 million and a fair value of $355 million which
were previously classified as held-to-maturity were reclassified as available-
for-sale. Investments classified as available-for-sale are carried at fair
value. Unrealized gains and losses on available-for-sale investments are
reported within accumulated other comprehensive income as a separate component
of stockholders' equity, net of applicable deferred taxes. Fixed income
securities may be sold to take advantage of investment opportunities generated
by changing interest rates, prepayments and tax and credit considerations, as
part of the Company's asset/liability strategy, or for similar factors. As a
result, the Company considers all of its fixed maturity securities (bonds and
redeemable preferred stocks) and all equity securities as available-for-sale.
The amortized cost of debt securities is adjusted for amortization of premiums
and accretion of discounts to expected maturity. Such amortization and
accretion are included in net investment income.
 
  The cost of each security sold was specifically identified in computing the
related gain or loss. The Company continually monitors the difference between
the cost and estimated fair value of the investments. When impairment of the
value of an investment is considered other than temporary, the decrease in
value is reported in earnings as a realized investment loss and a new cost
basis is established.
 
 Cash and Cash Equivalents
 
  The Company defines cash equivalents as short-term, highly liquid
investments that are readily convertible to known amounts of cash. In general,
only investments with original maturities of three months or less qualify as
cash equivalents.
 
 Debt Issuance Costs
 
  Deferred financing and related costs consist of capitalized fees associated
with the $65 million senior revolving credit facility and the issuance of
$62.85 million in principal amount of 10% convertible subordinated debentures
(Debentures). These costs include underwriting, legal and accounting fees.
Debt issuance costs of $5.6 million were capitalized in connection with the
above and are being amortized on the straight line basis and charged to income
over the remaining life of each instrument.
 
 Certain Risks and Uncertainties
 
  The preparation of these financial statements requires management to make
estimates and assumptions as of the date of the financial statements that
affect the reported amounts of assets and liabilities as well as disclosures
of contingent assets and liabilities. Management must make estimates and
assumptions that affect amounts of revenues and expenses for the reporting
period, primarily for loss and loss adjustment expense incurred. Management
must also make estimates and assumptions in determining reinsurance
collectibility and in determining litigation accruals. Actual results could
differ from these estimates. Future events, which could impact the estimates
used in these financial statements, include inflationary pressures that may
tend to affect the amount of loss; judicial, legislative and regulatory
decisions affecting insurers' liabilities; and fluctuations in interest rates.
 
                                      F-9
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
 Accounting Standards
 
  In 1997, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS 128). SFAS
128 replaced the calculation of primary and fully diluted earnings per share
with basic and diluted earnings per share. Unlike primary earnings per share,
basic earnings per share excludes any dilutive effects of options, warrants
and convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings per share
amounts for all periods have been presented and, where appropriate, restated
to conform to the SFAS 128 requirements.
 
  In June 1997, FASB issued Statement of Financial Accounting Standards No.
130, "Comprehensive Income" (SFAS 130). SFAS 130 establishes standards for the
reporting and disclosure of comprehensive income and its components (revenues,
expenses, gains and losses). SFAS 130 requires that all items that are
required to be recognized under accounting standards as components of
comprehensive income be reported in the financial statements. SFAS 130
requires that an enterprise (a) classify items of other comprehensive income
by their nature in the financial statements and (b) display the accumulated
balance of other comprehensive income separately from retained earnings and
additional paid-in capital in the equity section of the balance sheet.
Unrealized investment gains and losses is Highlands Group's significant item
of other comprehensive income. SFAS 130 is effective for fiscal years
beginning after December 15, 1997. The Company has presented a consolidated
statement of comprehensive income.
 
  In June 1997, FASB issued Statement of Financial Accounting Standards
Statement No. 131, "Disclosure about Segments of an Enterprise and Related
Information" (SFAS 131). SFAS 131 establishes standards for public business
enterprises to report information about operating segments in annual financial
statements. SFAS 131 requires that those enterprises report selected
information about operating segments in interim financial reports issued to
stockholders. SFAS 131 is effective for fiscal years beginning after December
15, 1997. For reporting purposes, the Company has one segment.
 
  In December 1997, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants (AcSEC) issued Statement of
Position (SOP) 97-3, "Accounting by Insurance and Other Enterprises for
Insurance-Related Assessments." This statement provides guidance for the
recording of a liability for insurance-related assessments. The statement
requires that a liability be recorded when all of the following conditions
have been met: an assessment has been imposed or it is probable that an
assessment will be imposed; the event obligating an entity to pay an imposed
or probable assessment has occurred on or before the date of the financial
statements; and the amount of the assessment can be reasonably estimated. This
statement is effective for fiscal years beginning after December 15, 1998. The
Company anticipates that the adoption of the provisions of SOP 97-3 will not
have a material impact on results of operations, financial condition or cash
flows.
 
  In March 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." This statement specifies the
types of costs that must be capitalized and amortized over the software's
expected useful life and the types of costs which must be immediately
recognized as expense. For purposes of this SOP, internal-use software is
software acquired, internally developed or modified solely to meet the
entity's internal needs for which no substantive plan exists or is being
developed to market the software externally during the software's development
or modification. Certain internal and external costs incurred to develop
internal-use computer software that relate to system design, software
configuration and interfaces, coding, testing and installation to hardware
should generally be capitalized. This statement is effective for fiscal years
beginning after December 15, 1998. The Company's current policy is to
capitalize such costs and therefore anticipates that the adoption of the
provisions of SOP 98-1 will not have a material impact on results of
operations, financial condition or cash flows.
 
                                     F-10
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
2. Business Acquisition
 
  On April 30, 1997, Highlands Group acquired Vik Brothers Insurance, Inc. and
its subsidiaries (VBI). Immediately after the consummation of the acquisition,
VBI was renamed American Reliance, Inc. The acquisition was accounted for as a
purchase and, accordingly, the financial results of American Reliance, Inc.
and subsidiaries (American Reliance) are included in these consolidated
financial statements effective April 30, 1997.
 
  The acquisition was financed with a combination of common stock, bank debt,
preferred stock and cash. In connection with the acquisition, Highlands Group
paid approximately $55.4 million in cash (including $35.6 million to repay
American Reliance's outstanding bank debt), issued 1,656,700 shares of its
common stock (representing approximately 12.6% of Highlands Group's then
outstanding common stock) and issued 21,366 shares of newly issued series one
preferred stock to the holders of the common stock warrants, preferred
stockholders and creditors of American Reliance. The closing price of
Highlands Group's common stock was $17.625 on April 30, 1997. The preferred
stock is currently owned by a subsidiary of American Reliance and has a
preference value of $1,000 per share. Simultaneously with the closing,
Highlands Group contributed approximately $41.5 million to the capital of the
insurance companies within the American Reliance organization.
 
  In connection with the acquisition, Highlands Group obtained a $65 million
senior revolving credit facility from a consortium of banks led by The Chase
Manhattan Bank (Credit Agreement). Highlands Group funded the cash portion of
the acquisition and capital contribution by utilizing the credit facility and
available working capital.
 
  American Reliance is an insurance holding company for the following property
and casualty insurance companies: Northwestern National Casualty Company
(NNCC); Pacific National Insurance Company (PNIC); Pacific Automobile
Insurance Company (PAIC); State Capital Insurance Company (SCIC); American
Professionals Insurance Company (APIC); NN Insurance Company (NNIC); Statesman
Insurance Company (SIC); and LMI Insurance Company (LMI).
 
3. Disposal of Assets
 
  In December 1997, the Company sold its management contract, which
established control over Northwestern National Casualty Mutual (NNCM), to an
independent purchaser. NNCM, a Texas county mutual insurance company that
wrote non-standard personal automobile insurance business in Texas, was 100%
reinsured by NNCC. In a separate transaction, all of the existing in force
business of NNCM, including the outstanding unearned premium reserves and
outstanding loss reserves, the renewal rights and broker agreements, were
transferred to an independent purchaser. Highlands Group has provided a
partial guarantee (up to $1.3 million) of the adequacy of the loss reserves.
 
  Total proceeds to the Company from both transactions were $13.5 million.
NNCC's historical cost basis for the assets being sold did not exceed $2.5
million. These transactions were part of the fair value allocation of the
purchase price of American Reliance.
 
                                     F-11
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
4. American Reliance Acquisition--Pro Forma Results of Operations
 
  The following unaudited pro forma information presents the results of
operations of the Company and American Reliance for the years ended December
31, 1997 and 1996, with pro forma adjustments as if the acquisition and
transactions related to the funding of the acquisition had been consummated as
of the beginning of the periods presented. This pro forma information is not
necessarily indicative of what would have occurred had the acquisition and
related transactions been made on the dates indicated, or of future results of
the Company.
 
<TABLE>
<CAPTION>
                                                                 Years Ended
                                                                 December 31,
                                                               ----------------
                                                                 1997    1996
                                                               -------- -------
                                                                (In thousands,
                                                                    except
                                                               per share data)
      <S>                                                      <C>      <C>
      Revenues................................................ $507,038 571,845
      Net income (loss)....................................... $ 18,372 (68,574)
      Basic earnings (loss) per share......................... $   1.46   (5.23)
      Diluted earnings (loss) per share....................... $   1.19   (5.23)
</TABLE>
 
5. Investments and Investment Income
 
  Net investment income for the years ended December 31, 1998, 1997 and 1996
is comprised of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                            1998    1997   1996
                                                           ------- ------ ------
      <S>                                                  <C>     <C>    <C>
      Gross investment income:
        Fixed maturity securities......................... $74,075 68,074 43,558
        Equity securities.................................     517  2,073  2,180
        Cash equivalents..................................   3,993  4,997  5,807
        Other investments.................................      57    372     54
                                                           ------- ------ ------
          Gross investment income.........................  78,642 75,516 51,599
        Investment expenses...............................     673  1,133    611
                                                           ------- ------ ------
          Net investment income........................... $77,969 74,383 50,988
                                                           ======= ====== ======
</TABLE>
 
                                     F-12
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
  The following is a summary of available-for-sale securities as of December
31, 1998 and 1997 (in thousands):
 
<TABLE>
<CAPTION>
                                                           Gross
                                                        Unrealized
                                            Amortized  -------------    Fair
                                               Cost    Gains  Losses    Value
                                            ---------- ------ ------  ---------
<S>                                         <C>        <C>    <C>     <C>
December 31, 1998--
  Fixed maturities available-for-sale:
    United States Government and government
     agencies.............................. $  202,499  3,076    (63)   205,512
    States, municipalities and political
     subdivisions..........................     57,227  4,035    (73)    61,189
    Mortgage-backed securities.............    407,565  8,688 (1,242)   415,011
    Corporate securities...................    307,479 11,665   (734)   318,410
    Foreign governments....................         88     26     --        114
    Sinking fund preferred stock...........      1,000     --     --      1,000
                                            ---------- ------ ------  ---------
                                               975,858 27,490 (2,112) 1,001,236
Equity securities..........................     20,585    487    (15)    21,057
                                            ---------- ------ ------  ---------
                                            $  996,443 27,977 (2,127) 1,022,293
                                            ========== ====== ======  =========
December 31, 1997--
  Fixed maturities available-for-sale:
    United States Government and government
     agencies.............................. $  272,708  3,812   (115)   276,405
    States, municipalities and political
     subdivisions..........................    174,587 14,945     (6)   189,526
    Mortgage-backed securities.............    411,469  6,649   (563)   417,555
    Corporate securities...................    272,908  9,996   (417)   282,487
    Foreign governments....................         89     27     --        116
    Sinking fund preferred stock...........        488      8     --        496
                                            ---------- ------ ------  ---------
                                             1,132,249 35,437 (1,101) 1,166,585
  Equity securities........................      1,410    162    (18)     1,554
                                            ---------- ------ ------  ---------
                                            $1,133,659 35,599 (1,119) 1,168,139
                                            ========== ====== ======  =========
</TABLE>
 
  The fair value of investments is based on quoted market prices, where
available, or quotes from external pricing sources such as brokers for those
or similar investments and issues. With the exception of the securities of
United States Government and government agencies, the Company has no
investment in any one individual security issuer exceeding 10 percent of total
assets.
 
  The amortized cost and estimated fair value of securities as of December 31,
1998, by contractual maturity, are presented below (in thousands). Actual
maturities may differ from contractual maturities as securities may be
restructured, called or prepaid. Securities with multiple maturity dates are
disclosed separately rather than allocated over several maturity groupings.
 
<TABLE>
<CAPTION>
                                                             Amortized   Fair
                                                               Cost      Value
                                                             --------- ---------
      <S>                                                    <C>       <C>
      Available-for-sale:
        Within one year..................................... $ 67,474     68,096
        After one year through five years...................  136,645    141,594
        After five years through ten years..................  159,686    165,389
        After ten years.....................................  204,488    211,146
        Mortgage-backed securities..........................  407,565    415,011
                                                             --------  ---------
                                                             $975,858  1,001,236
                                                             ========  =========
</TABLE>
 
                                     F-13
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
  The change in net unrealized gains and losses on investments available-for-
sale follows (in thousands):
 
<TABLE>
<CAPTION>
                                                             Years Ended
                                                             December 31,
                                                      ------------------------
                                                       1998     1997     1996
                                                      -------  -------  ------
      <S>                                             <C>      <C>      <C>
      Fixed maturity securities...................... $(8,751)  30,291  (7,420)
      Equity securities..............................     328     (687) (1,057)
                                                      -------  -------  ------
                                                       (8,423)  29,604  (8,477)
      Deferred income taxes..........................   2,948  (10,362)  2,966
                                                      -------  -------  ------
        Change in net unrealized gains and losses,
         net of tax.................................. $(5,475)  19,242  (5,511)
                                                      =======  =======  ======
</TABLE>
 
 Sales of Securities
 
  Gross realized investment gains and losses and proceeds from the sale of
investments for the years ended December 31, 1998, 1997 and 1996 are as
follows (in thousands):
 
<TABLE>
<CAPTION>
                                                          1998     1997    1996
                                                        --------  -------  ----
      <S>                                               <C>       <C>      <C>
      Fixed maturities:
        Gross realized gains........................... $ 18,975    2,597  658
        Gross realized losses..........................   (3,050)    (238)  --
                                                        --------  -------  ---
                                                        $ 15,925    2,359  658
                                                        ========  =======  ===
      Equity securities:
        Gross realized gains........................... $    387    1,987   --
        Gross realized losses..........................     (385)      --  (52)
                                                        --------  -------  ---
                                                        $      2    1,987  (52)
                                                        ========  =======  ===
      Other investments:
        Gross realized gains........................... $    999    1,239  593
        Gross realized losses..........................      (52)      --   --
                                                        --------  -------  ---
                                                        $    947    1,239  593
                                                        ========  =======  ===
      Proceeds from sale of fixed maturity securities
       (calls and maturities excluded)................. $409,954  140,985   --
                                                        ========  =======  ===
</TABLE>
 
6. Dividends from Subsidiaries and Statutory Information
 
  The Company's insurance subsidiaries are restricted by law as to the amount
of dividends they may pay without the approval of regulatory authorities.
During 1999, the total maximum amount of dividends which can be paid without
such approval is approximately $39.9 million.
 
  Combined net income and policyholders' surplus of the Company's combined
insurance subsidiaries, as determined in accordance with statutory accounting
practices, follows (in thousands):
 
<TABLE>
<CAPTION>
                                                             1998   1997  1996
                                                            ------ ------ -----
      <S>                                                   <C>    <C>    <C>
      Net income (loss).................................... $ 13.4 $ 18.5  (2.0)
                                                            ====== ====== =====
      Policyholders' surplus............................... $313.5 $333.1 188.5
                                                            ====== ====== =====
</TABLE>
 
                                     F-14
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
  The National Association of Insurance Commissioners (NAIC) adopted risk
based capital (RBC) requirements that require insurance companies to calculate
and report information under a risk-based formula which measures statutory
capital and surplus needs based on a regulatory definition of risk for a
company's mix of products and its balance sheet. LMI, whose surplus was within
the company action level (as defined by the NAIC) at December 31, 1998, has
ceased writing insurance and is in runoff. During December 1997, Highlands
Group contributed $10 million to LMI to facilitate the runoff of LMI's
business. LMI previously submitted a corrective action plan to the Ohio
Insurance Department which accepted the plan. Management believes that the
regulatory matters concerning LMI will not have a material impact on the
Company's results of operations or financial position. The remaining insurance
subsidiaries have an RBC amount above the company action level, as defined by
the NAIC.
 
  The NAIC Insurance Regulatory Information System ("IRIS") was developed to
assist state Insurance Commissioners to oversee the financial condition of
insurance companies operating in their respective states. If the review
confirms that the insurer's situation should be accorded the highest
surveillance priority, the insurer receives a "first priority" designation.
The "second priority" and "third priority" designations signify
recommendations for lower levels of increased regulatory attention. LMI
received "first priority" designation and SCIC received "second priority"
designation as a result of the review of each company's financial ratio
results and statutory annual statements for 1997. The NAIC's review of each
company's financial ratio results and statutory annual statements for 1998 has
not been completed.
 
7. Federal and Foreign Income Taxes
 
  The Company provides for income taxes on its statements of operations
pursuant to Statement of Financial Accounting Standards 109, "Accounting for
Income Taxes" (SFAS 109). With respect to losses for periods preceding the
Distribution (January 23, 1996), no tax benefit was recorded in the statements
of operations pursuant to SFAS 109 due to the Company's tax-sharing
arrangement with its former parent, Halliburton. Tax receipts under its
intercompany tax-sharing arrangements with its former parent were recorded as
additions to stockholders' equity for the periods preceding the Distribution.
 
  The tax-sharing arrangement resulted in Halliburton acquiring the domestic
deferred tax assets and liabilities from its domestic subsidiaries. In
contemplation of Halliburton's distribution of its Highlands Group shares,
Halliburton contributed to Highlands the net deferred tax assets attributable
to Highlands which Highlands Group recorded as a contribution to capital. The
contribution of the net deferred tax asset is considered a non-cash financing
transaction for the purposes of the statement of cash flows. Based upon the
tax-free nature of the Distribution of Highlands Group from Halliburton, the
deferred tax asset attributes are available to Highlands Group.
 
                                     F-15
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
  The primary components of the Company's deferred tax assets and liabilities
and the related valuation allowance as of December 31, 1998 and 1997,
respectively, follow (in thousands):
 
<TABLE>
<CAPTION>
                                                                1998     1997
                                                              --------  -------
      <S>                                                     <C>       <C>
      Deferred tax assets--
        Loss and loss adjustment expense reserves............ $ 51,301   56,606
        Net operating loss carryforward......................   50,222   39,992
        Unearned premiums....................................    9,475    9,946
        Vacation and employee benefit reserves...............    1,163    1,518
        Policyholder dividends...............................      578      392
        Deferred credits for processing fees.................    3,642    4,169
        Bad debt reserves....................................    2,111    2,111
        Other................................................    3,740    2,684
                                                              --------  -------
          Gross deferred tax assets..........................  122,232  117,418
        Valuation allowance..................................  (18,994) (19,567)
                                                              --------  -------
          Net deferred tax assets............................  103,238   97,851
                                                              --------  -------
      Deferred tax liabilities--
        Accrued retrospective premiums.......................    8,629    8,629
        Deferred acquisition costs...........................   11,038   11,310
        Net unrealized gain on investments...................    9,048   11,998
        Other................................................    4,090    1,871
                                                              --------  -------
          Gross deferred tax liabilities.....................   32,805   33,808
                                                              --------  -------
            Net deferred tax asset........................... $ 70,433   64,043
                                                              ========  =======
</TABLE>
 
  The realization of the net deferred tax asset is dependent upon the
Company's ability to generate sufficient taxable income in future periods. The
net deferred tax asset is net of valuation allowances of $19.0 and $19.6
million as of December 31, 1998 and 1997, respectively. The valuation
allowances are based upon management's assessment that it is more likely than
not that the portion of the deferred tax asset related to American Reliance's
purchased net operating loss carryforwards and Highlands (UK)'s net operating
loss carryforwards will not be realized. Based upon Highlands Group's
anticipated future earnings, projected reversal of the temporary differences,
tax planning strategies available if required and all other available
evidence, both positive and negative, management has concluded it is more
likely than not that the net deferred tax asset will be realized. Adjustments
to the valuation allowance will be made if there is a change in management's
assessment of the amount of the deferred tax asset that is realizable.
 
  The income tax expense (benefit) was different from the amount computed by
applying the federal income tax rate to income (loss) before income taxes for
the following reasons (in thousands):
 
<TABLE>
<CAPTION>
                                                        1998     1997    1996
                                                       -------  ------  -------
<S>                                                    <C>      <C>     <C>
Income (loss) before income taxes..................... $  (790) 18,519  (17,441)
Tax rate..............................................      35%     35%      35%
                                                       -------  ------  -------
  Application of the tax rate.........................    (277)  6,482   (6,104)
Tax effect of:
  Tax-exempt interest.................................  (2,547) (4,731)  (5,889)
  Other...............................................  (1,063)    (68)    (105)
                                                       -------  ------  -------
    Income tax (benefit) expense--deferred............ $(3,887)  1,683  (12,098)
                                                       =======  ======  =======
</TABLE>
 
                                     F-16
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
8. Earnings Per Share
 
  The following table sets forth the computation of basic and diluted earnings
per share (in thousands, except per share data):
 
<TABLE>
<CAPTION>
                                                           1998   1997   1996
                                                          ------ ------ ------
<S>                                                       <C>    <C>    <C>
NUMERATOR:
  Net income (loss), as reported and for basic earnings
   (loss) per share...................................... $3,097 16,836 (5,343)
  Effect of dilutive securities--after-tax debt expense
   applicable to convertible subordinated debentures.....     --     --     --
                                                          ------ ------ ------
  Numerator for diluted earnings (loss) per common
   share--income available to common stockholders after
   assumed conversions................................... $3,097 16,836 (5,343)
                                                          ====== ====== ======
DENOMINATOR:
  Denominator for basic earnings (loss) per share--
   weighted average shares............................... 13,095 12,600 11,448
  Effect of dilutive securities:
    Common stock warrants and outstanding stock options
     (based on treasury stock method)....................  2,716  2,788     --
    Convertible subordinated debentures..................     --     --     --
                                                          ------ ------ ------
  Denominator for diluted earnings per share--adjusted
   weighted average shares and assumed conversions....... 15,811 15,388 11,448
                                                          ====== ====== ======
  Basic earnings (loss) per share........................ $  .24   1.34   (.47)
  Diluted earnings (loss) per share...................... $  .20   1.09   (.47)
</TABLE>
 
  The Debentures, which are convertible into approximately 3.9 million shares,
were outstanding during 1998 and 1997, but were not included in the
computation of diluted earnings per share because the assumed conversion would
be antidilutive.
 
  For 1998, 400,048 stock options were not included in earnings per share
calculations since they were antidilutive.
 
9. Debt Outstanding
 
  On April 30, 1997, the Company entered into a $65 million Credit Agreement,
with a consortium of banks. The Credit Agreement, which contains customary
terms and restrictions, currently provides for an interest rate of LIBOR plus
125 to 200 basis points based upon a performance grid with the full principal
amount thereunder due on April 30, 2002. The Credit Agreement was used to
finance the purchase of American Reliance. The average interest rate for 1998
was 7.3%. The Company is in compliance with the covenants in the Credit
Agreement, including various financial covenants and restrictions.
 
  On January 23, 1996, Highlands Group issued $62.85 million in principal
amount of 10% convertible subordinated debentures (Debentures) due December
31, 2005, together with Series A and A-2 (collectively, the Series A Warrants)
and B and B-2 (collectively, the Series B Warrants) common stock purchase
warrants, to Insurance Partners, L.P., and Insurance Partners Offshore
(Bermuda), L.P. (collectively, IP) and certain members of the Company's
management team (Management Investors). The Company received $60 million in
cash from IP and the Management Investors and individual promissory notes
(each, a Note and, collectively, the Notes) in the aggregate principal amount
of $2.85 million made by the individual Management Investors without personal
liability and secured by a pledge of Debentures. The Debentures issued in
exchange for the Management Investors Notes were issued pursuant to a
Purchase, Redemption and Bonus Agreement (the Purchase Agreement).
 
                                     F-17
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
  The carrying values of the Debentures, Series A Warrants and Series B
Warrants at the Distribution date were determined by allocating the $62.85
million purchase price based upon the estimated relative fair value of such
securities. The estimated fair value of the Series A Warrants and Series B
Warrants amounting to $8.2 million was recorded in paid-in capital, net of $.8
million of Debentures' acquisition costs. The debt discount related to the
value allocated to the Series A Warrants and Series B Warrants is being
amortized over the ten-year life of the Debentures and amounted to $.8 million
for the year ended December 31, 1998.
 
  The Debentures are convertible, at the option of the holders, into Common
Stock of Highlands Group. If all of the Debentures are converted into
Highlands Group Common Stock at the conversion price of $16.16 per share, the
holders would receive approximately 3.9 million shares of Highlands Group
Common Stock and have an ownership interest in Highlands Group of
approximately 24%. Interest on the Debentures is payable semi-annually in cash
at 10% per annum. Highlands Group can redeem the Debentures at any time after
December 31, 2002. Total interest expense incurred and paid on the Debentures
was $6.0 million, $6.0 million and $5.6 million in 1998, 1997 and 1996,
respectively. The total amortization of debt discount and acquisition costs
related to the Debentures was $1.3 million in 1998, 1997 and 1996.
 
  The detachable Series A Warrants enable the holders to purchase Highlands
Group Common Stock at an exercise price of $8.83 per share, equal to an
additional ownership interest in Highlands Group of approximately 19% after
giving effect to the assumed conversion of the Debentures and the exercise of
the Series A Warrants. If all of the Series A Warrants were exercised, the
holders would receive approximately 4.0 million shares of Common Stock of
Highlands Group. The Series A Warrants exercise price is subject to adjustment
related to adverse loss reserve and uncollectible reinsurance development.
Such adjustment reduced the exercise price by $2.04, $2.02 and $1.80 per share
in 1998, 1997 and 1996, respectively. The detachable Series A Warrants expire
on December 31, 2005.
 
  The detachable Series B Warrants enable the holders to purchase Highlands
Group Common Stock at an exercise price of $8.83 per share, equal to an
additional ownership interest of 5% after giving effect to the assumed
conversion of the Debentures and the exercise of the Series A and B Warrants.
The Series B Warrants become exercisable by the holders in the event that the
average closing market price of Highlands Group Common Stock exceeds 1.61
times the exercise price for any 30 consecutive trading days between January
1, 1999 and December 31, 2000. If all of the Series B Warrants were exercised,
the holders would receive approximately 1.0 million additional shares of
Highlands Group Common Stock. The Series B Warrants exercise price is subject
to the same adjustment as the Series A Warrants. The detachable Series B
Warrants expire on December 31, 2005.
 
  The Purchase Agreement further provides for a bonus to be paid to each
Management Investor on the fifth anniversary of the Purchase Agreement if the
average closing price of the Company's Common Stock is equal to or greater
than prices expressed as a percentage of the exercise price of the Series A
Warrants (as adjusted from time to time) and specified in the Purchase
Agreement (the Bonus Trigger Stock Price). The amount of the bonus is stated
as a percentage of a maximum bonus amount separately determined for each
Management Investor and equal to the aggregate principal amount of each
Management Investor's Note. If the Bonus Trigger Stock Price is at least 1.40
times but less than 1.50 times the Series A Warrant exercise price, the bonus
is 25% of the maximum bonus amount, 50% if the Bonus Trigger Stock Price is at
least 1.50 but less than 1.61 times the Series A Warrant exercise price and
100% if the Bonus Trigger Stock Price is 1.61 times the Series A Warrant
exercise price or higher.
 
  If the Debentures are converted into Common Stock of Highlands Group and the
Series A and B Warrants are utilized by the holders to purchase Common Stock
of Highlands Group, the holders will have an ownership interest in Highlands
Group of approximately 42%.
 
                                     F-18
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
10. Reinsurance
 
  The Company assumes and cedes insurance with other insurers and reinsurers
and members of various reinsurance pools and associations and syndicates. The
Company utilizes reinsurance arrangements to limit its maximum loss, to
provide greater diversification of risks and to minimize exposures on larger
risks. Generally, reinsurance coverage is on an excess of loss basis. In
addition, the Company has catastrophe coverage for certain types of losses
over stipulated aggregate amounts arising from any one occurrence or event.
 
  The ceding of insurance does not discharge the primary liability of the
original insurer. The Company currently places reinsurance with other carriers
only after careful review of the nature of the contract and a thorough
assessment of the reinsurer's current credit quality and claim settlement
performance.
 
  Based upon its evaluations of reinsurers, the Company has established an
allowance for uncollectible reinsurance ($1.7 million and $2.2 million as of
December 31, 1998 and 1997, respectively) or does not record certain contracts
as ceded business but retains these amounts ($22.3 million and $18.2 million
as of December 31, 1998 and 1997, respectively) as loss reserves for
potentially uncollectible reinsurance at such time as an uncollectible amount
is probable and the amount may be reasonably estimated. Because of the
difficulty of acquiring accurate information for certain reinsurers, including
Lloyds' syndicates and members, the Company believes that no meaningful range
of potentially uncollectible reinsurance can be established beyond recorded
reserves. With respect to its domestic book of business and reinsurers that
are not authorized reinsurers as determined by the appropriate Department of
Insurance, the Company often receives collateral primarily in the form of bank
letters of credit generally securing the reinsurance recoverable regarding
reported losses and in some instances IBNR. As of December 31, 1998, such
collateral totaled approximately $18.9 million.
 
  The Company's three largest recoverables as of December 31, 1998, were
approximately $123.5 million with Underwriters at Lloyds of London, $113.7
million with American Reinsurance Company and $70.1 million with General
Reinsurance Company. American Reinsurance Company and General Reinsurance
Company are rated by A. M. Best "A+" and "A++," respectively.
 
                                     F-19
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
  The effects of assumed and ceded reinsurance on net premiums and losses
follows (in thousands):
 
<TABLE>
<CAPTION>
                            Direct  Assumed   Ceded      Net
                           -------- -------  --------  -------
<S>                        <C>      <C>      <C>       <C>
Year ended December 31,
 1998--
  Written premiums........ $370,210  7,874     (3,268) 374,816
  Earned premiums......... $406,028  8,464    (25,679) 388,813
  Loss and loss adjustment
   expense incurred....... $321,033 27,573    (20,206) 328,400
                           ======== ======   ========  =======
Year ended December 31,
 1997--
  Written premiums........ $342,414  3,631    (68,308) 277,737
  Earned premiums......... $367,630 (8,879)   (46,758) 311,993
  Loss and loss adjustment
   expense incurred....... $273,114 79,269   (105,904) 246,479
                           ======== ======   ========  =======
Year ended December 31,
 1996--
  Written premiums........ $147,474 11,072    (23,495) 135,051
  Earned premiums......... $160,776 13,903    (22,631) 152,048
  Loss and loss adjustment
   expense incurred....... $159,611 53,548    (56,570) 156,589
                           ======== ======   ========  =======
</TABLE>
 
11. Loss and Loss Adjustment Expense Reserves
 
  The Company establishes loss reserves which are estimates of future payments
of reported and unreported claims for losses and the related expenses with
respect to insured events that have occurred. The process of establishing loss
reserves is subject to uncertainties that are normal, recurring and inherent
in the property and casualty business. The process requires reliance upon
estimates based on available data that reflect past experience, current trends
and other information and the exercise of informed judgment. As information
develops that varies from experience, provides additional data or, in some
cases, augments data that previously were not considered sufficient for use in
determining reserves, changes in the Company's estimate of ultimate
liabilities may be required. The effect of these changes, net of reinsurance,
is charged or credited to income for the periods in which they are determined.
 
  Reserving for asbestos, environmental-related and certain other long-term
exposure claims is subject to significant additional uncertainties that are
not generally present for other types of claims. Developed case law and
adequate claim history do not exist for such claims. Highlands and the
insurance industry dispute coverage for certain environmental, pollution and
asbestos liabilities of their policyholders. These claims differ from almost
all others in that it is not often clear that an insurable event has occurred
and which, if any, multiple policy years and insurers will be liable. These
uncertainties prevent identification of applicable policy and policy limits
until after a claim is reported and substantial time is spent (many years in
some cases) resolving contract issues and determining facts necessary to
evaluate the claim. If the courts continue in the future to expand the intent
of the policies and the scope of the coverage as they have in the past,
additional liabilities could emerge for amounts in excess of the current
reserves held.
 
  The Company uses methods and assumptions that are consistent with prevailing
actuarial practice and are modified periodically based on changes in
circumstance. However, estimation of loss reserves for asbestos, environmental
related and other long-term exposure claims is one of the most difficult
aspects of establishing reserves, especially given the above uncertainties.
The Company has recorded its best estimate of loss and loss adjustment expense
reserves; however, because of the significant uncertainties involved and the
likelihood that these uncertainties will not be resolved in the near future,
the ultimate amounts paid upon settlement of these matters may be more or less
than the current estimate.
 
  In management's judgment, information currently available has been
appropriately considered in estimating the Company's loss reserves. However,
future changes in estimates of the Company's liability for insured events may
adversely affect results in future periods although such effects cannot be
reasonably estimated.
 
                                     F-20
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
  The following table represents a reconciliation of beginning and ending
consolidated loss and loss adjustment expense reserves for each of the last
three years (in thousands).
 
<TABLE>
<CAPTION>
                                                    1998      1997      1996
                                                 ---------- --------- ---------
<S>                                              <C>        <C>       <C>
Balance at January 1............................ $1,605,374 1,156,824 1,253,627
  Acquisition of American Reliance..............         --   520,719        --
  Less--Reinsurance recoverables................    692,668   652,449   599,558
                                                 ---------- --------- ---------
Net balance at January 1 .......................    912,706 1,025,094   654,069
                                                 ---------- --------- ---------
Incurred related to--
  Current year..................................    256,528   230,033   133,717
  Commutation of Aggregate Excess of Loss
   Reinsurance Agreement........................     50,000        --        --
  Prior year--
    Asbestos and environmental..................     21,840     5,433     6,557
    All other...................................         32    11,013    16,315
                                                 ---------- --------- ---------
  Total prior year..............................     21,872    16,446    22,872
                                                 ---------- --------- ---------
    Total incurred..............................    328,400   246,479   156,589
                                                 ---------- --------- ---------
Paid related to--
  Current year..................................     90,635   120,705    37,020
  Prior year--
    Asbestos and environmental..................     13,373     6,812     7,855
    All other...................................    266,117   231,350   155,666
                                                 ---------- --------- ---------
  Total prior year..............................    279,490   238,162   163,521
                                                 ---------- --------- ---------
    Total paid..................................    370,125   358,867   200,541
                                                 ---------- --------- ---------
Net balance at December 31......................    870,981   912,706   610,117
  Add--Reinsurance recoverables.................    732,567   692,668   546,707
                                                 ---------- --------- ---------
Balance at December 31.......................... $1,603,548 1,605,374 1,156,824
                                                 ========== ========= =========
</TABLE>
 
  As a result of changes in estimates of insured events in prior years,
primarily environmental and pollution claims, the provision for losses and
loss adjustment expenses (net of reinsurance recoveries of $69.3 million,
$112.5 million, and $47.8 million for 1998, 1997 and 1996, respectively)
increased by $71.9 million in 1998, $16.4 million in 1997, $22.9 million in
1996.
 
12. Employee Benefits
 
  The Company has a retirement and savings plan (defined contribution plan)
for which all employees are eligible to participate. The Company's
contributions are restricted to amounts authorized annually by the board of
directors. Employees, at their option, may contribute a portion of their
eligible earnings to the plan. Retirement benefits are based on the balance in
each employee's account, including the amount vested in employer
contributions. The plan may be canceled at any time at the option of the
Company. The Company's net contributions to the plan for 1998, 1997 and 1996
were approximately $1.1 million, $1.3 million, and $.6 million, respectively.
 
                                     F-21

<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
13. Stock Compensation Plans
 
  At December 31, 1998, the Company had two types of stock-based compensation
plans, a stock option plan and a restricted stock plan. The Company applies
APB Opinion No. 25 and related Interpretations in accounting for its plans.
Accordingly, compensation cost has been recognized for the grant of options to
acquire the Company Common Stock prior to the Distribution and prior to a
market price for the Company's Common Stock. The compensation cost that has
been charged against income for its stock-based plans was $472,000, $500,000
and $700,000 for 1998, 1997 and 1996, respectively. However, no compensation
cost has been recognized for shares issued subsequent to the Distribution,
with an exercise price equal to the market value at date of grant. Had all
compensation cost for the Company's stock-based compensation plans been
determined consistent with SFAS 123, the Company's net income (loss) and
earnings (loss) per share would have been the pro forma amounts indicated
below (in thousands, except per share data):
 
<TABLE>
<CAPTION>
                                                            1998   1997   1996
                                                           ------ ------ ------
      <S>                                      <C>         <C>    <C>    <C>
      Net income (loss)....................... As reported $3,097 16,836 (5,343)
                                               Pro forma   $1,915 15,568 (6,609)
      Basic earnings (loss) per share......... As reported $  .24   1.34   (.47)
                                               Pro forma   $  .15   1.24   (.58)
      Diluted earnings (loss) per share....... As reported $  .20   1.09   (.47)
                                               Pro forma   $  .12   1.01   (.58)
</TABLE>
 
 Stock Option Plan
 
  Pursuant to the Company's 1995 Stock Option Plan, Highlands Group may grant
either incentive stock options (ISO) or non-qualified stock options (NQSO).
The exercise price for each share subject to an option will be an amount that
the Compensation Committee of the Board of Directors determines, in its good
faith judgment. In the case of ISOs, however, the exercise price per share may
not be less than the amount the Committee determines, in its good faith
judgment, to be not less than 100% of the fair value of the Company's Common
Stock on the date the option is granted. Options are typically exercisable
over a period not in excess of ten years. The options generally vest over
three to four years, or in full upon a change of control of the Company. The
maximum number of shares that are reserved for issuance under all option plans
is 1,200,000 at December 31, 1998.
 
  A summary of the status of the Company's stock option plans at December 31,
1998 and changes during the three years then ended is presented below:
 
<TABLE>
<CAPTION>
                                 1998               1997               1996
                          ------------------- ------------------ ------------------
                                    Weighted-          Weighted-          Weighted-
                                     Average            Average            Average
                                    Exercise           Exercise           Exercise
Fixed Options              Shares     Price   Shares     Price   Shares     Price
-------------             --------  --------- -------  --------- -------  ---------
<S>                       <C>       <C>       <C>      <C>       <C>      <C>
Outstanding at beginning
 of year................   751,983   $17.22   486,000   $15.03        --   $   --
Granted.................   233,150   $23.78   333,000   $20.31   522,000   $15.03
Exercised...............    (8,375)  $17.31   (10,599)  $14.69        --   $   --
Forfeited...............  (134,838)  $21.47   (56,418)  $17.06   (36,000)  $15.02
                          --------   ------   -------   ------   -------   ------
Outstanding at end of
 year...................   841,920   $18.35   751,983   $17.22   486,000   $15.03
                          ========            =======            =======
Options exercisable at
 year-end...............   299,757            125,589               None
                          ========            =======            =======
</TABLE>
 
<TABLE>
<CAPTION>
                                                              1998  1997 1996
                                                             ------ ---- ----
     <S>                                                     <C>    <C>  <C>
     Weighted-average estimated per share fair value of
      options granted:
       Issued prior to the Distribution..................... $   --   -- 9.92
       Issued equal to market value......................... $13.25 6.80 7.88
</TABLE>
 
                                     F-22
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
  The following table summarizes information about fixed stock options
outstanding at December 31, 1998:
 
<TABLE>
<CAPTION>
                                Options Outstanding        Options Exercisable
                          -------------------------------- --------------------
                                       Weighted
                                        Average   Weighted             Weighted
                            Number     Remaining  Average    Number    Average
                          Outstanding Contractual Exercise Exercisable Exercise
Range of Exercise Prices  at 12/31/98    Life      Price   at 12/31/98  Price
------------------------  ----------- ----------- -------- ----------- --------
<S>                       <C>         <C>         <C>      <C>         <C>
$10.38-14.88.............   441,872      7.27      $14.49    217,950    $14.69
$18.75-23.56.............   250,998      8.43      $20.23     81,807    $20.30
$23.69-28.38.............   149,050      9.07      $26.65         --    $   --
                            -------                          -------
$10.38-28.38.............   841,920      7.93      $18.35    299,757    $16.22
                            =======                          =======
</TABLE>
 
  The fair value of stock options granted during the years ended December 31,
1998, 1997 and 1996 were $3.1 million, $2.3 million and $4.8 million,
respectively. The fair value of each option is estimated on the date of the
grant using the Black-Scholes option-pricing model.
 
  The following weighted average assumptions were used in the Black-Scholes
option pricing model for grants in 1998, 1997 and 1996, respectively: dividend
yields of -0-%; expected volatilities of 48%, 15%, and 15%; risk-free interest
rates of 5.9%, 5.8%, and 6.5%; and expected terms of 6.5 years.
 
 Employee Stock Purchase Plan
 
  In May 1998, the Company adopted a tax-qualified employee stock purchase
plan (the Purchase Plan). An aggregate of 300,000 shares of the Common Stock
has been reserved for issuance under the Purchase Plan. All employees of the
Company with at least three months of service can purchase Common Stock on the
annual offering date at a price equal to 85% of its fair market value at the
time of purchase. Employees can authorize payroll deductions in order to
accumulate funds for any offering during the year prior to any offering. At
December 31, 1998, 14,609 shares were issued under the Purchase Plan.
 
 Restricted Stock Plans
 
  In May 1997, the Company adopted a restricted stock plan (Restricted Stock
Plan) pursuant to which participants are granted an award of shares of the
Company's Common Stock (Restricted Stock) subject to restrictions. The number
of shares of Restricted Stock granted to each participant is equal to the
number of shares of Common Stock of the Company, if any, that the participant
purchases under the Restricted Stock Plan. There are restrictions as to the
transferability of the Restricted Stock, which restrictions lapse on the fifth
anniversary from the date of issuance if the closing price of the Company's
Common Stock is equal to or greater than the prices expressed as a percentage
of the price on the date of issuance (the Restricted Stock Trigger Price). If
the Restricted Stock Trigger Price is at least 1.40 times but less than 1.50
times the price on the date of issuance, 75% of the Restricted Stock shall be
forfeited and transferred to the Company, 50% if the Restricted Stock Trigger
Price is at least 1.50 times but less than 1.61 times the price on the date of
issuance and 0% if the Restricted Stock Trigger Price is 1.61 times the price
on date of issuance or higher. Termination of employment with the Company
during the restricted period will also cause the Restricted Stock to be
forfeited and transferred to the Company.
 
  As of December 31, 1998, the number of shares of Common Stock reserved under
the Restricted Stock Plan was 100,000. The Company granted 10,695 and 63,525
shares of Restricted Stock at weighted average fair values of $18.20 and
$23.20 per share during 1998 and 1997, respectively. Restricted Stock is
considered issued and outstanding when awarded. As of December 31, 1998,
25,632 shares of Restricted Stock have been forfeited to the Company. The fair
market value of Restricted Stock on the date of issuance has been recorded as
a
 
                                     F-23
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

deferred expense and included as a component of stockholder's equity. No
amortization of the deferred expense was recorded in 1998 or 1997. The
deferred expense will be amortized over the remaining vesting period once
certain closing prices of the Company's Common Stock are achieved.
 
14. Fair Value of Financial Instruments
 
  The Company has identified certain assets as financial instruments that
require fair value disclosure. The estimated fair value of financial
instruments has been determined by the Company using available market
information and appropriate valuation methodologies. However, considerable
judgment is necessarily required in interpreting market data to develop the
estimates of fair value. Accordingly, the Company's estimates of fair value
are not necessarily indicative of the amounts that the Company could realize
in a current market exchange. Potential taxes and other transaction costs have
not been considered in estimating fair value. As a number of the Company's
significant assets (including deferred policy acquisition costs, property and
equipment, and deferred taxes) and liabilities (loss and loss adjustment
expense reserves) are not considered financial instruments, the disclosures
that follow do not reflect the fair value of the Company as a whole.
 
  The carrying values and estimated fair values of financial instruments at
December 31, 1998 and 1997, were as follows (in thousands):
 
<TABLE>
<CAPTION>
                                   1998                1997
                           -------------------- -------------------
                            Carrying    Fair    Carrying    Fair
                             Value      Value     Value     Value
                           ---------- --------- --------- ---------
<S>                        <C>        <C>       <C>       <C>
Assets:
  Fixed maturity
   securities............. $1,001,236 1,001,236 1,166,585 1,166,585
  Equity securities....... $   21,057    21,057     1,554     1,554
  Other investments....... $    3,107     3,107     4,061     4,061
  Cash and cash
   equivalents............ $   70,747    70,747    60,717    60,717
  Premium installment
   receivables............ $    1,114     1,114     1,807     1,807
  Accrued investment
   income................. $   13,916    13,916    16,459    16,459
Liabilities:
  Convertible subordinated
   debentures............. $   57,017    60,000    56,229    60,000
  Senior bank debt........ $   65,000    65,000    65,000    65,000
</TABLE>
 
  Fair values for fixed maturity securities are based on quoted market prices,
where available. If quoted market prices were not available, fair values were
determined by dealers specializing in those securities. Equity securities are
valued based on quoted market prices. Cash and cash equivalents, premium
installment receivables, accrued investment income and other investments are
valued at their carrying value as they are highly liquid financial assets with
maturities of less than one year. The fair value for convertible subordinated
debentures was estimated using discounted cash flow calculations based upon
Highlands Group's current incremental borrowing for similar types of borrowing
arrangements. The senior bank debt is carried at fair value.
 
15. Contingent Liabilities
 
 Year 2000
 
  The Company is dependent on computers to process and report its business.
Information technology ("IT") systems are used for billing and collecting
premiums, issuing policies, processing claims, managing assets and reporting
financial results. A failure of the Company's IT systems to function properly
would have a material adverse effect on the Company's financial condition and
results of operations. The process of becoming ready for the Year 2000
consists of (i) identifying and assessing IT systems requiring renovation
(whether through
 
                                     F-24
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
modification or replacement); (ii) renovating systems; (iii) validating or
testing systems for Year 2000 compliance; and (iv) implementing compliance
solutions. The Company has identified and assessed its IT systems which
require renovation to properly process the Year 2000. The Company began
installing a new management and financial reporting IT system during 1998.
 
 Legal Actions
 
  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.
 
 Leases
 
  At December 31, 1998, the Company was obligated under noncancelable
operating leases, expiring on various dates through 2003, principally for
office space and computer software. Future aggregate minimum rentals on
noncancelable operating leases are as follows: $4.2 million in 1999, $3.8
million in 2000, $2.1 million in 2001, $.6 million in 2002 and $.1 million
thereafter.
 
  The Company's gross rental expense was approximately $4.3 million, $6.6
million, and $4.5 million for 1998, 1997 and 1996, respectively.
 
16. Business Concentration and Foreign Operations
 
  In the normal course of business, the Company underwrites risks of
Halliburton and various subsidiaries and affiliates of Halliburton. During
1998, 1997 and 1996, net premiums earned from Halliburton aggregated
approximately $53.9 million, $44.7 million, and $30.7 million, respectively.
 
  A portion of this business is retrospectively rated, meaning that ultimate
premiums will approximate ultimate losses plus certain expenses. Future
premiums due from Halliburton under these retrospective arrangements
approximate $109.5 million and $85.3 million at December 31, 1998 and 1997,
respectively.
 
  The Company's United Kingdom operations as a percentage of the Company's
consolidated revenues, loss before income taxes and identifiable assets
amounted to 2.5%, 8.5% and 16.0%, respectively, as of and for the year ended
December 31, 1996. The amounts are not material for 1998 and 1997.
 
                                     F-25
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
17. Quarterly Financial Data (Unaudited)
 
  The following quarterly financial information for each of the three months
ended March 31, June 30, September 30 and December 31, 1998 and 1997 is
unaudited. However, in the opinion of management, all adjustments (consisting
of normal recurring adjustments) necessary to present fairly the results of
operations for such periods, have been made for a fair presentation of the
results shown. The earnings per share amounts for the first three quarters of
1997 have been restated to comply with SFAS No. 128.
 
<TABLE>
<CAPTION>
Quarter Ended                                 March 31 June 30  Sept 30 Dec 31
-------------                                 -------- -------  ------- -------
                                               (dollars in thousands, except
                                                      per share data)
<S>                                           <C>      <C>      <C>     <C>
1998
  Net premiums earned........................ $ 83,230  85,652   85,027 134,904
  Total revenues............................. $107,053 107,962  111,013 157,628
  Total expenses............................. $ 98,562 121,211  100,847 163,826
  Net income (loss).......................... $  6,386  (7,732)   6,725  (2,282)
  Earnings (loss) per common share:
    Basic.................................... $    .48    (.59)     .51    (.18)
    Diluted.................................. $    .37    (.59)     .43    (.18)
1997
  Net premiums earned........................ $ 29,715  78,675  107,640  95,963
  Total revenues............................. $ 43,056  97,723  130,728 120,454
  Total expenses............................. $ 39,507 100,544  123,058 110,333
  Net income (loss).......................... $  2,957  (2,268)   6,744   9,403
  Earnings (loss) per common share:
    Basic.................................... $    .26    (.18)     .51     .71
    Diluted.................................. $    .22    (.18)     .40     .52
</TABLE>
 
                                      F-26
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                                   SCHEDULE I
 
                             SUMMARY OF INVESTMENTS
                   OTHER THAN INVESTMENTS IN RELATED PARTIES
 
                               DECEMBER 31, 1998
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                                    Amount at
                                                                   which Shown
                                              Amortized   Fair       in the
Type of investment                              Cost      Value   Balance Sheet
------------------                            --------- --------- -------------
<S>                                           <C>       <C>       <C>
At December 31, 1998:
 Fixed maturity securities available-for-
  sale:
  United States Government and government
   agencies.................................. $202,499    205,512     205,512
  States, municipalities and political
   subdivisions..............................   57,227     61,189      61,189
  Mortgage-backed securities.................  407,565    415,011     415,011
  Corporate securities.......................  307,479    318,410     318,410
  Foreign governments........................       88        114         114
  Sinking fund preferred stock...............    1,000      1,000       1,000
                                              --------  ---------   ---------
                                               975,858  1,001,236   1,001,236
 Equity securities...........................   20,585     21,057      21,057
                                              --------  ---------   ---------
    Total securities, available-for-sale.....  996,443  1,022,293   1,022,293
                                              --------  ---------   ---------
 Other investments...........................    3,107      3,107       3,107
                                              --------  ---------   ---------
    Total investments........................ $999,550  1,025,400   1,025,400
                                              ========  =========   =========
</TABLE>
 
 
                       See accompanying auditor's report.
 
                                      F-27
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                                  SCHEDULE II
 
                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                                 BALANCE SHEETS
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                                December 31,
                                                              -----------------
                           ASSETS                               1998     1997
                           ------                             --------  -------
<S>                                                           <C>       <C>
Investment in subsidiaries..................................  $427,963  449,205
Fixed maturity securities available-for-sale, at fair value.     5,092    5,033
Cash and cash equivalents...................................     4,175    1,285
Accrued investment income...................................     2,086       86
Net deferred tax asset......................................     2,809       --
Taxes receivable from subsidiaries..........................     3,539    3,823
Deferred debt expense.......................................     4,161    3,984
Other assets................................................     3,594    3,208
                                                              --------  -------
    Total assets............................................  $453,419  466,624
                                                              ========  =======
<CAPTION>
            LIABILITIES AND STOCKHOLDERS' EQUITY
            ------------------------------------
<S>                                                           <C>       <C>
Senior bank debt............................................  $ 65,000   65,000
Convertible subordinated debentures.........................    57,017   56,229
Payable to subsidiaries.....................................       275      508
Net deferred tax liability..................................        --    5,904
Accounts payable and accrued liabilities....................    12,573    9,690
                                                              --------  -------
    Total liabilities.......................................   134,865  137,331
                                                              --------  -------
Stockholders' equity:
  Common stock, $.01 par value; 50,000,000 shares
   authorized; 13,235,316 shares issued and outstanding in
   1998, 13,187,273 shares issues and outstanding in 1997...       132      132
  Additional paid-in capital................................   223,976  223,460
  Accumulated other comprehensive income....................    16,803   22,278
  Treasury stock, at cost, 724,400 shares in 1998...........    (9,268)      --
  Deferred compensation on restricted stock.................    (1,074)  (1,465)
  Retained earnings.........................................    87,985   84,888
                                                              --------  -------
    Total stockholders' equity..............................   318,554  329,293
                                                              --------  -------
    Total liabilities and stockholders' equity..............  $453,419  466,624
                                                              ========  =======
</TABLE>
 
                       See accompanying auditor's report.
 
                                      F-28
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                                  SCHEDULE II
 
                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                            STATEMENTS OF OPERATIONS
                  (in thousands, except per common share data)
 
<TABLE>
<CAPTION>
                                                         For the Years ended
                                                             December 31,
                                                         ---------------------
                                                          1998    1997   1996
                                                         ------  ------ ------
<S>                                                      <C>     <C>    <C>
Revenues:
  Net investment income................................. $  595   1,507  2,539
                                                         ------  ------ ------
    Total revenues......................................    595   1,507  2,539
                                                         ------  ------ ------
Equity in net income (loss) of subsidiaries............. 11,890  24,854 (1,186)
                                                         ------  ------ ------
Expenses:
  Interest expense...................................... 12,291  10,210  5,639
  Debt amortization.....................................  1,286   1,411  1,264
  Other expenses........................................  3,041   2,222  2,031
                                                         ------  ------ ------
    Total expenses...................................... 16,618  13,843  8,934
                                                         ------  ------ ------
  Income (loss) before income tax benefit............... (4,133) 12,518 (7,581)
  Income tax benefit....................................  7,230   4,318  2,238
                                                         ------  ------ ------
    Net income (loss)................................... $3,097  16,836 (5,343)
                                                         ======  ====== ======
Earnings (loss) per common share:
  Basic................................................. $  .24    1.34   (.47)
  Diluted............................................... $  .20    1.09   (.47)
Weighted average number of common shares outstanding:
  Basic................................................. 13,095  12,600 11,448
  Diluted............................................... 15,811  15,388 11,448
</TABLE>
 
 
                       See accompanying auditor's report.
 
                                      F-29
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                                  SCHEDULE II
 
                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                            STATEMENTS OF CASH FLOWS
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                       For the Years ended
                                                          December 31,
                                                     -------------------------
                                                      1998     1997     1996
                                                     -------  -------  -------
<S>                                                  <C>      <C>      <C>
Cash flow from operating activities:
  Net income (loss)................................. $ 3,097   16,836   (5,343)
  Adjustments to reconcile net income (loss) to net
   cash provided by (used in) operating activities:
    Equity in net (income) loss of subsidiaries..... (11,890) (24,854)   1,186
    Debt amortization...............................   1,286    1,411    1,264
    Dividends received from subsidiaries............  17,500    5,000    3,000
    Decrease (increase) in net deferred tax asset...  (5,765)   1,634   (2,238)
    Increase in taxes receivable from subsidiaries..     284   (3,823)      --
    Changes in other operating assets and
     liabilities....................................   2,222    6,371    1,038
                                                     -------  -------  -------
      Total adjustments.............................   3,637  (14,261)   4,250
                                                     -------  -------  -------
    Net cash provided by (used in) operating
     activities.....................................   6,734    2,575   (1,093)
                                                     -------  -------  -------
Cash flows from investing activities:
  Maturities or calls of fixed maturity securities
   available-for-sale...............................      --   34,520       --
  Investment purchases of fixed maturity securities
   available-for-sale...............................      --  (14,978) (24,475)
  Acquisition of subsidiary, net....................      --  (15,000)      --
  Capital contributions to subsidiaries.............      --  (53,244) (52,174)
  Cash returned by (sent to) former affiliates, net.      --       --    3,800
  Payment of acquisition expenses...................      --   (3,730)      --
  Other proceeds....................................      --       92       --
  Proceeds from disposal of subsidiary, net.........      --       --       22
                                                     -------  -------  -------
      Net cash used in investing activities.........      --  (52,340) (72,827)
                                                     -------  -------  -------
Cash flows from financing activities:
  Proceeds from senior bank debt....................           65,000       --
  Proceeds from issuance of convertible subordinated
   debentures.......................................               --   60,000
  Payment for debt issuance expense.................    (675)  (1,017)  (5,705)
  Repayment of acquired bank debt...................          (35,638)      --
  Issuance of Common Stock..........................     831      156       --
  Acquisition of treasury stock.....................  (4,000)      --       --
  Contribution from former parent of net current tax
   asset............................................      --       --   42,174
                                                     -------  -------  -------
      Net cash provided (used) by financing
       activities...................................  (3,844)  28,501   96,469
                                                     -------  -------  -------
Net increase (decrease) in cash and cash
 equivalents........................................   2,890  (21,264)  22,549
Cash and cash equivalents at beginning of year......   1,285   22,549       --
                                                     -------  -------  -------
Cash and cash equivalents at end of year............ $ 4,175    1,285   22,549
                                                     =======  =======  =======
Supplemental disclosure of cash flow information:
  Interest paid..................................... $10,603    8,803    5,639
                                                     =======  =======  =======
Noncash financing activities:
  Parent company stock acquired by subsidiaries and
   held in treasury................................. $ 5,268       --       --
                                                     =======  =======  =======
</TABLE>
 
                       See accompanying auditor's report.
 
                                      F-30
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
               SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                        As of December 31,
                                                  ------------------------------
                                                   Deferred    Losses,
                                                    Policy     Claims
                                                  Acquisition and Loss  Unearned
Property/Casualty Operations                         Costs    Expenses  Premiums
----------------------------                      ----------- --------- --------
<S>                                               <C>         <C>       <C>
1998.............................................   $31,537   1,603,548 137,353
                                                    =======   ========= =======
1997.............................................   $32,313   1,605,374 173,411
                                                    =======   ========= =======
1996.............................................   $ 6,436   1,156,824  31,474
                                                    =======   ========= =======
</TABLE>
 
<TABLE>
<CAPTION>
                                        For the Years Ended December 31,
                         --------------------------------------------------------------
                                                        Amortization
                                              Loss and  of Deferred
                                     Net        Loss       Policy      Other     Net
Property/Casualty        Premium  Investment Adjustment Acquisition  Operating Premiums
Operations               Revenue    Income    Expense      Costs     Expenses  Written
-----------------        -------- ---------- ---------- ------------ --------- --------
<S>                      <C>      <C>        <C>        <C>          <C>       <C>
1998.................... $388,813   77,969    328,400      71,538     67,890   374,816
                         ========   ======    =======      ======     ======   =======
1997.................... $311,993   74,383    246,479      61,745     51,375   277,737
                         ========   ======    =======      ======     ======   =======
1996.................... $152,048   50,988    156,589      28,829     27,324   135,051
                         ========   ======    =======      ======     ======   =======
</TABLE>
 
 
 
                       See accompanying auditor's report.
 
                                      F-31
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                            SCHEDULE IV--REINSURANCE
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                               Assumed          Percent Of
                                    Ceded to    From              Amount
                            Direct    Other     Other     Net   Assumed to
                            Amount  Companies Companies Amount     Net
                           -------- --------- --------- ------- ----------
<S>                        <C>      <C>       <C>       <C>     <C>
Year ended December 31,
 1998
  Property-liability
   insurance.............. $406,028  (25,679)   8,464   388,813     2.2%
                           ========  =======   ======   =======    ====
Year ended December 31,
 1997
  Property-liability
   insurance.............. $367,630  (46,758)  (8,879)  311,993    (2.8%)
                           ========  =======   ======   =======    ====
Year ended December 31,
 1996
  Property-liability
   insurance.............. $160,776  (22,631)  13,903   152,048     9.1%
                           ========  =======   ======   =======    ====
</TABLE>
 
 
 
                       See accompanying auditor's report.
 
                                      F-32
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                 SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                 Additions
                                    ------------------------------------
                         Balance at  Charges to                           Balance
                         Beginning      Cost       Other                  at End
                         of Period  and Expenses Additions Deductions(1) of Period
                         ---------- ------------ --------- ------------- ---------
<S>                      <C>        <C>          <C>       <C>           <C>
Year ended December 31,
 1998
  Allowance for
   uncollectible
   reinsurance.........    $2,157        --          --          455       1,702
                           ======       ===         ===        =====       =====
Year ended December 31,
 1997
  Allowance for
   uncollectible
   reinsurance.........    $2,410        --          --          253       2,157
                           ======       ===         ===        =====       =====
Year ended December 31,
 1996
  Allowance for
   uncollectible
   reinsurance.........    $4,598        --          --        2,188       2,410
                           ======       ===         ===        =====       =====
</TABLE>
--------
(1) Deductions in the allowance for uncollectible reinsurance represent write-
    offs, net of recoveries, of amounts determined to be uncollectible.
 
 
 
 
                       See accompanying auditor's report.
 
                                      F-33
<PAGE>
 
                        HIGHLANDS INSURANCE GROUP, INC.
 
                                  SCHEDULE VI
 
                SUPPLEMENTAL INFORMATION CONCERNING CONSOLIDATED
                     PROPERTY/CASUALTY INSURANCE OPERATIONS
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                       As of December 31,
                                                 ------------------------------
                                                    1998      1997      1996
                                                 ---------- --------- ---------
<S>                                              <C>        <C>       <C>
Deferred policy acquisition costs............... $   31,537    32,313     6,436
Loss and loss adjustment expense reserves....... $1,603,548 1,605,374 1,156,824
Unearned premiums............................... $  137,353   173,411    31,474
 
<CAPTION>
                                                  For the Years Ended December
                                                              31,
                                                 ------------------------------
                                                    1998      1997      1996
                                                 ---------- --------- ---------
<S>                                              <C>        <C>       <C>
Net premiums earned............................. $  388,813   311,993   152,048
Net investment income........................... $   77,969    74,383    50,988
Loss and loss adjustment expense incurred
  Current year.................................. $  256,528   230,033   133,717
  Commutation of Aggregate Excess of Loss
   Reinsurance..................................     50,000        --        --
  Prior year....................................     21,872    16,446    22,872
                                                 ---------- --------- ---------
                                                 $  328,400   246,479   156,589
                                                 ========== ========= =========
Amortization of deferred policy acquisition
 costs.......................................... $   71,538    61,745    28,829
Paid loss and loss adjustment expense........... $  370,125   358,867   200,541
Net premiums written............................ $  374,816   277,737   135,051
</TABLE>
 
 
 
                       See accompanying auditor's report.
 
                                      F-34
<PAGE>
 
                               ----------------
 
                       The Company's transfer agent is:
 
                   ChaseMellon Shareholder Services, L.L.C.
                              85 Challenger Road
                                Overpeck Centre
                    Ridgefield Park, New Jersey 07660-2104
                                1-800-635-9270
 
                               ----------------
 
                  The Company's Common Stock is traded on the
                New York Stock Exchange under the symbol "HIC."
 
                               ----------------
 
           The Company's Annual Meeting of Stockholders will be held
        on May 10, 1999 at 1000 Lenox Drive, Lawrenceville, New Jersey.
 
  To obtain a copy of the Company's 1998 annual report on Form 10-K (including
financial statements and financial statement schedules) as filed with the
Securities and Exchange Commission, please send a written request to Charles
J. Bachand, Vice President and Treasurer, Highlands Insurance Group, Inc.,
10370 Richmond Avenue, Houston, Texas 77042.