<PAGE>

--------------------------------------------------------------------------------
                      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, 2001
                                      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 Offices)                      (Zip Code)

                                (609) 896-1921
             (Registrant's Telephone Number, Including Area Code)

          Securities registered pursuant to Section 12(b) of the Act:


                                           Name of each exchange on
    Title of each class                        which registered
    -------------------                        ----------------
Common Stock $.01 Par Value                          None
                               New York Stock Exchange (until December 12, 2001)



          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 February 28, 2002, was $454,248.65 (based on $0.035 per share).
At March 1, 2002, the Registrant had outstanding 13,424,433 shares of its Common
Stock, par value $.01 per share.

--------------------------------------------------------------------------------
<PAGE>

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
     Item                                                                                                              Page
     ----                                                                                                              ----
     <S>                                                                                                     <C>
                                                          PART I

            1.  Business.......................................................................................          1
            2.  Properties.....................................................................................         11
            3.  Legal Proceedings..............................................................................         11
            4.  Submission of Matters to a Vote of Security Holders............................................         12

                                                          PART II

            5.  Market for Company's Common Stock and Related Stockholder Matters..............................         13
            6.  Selected Financial Data........................................................................         14
            7.  Management's Discussion and Analysis of Financial Condition and Results of Operations..........         15
           7A.  Quantitative and Qualitative Disclosures about Market Risk.....................................         20
            8.  Financial Statements and Supplemental Data.....................................................         20
            9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...........         20

                                                         PART III

           10.  Directors and Executive Officers of the Registrant.............................................         21
           11.  Executive Compensation.........................................................................         23
           12.  Security Ownership of Certain Beneficial Owners and Management.................................         29
           13.  Certain Relationships and Related Transactions.................................................         31

                                                          PART IV

           14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K...............................         32
</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. In April 1997, the Highlands Group acquired Vik
Brothers Insurance, Inc. and its subsidiaries which was renamed American
Reliance, Inc. The acquisition was accounted for as a purchase and, accordingly,
the financial results of American Reliance, Inc. and its subsidiaries ("American
Reliance") are included in the consolidated financial statements effective as of
the date of acquisition.

     The Company incurred a net loss of $341.9 million in 2001 and a net loss of
$106.6 million in 2000.  The Company currently owes $47.5 million to secured
lenders under a Credit Agreement.  This loan, which is collateralized by a first
lien on the stock of the Company's insurance subsidiaries, comes due on April
30, 2002.  In addition, the Company is currently in default under the terms of
the Credit Agreement.  The Company also has outstanding Convertible Subordinated
Debentures in the principal amount of  $62.85 million which are due December 31,
2005.  However, by virtue of the cross default provisions of the debentures, if
either the senior bank debt becomes due and is not paid or is in default and the
maturity of the debt is accelerated, the holders of the debentures have the
right to declare the debentures in default and accelerate their maturity.  Due
to the Company's current financial condition, see Item 6:  "Selected Financial
Data" and Item 7:  "Management's Discussion and Analysis of Financial Condition
and Results of Operations," Highlands Group is currently investigating the
possibility of filing a petition for reorganization under Chapter 11 of the
United States Bankruptcy Code.

     In February 2002, the Texas Department of Insurance issued Supervisory
Orders to the Company's Texas insurance subsidiaries, including Highlands
Insurance Company, the Company's principal insurance subsidiary. By their terms,
the orders are also binding on all the companies' affiliates. A Supervisory
Order for another of the insurance subsidiaries, State Capital Insurance
Company, was issued by the North Carolina Department of Insurance in December
2001, and in October 2001, the Wisconsin Commissioner of Insurance issued a
Stipulation and Order covering Northwestern National Casualty Company, the
Company's second largest insurance subsidiary, and NN Insurance Company, another
of the Company's insurance subsidiaries. In addition to these orders, the
Company's insurance subsidiaries have had their licenses to transact business
suspended in Florida, Illinois, Kansas, Kentucky, Minnesota, Missouri, New
Mexico, Ohio and Rhode Island, and by the U.S. Department of Treasury and the
U.S. Department of Labor with respect to federal surety and workers'
compensation programs. The licenses in Connecticut and North Carolina have been
amended to allow the companies to service existing business only. The Company
has also agreed to cease writing new and renewal business in Colorado, Maine,
Michigan and South Carolina and has been removed from the list of eligible
surplus lines insurers in New Mexico, Texas and Virginia. Except where
prohibited by regulation or where withdrawal plans have been filed and are
pending, the Company is not renewing any business upon policy term expiration.
See "Regulation."

     On November 19, 2001, A.M. Best Company downgraded the financial rating of
the Company from B (Fair) to C- (Weak). On March 25, 2002, the Company was rated
NR-4 (not rated at Company's request) by A.M. Best. As a result of the downgrade
in November 2001 and continuing financial losses, on December 7, 2001, the
Company announced its intention to cease writing new and renewal business and to
"run-off" existing claims and business. As part of the run-off plan, the Company
closed underwriting operations in Woodland Hills and Sacramento, California,
Denver, Colorado, Nashville, Tennessee, Houston, Texas and Brookfield,
Wisconsin. Underwriting operations in Raleigh, North Carolina and Lawrenceville,
New Jersey are scheduled to close in 2002.

     The Company intends to maintain its Lawrenceville, New Jersey office to
manage run-off operations and processing. Finance and information technology
functions will continue to operate out of the Houston, Texas office and
statistical reporting functions will operate out of Brookfield, Wisconsin. The
Company has claim operations in Lawrenceville, New Jersey, Raleigh, North
Carolina, Brookfield, Wisconsin, Tustin and Woodland Hills, California and
Houston, Texas.

     As of December 31, 2001, the Company had 629 employees. The Company will
continue to reduce its employee headcount throughout 2002.

                                       1
<PAGE>

Products

     The Company no longer writes new business and has requested, and in the
vast majority of cases received, permission from state insurance departments to
nonrenew existing business. As a result, the Company's insurance operations are
in run-off.

     Prior to going into run-off, the Company wrote commercial and personal
property and casualty coverage. The commercial lines included primarily
commercial multiple peril, workers' compensation, general liability and
commercial automobile insurance. Policies written for large commercial accounts
were underwritten on a high deductible or retrospectively rated basis, with
significant risk retention by the insured. Policies written for small to medium-
sized accounts were generally on a fixed premium basis where the insured had
little or no retained risk, although certain workers' compensation policies
provided for profit sharing participation to the insured in the form of
dividends. The personal lines consisted of homeowners multiple peril and
dwelling fire and personal automobile insurance. Additionally, the Company wrote
inland marine insurance which was 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.

                                                    Years Ended December 31,
                                                    ------------------------
                                                      2001      2000      1999
                                                     ------    ------     -----
                                                           (in millions)
     Workers' compensation.....................     $129.2     128.0      70.8
     Commercial automobile.....................      119.1     115.2      50.5
     Commercial multiple peril.................      112.9     137.2     101.4
     Homeowners multiple peril and fire........       54.7      52.6      49.0
     Personal automobile.......................       25.2      26.6      29.9
     General liability.........................       25.1      48.2      42.4
     Inland marine.............................        7.2       1.1       7.2
     Ocean marine..............................         .1        --       8.6
     Discontinued lines........................          0       1.6       1.3
     Other.....................................       25.5       6.6       3.0
                                                    ------     -----     -----
               Total...........................     $499.0     517.1     364.1
                                                    ======     =====     =====

     The following is a description of the types of insurance products that were
sold by the Company.

     Commercial Multiple Peril.  Commercial multiple peril policies insure
businesses against property loss 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.

     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.

     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.

     Inland Marine.  Inland marine insures against loss or damage to persons or
property in connection with risks of navigation or transportation on land, air
or water or while being assembled, packed or similarly prepared for or waiting
for shipment. Coverages include marine builders risks; personal property
floaters; precious metals or stones; bridges and tunnels; instrumentalities of
communication; and on all aids to navigation and transportation.

                                       2
<PAGE>

Geographic Distribution

     The following table sets forth the geographic distribution of the Company's
gross premiums written for the periods indicated.

                                                    Years Ended December 31,
                                                    ------------------------
                                                  2001         2000        1999
                                                 ------       ------      ------
                                                          (in millions)
     California..............................   $ 54.6         81.2        53.0
     New York................................     49.1         47.5        13.3
     New Jersey..............................     48.7         44.6        39.1
     Pennsylvania............................     38.6         40.2        32.2
     Texas...................................     27.9         67.7        46.7
     Illinois................................     21.5         15.1         6.1
     North Carolina..........................     20.2         23.3        23.6
     Wisconsin...............................     19.2         16.0        10.2
     Tennessee...............................     12.6          9.6         2.5
     Minnesota...............................     11.4         10.5         4.5
     Other...................................    195.2        161.4       132.5
                                                ------        -----       -----
                                                $499.0        517.1       364.1
                                                ======        =====       =====

Claim

     Claims are processed out of six offices located in Lawrenceville, New
Jersey, Raleigh, North Carolina, Houston, Texas, Tustin and Woodland Hills,
California and Brookfield, Wisconsin. The Company intends to adjust claim staff
and locations as appropriate based on caseloads. Home office claim support is
located in Lawrenceville, New Jersey, which established claim policies and
procedures for the regional claim offices. The home office also provides support
on complex claims, such as environmental/mass tort, 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. The Company uses in-house
counsel for a portion of its claims litigation.

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
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 2001 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 involves 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.

     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

                                       3
<PAGE>

reported ("unreported losses") and to provide for adverse development on
reported losses. A significant portion of the Company's loss reserves are the
reserves 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.

     As a result of a reserve analysis done in the fourth quarter of 2001 by the
Company and its independent actuary, it was determined that there had been
adverse development in the 2000 accident year of approximately $89 million. The
2000 accident year net loss and net loss adjustment expense ratio is 100.1%.
Also, the reserve analysis demonstrated that losses incurred and loss adjustment
expenses in the 2001 accident year would exceed the Company's estimates by more
than 10 percentage points. For 2001, the Company recorded a 95% accident year
and a 134.3% calendar year loss and loss adjustment expense ratio on $496.6
million of net earned premium. The adverse development in 2001 and 2000 came
primarily from the following four lines of business--workers' compensation,
general liability, commercial multiple peril and commercial auto liability. The
adverse development amounts related to asbestos and environmental claims for
2001, 2000 and 1999 were $14.8 million, $7.8 million and $1.8 million,
respectively.

     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>
                                                                      2001          2000          1999
                                                                   ----------     ---------     ---------
                                                                              (in millions)
<S>                                                              <C>           <C>           <C>
Balance at January 1...........................................    $1,392,497     1,353,524     1,603,548
  Less--Reinsurance recoverables...............................       626,647       614,208       732,567
                                                                   ----------     ---------     ---------
Net balance at January 1.......................................       765,850       739,316       870,981
                                                                   ----------     ---------     ---------
Incurred related to--
  Current year.................................................       470,038       321,181       247,027
  Prior year--
     Asbestos and environmental................................        14,748         7,762         1,795
     All other.................................................       182,332        17,194        (9,882)
                                                                   ----------     ---------     ---------
  Total prior year.............................................       197,080        24,956        (8,087)
                                                                   ----------     ---------     ---------
     Total incurred............................................       667,118       346,137       238,940
                                                                   ----------     ---------     ---------
Paid related to--
  Current year.................................................       163,428       136,565       101,294
  Prior year--
     Asbestos and environmental................................         7,258        11,041        15,038
     All other.................................................       272,032       171,997       230,240
                                                                   ----------     ---------     ---------
  Total prior year.............................................       279,290       183,038       245,278
                                                                   ----------     ---------     ---------
     Total paid................................................       442,718       319,603       346,572
                                                                   ----------     ---------     ---------
Elimination of LMI reserves(1).................................            --            --        24,033
                                                                   ----------     ---------     ---------
Net balance at December 31.....................................       990,250       765,850       739,316
Add--Reinsurance recoverables..................................       608,877       626,647       614,208
                                                                   ----------     ---------     ---------
Balance at December 31.........................................    $1,599,127     1,392,497     1,353,524
                                                                   ==========     =========     =========
</TABLE>

__________
     (1) The Company wrote off its investment in LMI Insurance Company("LMI") in
1999.  See Item 7: "Management's Discussion and Analysis of Financial Condition
and Results of Operations."

     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 for 1991 through 2001. The
top three lines of the table reconcile gross loss and loss adjustment expense
reserves to net loss and loss adjustment expense reserves for 1993 through 2001.
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

                                       4
<PAGE>

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 of reinsurance basis for 1991.

     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.

<TABLE>
<CAPTION>
                                             1991         1992        1993        1994        1995        1996        1997
                                          ----------   ----------   ---------   ---------   ---------   ---------   ---------
                                                                                                    (in thousands)
<S>                                       <C>          <C>          <C>         <C>         <C>         <C>         <C>
Gross reserves for loss and adjustment
 Expense................................. $       --                1,225,242   1,149,173   1,253,627   1,156,824   1,605,374
 Deduct: reinsurance recoverable.........         --                  627,285     557,096     599,558     546,707     692,668
Net reserves for loss and loss
 adjustment
 Expense.................................    652,925      565,971     597,957     592,077     654,069     610,117     912,706
Net paid (cumulative) as of:
 One year later..........................    263,755      268,072     184,586     198,415     163,521     135,747     279,490
 Two years later.........................    420,876      395,244     333,366     323,737     266,093     231,409     459,712
 Three years later.......................    518,442      513,135     426,022     404,287     348,713     316,905     545,261
 Four years later........................    608,865      587,726     488,676     473,059     424,307     358,041     630,639
 Five years later........................    668,889      639,647     548,333     542,484     456,108     406,177
 Six years later.........................    714,843      692,851     612,998     570,475     499,733
 Seven years later.......................    763,008      753,462     636,731     611,387
 Eight years later.......................    820,177      773,148     674,482
 Nine years later........................    836,369      808,683
 Ten years later.........................    871,395
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     590,529
 Three years later.......................               1,113,503     836,921     650,471     556,177     453,634     729,053
 Four years later........................               1,296,333     945,321     762,957     674,906     551,313     859,415
 Five years later........................               1,392,285   1,047,819     875,842     763,058     637,714
 Six years later.........................               1,486,879   1,155,295     959,651     845,093
 Seven years later.......................               1,587,715   1,231,710   1,039,058
 Eight years later.......................               1,657,188   1,307,920
 Nine years later........................               1,660,482
Net liability re-estimated as of:
 End of year.............................    652,925      565,971     597,957     592,077     654,069     610,117     912,706
 One year later..........................    694,248      688,811     662,841     735,647     676,940     626,563     984,578
 Two years later.........................    785,147      772,020     788,454     750,941     702,633     689,107     971,903
 Three years later.......................    828,241      894,071     805,313     783,138     765,168     676,970     987,611
 Four years later........................    938,216      915,163     835,720     863,781     753,158     711,769   1,067,446
 Five years later........................    957,726      943,789     913,664     850,726     792,861     787,504
 Six years later.........................    988,466    1,035,577     900,015     894,614     860,468
 Seven years later.......................  1,084,762    1,023,488     948,416     962,138
 Eight years later.......................  1,073,281    1,069,581   1,010,428
 Nine years later........................  1,127,817    1,127,533
 Ten years later.........................  1,177,123
Net (deficiency) redundancy..............   (524,198)    (561,562)   (412,471)   (370,061)   (206,399)   (177,387)   (154,740)
Impact of 1997 Third Quarter Change......     96,640      103,483     107,594     117,000          --                      --

Aggregate Stop Loss Adjustment...........     50,000       50,000      50,000      50,000      50,000      50,000      50,000
Remaining net (deficiency) redundancy....   (377,558)    (408,079)   (254,877)   (203,061)   (156,399)   (127,387)   (104,740)
                                          ==========   ==========   =========   =========   =========   =========   =========
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   1,457,923   1,693,237
 Three years later.......................               2,102,378   1,741,108   1,644,068   1,644,067   1,414,284   1,732,603
 Four years later........................               2,157,078   1,895,541   1,820,250   1,601,476   1,486,184   1,797,411
 Five years later........................               2,307,982   2,071,815   1,777,438   1,661,484   1,502,911
 Six years later.........................               2,472,233   2,031,628   1,832,012   1,685,195
 Seven years later.......................               2,437,690   2,079,767   1,867,081
 Eight years later.......................               2,476,651   2,111,158
 Nine years later........................               2,434,359
                                                       ==========
Gross cumulative (deficiency)
redundancy...............................              (1,041,007)   (885,916)   (717,908)   (431,568)   (346,087)   (192,037)
                                                       ==========   =========   =========   =========   =========   =========
Gross re-estimated liability.............               2,434,359   2,111,158   1,867,081   1,685,195   1,502,911   1,797,411
Less: re-estimated recoverable...........               1,306,826   1,100,730     904,943     824,727     715,407     729,965
                                                       ----------   ---------   ---------   ---------   ---------   ---------
Net re-estimated liability...............               1,127,533   1,010,428     962,138     860,468     787,504   1,067,446
                                                       ==========   =========   =========   =========   =========   =========


<CAPTION>
                                              1998        1999        2000        2001
                                           ---------   ---------   ---------   ---------
<S>                                       <C>         <C>         <C>         <C>
Gross reserves for loss and adjustment
 Expense.................................  1,603,548   1,353,524   1,392,497   1,599,127
 Deduct: reinsurance recoverable.........    732,567     614,208     626,647     608,877
Net reserves for loss and loss
 adjustment
 Expense.................................    870,981     739,316     765,850     990,250
Net paid (cumulative) as of:
 One year later..........................    245,278     183,038     279,290
 Two years later.........................    364,188     342,291
 Three years later.......................    479,121
 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..........................    333,982     240,167     331,245
 Two years later.........................    504,850     443,087
 Three years later.......................    665,809
 Four years later........................
 Five years later........................
 Six years later.........................
 Seven years later.......................
 Eight years later.......................
 Nine years later........................
Net liability re-estimated as of:
 End of year.............................
 One year later..........................    870,981     739,316     765,850     990,250
 Two years later.........................    862,894     764,272     962,930
 Three years later.......................    866,204     874,167
 Four years later........................    950,704
 Five years later........................
 Six years later.........................
 Seven years later.......................
 Eight years later.......................
 Nine years later........................
 Ten years later.........................
Net (deficiency) redundancy..............    (79,723)   (134,851)   (197,080)
Impact of 1997 Third Quarter Change......         --          --

Aggregate Stop Loss Adjustment
Remaining net (deficiency) redundancy....    (79,723)   (134,851)   (197,080)
                                           =========   =========   =========
Gross re-estimated liability as of:
 End of year.............................  1,603,548   1,353,524   1,392,497   1,599,127
 One year later..........................  1,574,814   1,413,887   1,563,832
 Two years later.........................  1,579,515   1,489,808
 Three years later.......................  1,646,625
 Four years later........................
 Five years later........................
 Six years later.........................
 Seven years later.......................
 Eight years later.......................
 Nine years later........................

Gross cumulative (deficiency)
redundancy...............................    (43,077)   (136,284)   (171,335)
                                           =========   =========   =========
Gross re-estimated liability.............  1,646,625   1,489,808   1,563,832
Less: re-estimated recoverable...........    695,921     615,641     600,902
                                           ---------   ---------   ---------
Net re-estimated liability...............    950,704     874,167     962,930
                                           =========   =========   =========
</TABLE>

     Effective December 1999, the Company wrote off its investment in LMI. See
Item 7: "Management's Discussion and Analysis of Financial Condition and Results
of Operations." This created a more favorable development in 1997 of
approximately $52.8 million gross and $23.6 million net. It also created a more
favorable development in 1998 of approximately $60.3 million gross and $24.0
million net.

     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."

                                       5
<PAGE>

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.

  The Company maintained excess of loss reinsurance treaties for each of its
main property, casualty and marine coverages during 2001. 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 in addition to 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 $1,000,000 up to $25 million per risk subject. For larger limits or
whenever unusual exposures are present, the Company purchases individual policy
reinsurance which is referred to as facultative.  On marine business, reinsurers
assumed liability on loss occurrences which exceed $125,000 per occurrence up to
$22 million.  In addition, the Company purchased property catastrophe
reinsurance to reduce its exposure to losses resulting from any single
catastrophic event. Under this treaty, which is effective from July 1, 2001
through June 30, 2002, the Company retains $6 million of a loss occurrence and
there are four layers of coverage above the $6 million retention. The first
layer, which is 91.56% placed, covers $4 million of losses in excess of $6
million and the Company retains 5%; the second layer covers $10 million of
losses in excess of $10 million and the Company retains 2.5%; the third layer
covers $20 million of losses in excess of $20 million with no retention by the
Company; and the fourth layer covers $30 million in losses in excess of $40
million with no retention by the Company. The Company intends to renew the
treaties for additional years as necessary at limits and terms commensurate with
its run-off business.  Due to the Company's run-off status, there can be no
assurance that reinsurers will offer treaties with similar terms and limits to
the Company.

  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, 2001.

                                                            December 31,
  Category                                                      2001
  --------                                                      ----
                                                           (in millions)
  A.M. Best Rated:
        B++ or better.................................        $343.4
        B+ or less....................................         104.6
  Non A.M. Best Rated:
        Equitas/Lloyds................................         135.2
        Other foreign reinsurers......................          99.0
        Pools and associations........................           9.7
                                                              ------
           Total reinsurance recoverable..............        $691.9
                                                              ======

  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. In
addition, there are instances where the Company and one or more of its
reinsurers disagree on the terms or extent of reinsurance coverage with respect
to particular losses. In those situations, the Company attempts to negotiate an
acceptable settlement of the disagreement or, failing to reach a settlement,
takes the matter to arbitration. The largest such disagreement, in the amount of
$12.0 million of reinsurance recoverable (net of a valuation allowance),
concerns reinsurance on California construction defect claims.

  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

                                       6
<PAGE>

recorded reserves. With respect to certain carriers, including those that are
not authorized reinsurers as determined by an insurance subsidiary's domiciliary
department of insurance, the Company sometimes 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, 2001, such collateral totaled approximately $60.8 million, of which
$33.3 million was received from other foreign reinsurers above. The Company's
three largest reinsurance recoverable exposures at December 31, 2001 were
approximately $135.2 million with Lloyds of London/Equitas, $72.1 million with
American Re-Insurance Company and $52.5 million with General Reinsurance
Corporation. See Item 7: "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources--
Reinsurance Receivables."


Investments

  The Company invests primarily in fixed maturity investment-grade securities
and managed its portfolio internally until December 31, 2000. Beginning in 2001,
the Company began using an outside firm to help manage its portfolio. The table
below shows the carrying value and classification of the Company's investments
at the dates indicated.

<TABLE>
<CAPTION>
                                                                       December 31,
                                                                 ------------------------
                                                                 2001      2000      1999
                                                                 ----      ----      ----
                                                                      (in millions)
<S>                                                            <C>        <C>       <C>
Fixed maturities:
  United States Government and government agencies..........    $134.4     138.3     116.0
  States, municipalities and political subdivisions.........      13.3      15.9      41.3
  Asset-backed and collateralized securities................     282.7     345.0     336.6
  Corporate securities......................................     283.8     277.2     268.6
Equity securities...........................................      29.7      32.1      26.6
Other investments...........................................       0.1       2.0       3.1
Cash and cash equivalents...................................     109.6     109.8      78.3
                                                                ------     -----     -----
                                                                $853.6     920.3     870.5
                                                                ======     =====     =====
</TABLE>

  Fixed Maturities.  Fixed maturities constituted 83.7% of the Company's cash
and investments at December 31, 2001. Fixed maturity investments are classified
as available-for-sale and carried on the Company's balance sheet at estimated
fair value, with unrealized gains and losses (net of taxes) recorded in
stockholders' equity as accumulated other comprehensive income (loss). At
December 31, 2001, the pre-tax net unrealized losses on available-for-sale fixed
maturities totaled $9.2 million.

  The fixed maturities portfolio is managed 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.


                          Moody's                     December 31,
                        Description              ----------------------
      NAIC Ratings      Equivalent        2001            2000           1999
      ------------      ----------        ----            ----           ----

              1          AAA/AA/A         85.9%           88.3%          90.9%
              2          BAA              11.1%           10.9%           8.8%
              3          BA                2.6%             .8%           0.3%
              4          B                  .4%             --             --
                                         -----           -----          -----
                                         100.0%          100.0%         100.0%
                                         =====           =====          =====

  See Notes to Consolidated Financial Statements for a description of the
contractual maturities of the Company's fixed maturities portfolio at December
31, 2001.

  Equity Securities.  Equity holdings comprised 3.5% of the Company's
investments at December 31, 2001, and consist of a diversified portfolio of
unaffiliated preferred stocks.

  Other Investments.  Other investments represent amounts invested in limited
partnerships.

  Cash and Cash Equivalents.  The Company's portfolio also includes short-term
securities and other miscellaneous investments, which in the aggregate comprised
12.8% of total investments at December 31, 2001.

                                       7
<PAGE>

     The following table sets forth the Company's gross investment income and
the pre-tax yield of its investment portfolio.

<TABLE>
<CAPTION>
                                                            Years ended December 31,
                                                            ------------------------
                                           2001                       2000                        1999
                                  ----------------------     ----------------------      ----------------------
                                  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.......  $52,496       7.03%        $55,697       7.33%          $62,981       6.76%
Equity securities...............    2,219       6.99           2,469       8.33             1,973       7.21
Short-term......................    4,963       4.52           5,268       5.82             3,343       4.45
Other invested assets...........       16       1.82              41       1.59               113       3.76
                                  -------       ----         -------       ----           -------       ----
    Total.......................  $59,694       6.72%        $63,475       7.19%          $68,410       6.60%
                                  =======       ====         =======       ====           =======       ====
</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.

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 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 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, 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;
and (iii) restrict the ability of any one person to acquire certain levels of
the Company's voting securities without prior regulatory approval.

     On April 20, 2001, the Company entered into a letter agreement with the
Texas Department of Insurance whereby the Company agreed to obtain prior
approval from the Department for any affiliated transaction of $1,000,000 or
more in any year. The Company also agreed to provide the Department notice of
any proposed material transaction between the Company and any non-affiliated
entity and to provide additional financial and informational reports to the
Department. On October 9, 2001, the Department requested that the Company submit
a plan to show how it intended to correct certain operational and financial
issues. The requested plan was submitted on November 13, 2001. On February 22,
2002, the Department issued orders placing the Company's Texas insurance
subsidiaries, including Highlands Insurance Company, the Company's principal
insurance subsidiary, under supervision. By their terms, the orders are also
binding on all the companies' affiliates. Under the terms of the orders, the
companies may not do any of the following without the approval of the Texas
Department of Insurance: dispose of, convey or encumber any of their assets,
property or business in force; withdraw from any of their bank accounts; lend
any of their funds or assets; invest any of their funds or assets; transfer any
of their property; incur any debt, obligation or liability, either direct or
contingent, or enter into any new contract or amendment, or amend any existing
contract or agreement; merge or consolidate with any other company; enter into
any new or amend a reinsurance contract or treaty, or amend or commute an
existing reinsurance contract or treaty; terminate, surrender, forfeit, convert
or lapse any policy or contract of insurance, except for nonpayment of premiums
due, or release, pay, or refund premiums or deposits, accrued cash loan values,
unearned premiums, or other reserves on any insurance policy or contract; or
enter into any, or amend any existing, transaction with any affiliated person or
entity, or transfer any asset or funds to any affiliated person or entity. Due
to their financial condition, the Texas insurance subsidiaries are prohibited
from declaring or paying dividends or distributions without prior approval.

     On October 29, 2001, the Wisconsin Insurance Department issued a
Stipulation and Order to Northwestern National Casualty Company and NN Insurance
Company, two of the Company's insurance subsidiaries. Under the terms of the
Order, neither company may perform functions that are not in the ordinary course
of business without the prior approval of the

                                       8
<PAGE>

Wisconsin Insurance Department. Such actions include: affiliated transactions,
including entering into new reinsurance, cost-sharing or service contracts;
declaring any dividend or distribution; any transaction (with a value greater
than $200,000) relating to a transfer of business, sale of renewal rights,
portfolio reinsurance contracts, or any other restructuring or sale of assets or
transfer of a material portion of business or transfer of business other than in
the normal course of business. The companies must also notify the Department
within three business days of any change to their officers and directors.

  On December 20, 2001, the North Carolina Insurance Department issued a Summary
Order to State Capital Insurance Company, an insurance subsidiary of the
Company.  Under the terms of the Order, State Capital Insurance Company may not
perform the following functions without the Department's prior approval: dispose
of, convey or encumber any of its assets or its business in force; withdraw from
any of its bank accounts; lend or invest any of its funds; transfer any of its
property; incur any debt, obligation or liability; merge or consolidate with
another company; establish premiums or renew any policies; enter into any new
reinsurance contract or treaty; terminate, surrender, forfeit, convert or lapse
any insurance coverage, except for nonpayment of premium; or make any other
change in its operations that the Department considers to be material.  Due to
its financial condition, State Capital Insurance Company is prohibited from
declaring or paying dividends or distributions without prior approval.

  In addition to the above described Orders, the Company's insurance
subsidiaries have had their licenses to transact business suspended in Florida,
Illinois, Kansas, Kentucky, Minnesota, Missouri, New Mexico, Ohio and Rhode
Island, and by the U.S Department of Treasury and the U.S. Department of Labor
with respect to federal surety and workers' compensation programs.  The licenses
in Connecticut and North Carolina have been amended to allow the companies to
service existing business only.  The Company has also agreed to cease writing
new and renewal business in Colorado, Maine, Michigan and South Carolina and has
been removed from the list of eligible surplus lines insurers in New Mexico,
Texas and Virginia.  Except where prohibited by regulation or where withdrawal
plans have been filed and are pending, the Company is not renewing any business
upon policy term expiration.

  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.

  The Company obtained permission from the Texas, Wisconsin and California
insurance departments to discount its loss and loss adjustment expense reserves
by 5% in connection with the preparation of the 2001 annual statutory statements
for the Company's insurance subsidiaries domiciled in those states.  Without
this permitted statutory accounting for loss and loss adjustment expense
reserves, the Company's principal insurance subsidiaries, Highlands Insurance
Company, Northwestern National Casualty Company and Pacific National Insurance
Company, would have reported negative surplus at December 31, 2001.  Taking into
account the permitted discounting in 2001, the combined statutory surplus of the
Company's insurance subsidiaries declined in 2001 from $204.0 million to $42.2
million.  As indicated above, insurance subsidiaries of the Company are subject
to regulatory orders.

  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

                                       9
<PAGE>

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.

Employees

  The Company reduced its workforce in 2001 by 283 and had 629 employees as of
December 31, 2001. The Company intends to make further reductions to its
employee workforce during 2002.

Risk Factors

  Loss Reserves.  The Company maintains loss reserves for what it expects the
ultimate settlement and administration of its claims will cost. The Company
bases the reserve amounts on facts and circumstances of which it is aware,
predictions of future events, estimates of future trends in claims severity and
frequency and other subjective factors. However, there is no method for
precisely estimating the Company's ultimate liability.

  The Company regularly reviews its reserving techniques and its overall amount
of reserves. It also reviews: information regarding each claim for losses; its
loss history and the industry's loss history; legislative enactments, judicial
decisions and legal developments regarding damages; changes in political
attitudes; and trends in general economic conditions, including inflation. As a
result of an analysis made at the end of 2001, it was determined that there had
been adverse development in the commercial multiple peril, general liability,
commercial automobile liability and workers' compensation lines of business, see
Item One:  "Business - Loss and Loss Adjustment Expense Reserves."  At the end
of 2001, significant reserve increases were made covering these lines of
business.

  Reinsurance.  The Company transfers its exposure to certain risks to others
through reinsurance arrangements. Under these arrangements, other insurers
assume a portion of the Company's losses and expenses associated with reported
and unreported claims in exchange for a portion of policy premiums. The
availability, amount and cost of reinsurance depend on general market conditions
and may vary significantly. Furthermore, the Company faces a credit risk with
respect to reinsurance. When the Company obtains reinsurance, it is still liable
for those transferred risks if the reinsurer cannot meet its obligations.
Therefore, the inability of the Company's reinsurers to meet their financial
obligations could materially affect its operations.

  The Company, from time to time, assumes reinsurance from other insurers and
reinsurers. During 2001, the Company incurred a loss of approximately $65.5
million gross and $43.2 million net on this assumed reinsurance business.

  Debt Obligations.  The Company has outstanding $47.5 million in senior bank
debt and $62.85 million principal amount of convertible subordinated debentures.
The bank debt matures on April 30, 2002, and is collaterized by a first lien on
the stock of the Company's principal insurance subsidiaries. The Company is
currently in default under the terms of the Credit Agreement for the senior bank
debt. The convertible subordinated debentures are due December 31, 2005;
however, by virtue of the cross default provisions of the debentures, if either
the senior bank debt becomes due and is not paid or is in default and the
maturity of the debt is accelerated, the holders of the debentures have the
right to declare the debentures in default and accelerate their maturity. Due to
the Company's current financial condition, see Item 6: "Selected Financial Data"
and Item 7: "Management's Discussion and Analysis of Financial Condition and
Results of Operations," Highlands Group is currently investigating the
possibility of filing a petition for reorganization under Chapter 11 of the
United States Bankruptcy Code.

  Continuing Losses.  In 2001, the Company incurred a net loss of $341.9 million
and in 2000, a net loss of $106.6 million, and at December 31, 2001, it had a
deficit in stockholders' equity of $163.3 million. The Company's independent
auditors have declined to express an opinion on the Company's 2001 financial
statements.

  Regulation.  The Company is subject to extensive supervision and regulation in
the states in which it operates. The supervision and regulation relate to
numerous aspects of its business and financial condition. The primary purpose of
the supervision and regulation is the protection of the Company's insurance
policyholders, and not the Company's shareholders or other investors. The extent
of regulation varies, but generally is derived from state statutes. These
statutes delegate regulatory, supervisory and administrative authority to state
insurance commissioners.

  In February 2002, the Texas Department of Insurance issued Supervisory Orders
to the Company's Texas insurance subsidiaries, including Highlands Insurance
Company, the Company's principal insurance subsidiary.  By their terms, the
orders are also binding on all the companies' affiliates.  A Supervisory Order
for another of the insurance subsidiaries, State Capital Insurance Company, was
issued by the North Carolina Department of Insurance in December 2001, and in
October 2001, the Wisconsin Commissioner of Insurance issued a Stipulation and
Order covering Northwestern National Casualty Company, the

                                       10
<PAGE>

Company's second largest insurance subsidiary, and NN Insurance Company, another
of the Company's insurance subsidiaries. In addition to these orders, the
Company's insurance subsidiaries have had their licenses to transact business
suspended in Florida, Illinois, Kansas, Kentucky, Minnesota, Missouri, New
Mexico, Ohio and Rhode Island, and by the U.S. Department of Treasury and the
U.S. Department of Labor with respect to federal surety and workers'
compensation programs. The licenses in Connecticut and North Carolina have been
amended to allow the companies to service existing business only. The Company
has also agreed to cease writing new and renewal business in Colorado, Maine,
Michigan and South Carolina and has been removed from the list of eligible
surplus lines insurers in New Mexico, Texas and Virginia. Except where
prohibited by regulation or where withdrawal plans have been filed and are
pending, the Company is not renewing any business upon policy term expiration.
See "Regulation."

  As a result of the losses incurred by the Company's insurance subsidiaries,
one or more state insurance commissioners could seek to place the Company's
insurance subsidiaries that are under their jurisdiction in rehabilitation or
liquidation. If an insurance subsidiary were placed in rehabilitation or
liquidation, the Company would lose control of that insurance subsidiary.

  Restrictions on Dividends.  As an insurance holding company, the Company's
principal assets consist of the capital stock of its insurance subsidiaries, and
its principal source of revenues is dividends from the insurance subsidiaries.
The Company's insurance subsidiaries may only pay dividends if they are
permitted to do so under the insurance regulations of their domiciliary states.
All of the domiciliary states of the Company's insurance subsidiaries regulate
the payment of dividends. Due to the losses incurred by the Company in 2000 and
2001, the Company's insurance subsidiaries have been prohibited from paying cash
dividends without prior regulatory approval, and no further dividends from the
insurance subsidiaries are likely to be paid.


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
has terminated the lease for its Woodland Hills, California office and has
relocated the claim operations staff to a new Woodland Hills location with a
six-month lease, continuing month to month thereafter. Leased properties have
been sublet in Nashville, Tennessee and New Orleans, Louisiana. The Company has
extended buyout offers for leased properties in Brookfield, Wisconsin, Dallas,
Texas, Denver, Colorado, Des Moines, Iowa and San Antonio, Texas. Brokers have
been engaged to attempt to sublet leased properties in Brookfield, Wisconsin,
Des Moines, Iowa, Raleigh, North Carolina and Sacramento, California. The lease
on the Company's claim office in Missoula, Montana can be terminated with
ninety-days notice.


ITEM 3: Legal Proceedings.

  Halliburton. From 1958 to 1986, the Company issued fixed premium, guaranteed
cost (not retrospectively rated) insurance policies to Brown & Root, a
subsidiary of Halliburton Company. Beginning in 1987, the Company's insurance
policies with Halliburton (including Brown & Root) were written on a
retrospectively rated or high-deductible basis. Based on the Form 10-K filed by
Halliburton on March 12, 2002, there were approximately 32,000 open and
unresolved third party asbestos claims which have been made against
Halliburton's Engineering and Construction Group. Through December 31, 2000, the
Company paid $1.2 million on behalf of Halliburton under the fixed premium
policies on asbestos claims, and billed Halliburton $8.5 million under the
retrospectively rated and high-deductible policies on asbestos claims.
Halliburton has not paid this billed amount and has questioned the proper
allocation of the asbestos claims between the fixed premium and the
retrospectively rated and high-deductible policies.

  On April 5, 2000, the Company filed an action in the Delaware Court of
Chancery ("Delaware Action") asserting that indemnification obligations exist
pursuant to the Distribution Agreement dated October 10, 1995 between the
Company and Halliburton, which was executed as part of the distribution by
Halliburton of the shares of the Company's Common Stock to Halliburton's
stockholders and the public. The action sought (i) a declaratory judgment that
Halliburton is responsible for indemnifying the Company for losses and expenses
incurred on the Halliburton/Brown & Root policies; (ii) an injunction ordering
Halliburton to assume responsibility for such losses and expenses; (iii) a
judgment against Halliburton for non-payment of the amounts billed under the
retrospectively rated and high-deductible policies; and (iv) a declaration
estopping Brown & Root from invoking insurance under the fixed premium policies.

  On July 13, 2000, the Company amended its complaint in the Delaware Action,
adding a count seeking a declaratory judgment that the Company is not liable
under the fixed premium policies because those policies were terminated pursuant
to the Investment Agreement dated October 10, 1995 among the Company,
Halliburton, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda)
L.P. The Company also filed a motion for a preliminary injunction enjoining
Halliburton from instituting, continuing or prosecuting any action in any other
jurisdiction arising out of or related to the subject matter of the Delaware

                                       11
<PAGE>

Action. On July 26, 2000, Halliburton filed motions to dismiss the Delaware
Action on the grounds of forum non conveniens and failure to state a claim upon
which relief can be granted. On September 8, 2000, the Company filed a motion
for judgment on the pleadings in the Delaware Action. Oral argument on
Halliburton's motions to dismiss and the Company's motion for judgment on the
pleadings in the Delaware Action was held on November 30, 2000. On March 21,
2001, the Chancery Court in the Delaware Action issued its decision in favor of
the Company, finding that the fixed premium policies had been terminated
pursuant to the Investment Agreement. An order was issued to that effect on
April 3, 2001. Halliburton appealed the decision of the Chancery Court to the
Delaware Supreme Court and on March 13, 2002, the Delaware Supreme Court issued
an Order affirming the decision of the Chancery Court. On March 28, 2002,
Halliburton filed a motion with the Delaware Supreme Court requesting
reargument.

  On April 24, 2000, Halliburton filed an action in the District Court of Harris
County, Texas ("Texas Action") seeking (i) a declaratory judgment that the
Company is liable for costs and expenses under the fixed premium policies; (ii)
a declaratory judgment that Halliburton has the right to select the policy under
which such coverage is to be paid; and (iii) damages. The Company filed its
answer in the Texas Action on July 26, 2000 denying the allegations in
Halliburton's complaint. On July 27, 2000, Halliburton filed an amended petition
in the Texas Action adding Brown & Root as plaintiff. On November 6, 2000,
Halliburton filed a second amended petition in the Texas Action adding Highlands
Group as a defendant. Proceedings in the Texas Action have largely been held in
abeyance by the parties pending the resolution of the Delaware Action, although
there is no assurance that Halliburton will not attempt to activate the Texas
Action in the future.  Following the decision of the Delaware Supreme Court on
March 13, 2002, Halliburton announced that it is "reviewing its options."

  Regulatory Proceedings. In February 2002, the Texas Department of Insurance
issued Supervisory Orders to the Company's Texas insurance subsidiaries,
including Highlands Insurance Company, the Company's principal insurance
subsidiary. By their terms, the orders are also binding on all the companies'
affiliates. A Supervisory Order for another of the insurance subsidiaries, State
Capital Insurance Company, was issued by the North Carolina Department of
Insurance in December 2001, and in October 2001, the Wisconsin Commissioner of
Insurance issued a Stipulation and Order covering Northwestern National Casualty
Company, the Company's second largest insurance subsidiary, and NN Insurance
Company, another of the Company's insurance subsidiaries. In addition to these
orders, the Company's insurance subsidiaries have had their licenses to transact
business suspended in Florida, Illinois, Kansas, Kentucky, Minnesota, Missouri,
New Mexico, Ohio and Rhode Island, and by the U.S. Department of Treasury and
the U.S. Department of Labor with respect to federal surety and workers'
compensation programs. The licenses in Connecticut and North Carolina have been
amended to allow the companies to service existing business only. The Company
has also agreed to cease writing new and renewal business in Colorado, Maine,
Michigan and South Carolina and has been removed from the list of eligible
surplus lines insurers in New Mexico, Texas and Virginia. Except where
prohibited by regulation or where withdrawal plans have been filed and are
pending, the Company is not renewing any business upon policy term expiration.
See Item 1: "Business--Regulation."


ITEM 4: Submission of Matters to a Vote of Security Holders.

  None.

                                       12
<PAGE>

                                    PART II

ITEM 5: Market for Company's Common Stock and Related Stockholder Matters.

     The Company's Common Stock was delisted from the New York Stock Exchange on
December 12, 2001. It is currently traded on the NASD Over the Counter Bulletin
Board under the trading symbol "HIGP." As of March 1, 2002, approximately
13,424,433 shares of Common Stock were issued and outstanding, 445,900 of which
are held by subsidiaries of the Company. In addition, 1,700,000 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" and Item 12:
"Security Ownership of Certain Beneficial Owners and Management."

     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 until December 12, 2001 when trading on the NYSE ceased.
The table also sets forth the high and low prices reported on the Over the
Counter Bulletin Board from December 13, 2001 to December 31, 2001.

    Period                                          High      Low
 ----------                                         ----      ---
2000 First Quarter..............................   $10.63    $6.81
2000 Second Quarter.............................     9.38     7.06
2000 Third Quarter..............................     9.63     8.38
2000 Fourth Quarter.............................     9.63     8.69
2001 First Quarter..............................     9.25     2.55
2001 Second Quarter.............................     5.74     1.20
2001 Third Quarter..............................     6.20     2.30
2001 Fourth Quarter through 12/12/01............     2.40     0.17
2001 Fourth Quarter - 12/13/01 to 12/31/01......     0.19     0.06

     The approximate number of stockholders of record of Common Stock as of
March 1, 2002 was 11,074.


     Dividends. The Company has not previously paid any dividends and does not
intend to pay dividends on the Common Stock.

     Unregistered Sales of Securities. On May 10, 1999, the Company sold in a
private transaction for cash 454,546 shares of its Common Stock at $11.00 per
share, which was the closing price of the Common Stock on the New York Stock
Exchange, to Willis T. King, Jr., former Chairman and Chief Executive Officer of
the Company, pursuant to an Employment Agreement entered into between the
Company and Mr. King. The aggregate price for those shares was $5,000,000 and no
underwriting discounts or commissions were paid. That sale of Common Stock was
exempt from registration under the Securities Act of 1933 pursuant to Section
4(2) as a transaction not involving a public offering.

                                       13
<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,
                                                                        ------------------------
                                                         2001         2000        1999        1998        1997
                                                      ----------    --------    --------    --------    --------
                                                             (dollars in thousands, except per share data)
<S>                                                   <C>           <C>         <C>         <C>         <C>
Statement of Operations Data:
Revenues:
  Net premiums earned..............................   $  496,559     388,505     325,305     388,813     311,993
  Net investment income............................       58,782      62,453      67,684      77,969      74,383
  Net realized investment gains....................       11,823         974          22      16,874       5,585
                                                      ----------   ---------   ---------   ---------   ---------
       Total revenues..............................      567,164     451,932     393,011     483,656     391,961
Expenses:
  Loss and loss adjustment expense incurred........      667,118     346,137     238,940     328,400     246,479
  Underwriting expenses............................      227,198     134,470     130,121     141,788     115,564
  Debt interest and amortization expense...........       11,393      12,392      11,753      12,258      10,542
  Loss on write-off of subsidiary..................           --          --      10,452          --          --
  Other expenses (income), net.....................        2,314      (2,538)      2,210       2,000         857
                                                      ----------   ---------   ---------   ---------   ---------
       Total expenses..............................      908,023     490,461     393,476     484,446     373,442
Income (loss) before taxes.........................     (340,859)    (38,529)       (465)       (790)     18,519
Income tax expense (benefit)(1)....................          744      67,747      12,984      (3,887)      1,683
                                                      ----------   ---------   ---------   ---------   ---------
Net income (loss)..................................     (341,603)   (106,276)    (13,449)      3,097      16,836
Dividends paid on mandatorily redeemable
 Preferred stock...................................          305         289          --          --          --
                                                      ----------   ---------   ---------   ---------   ---------
Net income (loss) attributable to common
 Stockholders......................................   $ (341,908)   (106,565)    (13,449)      3,097      16,836
                                                      ==========   =========   =========   =========   =========
Earnings (loss) per common share:
  Basic............................................   $   (25.89)      (8.06)      (1.04)        .24        1.34
  Diluted..........................................   $   (25.89)      (8.06)      (1.04)        .20        1.09
Balance Sheet Data (at end of period):
Investments, cash and cash equivalents.............   $  853,596     920,259     870,455   1,096,147   1,232,917
Receivable from reinsurers.........................   $  691,938     683,439     684,525     787,344     723,114
Total assets.......................................   $1,820,612   2,001,150   1,961,287   2,265,043   2,366,656
Loss and loss adjustment expense reserves..........   $1,599,127   1,392,497   1,353,524   1,603,548   1,605,374
Mandatorily redeemable preferred stock.............   $    5,235       4,930       4,641          --          --
Stockholders' equity (deficit).....................   $ (163,282)    174,549     264,401     318,554     329,293
Certain Financial Ratios and Other Data:
GAAP:
  Loss ratio.......................................        134.3%       89.1%       73.5%       84.4%       79.0%
  Expense ratio....................................         45.8        34.6        40.0        36.5        37.0
                                                      ----------   ---------   ---------   ---------   ---------
      Combined ratio...............................        180.1%      123.7%      113.5%      120.9%      116.0%
                                                      ==========   =========   =========   =========   =========
Statutory surplus(3)...............................   $   41,181     204,042     270,783     313,542     333,141
Net premiums written to policyholder surplus.......         11.4x        2.2x        1.2x        1.2x        1.2x(2)
</TABLE>
     _________
(1) 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." For
    further information regarding federal and foreign income taxes, see Note 7
    to Consolidated Financial Statements.
(2) Net Premiums written to policyholder surplus includes twelve months pro
    forma net premiums written for American Reliance.
(3) The Company obtained permission from the Texas, Wisconsin and California
    insurance departments to discount its loss and loss adjustment expense
    reserves by 5% in connection with the preparation of the 2001 annual
    statutory statements for the Company's insurance subsidiaries domiciled in
    those states.  Without this permitted statutory accounting for loss and loss
    adjustment expense reserves, the Company's principal insurance subsidiaries,
    Highlands Insurance Company, Northwestern National Casualty Company and
    Pacific National Insurance Company, would have reported negative surplus at
    December  31, 2001.  The above table reflects the permitted discounting.

                                       14
<PAGE>

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.

  Property and casualty insurers are regulated by the various state insurance
commissioners who coordinate their efforts through the NAIC. See Item 1:
"Business--Regulation." Regulation includes rate and policy form approval,
licensing of insurance agents and companies and solvency oversight.

Critical Accounting Policies

  The Company's most critical accounting policy is its estimate of incurred
losses and loss adjustment expenses, including the reserve for loss and loss
adjustment expenses.  These estimates also directly impact the reinsurance
items, primarily the receivable from reinsurers included in the consolidated
financial statements.

  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 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 2001 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 involves 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.

  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 on reported losses.  A significant portion of the Company's loss
reserves are the reserves 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.

                                       15
<PAGE>

  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.

  As a result of a reserve analysis done in the fourth quarter of 2001 by the
Company and its independent actuary, it was determined that there had been
adverse development in the 2000 accident year of approximately $89 million.  The
2000 accident year net loss and net loss adjustment expense ratio is 100.1%.
Also, the reserve analysis demonstrated that losses incurred and loss adjustment
expenses in the 2001 accident year would exceed the Company's estimates by more
than 10 percentage points.  For 2001, the Company recorded a 95% accident year
and a 134.3% calendar year loss and loss adjustment expense ratio on $496.6
million of net earned premium.  The adverse development in 2001 and 2000 came
primarily from the following four lines of business--workers' compensation,
general liability, commercial multiple peril and commercial auto liability.  The
adverse development amounts related to asbestos and environmental claims for
2001, 2000 and 1999 were $14.8 million, $7.8 million and $1.8 million,
respectively.


Results of Operations

  The results of the Company's consolidated operations for the periods indicated
are set forth below:

<TABLE>
<CAPTION>
                                                       Years Ended December 31,
                                                   ---------------------------------
                                                     2001         2000         1999
                                                   -------       ------       ------
                                                   (dollars in millions, except per
                                                             share data)
<S>                                                <C>           <C>          <C>
Consolidated Results:
Gross premiums written........................     $ 499.0        517.1        364.1
Net premiums written..........................     $ 442.0        461.0        333.6
                                                   =======       ======       ======
Net premiums earned...........................     $ 496.6        388.5        325.3
Loss and loss adjustment expense..............      (667.2)      (346.1)      (238.9)
Underwriting expenses.........................      (227.2)      (134.5)      (130.1)
                                                   -------       ------       ------
Underwriting loss.............................      (397.8)       (92.1)       (43.7)
Net investment income.........................        58.8         62.5         67.7
Net realized investment gains.................        11.8          1.0           --
Debt interest and amortization expense........       (11.4)       (12.4)       (11.8)
Loss on write-off of subsidiary...............          --           --        (10.5)
Other income (expenses), net..................        (2.3)         2.5         (2.2)
                                                   -------       ------       ------
Loss before income taxes......................      (340.9)       (38.5)        (0.5)
Income tax expense (benefit)..................          .7         67.8         12.9
                                                   -------       ------       ------
Net income (loss).............................     $(341.6)      (106.3)       (13.4)
Dividends paid on mandatorily redeemable
preferred stock                                         .3           .3          ---
                                                   -------       ------       ------
Net loss attributable to common shareholders..      (341.9)      (106.6)       (13.4)
Earnings (loss) per share:
         Basic................................     $(25.89)       (8.06)       (1.04)
         Diluted..............................     $(25.89)       (8.06)       (1.04)
Ratios:
Loss..........................................       134.3%        89.1%        73.5%
Expense.......................................        45.8         34.6         40.0
                                                   -------       ------       ------
Combined......................................       180.1%       123.7%       113.5%
                                                   =======       ======       ======
</TABLE>

                                       16
<PAGE>

Period to Period Comparisons

  Gross Premiums Written.  Gross premiums written for 2001, 2000 and 1999 were
$499.0 million, $517.1 million and $364.1 million, respectively.   The decrease
in gross premiums written of $18.1 million or 3.5% in 2001 is primarily due to
the implementation of the Company's financial plan to reduce premiums and
operating expenses. The increase in gross premiums written of $153.0 million or
42.0% in 2000 is primarily due to increases in premium volume from the Company's
regional offices as well as new programs introduced in 2000, principally a golf
course program ($15.3 million) and a livery program ($27.5 million). In
addition, the Company increased prices on its commercial lines in 2000,
reflecting the hardening commercial insurance market.

  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, net
premiums written and net premiums earned to fluctuate significantly from period
to period. Experience rated insurance policies reduce but do not eliminate risk
to the insurer.

  Net Premiums Written.  Net premiums written for 2001, 2000 and 1999 were
$442.0 million, $461.0 million and $333.6 million, respectively.  The decrease
in 2001 of $19.0 million or 4.1% and the increase in 2000 of $127.4 million or
38.4% relate to the same factors noted above for gross written premiums.

  Net Premiums Earned.  Net premiums earned for 2001, 2000 and 1999 were $496.6
million, $388.5 million and $325.3 million, respectively. The increase in 2001
compared to 2000 and the increase in 2000 compared to 1999 are related to the
same items affecting gross and net premiums written as noted above, but also
reflects the recognition of net premiums earned over the coverage period rather
than when the premiums were written.

  Loss and Loss Adjustment Expense Incurred.  Loss and loss adjustment expense
incurred for 2001, 2000 and 1999 were $667.2 million, $346.1 million and $238.9
million, respectively.  The loss and loss adjustment expense ratios for 2001,
2000 and 1999 were 134.3%, 89.1% and 73.5%,  respectively.  During the fourth
quarter of 2001, the Company, along with its independent actuary, determined
that there had been adverse development in the Company's major lines of
business.  Following this analysis, loss and loss adjustment expense reserves
were increased at the end of 2001 by approximately $190 million.  The increase
in reserves affected current as well as prior year business, and increased the
2001 calendar year loss ratio by approximately 10 percentage points, excluding
the effects of certain reserve adjustments on retrospectively rated policies
which were offset by net premiums earned.  During the fourth quarter of 2000,
the Company, along with its independent actuary, determined that there had been
adverse development in the commercial multiple peril and workers' compensation
lines.  Following this analysis, loss and loss adjustment expense reserves were
increased at the end of 2000 by approximately $48.0 million, covering those
lines as well as increases and decreases in other lines.

  Underwriting Expenses.  Underwriting expenses for 2001, 2000 and 1999 were
$227.2 million, $134.5 million and $130.1 million, respectively. The
underwriting expense ratios for 2001, 2000 and 1999 were 45.8%, 34.6% and 40.0%
respectively.  The increase in 2001 compared to 2000 is primarily related to the
write-off of $49.6 million of deferred acquisition costs that were determined to
be unrecoverable.  In addition, a $5.0 million provision was established for
uncollectible premiums related to a large commercial automobile (livery)
program.  The decline in the 2000 underwriting expense ratio, compared to the
1999 expense ratio, of 5.4 points to 34.6%, resulted from expense savings
initiatives instituted in 1999, principally reducing systems out-sourcing costs
by $5.1 million and reducing salary and benefits by $3.5 million. Additionally,
lower fixed costs were spread over higher premium volume in 2000.

  Investment Results.  Net investment income for 2001, 2000 and 1999 was $58.8
million, $62.5 million and $67.7 million, respectively.  Net investment income
decreased $3.7 million in 2001 compared to 2000 and $5.2 million in 2000
compared to 1999 primarily due to reductions in the investment portfolio's
average amortized cost.

  Debt Interest and Amortization Expense.  Debt interest and amortization
expense for 2001, 2000 and 1999 was $11.4 million, $12.4 million and $11.8
million, respectively.  The decrease in debt interest and amortization expense
of $1.0 million in 2001 reflects the paydown of the Company's senior bank debt
and a lower variable interest rate in 2001.  The increase in debt interest and
amortization expense for 2000 compared to 1999 was due to the increase in the
underlying variable interest rate and variable performance add-ons associated
with the Company's senior bank debt.

  Loss on Write-off of Subsidiary.  Effective December 1999, the Company wrote-
off its remaining investment in LMI which was in run-off since April 1997 when
it was acquired in the purchase of American Reliance. In March 2000, the Court
of Common Pleas in Franklin County, Ohio entered an Order appointing the
Superintendent of Insurance of the State of Ohio as the

                                       17
<PAGE>

Rehabilitator of LMI. As Rehabilitator, the Superintendent is by operation of
law vested with control of LMI, including title to all of LMI's assets.

  Other Income (Expenses), Net.  This consists of parent company expenses and
miscellaneous expenses from the insurance subsidiaries offset by miscellaneous
income. During 2000, the Company recognized as income: (i) $1.3 million
associated with a reserve guarantee finalized in 2000 (see Note 3 of Notes to
the Consolidated Financial Statements); (ii) a reduction of the bonus accrual of
$1.8 million associated with the Management Investor's Purchase Agreement (see
Note 8 of Notes to the Consolidated Financial Statements); and (iii) a reduction
of $1.8 million of other accruals.

  Income Taxes.  During 2000, the Company increased its valuation allowance for
deferred tax assets by $82.8 million. Based on the results of operations,
management does not currently believe that it is more likely than not that the
tax benefits for which it increased the valuation allowance will be realized in
the near future. Total tax expense for 2000 was $67.7 million and reflects the
increase in valuation allowance. The total tax expense for 1999 was $13.0
million. In 1999, the Company recorded a charge totaling $11.6 million of
deferred taxes related to the write-off of LMI because it was determined that
deferred tax assets associated with LMI would not be recoverable by the Company.
Total tax expense for 2001 was $744,000, for state income taxes.

Liquidity and Capital Resources

  Highlands Group is a holding company, the principal assets of which at
December 31, 2001 are all of the capital stock of Highlands Holding Company,
Inc. and American Reliance, Inc. The Company's property and casualty insurance
business is conducted by its wholly-owned insurance subsidiaries. The liquidity
and capital resource considerations for the Highlands Group are different than
those of the Company's insurance operations. As described more fully below, due
to the Company's current financial condition, see Item 6:  "Selected Financial
Data," Highlands Group is currently investigating the possibility of filing a
petition for reorganization under Chapter 11 of the United States Bankruptcy
Code.

Holding Company

  As a holding company, Highlands Group's principal requirements for funds are
to pay operating expenses, franchise and other taxes and debt service. Operating
expenses and franchise and other taxes imposed on the Company are not material.
The Company has outstanding $47.5 million in senior bank debt and $62.85 million
principal amount of convertible subordinated debentures. The bank debt matures
on April 30, 2002, and is collaterized by a first lien on the stock of the
Company's principal insurance subsidiaries.  The Company is currently in default
under the terms of the Credit Agreement for the senior bank debt.  The
convertible subordinated debentures are due December 31, 2005; however, by
virtue of the cross default provisions of the debentures, if either the senior
bank debt becomes due and is not paid or is in default and the maturity of the
debt is accelerated, the holders of the debentures have the right to declare the
debentures in default and accelerate their maturity.

  Highlands Group's only significant sources of funds are dividends and tax
sharing payments from its subsidiaries.  As a result of orders issued by state
insurance regulators and losses incurred by the Company's insurance
subsidiaries, no further payments from the insurance subsidiaries are likely to
be made.  As a result, Highlands Group is currently investigating the
possibility of filing a petition for reorganization under Chapter 11 of the
United States Bankruptcy Code.

   As a result of the losses incurred by the Company's insurance subsidiaries,
one or more state insurance commissioners could seek to place the Company's
insurance subsidiaries that are under their jurisdiction in rehabilitation or
liquidation.  If an insurance subsidiary were placed in rehabilitation or
liquidation, the Company would lose control of that insurance subsidiary.

Insurance Subsidiaries

  Insurance Operations.  The principal sources of funds for the insurance
subsidiaries are premiums and amounts earned from the investment of such
premiums. The principal uses of funds by these subsidiaries are loss payments
and related expenses, underwriting expenses, other operating expenses and
dividends and tax sharing payments to Highlands Group.  As a result of the
insurance subsidiaries ceasing to write any new business and not renewing
existing business, premium income to the Company will be materially reduced in
the future.

  In the insurance industry, liquidity refers to the ability of an enterprise to
generate adequate amounts of cash from its operations, including its investment
portfolio, in order to meet its financial commitments, which are principally
obligations under the insurance policies it has written. Liquidity requirements
of insurance companies are influenced significantly by product mix and the
profitability of the products. Continuing operating losses, including those from
future catastrophe claims, the timing and amount of which are inherently
unpredictable, may create increased liquidity requirements for the insurance
subsidiaries. The

                                       18
<PAGE>

liquidity requirements of the insurance subsidiaries are met by that portion of
the investment portfolio that is held in cash and highly liquid securities.

  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. As a result of operating losses, the statutory
surplus of the Company's insurance subsidiaries has declined from $204.0 million
at December 31, 2000, to $41.2 million at December 31, 2001.  In November 2001,
the Company's principal insurance subsidiaries were downgraded to an A.M. Best
rating of "C-" (Weak).  On March 25, 2002, the Company was rated NR-4 (not rated
at Company's request) by A.M. Best.

  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,
                                                         ------------------
                                                           2001       2000
                                                           ----      -----
                                                       (dollars in millions)
  <S>                                                     <C>          <C>
  Statutory surplus..................................      41.2      204.0
  Net premiums written to surplus ratio..............      11.4x       2.2x
</TABLE>

  The Company obtained permission from the Texas, Wisconsin and California
insurance departments to discount its loss and loss adjustment expense reserves
by 5% in connection with the preparation of the 2001 annual statutory statements
for the Company's insurance subsidiaries domiciled in those states.  Without
this permitted statutory accounting for loss and loss adjustment expense
reserves, the Company's principal insurance subsidiaries, Highlands Insurance
Company, Northwestern National Casualty Company and Pacific National Insurance
Company, would have reported negative surplus at December 31, 2001.  The above
table reflects the permitted discounting.

  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 $10.4 million and $7.4 million as of December 31, 2001 and 2000,
respectively. Additionally, the Company has retained $26.4 million and $25.1
million of ceded reserves related to potentially uncollectible reinsurance at
December 31, 2001 and 2000. 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, 2001, such collateral totaled
approximately $60.8 million. The Company's three largest reinsurance recoverable
exposures at December 31, 2001 were approximately $135.2 million with Lloyds of
London/Equitas, $72.1 million with American Re-Insurance Company and $52.5
million with General Reinsurance Company.  American Re-Insurance Company and
General Reinsurance Corporation are both rated "A++" by A. M. Best.


Forward Looking Information

  The statements included in this Annual Report on Form 10-K for the year ended
December 31, 2001, regarding future financial performance and results and other
statements that are not historical facts are forward-looking statements. The
words "expect," "project," "estimate," "predict," "anticipate," "believes" and
similar expressions are also intended to identify forward-looking statements.
Such statements are subject to numerous risks, uncertainties and assumptions,
including but not limited to, the uncertainties relating to industry and market
conditions, natural disasters and other catastrophes, and other risks and
uncertainties described in this 2001 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.

                                       19
<PAGE>

ITEM 7A: Quantitative and Qualitative Disclosures about Market Risk.

Market Risk

     Market risk is the risk of lower securities and portfolio values resulting
from adverse changes in interest rates, foreign currency exchange rates and
other relevant market rate or price changes. The Company's investment strategy
is to maximize income and total return by investing in a diverse portfolio of
high-quality investment grade securities. The carrying value of the Company's
investment portfolio as of December 31, 2001 and 2000 was $744.0 million and
$810.5 million, respectively. The primary market risk to the investment
portfolio is interest rate risk associated with investments in fixed maturity
securities. The Company's exposure to equity price risk and foreign exchange
risk is not material. The Company has no direct commodity 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 and one-half 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. For the Company's investment portfolio, there
were no significant changes in the Company's primary risk exposures or in how
those exposures are managed for 2001 compared to 2000. The Company does not
currently anticipate significant changes in its primary market risk exposures or
in how those exposures are managed in future reporting periods based upon what
is known or expected to be in effect in future reporting periods.

     Sensitivity Analysis. Sensitivity analysis is defined as the measurement of
potential loss in future earnings, fair values or cash flows of market sensitive
instruments resulting from one or more selected hypothetical changes in interest
rates and other market rates or prices over a selected time. In the Company's
sensitivity analysis model, a hypothetical change in market rates is selected
that is expected to reflect reasonably possible changes in those rates over a
one-year period. Actual results may differ from the hypothetical change in
market rates assumed in this disclosure, especially since this sensitivity
analysis does not reflect the results of any actions that would be taken by the
Company to mitigate such hypothetical losses in fair value. In this sensitivity
analysis model, the Company uses fair values to measure its potential loss. The
sensitivity analysis model uses a 100 basis point change in interest rates to
measure the hypothetical change in fair value of financial instruments included
in the model. For this analysis, the Company assumes an instantaneous shift in
interest rates 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.

     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 on the Company's income, cash flow and
stockholders' equity.

     The sensitivity analysis model used by the Company produces a loss in fair
value of market sensitive instruments of $35.0 million and $37.8 million based
on a 100 basis point increase in interest rates as of December 31, 2001 and
2000, respectively. This loss value only reflects the impact of an interest rate
increase on the fair value of the Company's financial instruments, which
constitute approximately 46.9% of total assets and approximately 43.1% of total
liabilities as of December 31, 2001 and approximately 45.9% of total assets and
approximately 50.4% of total liabilities as of December 31, 2000. As a result,
the loss value excludes a significant portion of the Company's consolidated
balance sheet which would materially mitigate the impact of the loss in fair
value.

     In addition to the above, 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 $.5 million.


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.

                                       20
<PAGE>

                                   PART III

ITEM 10: Directors and Executive Officers of the Registrant.

Board of Directors

     The Board of Directors of the Company consists of five directors divided
into three classes serving staggered terms of three years each. The following
tables provide information regarding each director of the Company:


Class I Directors With Terms of Office Expiring at the 2002 Annual Meeting of
Stockholders

<TABLE>
<CAPTION>
  Name of Class I Directors     Age          Business Experience During Past Five Years and Other Information
------------------------------  ---   ------------------------------------------------------------------------------
<S>                             <C>   <C>
W. Bernard Pieper...........    69    Self-employed investor, 1996 to present; Vice Chairman of Halliburton Co.,
                                      1992 to 1996. Mr. Pieper is a director of NCI Building Systems, Inc. and
                                      OSCA, Inc. Mr. Pieper is currently a director of the Company.

Philip J. Hawk..............    48    Chairman and Chief Executive Officer of Team, Inc., 1998 to present; President
                                      and Chief Executive Officer of EOTT Energy Partners, L.P., 1993 to 1998. Mr.
                                      Hawk is a director of Team, Inc. Mr. Hawk is currently a director of the
                                      Company.
</TABLE>

 Class II Directors with Terms of Office Expiring at the 2003 Annual Meeting of
Stockholders

<TABLE>
<CAPTION>
      Name of Class II Directors        Age  Business Experience During Past Five Years and Other Information
--------------------------------------  ---  ----------------------------------------------------------------
<S>                                     <C>  <C>
                                                       There are currently no Class II Directors.
</TABLE>

Class III Directors With Terms of Office Expiring at the 2004 Annual Meeting of
Stockholders

<TABLE>
<CAPTION>
 Name of Class III Directors     Age         Business Experience During Past Five Years and Other Information
------------------------------   ---   -----------------------------------------------------------------------------
<S>                              <C>   <C>
Robert A. Spass (1).........     46    Deputy Chairman of the Board of Capital Z Management, LLC and Capital Z
                                       Partners, Ltd., 1998 to present; Managing Partner of Insurance Partners
                                       Advisors, L.P., 1994 to present; President and Chief Executive Officer of
                                       International Insurance Advisors, Inc., 1990-1994. In addition to holding
                                       directorships in non-public companies, Mr. Spass is a director of SNTL
                                       Group, Inc., Ceres Group, Inc., Aames Financial Corporation, Lending Tree,
                                       Inc. and Universal American Financial Corp.

Bradley E. Cooper (1).......     35    Senior Vice President of Capital Z Management, LLC and Capital Z Partners,
                                       Ltd., 1998 to present; Partner of Insurance Partners Advisors, L.P., 1994 to
                                       present; Vice President of International Insurance Advisors, Inc., 1990-1994.
                                       In addition to holding directorships in non-public companies, Mr. Cooper is a
                                       director of SNTL Group, Inc., Ceres Group, Inc. and Universal American
                                       Financial Corp.

Stephen L. Kibblehouse......     46    Chief Executive Officer and General Counsel of the Company and the
                                       subsidiaries of the Company, December 7, 2001 to present; Vice President,
                                       General Counsel & Secretary of the Company, May 9, 2000 to December 7, 2001;
                                       Senior Vice President, General Counsel and Secretary of the subsidiaries of
                                       the Company, May 2000 to December 7, 2001; Senior Vice President, Assistant
                                       General Counsel and Assistant Secretary of the subsidiaries of the Company,
                                       May 1997 to May 2000; Senior Vice President, Assistant General Counsel and
                                       Assistant Secretary of American Reliance, Inc. (formerly Vik Brothers
                                       Insurance, Inc.), June 1995 to May 2000.
</TABLE>

                                       21
<PAGE>

_________
(1) The Company's convertible subordinated debentures obligate the Company to
    nominate, and recommend the election of, persons designated by a majority in
    interest of the holders of the Debentures so that the number of persons so
    designated will at all times constitute, if elected, at least 28% of the
    Board of Directors. Messrs. Spass and Cooper were so elected to the Board of
    Directors of the Company.

    On November 7, 2001, Willis T. King, Jr. and Rufus J. Williams, III resigned
from their positions as Directors. Richard M. Haverland resigned as a Director
on February 12, 2002. Robert W. Shower resigned as a Director on March 8, 2002.

Executive Officers

    The following table provides information regarding persons currently serving
as executive officers of the Company:

<TABLE>
<CAPTION>
            Name               Age                    Title and Business Experience During Past Five Years
----------------------------   ---   --------------------------------------------------------------------------------------
<S>                           <C>    <C>
Stephen L. Kibblehouse......   46    Chief Executive Officer and General Counsel of the Company and the subsidiaries of
                                     the Company, December 7, 2001 to present; Vice President, General Counsel and
                                     Secretary of the Company, May 9, 2000 to December 7, 2001; Senior Vice President,
                                     General Counsel and Secretary of the subsidiaries of the Company, May 9, 2000 to
                                     December 7, 2001; Senior Vice President, Assistant General Counsel and Assistant
                                     Secretary of the subsidiaries of the Company, May 1997 to April 2000; Senior Vice
                                     President, Assistant General Counsel and Assistant Secretary of American Reliance,
                                     Inc. (formerly Vik Brothers Insurance, Inc.), June 1995 to May 2000.

Albert J. Marino............   56    Chief Financial Officer and Treasurer, December 7, 2001 to present; Self Employed
                                     Consultant, August 2000 to present; Executive Vice President and Chief Financial
                                     Officer, Reliance National Insurance Company, January 1990 to August 2000.

Georgean M. Wardzinski......   47    Vice President and Secretary, December 7, 2001 to present; Senior Vice President -
                                     Human Resources and Administration of the subsidiaries of the Company, July 1999 to
                                     present; Vice President - Human Resources of the subsidiaries of the Company,
                                     December 1997 to July 1999; Self Employed Consultant 1993 to December 1997.
</TABLE>

                                       22
<PAGE>

Section 16(a) Beneficial Ownership Reporting Compliance

     Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
the directors and executive officers of the Company, and persons who own more
than 10% of a registered class of our equity securities, to file with the
Securities and Exchange Commission reports of ownership and reports of changes
in ownership of the Common Stock and other equity securities of the Company. The
Company believes that all such reports required to be filed during 2001 were
timely filed.


ITEM 11: Executive Compensation.

     Summary Compensation Table. The following table sets forth information
concerning compensation for services in all capacities to the Company and its
subsidiaries during each of the last three years of those persons who were the
Company's Chief Executive Officer and its other executive officers during 2001
(collectively, the "named executive officers"):


                          Summary Compensation Table

<TABLE>
<CAPTION>
                                                 Annual Compensation                        Long-Term Compensation
                                       ----------------------------------------     ------------------------------------
                                                                                 Restricted     Securities    All Other
                                                                Other Annual       Stock        Underlying   Compensation
 Name and Principal Position    Years   Salary ($)  Bonus ($)   Compensation     Award ($)      Options (#)     ($)(1)
-----------------------------   -----  ----------- -----------  ------------     ----------     -----------     ------
<S>                             <C>    <C>         <C>          <C>              <C>            <C>          <C>
Stephen L. Kibblehouse.........  2001   $236,013   $331,004(2)                                                     $5,100
 Chief Executive Officer and     2000   $199,707   $  6,500               --             --          7,500         $5,100
 General Counsel of the
 Company

Albert J. Marino...............  2001                               $ 40,874(3)
 Chief Financial Officer and
 Treasurer of the Company

Georgean M. Wardzinski.........  2001   $170,936   $203,625(2)                                                     $5,026
 Vice President and
 Secretary of the Company

Willis T. King, Jr. (4)........  2001   $480,000   $575,625(2)
 Director, Chairman and          2000   $455,230   $210,000               --             --        120,000         $5,100
 Chief Executive Officer of      1999   $254,692   $210,000               --     $2,750,000(5)     150,000             --
 the Company

John W. Cowley (4).............  2001   $355,128   $498,750(2)                                                     $5,000
 President and Chief             2000   $282,212         --         $116,506(6)          --         60,000         $4,875
 Operating Officer of the
 Company

Charles J. Bachand (4).........  2001   $223,255   $130,802(2)                                                     $5,100
 Vice President and              2000   $240,615         --         $    663(6)          --             --         $5,100
 Treasurer of the Company        1999   $188,500         --         $ 85,436(6)          --          6,000         $3,360
</TABLE>
_______
(1)  The amounts shown for Ms. Wardzinski and Messrs. Kibblehouse, King, Cowley
     and Bachand are matching and profit sharing contributions under the 401(k)
     plan.
(2)  Amounts represent payments under the Retention Agreements.
(3)  Mr. Marino serves in his capacity as Chief Financial Officer and Treasurer
     on a consultant basis.  The amount shown represents fees paid for his
     service during 2001.

                                       23
<PAGE>

(4)  Mr. King resigned from the Company as of November 7, 2001.  Mr. Bachand
     resigned from the Company on November 6, 2001.  Mr. Cowley's employment was
     terminated as of January 31, 2002.
(5)  Represents value at time of issuance of 250,000 Restricted Shares issued to
     Mr. King under the Restricted Stock Plan.  As of December 31, 2001, the
     value of the listed shares was $0.00 as Mr. King forfeited his interest in
     the shares when he resigned.
(6)  Amounts paid to Messrs. Cowley and Bachand represent reimbursement of
     relocation expenses.

     Stock Option Grants in the Last Fiscal Year. The following table sets forth
certain information with respect to stock options to purchase shares of the
Company's Common Stock that were granted to each of the named executive officers
during the fiscal year ended December 31, 2001.


                       Option Grants in Last Fiscal Year

<TABLE>
<CAPTION>
                                                     Individual Grants
                                                 -------------------------
               (a)                        (b)          (c)         (d)         (e)       (f)             (g)
                                                    % of Total
                                       Number of      Options                             Potential Realizable
                                      Securities    Granted to   Exercise                   Value of Assumed
                                      Underlying     Employees    or Base   Expiration    Annual Appreciation
                                        Options      in Fiscal     Price       Date        for Option Term(2)
               Name                   Granted(1)       Year       ($/Sh.)      ----       -------------------
-----------------------------------   ----------       ----       -------
                                                                                          5% ($)      10% ($)
                                                                                          -----       -------
<S>                                   <C>           <C>          <C>        <C>           <C>         <C>
</TABLE>

                       No options were granted in 2001.

______________
     Option Exercises and Year-End Option Holdings. The following table
summarizes the number and value of the unexercised options to purchase Common
Stock held by the named executive officers at December 31, 2001. None of the
named executive officers exercised options during 2001.


                Aggregated Option Exercises in Last Fiscal Year
                       and Fiscal Year-End Option Values

<TABLE>
<CAPTION>
                                                                     Number of Shares of
                                                                   Common Stock Underlying       Value of Unexercised
                                                                  Unexercised Options Held       In-The-Money Options
                                                                    at December 31, 2001       Held at December 31, 2001
                                                                 ---------------------------  ---------------------------
                                 Name                            Exercisable   Unexercisable  Exercisable   Unexercisable
                                 ----                            ------------  -------------  ------------  -------------
<S>                                                              <C>           <C>            <C>           <C>
Stephen L. Kibblehouse.....................................           5,395        13,105          $0             $0
Georgean M. Wardzinski.....................................           2,803         7,197          $0             $0
John W. Cowley.............................................          20,000        40,000          $0             $0
</TABLE>

Compensation of Directors

     Directors who are employees of the Company are not paid any fees or
additional compensation for service as members of the Board or any committee
thereof. Directors who are not employees of the Company ("Non-Employee
Directors"), other than Messrs. Spass and Cooper, receive an annual retainer fee
of $22,500, as well as a fee of $1,100 per day for attendance at meetings of the
Board and any committee meetings held on the same day as a Board meeting and a
fee of $800 per day for attendance at committee meetings not held on the same
day as a Board meeting. In addition, all Directors are reimbursed for reasonable
out-of-pocket expenses incurred in connection with traveling to any Board or
committee meeting. Pursuant to an agreement described below, Insurance Partners'
designated directors do not receive compensation as Directors in the form of
cash or stock and, accordingly, although they are not employees of the Company,
the term Non-Employee Directors defined above is deemed not to include them.

     Each Non-Employee Director of the Company as of January 1996 was granted an
option to purchase 10,000 shares of Common Stock under the 1995 Directors' Stock
Plan (the "Directors Plan"). The purposes of the Directors Plan are to (i)
encourage the Directors to own shares of Common Stock and thereby align their
interests more closely with the interests of other stockholders of the Company,
(ii) encourage the highest level of Director performance by providing the
Directors with a direct interest in the Company's attainment of its financial
goals and continuing success, and (iii) provide a financial incentive that will
help attract and retain the most qualified Directors. Pursuant to the Directors
Plan, the Company may grant options and issue stock with respect to an aggregate
of up to 550,000 shares. No individual will receive more than 300,000 shares of
Common Stock in the aggregate upon the issuance of stock and the exercise of
options granted under the Directors Plan. Options granted

                                       24
<PAGE>

under the Directors Plan are non-qualified stock options ("Options") and shares
of Common Stock issued under the Directors Plan are from authorized and unissued
shares.

     An agreement among the Company, Insurance Partners, L.P. ("IP") and IP
Bermuda provides that, in the event of election of certain individuals
associated with IP and IP Bermuda to the Board of Directors pursuant to the
terms of the Investment Agreement among the Company, Halliburton Company and the
Investors therein dated October 10, 1995 and the Debentures, such individuals
will not be entitled to participate in the Directors Plan or any similar plan.

     Options granted under the Directors Plan vest and become exercisable as to
33%, 66% and 100% of the shares of Common Stock subject thereto on each of the
first, second and third anniversaries of the option grant. Each Option is
evidenced by a stock option agreement which may contain such terms and
conditions as may be determined by the Committee and are not inconsistent with
the Directors Plan. The term of an Option is ten years from the date of grant.
During a Director's lifetime, an Option granted pursuant to the Directors Plan
will be exercisable only by the Director. The Option will not be transferable by
a Director other than by will or the laws of descent and distribution.

Employment Contracts and Retention Agreements

     Employment Contracts. During 1999, the Company entered into an Employment
Agreement with Willis T. King, Jr., under which Mr. King became and served as
Chairman and Chief Executive Officer of the Company. The period of Mr. King's
employment would end pursuant to the Employment Agreement, as amended, no
earlier than June 1, 2003, unless his employment is terminated prior to such
date pursuant to the terms of his Employment Agreement. Under the terms of the
Employment Agreement, as amended, Mr. King was paid an annual salary which was
$480,000 for 2001. He was also eligible for an annual bonus of up to 150% of
annual salary, but no less than $210,000 for 1999 and 2000, to be determined by
the Board of Directors of the Company. Mr. King was not awarded a bonus under
his Employment Agreement for 2001. The Company also granted Mr. King options to
purchase 150,000 shares of Common Stock at an exercise price of $11.00 per
share, which was the closing price of the Common Stock on the New York Stock
Exchange on the date of the Employment Agreement. Mr. King purchased $5 million
of Common Stock of the Company at a price of $11.00 per share. Mr. King also
received 250,000 shares of Restricted Shares under the Restricted Stock Plan,
with a base price of $11.00 per share. Mr. King resigned as Chairman and Chief
Executive Officer of the Company on November 7, 2001. Under the terms of his
resignation, Mr. King was paid his salary until December 31, 2001 and for
vacation days not used during 2001.

     In 2000, the Company entered into an Employment Agreement with John W.
Cowley, under which Mr. Cowley became and served as President and Chief
Operating Officer of the Company. The period of Mr. Cowley's employment would
end pursuant to the Employment Agreement, as amended, no earlier than January 1,
2004, unless his employment is terminated prior to such date pursuant to the
terms of his Employment Agreement. Under the terms of the Employment Agreement,
Mr. Cowley was paid an annual salary which was $350,000 for 2001. He was also
eligible for an annual bonus of up to 75% of annual salary based on the
performance of the Company as measured by the achievement of specified
performance objectives determined by the Chief Executive Officer of the Company
in his sole discretion. Mr. Cowley was not paid a bonus under his Employment
Agreement for 2001. The Company also granted Mr. Cowley options to purchase
50,000 shares of Common Stock at an exercise price of $8.13 per share, which was
the closing price of the Common Stock on the New York Stock Exchange on the date
the options were issued. Mr. Cowley's Employment Agreement terminated on January
31, 2002.

     In November 2001, the Highlands Insurance Company, a subsidiary of
Highlands Group, entered into an Independent Contractor Services Agreement with
Albert J. Marino pursuant to which Mr. Marino provides expert advice and
consultation to the Company on any and all financial, accounting and related
matters, including the preparation, review and approval of financial reports and
assembly of financial data for both internal and external use. Mr. Marino also
performs such other services as required to maintain adequate financial controls
applicable to a group of affiliated insurance companies and financial holding
companies the ultimate parent of which is a publicly traded holding company. In
consideration for the services performed, Highlands Insurance Company pays Mr.
Marino $1,500.00 per day based on a minimum of eight hours worked per day. Mr.
Marino is also reimbursed for reasonable travel and related expenses, excluding
expenses related to normal commuting to and from the Company's Lawrenceville
office. Mr. Marino is not eligible to participate in any pension, profit
sharing, bonus, insurance or medical plan or other employee benefit normally
offered to the Company's employees. The agreement may be terminated by either
party for any reason, effective immediately upon written notice.

     Retention Agreements. In 2001, the Company entered into Retention
Agreements with the Company's executive officers and certain key employees of
the Company's insurance subsidiaries (each an "Executive"). The purpose of the
Retention Agreements was to provide an incentive to Executives to continue to
manage the business of the Company and represent and protect the interests of
the Company's shareholders during and in connection with the Company's
exploration of the possibility of engaging in a transaction, including, but not
limited to a sale of the Company or any of its subsidiaries, a recapitalization
or reorganization of the Company or any of its subsidiaries, a liquidation of
the Company or any of its subsidiaries or any similar

                                       25
<PAGE>

transaction (a "Transaction"). The Company entered into Retention Agreements
with Messrs. Kibblehouse, King, Cowley, Bachand and Ms. Wardzinski, among
others. Under the terms of the Retention Agreements, each Executive was paid on
September 30, 2001, a retention payment equal to 25% of a multiple of the sum of
the Executive's 2001 base annual compensation and the average of his or her
annual cash bonuses paid in 1999 and 2000 (the "Base Amount"). Another retention
payment equal to 50% of the Base Amount was made December 10, 2001, which
payment was triggered by the Company's decision on December 7, 2001 to run-off
the business. A final retention payment equal to 25% of the Base Amount will be
made on June 7, 2002, provided the Executive is employed by the Company on the
payment date. The employment condition does not apply to the final retention
payment if the Executive is discharged (other than for cause) or resigns for
good reason before the payment date. In addition, if the Executive is discharged
(other than for cause) or resigns for good reason before June 7, 2002, the
Company is required to continue benefits for a number of years equal to the
Executive's Retention Agreement multiple. Such benefits include the Executive's
life, medical, dental, health, accident and disability insurance and other
benefits, including retirement plan benefits. The Base Amount and multiple under
the Retention Agreement entered into with Stephen L. Kibblehouse are $225,878
and 1.9 respectively, with Georgean M. Wardzinski are $181,000 and 1.5
respectively, with Willis T. King, Jr. are $585,000 and 2.5 respectively, with
John W. Cowley are $350,000 and 1.9 respectively, and with Charles J. Bachand
are $269,002 and 1.9 respectively.

     Restricted Stock Plan. In 1997, the Company adopted the 1997 Restricted
Stock Plan (the "Restricted Stock Plan"), which authorized grants of up to
100,000 shares of restricted Common Stock (the "Restricted Shares") to officers
of the Company's subsidiaries selected by the Compensation Committee. In 1999,
the Restricted Stock Plan was amended (i) to permit participants to have a one-
time opportunity to exchange restricted stock for new restricted stock equal to
75% of the number of shares surrendered for exchange and (ii) to allow for the
issuance of an additional 250,000 shares. In order to be issued Restricted
Shares, a grantee must purchase an equal number of shares of Common Stock at
market price ("Qualifying Shares"). Restricted Shares vest five years after the
date of grant, provided the following conditions are satisfied: (i) the grantee
remains employed by the Company or one of its subsidiaries until at least three
years from the date of grant; (ii) the grantee does not resign from the Company
and its subsidiaries, and is not terminated for cause, before the vesting date;
and (iii) the market price of the Common Stock on the vesting date is at least
40% greater than on the date of grant. If the market price has increased at
least 40% but less than 50%, 25% of the Restricted Shares vest, if the increase
is at least 50% but less than 61%, 50% vest, and if the market price increases
at least 61%, 100% vest. Pursuant to his employment agreement, Mr. King
purchased 250,000 Qualifying Shares at $11.00 per share and was issued 250,000
Restricted Shares in 1999. These shares were forfeited upon Mr. King's
resignation from the Company.

     Employees' Retirement and Savings Plan. The Company makes annual
contributions to the Highlands Insurance Group Employees' Retirement and Savings
Plan (the "Retirement Plan") for the benefit of qualified employees. The amount
of each year's contribution, if any, is determined by the Board of Directors of
the Company in its discretion. Before-tax contributions up to 6% of compensation
are matched by the Company at a 50% rate under the Retirement Plan. Matching
contributions by the Company to executive officers under the Retirement Plan for
2001, 2000 and 1999 are set forth in the Summary Compensation Table. It is not
possible to estimate the amount of benefits payable at retirement under the
Retirement Plan to Messrs. Kibblehouse, King, Cowley, Bachand and Ms. Wardzinski
because of some or all of the following: (i) amounts contributed in the future
will be contingent on future discretionary contributions by the Company as well
as contribution levels of the participant; (ii) earnings on trust fund assets
will vary; (iii) trust fund assets may appreciate or depreciate in value; (iv)
the compensation of the individual may vary; (v) age at date of retirement may
vary; and (vi) the Retirement Plan may be changed or discontinued.

Compensation Committee Interlocks and Insider Participation in Compensation
Decisions

     The Compensation Committee consists of Messrs. Hawk, Pieper and Spass
(Chairman). No member of the committee was an officer or employee of the Company
or any of its subsidiaries during 2001, nor was any member formerly an officer
of the Company or any of its subsidiaries.

                                       26
<PAGE>

Compensation Committee Report on Executive Compensation

     Compensation Philosophy.  The Company has applied a consistent philosophy
for all employees, including senior management. This philosophy is based on the
premise that the achievements of the Company result from the coordinated efforts
of all individuals working toward common objectives. The Company has tried to
achieve these objectives through teamwork that is focused on meeting the
expectations of customers and stockholders.

     The goals of the compensation program are to align compensation with
business objectives and performance. The Company's compensation program for
executive officers has been based on the same two principles applicable to
compensation decisions for all employees of the Company--paying competitively
and paying for sustained performance.

     The Company is committed to maintaining a compensation program that helps
retain key personnel. To ensure that pay is competitive, the Company will
regularly compare its pay practices with those of other regional companies and
set its pay parameters based on this review.

     Executive officers and senior managers are rewarded based upon corporate
performance and individual performance. Corporate performance is primarily
evaluated by determining the extent to which annually established goals are met.
Individual performance is evaluated by reviewing performance against set
individual objectives and goals and the degree to which Company values are
fostered.

     The Company's compensation program consists of cash-based compensation. The
Company believes its compensation program will allow the Company to retain key
employees. The Company establishes salary ranges for employees by reviewing the
aggregate of base salary and annual bonus for competitive positions in the
market. The Company performs an assessment of individual positions in an effort
to identify appropriate market salary ranges for all positions. Ranges for
officer positions are established based on competitive market data. These ranges
allow an officer to be placed above or below the midpoint according to that
officer's overall performance.

     For additional discussion regarding compensation, see "Employment Contracts
and Retention Agreements" under Item 11: "Executive Compensation."

     CEO Compensation.   Willis T. King was Chief Executive Officer and Chairman
of the Company until November 7, 2001. The Compensation Committee used the same
compensation policy described above for all employees to determine Mr. King's
2001 compensation. In setting both the cash-based and the equity based elements
of Mr. King's overall compensation, the Compensation Committee made an overall
assessment of Mr. King's ability to lead the Company in reaching its long-term
strategic and business goals.


                                  COMPENSATION COMMITTEE

                                  Robert A. Spass (Chairman)
                                  Phillip J. Hawk
                                  W. Bernard Pieper

                                       27
<PAGE>

                               Performance Graph

                     COMPARISON OF CUMULATIVE TOTAL RETURN*
               OF HIGHLANDS INSURANCE GROUP, INC., S&P 500 INDEX
                  AND S&P INSURANCE (PROPERTY-CASUALTY) INDEX

     Set forth below is a line graph comparing cumulative stockholder return
from December 31, 1996 to December 31, 2001 on the Common Stock, based on the
market price of the Common Stock, with the cumulative total return on the
Standard & Poor's 500 Stock Index and the Standard & Poor's Insurance (Property-
Casualty) Index:



                                      LOGO

<TABLE>
<CAPTION>
                                                               December 31,
                                                            ----------------------
<S>                                         <C>         <C>      <C>      <C>      <C>      <C>
                                              1996*      1997     1998     1999     2000     2001
                                              -----     -----    -----    -----    -----    -----
Highlands Insurance Group, Inc.........       100.0     140.1     64.5     46.6     44.4      0.5
S&P 500................................       100.0     133.3    171.5    207.6    188.7    166.2
S&P Insurance (Property-Casualty)......       100.0     145.5    135.4    100.9    157.1    144.5
</TABLE>

----------------
* Table assumes $100 invested on December 31, 1996 in Common Stock, the Standard
  & Poor's 500 Index and the Standard & Poor's Insurance (Property-Casualty)
  Index, including reinvestment of dividends with respect to the two indices.
  The Company has not paid dividends on Common Stock since December 1996.

                                       28
<PAGE>

ITEM 12: Security Ownership of Certain Beneficial Owners and Management.

     The following table sets forth information with respect to persons or
groups who, to the Company's knowledge, beneficially own, or have the right to
acquire within 60 days of March 30, 2002, more than five percent of the Common
Stock:

<TABLE>
<CAPTION>

                                                             Amount and
                                                              Nature of
                                                             Beneficial             Percent of
Name and Address of Beneficial Owner                       Ownership(1)(2)         Class(1)(2)
------------------------------------                       ---------------         -----------
<S>                                                        <C>                     <C>
Insurance Partners, L.P.(3).........................         4,568,759(4)             25.3%
 201 Main Street
 Fort Worth, TX 76102
Insurance Partners Offshore (Bermuda), L.P.(5)......         2,518,009(6)             15.8%
 Cedar House
 41 Cedar Avenue
 P.O. Box HM1179
 Hamilton, Bermuda
Option Opportunities Co. (7)........................         1,216,900(7)              9.1%
 225 W. Washington St., 3/rd/ Floor
 Chicago, IL  60606
State Street Bank and Trust Company (8).............         1,010,496(8)              7.5%
 225 Franklin Street
 Boston, MA  02110
Waveland Partners(9)................................           832,000                 6.2%
 227 West Monroe, Suite 4800
 Chicago, IL 60606
Richard M. Haverland(10)............................           825,285                 6.1%
 160 Coquille Way
 Vero Beach, FL 32963
Royce & Associates, Inc.(11)........................           818,600                 6.1%
 1414 Avenue of the Americas
 New York, NY 10019
</TABLE>

----------------
(1) Calculated pursuant to Rule 13d-3(d) of the Exchange Act. Unless otherwise
    stated below, each such person has sole voting and investment power with
    respect to all such shares.
(2) Based on 13,424,433 shares of Common Stock outstanding at the close of
    business on March 1, 2002.
(3) The general partner of Insurance Partners, L.P. is Insurance GenPar L.P., a
    Delaware limited partnership; the general partner of the latter is Insurance
    GenPar MGP, L.P., a Delaware limited partnership; and the general partner of
    the latter is Insurance GenPar MGP, Inc., a Delaware corporation. Robert A.
    Spass (a director of the Company) owns 40% of the voting stock of Insurance
    GenPar MGP, Inc., and Steven Gruber and Daniel Doctoroff each owns 30% of
    such voting stock.
(4) Represents the number of shares of Common Stock issuable upon conversion of
    the Company's 10% Convertible Subordinated Debentures due December 31, 2005
    (the "Debentures") and exercise of the Company's Common Stock Subscription
    Warrants, Series A (the "Series A Warrants") owned of record by Insurance
    Partners, L.P.
(5) The general partner of Insurance Partners Offshore (Bermuda), L.P. ("IP
    Bermuda") is Insurance GenPar (Bermuda), L.P., a Bermuda limited
    partnership; the general partner of the latter is Insurance GenPar (Bermuda)
    MGP, L.P.; and the general partner of the latter is Insurance GenPar
    (Bermuda) MGP, Ltd., a Bermuda corporation. Robert A. Spass (a director of
    the Company) owns 40% of the voting stock of Insurance GenPar (Bermuda) MGP,
    Ltd., and Steven Gruber and Daniel Doctoroff each owns 30% of such voting
    stock.
(6) Represents the number of shares of Common Stock issuable upon conversion of
    the Debentures and exercise of the Series A Warrants owned of record by IP
    Bermuda. Shares acquirable by IP Bermuda upon conversion or exercise of
    Debentures or Series A Warrants will be Series B Common Stock, which have
    reduced voting rights until such shares are transferred by IP Bermuda or the
    occurrence of certain events.
(7) Based on a Schedule 13G filed on January 11, 2002, Option Opportunities
    Company is a broker or dealer registered under Section 15 of the Act.
(8) State Street Bank and Trust Company, a bank as defined in Section (3)(A)(6)
    of the Act, holds the listed shares due to its various fiduciary capacities.
(9) Represents shared beneficial ownership by the following related entities:
    Waveland International, Ltd., a Cayman Islands exempted company; Waveland
    Partners L.P., an Illinois limited partnership; Waveland Capital Management,
    L.P., an

                                       29
<PAGE>

     Illinois limited partnership; Clincher Capital Corporation, an Illinois
     corporation; Waveland Capital Management, LLC, an Illinois limited
     liability company; and Waveland Partners, Ltd., a Cayman Islands exempted
     company.
(10) Mr. Haverland is a former Director and Chief Executive Officer of the
     Company. The shares beneficially owned were acquired as follows: 259,003
     issuable pursuant to warrants; 254,712 shares issuable pursuant to the
     Debentures; 300,000 shares issuable pursuant to stock options; and 12,570
     shares acquired through the Employee Stock Purchase Plan.
(11) Royce & Associates, Inc. ("Royce") and Royce Management Company ("RMC") are
     investment advisors registered under Section 203 of the Investment Advisors
     Act of 1940. Royce is the beneficial owner of 814,800 shares of the Common
     Stock outstanding of the Company; RMC beneficially owns 3,800 shares of the
     Common Stock outstanding of the Company. Charles M. Royce may be deemed to
     be a controlling person of Royce and RMC, and, as such, may be deemed to
     beneficially own the shares of Common Stock of the Company beneficially
     owned by Royce and RMC. Mr. Royce does not own any shares of Common Stock
     of the Company outside of Royce and RMC, and disclaims all beneficial
     ownership of the shares held by Royce and RMC.


     The following table sets forth information with respect to the numbers of
shares of Common Stock that the following persons beneficially own, or have the
right to acquire within 60 days of March 1, 2002: (i) each director of the
Company, (ii) each executive officer of the Company named in the table entitled
"Summary Compensation Table" and (iii) all executive officers and directors of
the Company as a group at March 30, 2002:


                                                 Amount and
                                                  Nature of
                                                 Beneficial          Percent of
Name                                            Ownership(1)          Class(1)
----                                            ------------         ----------
Stephen L. Kibblehouse....................      15,752(2)(5)(6)              *
Robert A. Spass...........................          --(4)                    *
Bradley E. Cooper.........................       3,000(4)                    *
Philip J. Hawk............................      14,056                       *
W. Bernard Pieper.........................      19,586                       *
Georgean M. Wardzinski....................      13,626(2)(5)(6)              *
Willis T. King, Jr........................     540,062                     4.0%
Charles J. Bachand........................      49,846(3)(6)                 *
John W. Cowley............................       9,538(6)                    *

All Directors and executive officers
 as a group (12 persons)..................     665,466(2)(3)(5)(6)         5.0%

----------------
*   Less than 1%.
(1) Based on 13,424,433 shares of Common Stock outstanding at the close of
    business on March 1, 2002.
(2) Includes 641 shares issued to Mr. Kibblehouse and 3,100 shares issued to Ms.
    Wardzinski under the 1997 Restricted Stock Plan. See Item 11:  "Executive
    Compensation -- Restricted Stock Plan."
(3) Includes the following numbers of shares of Common Stock issuable upon
    exercise of the Series A Warrants and the Company's Common Stock
    Subscription Warrants, Series A-2 Warrants and conversion of the Debentures
    and the Company's 10% Convertible Subordinated Debentures due December 31,
    2005, Series 2, respectively, held by Charles J. Bachand--12,003, 12,003,
    11,757 and 11,757 shares.
(4) Does not include shares owned beneficially by Insurance Partners, L.P. and
    IP Bermuda. See the prior table under "Security Ownership of Certain
    Beneficial Owners and Management."
(5) Includes the following shares issuable pursuant to stock options currently
    exercisable or exercisable within 60 days: Mr. Kibblehouse--12,666 shares
    and Ms. Wardzinski--8,291 shares.
(6) Includes shares beneficially owned as a result of participation in the
    Company's 401(k) Plan.

                                       30
<PAGE>

The following table sets forth securities authorized for issuance under equity
compensation plans which have been previously approved by security holders and
not previously approved by security holders:

                           Equity Compensation Plans

<TABLE>
<CAPTION>
         Plan Category               Number of securities to    Weighted-average exercise      Number of securities
         -------------               be issued upon exercise       price of outstanding      remaining available for
                                     of outstanding options,      options, warrants and       future issuance under
                                       warrants and rights                rights            equity compensation plans
                                       -------------------                ------            -------------------------
<S>                                 <C>                         <C>                         <C>
Equity compensation plans                      409,984                   $11.98                     371,042
approved by security holders

Equity compensation plans                      464,781                   $12.98                     435,219
not approved by security holders
Total
</TABLE>


ITEM 13: Certain Relationships and Related Transactions.

  None.

                                       31
<PAGE>

                                    PART IV

ITEM 14: Exhibits, Financial Statement Schedules, 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.

     *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

      4.15     Waiver of Certain Interest Payments on 10% Convertible Debentures
               due December 31, 2005 dated April 13, 2001

     *10.1     Credit Agreement among Highlands Insurance Group, Inc., Various
               Lending Institutions and The Chase Manhattan Bank, as
               Administrative Agent, dated April 30, 1997

     +10.2     Form of Registration Rights Agreement among Insurance Partners,
               L.P., Insurance Partners Offshore (Bermuda), L.P. and the
               Registrant

                                       32
<PAGE>

    +10.3   Form of 1995 Stock Option Plan

  +++10.4   Restricted Stock Plan

    +10.5   Form of Employment Agreement between the Registrant and Richard M.
            Haverland

  +++10.6   Retirement and Release Agreement between the Registrant and Richard
            M. Haverland

    +10.7   Form of Indemnification Agreement between the Registrant and each of
            its directors

    +10.8   Form of 1995 Directors' Stock Plan

    +10.9   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)

    +10.10  Form of note 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

    +10.11  Form of pledge agreement to secure the note filed as Exhibit 10.10

    +10.12  Form of Purchase, Redemption and Bonus Agreement entered into
            between the Company and the Management Investors with respect to the
            Management Securities

  ***10.13  Agency Stock Purchase Plan

   ++10.14  Employee Stock Purchase Plan

   ++10.15  Employees' Retirement And Savings Plan

  +++10.16  Amendment No. 1 to Employees' Retirement and Savings Plan

  +++10.17  Amendment No. 2 to Employees' Retirement and Savings Plan

  +++10.18  Employment Agreement between the Registrant and Willis T. King, Jr.

 ++++10.19  Employment Agreement between the Registrant and John W. Cowley

 ++++10.20  Form of Retention Agreement #

 ++++10.21  Seventh Amendment and Waiver to Credit Agreement dated as of
            December 31, 2000, among the Registrant, Various Lending
            Institutions and The Chase Manhattan Bank, as Administrative Agent

      21    List of Subsidiaries

      23    Consent of Independent Auditors

         _______
      +  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

    +++  Incorporated by reference to the Company's Report on Form 10-K, for the
         fiscal year ended December 31, 1999 as filed with the Commission

   ++++  Incorporated by reference to the Company's Report on Form 10-K, for the
         fiscal year ended December 31, 2000 as filed with the Commission.

                                      33
<PAGE>

# The Company has entered Retention Agreements with Willis T. King, Jr., John W.
  Cowley, Charles J. Bachand, Stephen L. Kibblehouse and Georgean M. Wardzinski,
  the particular terms of which are specified in "Employment -Contracts and
  Retention Agreements" under Item 11: "Executive Compensation."

     (b) Reports on Form 8-K during the quarter ended December 31, 2001.

     The Company filed a Form 8-K on November 8, 2001 and December 13, 2001.

                                       34
<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 on the 15th day of
April, 2002.

                                    Highlands Insurance Group, Inc.

                                    By:    /s/  Stephen L. Kibblehouse
                                        ----------------------------------
                                                 Stephen L. Kibblehouse
                                                 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>
<CAPTION>
                Signature                              Title                                 Date
                ---------                              -----                                 ----
<S>                                      <C>                                           <C>
     /s/ Stephen L. Kibblehouse          Chief Executive Officer and Director          April 15, 2002
------------------------------------
       Stephen L. Kibblehouse

        /s/ Albert J. Marino             Chief Financial Officer and Treasurer         April 15, 2002
------------------------------------
          Albert J. Marino

        /s/ Robert A. Spass              Director                                      April 15, 2002
------------------------------------
          Robert A. Spass

       /s/ Bradley E. Cooper             Director                                      April 15, 2002
------------------------------------
         Bradley E. Cooper

       /s/ W. Bernard Pieper             Director                                      April 15, 2002
------------------------------------
         W. Bernard Pieper

         /s/ Philip J. Hawk              Director                                      April 15, 2002
------------------------------------
           Philip J. Hawk
</TABLE>

                                      35
<PAGE>

                  INDEX TO FINANCIAL STATEMENTS AND SCHEDULES

<TABLE>
<CAPTION>
                                                                                                       Page
                                                                                                      ------
<S>                                                                                                   <C>
Audited Financial Statements
  Independent Auditors' Report......................................................................     F-2
  Consolidated Balance Sheets as of December 31, 2001 and 2000......................................     F-3
  Consolidated Statements of Operations for the Years Ended December 31, 2001, 2000 and 1999........     F-4
  Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2001, 2000
    and 1999........................................................................................     F-5
  Consolidated Statements of Comprehensive Loss for the Years Ended December 31, 2001, 2000
    and 1999........................................................................................     F-6
  Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000 and 1999........     F-7
  Notes to Consolidated Financial Statements........................................................     F-8


Financial Statement Schedules
  Schedule II--Condensed Financial Information of Registrant (Parent Company only):
     Balance Sheets--As of December 31, 2001 and 2000...............................................    F-30
     Statements of Operations--For the Years Ended December 31, 2001, 2000 and 1999.................    F-31
     Statements of Cash Flows--For the Years Ended December 31, 2001, 2000 and 1999.................    F-32
  Schedule III--Supplementary Insurance Information--As of and For the Years Ended
    December 31, 2001, 2000 and 1999................................................................    F-33
  Schedule V--Valuation and Qualifying Accounts--For the Years Ended December 31, 2001, 2000
    and 1999........................................................................................    F-34
</TABLE>

                                      F-1
<PAGE>

                         Independent Auditors' Report
                         ----------------------------

The Board of Directors
Highlands Insurance Group, Inc.:

We have audited the consolidated financial statements of Highlands Insurance
Group, Inc. and subsidiaries (the Company) as listed in the accompanying index.
In connection with our audits of the consolidated financial statements, we also
audited the financial statement schedules as listed in the accompanying index.
These financial statements and financial statement schedules are the
responsibility of the Company's management. Our responsibility is to report on
these financial statements based on the results of our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America.  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 report.

In our opinion, the 2000 and 1999 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, 2000, and the results of their
operations and their cash flows for each of the two years then ended in
conformity with accounting principles generally accepted in the United States of
America.  Also in our opinion, the related financial statement schedules for
2000 and 1999, when considered in relation to the basic consolidated financial
statements  taken as a whole, present fairly, in all material respects, the 2000
and 1999 information set forth therein.

The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company has suffered recurring losses and
has a net capital deficiency. As of December 31, 2001, the Company was in
violation with various debt covenants and such debt is due on demand, or if no
demand is made, April 30, 2002. In February 2002, the Company's significant
insurance subsidiaries were placed under regulatory supervision due to their
adverse financial condition, whereby the regulatory agencies have authority to
take any number of actions, including taking over control of the insurance
subsidiaries. At December 31, 2001, these circumstances raise substantial doubt
about the Company's ability to continue as a going concern. Management's plans
in regard to these matters are also described in Note 19. The 2001 consolidated
financial statements do not include any adjustments that might result from the
outcome of these uncertainties.

Because of the significance of the uncertainties discussed in the preceding
paragraph, we are unable to express, and we do not express, an opinion on the
accompanying 2001 consolidated financial statements and financial statement
schedules.

KPMG LLP

April 9, 2002

                                      F-2
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                          CONSOLIDATED BALANCE SHEETS

                          DECEMBER 31, 2001 AND 2000
                                (in thousands)

<TABLE>
<CAPTION>
                                        ASSETS                                                 2001           2000
                                        ------                                              ----------      ---------
<S>                                                                                         <C>             <C>
Investments:
  Fixed maturity securities available-for-sale, at fair value (amortized cost of
    $723,410 in 2001 and $797,092 in 2000)..............................................    $  714,243        776,453
  Equity securities, at fair value (cost of $28,940 in 2001 and $30,686 in 2000)........        29,665         32,091
  Other investments, at cost............................................................            54          1,952
                                                                                            ----------      ---------
     Total investments..................................................................       743,962        810,496
Cash and cash equivalents...............................................................       109,634        109,763
Premiums in course of collection, net...................................................        85,838        126,719
Premiums due under retrospective policies...............................................       108,952        138,119
Receivable from reinsurers..............................................................       691,938        683,439
Prepaid reinsurance premiums............................................................         7,523          8,576
Funds on deposit with reinsurers........................................................        20,035          9,019
Net deferred tax asset..................................................................             -          6,732
Accrued investment income...............................................................         9,723         11,084
Deferred policy acquisition costs.......................................................             -         49,622
Other assets............................................................................        43,007         47,581
                                                                                            ----------      ---------
     Total assets.......................................................................    $1,820,612      2,001,150
                                                                                            ==========      =========

                              LIABILITIES AND STOCKHOLDERS' EQUITY
                              ------------------------------------
Loss and loss adjustment expense reserves...............................................    $1,599,127      1,392,497
Unearned premiums.......................................................................       168,480        224,120
Senior bank debt........................................................................        49,004         49,004
Convertible subordinated debentures.....................................................        62,297         58,626
Accounts payable and accrued liabilities................................................        99,751         97,424
                                                                                            ----------      ---------
     Total liabilities..................................................................     1,978,659      1,821,671
                                                                                            ----------      ---------
Mandatorily redeemable preferred stock..................................................         5,235          4,930
                                                                                            ----------      ---------
Stockholders' equity (deficit):
  Common stock, $.01 par value; 50,000,000 shares authorized, 12,978,533 shares
    issued and outstanding in 2001, 13,225,411 shares issued and outstanding in
    2000................................................................................           137            140
  Additional paid-in capital............................................................       228,872        231,566
  Accumulated other comprehensive loss..................................................        (8,582)       (12,572)
  Treasury stock, at cost (739,400 shares in 2001 and 2000, including 445,900
    shares held by subsidiaries in 2001 and 2000).......................................        (9,459)        (9,459)
  Deferred compensation on restricted stock.............................................          (313)        (3,097)
  Retained (loss) earnings..............................................................      (373,937)       (32,029)
                                                                                            ----------      ---------
     Total stockholders' equity (deficit)...............................................      (163,282)       174,549
                                                                                            ----------      ---------
     Total liabilities, mandatorily redeemable preferred stock and stockholders'
       equity...........................................................................    $1,820,612      2,001,150
                                                                                            ==========      =========
</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, 2001, 2000 AND 1999
                 (in thousands, except per common share data)

<TABLE>
<CAPTION>
                                                                           2001         2000         1999
                                                                        ---------     --------      -------
<S>                                                                  <C>            <C>          <C>
Revenues:
  Net premiums earned..............................................     $ 496,559      388,505      325,305
  Net investment income............................................        58,782       62,453       67,684
  Net realized investment gains....................................        11,823          974           22
                                                                        ---------     --------      -------
     Total revenues................................................       567,164      451,932      393,011
                                                                        ---------     --------      -------
Expenses:
  Loss and loss adjustment expense incurred........................       667,118      346,137      238,940
  Underwriting expenses............................................       227,198      134,470      130,121
  Debt interest and amortization expense...........................        11,393       12,392       11,753
  Loss on write-off of subsidiary..................................            --           --       10,452
  Other expenses (income), net.....................................         2,314       (2,538)       2,210
                                                                        ---------     --------      -------
     Total expenses................................................       908,023      490,461      393,476
                                                                        ---------     --------      -------
Loss before income taxes...........................................      (340,859)     (38,529)        (465)
Income tax expense.................................................           744       67,747       12,984
                                                                        ---------     --------      -------
     Net income (loss).............................................      (341,603)    (106,276)     (13,449)
Dividends paid on mandatorily redeemable preferred stock...........           305          289           --
                                                                        ---------     --------      -------
     Net income (loss) attributable to common stockholders.........     $(341,908)    (106,565)     (13,449)
                                                                        =========     ========      =======
Earnings (loss) per common share:
  Basic............................................................     $  (25.89)       (8.06)       (1.04)
  Diluted..........................................................     $  (25.89)       (8.06)       (1.04)
Weighted average number of common shares outstanding:
  Basic............................................................        13,207       13,221       12,956
  Diluted..........................................................        13,207       13,221       12,956
</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, 2001, 2000 AND 1999
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                      2001          2000        1999
                                                                                   ---------      --------     -------
<S>                                                                                <C>            <C>          <C>
Common stock:
 Balance, beginning of year......................................................  $     140           140         132
  Issuance (cancellation) of common stock, par value.............................         (3)           --           8
                                                                                   ---------      --------     -------
 Balance, end of year............................................................        137           140         140
                                                                                   ---------      --------     -------
Additional paid-in capital:
 Balance, beginning of year......................................................    231,566       231,515     223,976
  Net issuance (cancellation) of common stock....................................     (2,694)           51       7,539
                                                                                   ---------      --------     -------
 Balance, end of year............................................................    228,872       231,566     231,515
                                                                                   ---------      --------     -------
Accumulated other comprehensive income (loss):
 Balance, beginning of year......................................................    (12,572)      (29,184)     16,803
  Changes in net unrealized investment gains (losses), net of tax................      7,015        16,682     (46,138)
  Change in valuation allowance for deferred taxes on unrealized investment
    gains and losses.............................................................     (2,955)           --          --
  Net unrealized investment losses of written-off subsidiary, net of tax.........         --            --         151
  Other..........................................................................        (70)          (70)         --
                                                                                   ---------      --------     -------
 Balance, end of year............................................................     (8,582)      (12,572)    (29,184)
                                                                                   ---------      --------     -------
Treasury stock, at cost:
 Balance, beginning of year......................................................     (9,459)       (9,459)     (9,268)
  Acquisition of treasury stock..................................................         --            --        (191)
                                                                                   ---------      --------     -------
 Balance, end of period..........................................................     (9,459)       (9,459)     (9,459)
                                                                                   ---------      --------     -------
Deferred compensation on restricted stock:
 Balance, beginning of year......................................................     (3,097)       (3,147)     (1,074)
  Net retirement (issuance) of restricted stock..................................      2,784            50      (2,073)
                                                                                   ---------      --------     -------
 Balance, end of year............................................................       (313)       (3,097)     (3,147)
                                                                                   ---------      --------     -------
Retained (loss) earnings:
 Balance, beginning of year......................................................    (32,029)       74,536      87,985
  Net income (loss) attributable to common stockholders..........................   (341,908)     (106,565)    (13,449)
                                                                                   ---------      --------     -------
 Balance, end of period..........................................................   (373,937)      (32,029)     74,536
                                                                                   ---------      --------     -------
Total stockholders' equity.......................................................  $(163,282)      174,549     264,401
                                                                                   =========      ========     =======
</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 LOSS

             FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
                                (in thousands)

<TABLE>
<CAPTION>
                                                                                        2001         2000         1999
                                                                                     ---------     --------      -------
<S>                                                                                  <C>           <C>           <C>
Net income (loss) attributable to common stockholders...........................     $(341,908)    (106,565)     (13,449)
                                                                                     ---------     --------      -------
Other comprehensive income (loss), net of taxes:
  Increase (decrease) in unrealized gains (losses) on investments net of
    taxes of $7,915; $9,323; and $(24,836)......................................        14,700       17,315      (46,124)
  Reclassification adjustments for realized gains in net income (loss) net of
    taxes of $4,138, $341; and $8...............................................        (7,685)        (633)         (14)
  Change in valuation allowance for deferred taxes on unrealized investment
    gains and losses............................................................        (2,955)          --           --
  Net unrealized investment losses of written-off subsidiary, net of taxes of
    $0; $0; and $8..............................................................            --           --          151
  Other.........................................................................           (70)         (70)          --
                                                                                     ---------     --------      -------
  Other comprehensive income (loss), net of taxes...............................         3,990       16,612      (45,987)
                                                                                     ---------     --------      -------
Comprehensive loss..............................................................     $(337,918)     (89,953)     (59,436)
                                                                                     =========     ========      =======
</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, 2001, 2000 AND 1999
                                (in thousands)

<TABLE>
<CAPTION>
                                                                                                   2001       2000       1999
                                                                                                ---------   --------   --------
<S>                                                                                            <C>          <C>        <C>
Cash flows from operating activities:
 Net income (loss)...........................................................................   $(341,603)  (106,276)   (13,449)
                                                                                                ---------   --------   --------
 Adjustments to reconcile net income (loss) to net cash provided by (used in) activities:
  operating activities:
  Depreciation and amortization..............................................................       6,473      5,162      3,768
  Net realized investment gains..............................................................     (11,823)      (974)       (22)
  Write-off of subsidiary....................................................................          --         --     10,452
  Deferred tax expense (benefit).............................................................          --     66,957     12,659
  Change in:
   Premiums in course of collection..........................................................      40,881    (70,145)    (2,771)
   Premiums due under retrospective policies.................................................      29,167      4,730      1,764
   Receivable from reinsurers................................................................      (8,499)     1,086     60,407
   Prepaid reinsurance premiums..............................................................       1,053     (4,799)    (1,254)
   Funds on deposit with reinsurers..........................................................     (11,016)     8,515        339
   Deferred policy acquisition costs.........................................................      49,622    (16,066)    (2,019)
   Loss and loss adjustment expense reserves.................................................     206,630     38,973   (189,740)
   Unearned premiums.........................................................................     (55,640)    77,288      9,554
   Other operating assets and liabilities....................................................      19,410     30,459     (2,679)
                                                                                                ---------   --------   --------
    Total adjustments........................................................................     266,258    141,186    (99,542)
                                                                                                ---------   --------   --------
    Net cash provided by (used in) operating activities......................................     (75,345)    34,910   (112,991)
                                                                                                ---------   --------   --------
Cash flows from investing activities:
 Proceeds from sales:
  Fixed maturity securities available-for-sale...............................................     156,836     87,714    184,817
  Equity securities..........................................................................       7,730      1,721      8,311
  Other investments..........................................................................       3,433      1,720         --
 Maturities or calls:
  Fixed maturity securities available-for-sale...............................................     186,793     56,713    149,610
 Investment purchases:
  Fixed maturity securities available-for-sale...............................................    (277,165)  (138,348)  (180,269)
  Equity securities..........................................................................          --     (1,000)   (18,940)
 Net purchases of property and equipment.....................................................      (2,411)    (2,011)   (10,313)
 Cash and cash equivalents of written-off subsidiary.........................................          --         --    (12,843)
 Other proceeds..............................................................................          --         --        867
                                                                                                ---------   --------   --------
  Net cash provided by investing activities..................................................      75,216      6,509    121,240
                                                                                                ---------   --------   --------
Cash flows from financing activities:
  Repayment of senior bank debt..............................................................          --    (10,000)    (5,996)
  Issuance of common stock...................................................................          --         61      5,474
  Acquisition of treasury stock..............................................................          --         --       (191)
                                                                                                ---------   --------   --------
  Net cash used in financing activities......................................................          --     (9,939)      (713)
                                                                                                ---------   --------   --------
Net increase in cash and cash equivalents....................................................        (129)    31,480      7,536
Cash and cash equivalents at beginning of year...............................................     109,763     78,283     70,747
                                                                                                ---------   --------   --------
Cash and cash equivalents at end of year.....................................................   $ 109,634    109,763     78,283
                                                                                                =========   ========   ========
Supplemental disclosure of cash flow information:
  Interest paid..............................................................................   $   3,933     10,700     10,163
                                                                                                =========   ========   ========
</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 Holding
Company, Inc. and its subsidiaries (Highlands), American Reliance, Inc. and its
subsidiaries (American Reliance), and Highlands Holdings (U.K.) Limited and its
subsidiary (Highlands UK) (a foreign reinsurance company located in the United
Kingdom) and certain other immaterial companies (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.

     The accompanying consolidated financial statements have been prepared as
though the Company will continue as a going concern. As described in Note 8,
since December 31, 2001, the Company has been in default under the terms of its
bank debt for noncompliance with certain financial ratios. The Company does not
have sufficient funds to satisfy the $47.5 million principal due on April 30,
2002. Representatives of the Company and the senior lenders have been in
discussions regarding the notes. As described in Note 16, in February 2002, the
Texas Department of Insurance issued Supervisory Orders to the Company's Texas
insurance subsidiaries, including Highlands Insurance Company, the Company's
principal insurance subsidiary. By their terms, the orders are also binding on
all the companies' affiliates. A Supervisory Order for another of the insurance
subsidiaries, State Capital Insurance Company, was issued by the North Carolina
Department of Insurance in December 2001, and in October 2001, the Wisconsin
Commissioner of Insurance issued a Stipulation and Order covering Northwestern
National Casualty Company, the Company's second largest insurance subsidiary,
and NN Insurance Company, another of the Company's insurance subsidiaries. In
addition to these orders, the Company's insurance subsidiaries have had their
licenses to transact business suspended in Florida, Illinois, Kansas, Kentucky,
Minnesota, Missouri, New Mexico, Ohio and Rhode Island, and by the U.S.
Department of Treasury and the U.S. Department of Labor with respect to federal
surety and workers' compensation programs. The licenses in Connecticut and North
Carolina have been amended to allow the companies to service existing business
only. The Company has also agreed to cease writing new and renewal business in
Colorado, Maine, Michigan and South Carolina and has been removed from the list
of eligible surplus lines insurers in New Mexico, Texas and Virginia. Except
where prohibited by regulation or where withdrawal plans have been filed and are
pending, the Company is not renewing any business upon policy term expiration.

     During the year ended December 31, 2001, the Company recorded adverse
development on losses incurred for accident years 2000 and prior of $197 million
and a total net loss for the year of $341.9 million.  The net loss in 2000 was
$106.6 million.  Consolidated stockholders' equity reflects a deficit of $163.3
million at December 31, 2001.  These matters raise substantial doubt about the
Company's ability to continue as a going concern.

     As discussed in Note 4, the Company wrote-off in December 1999 its
remaining investment in and deferred taxes associated with LMI Insurance Company
(LMI).

     The accompanying consolidated financial statements are presented in
accordance with accounting principles generally accepted in the United States of
America. Certain items in the December 31, 2000 and 1999 consolidated financial
statements have been reclassified to conform to the current year's presentation.
Such reclassifications had no impact on stockholders' equity or net income
(loss) as previously reported.

 Net Premiums Earned

     Insurance premiums on property/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.

                                      F-8
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 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 business line
profitability are considered in the determination of the recoverability of
deferred acquisition costs.  During 2001, deferred acquisition costs of $49.6
million were written off because they were considered to be unrecoverable.
Amortization of deferred acquisition costs was $89.9 million and $65.3 million
for the years ended December 31, 2000 and 1999, respectively.


 Investments

     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 loss 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 income 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.

                                      F-9
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Debt Issuance Costs

     Deferred financing and related costs consist of capitalized fees associated
with the issuance of $62.85 million in principal amount of 10% convertible
subordinated debentures (Debentures) and the $65 million senior revolving credit
facility. These costs include underwriting, legal and accounting fees. Debt
issuance costs of $5.6 million were capitalized in connection with the issuance
of the Debentures 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
makes estimates and assumptions in determining reinsurance and retrospective
premium collectibility, deferred tax asset utilization 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.

 Accounting Standards

     In July 2001, the FASB issued Statement No. 141, Business Combinations and
Statement No. 142, Goodwill and Other Intangible Assets.  Statement 141 requires
that the purchase method of accounting be used for all business combinations
initiated after June 30, 2001.  Statement 141 also specifies the criteria that
intangible assets acquired in a purchase method business combination must meet
to be recognized and reported apart from goodwill, noting that any purchase
price allocable to an assembled workforce may not be accounted for separately.
Statement 142 is effective January 1, 2002 and will require that goodwill and
intangible assets with indefinite useful lives no longer be amortized, but
instead tested for impairment at least annually in accordance with the
provisions of Statement 142.  Statement 142 will also require that intangible
assets with estimable useful lives be amortized over their respective estimated
useful lives to their estimated residual values, and reviewed for impairment in
accordance with FAS Statement No. 121, Accounting for the Impairment of Long
Lived Assets and for Long-Lived Assets to be Disposed Of.  As of December 31,
2001, the Company had recorded negative goodwill in the amount of $2.3 million.
Upon adoption of Statement 142, the remaining balance of negative goodwill will
be recognized as an extraordinary item.

     In August 2001, the FASB issued Statement No. 143, Accounting for Asset
Retirement Obligations.  Statement 143 requires entities  to  record  the  fair
value  of  a  liability  for  an  asset  retirement  obligation  in  the  period
in  which  it is incurred and a corresponding increase in the carrying amount of
the related long-lived asset and is effective for fiscal years beginning after
June 15, 2002.  The Company is currently assessing the impact of Statement 143
on its financial condition and results of operations.


                                      F-10
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


     In October 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets.  Statement 144 provides that long-
lived assets to be disposed of by sale be measured at the lower of carrying
amount or fair value less cost to sell, whether reported in continuing
operations or in discontinued operations, and broadens the reporting of
discontinued operations to include all components of an entity with operations
that can be distinguished from the rest of the entity and that will be
eliminated from the ongoing operations of the entity in a disposal transaction.
Statement 144 is effective for fiscal years beginning after December 15, 2001.
The Company is currently assessing the impact of Statement 144 on its financial
condition and results of operations.

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) and issued 1,656,700 shares of its
common stock (representing approximately 12.6% of Highlands Group's then
outstanding common stock) and 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. 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); and
Statesman Insurance Company (SIC).

3.   Disposal of Assets

     In December 1997, the Company sold to an independent purchaser a management
contract which established control over Northwestern National Casualty Mutual
(NNCM). NNCM, a Texas county mutual insurance company, which 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 provided a partial guarantee (up to $1.3 million) of
the adequacy of the loss reserves. The guarantee was finalized in 2000 and
Highlands recognized other income of approximately $1.3 million in 2000.

     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.   Write-off Of Subsidiary

     At December 31, 1999, the Company wrote-off its remaining investment in and
deferred tax assets associated with LMI, which had been in run-off since April
1997 when it was acquired in the purchase of American Reliance. The charge,
totaling $22.1 million, consists of $10.5 million for the Company's remaining
investment in LMI and $11.6 million of associated deferred tax assets. In March
2000, the Court of Common Pleas in Franklin County, Ohio, entered an order
appointing the Superintendent of Insurance of the State of Ohio as the
Rehabilitator of LMI. As Rehabilitator, the Superintendent is by operation of
law vested with control of LMI, including title to all LMI assets.

     Following is a summary of net assets and results of operations of LMI as of
December 31, 1999 (the date of disposal) and for the year ended December 31,
1999 (in thousands):

<TABLE>
<CAPTION>
                                                           December 31, 1999
                                                           -----------------
    <S>                                                    <C>
     Fixed maturity securities, at fair value............      $      18,686
     Highlands Group preferred stock.....................              4,641
                                                               -------------
           Total investments.............................             23,327
     Cash and cash equivalents...........................             12,843
     Receivable from reinsurers..........................             42,412
     Other assets                                                      2,247
                                                               -------------
           Total Assets..................................      $      80,829
                                                               =============
     Loss and loss adjustment expense reserves...........      $      60,284
     Other liabilities...................................             10,093
                                                               -------------
           Total liabilities.............................      $      70,377
                                                               =============
     Net Assets                                                $      10,452
                                                               =============

<CAPTION>
                                                              Year ended
                                                          December 31,  1999
                                                          ------------------
     <S>                                                  <C>
     Total revenues......................................      $       3,396
     Total expenses......................................              3,099
                                                               -------------
           Net income (loss) before taxes................                297
     Income tax expense (benefit)........................              2,604
                                                               -------------
           Net loss......................................      $      (2,307)
                                                               =============
</TABLE>



5.   Investments and Investment Income

     Net investment income for the years ended December 31, 2001, 2000 and 1999
is comprised of the following (in thousands):

<TABLE>
<CAPTION>
                                                              2001         2000        1999
                                                           ---------     -------     -------
     <S>                                                   <C>           <C>         <C>
     Gross investment income:
     Fixed maturity securities.......................      $  52,496      55,697      62,981
     Equity securities...............................          2,219       2,469       1,973
     Cash equivalents and other investments..........          4,979       5,309       3,456
                                                           ---------     -------     -------
           Gross investment income...................         59,694      63,475      68,410
     Investment expenses.............................            912       1,022         726
                                                           ---------     -------     -------
           Net investment income.....................      $  58,782      62,453      67,684
                                                           =========     =======     =======
</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, 2001 and 2000 (in thousands):

<TABLE>
<CAPTION>
                                                                            Amortized      Gross Unrealized
                                                                              Cost        Gains      Losses     Fair Value
                                                                              ----        -----      ------     ----------
<S>                                                                        <C>          <C>        <C>          <C>
December 31, 2001--
     Fixed maturities available-for-sale:
        United States Government and government agencies............       $132,897       1,937        (445)     134,389
        States, municipalities and political subdivisions...........         13,125         243         (78)      13,290
        Mortgage-backed securities..................................        285,111       4,717      (7,135)     282,693
        Corporate securities........................................        292,277       4,670     (13,076)     283,871
                                                                           --------     -------    --------     --------
                                                                            723,410      11,567     (20,734)     714,243
     Equity securities..............................................         28,940         981        (256)      29,665
                                                                           --------     -------    --------     --------
                                                                           $752,350      12,548     (20,990)     743,908
                                                                           --------     -------    --------     --------
December 31, 2000--
     Fixed maturities available-for-sale:
        United States Government and government agencies............       $137,800       1,252        (733)     138,319
        States, municipalities and political subdivisions...........         16,015         201        (275)      15,941
        Mortgage-backed securities..................................        346,124       2,340      (3,444)     345,020
        Corporate securities........................................        297,153       1,946     (21,926)     277,173
                                                                           --------     -------    --------     --------
                                                                            797,092       5,739     (26,378)     776,453
     Equity securities..............................................         30,686       2,690      (1,285)      32,091
                                                                           --------     -------    --------     --------
                                                                           $827,778       8,429     (27,663)     808,544
                                                                           ========     =======    ========     ========
</TABLE>

     The fair value of investments is based on quoted market prices, where
available, or quotes from external pricing sources such as brokers for similar
investments and issues. With the exception of the securities of the 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 fixed maturity securities as
of December 31, 2001, 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..............................    $   35,321     35,881
        After one year through five years............       171,140    174,141
        After five years through ten years...........        88,974     88,928
        After ten years..............................       142,864    132,600
        Mortgage-backed securities...................       285,111    282,693
                                                         ----------   --------
                                                         $  723,410    714,243
                                                         ==========   --------
</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,
                                                                     ---------------------------------
                                                                       2001          2000       1999
                                                                     -------       --------   --------
     <S>                                                             <C>           <C>        <C>
     Fixed maturity securities.....................................  $11,472        19,477    (65,889)
     Equity securities.............................................     (680)        6,187     (5,092)
     Write-off of subsidiary net unrealized loss...................       --            --        232
                                                                     -------       -------    -------
                                                                      10,792        25,664    (70,749)
     Deferred income taxes.........................................   (3,777)       (8,982)    24,762
                                                                     -------       -------    -------
           Change in net unrealized gains and losses,
            net of tax.............................................  $ 7,015        16,682    (45,987)
                                                                     =======       =======    =======
</TABLE>

Sales of Securities

     Gross realized investment gains and losses and proceeds from the sale of
investments for the years ended December 31, 2001, 2000 and 1999 are as follows
(in thousands):

<TABLE>
<CAPTION>
                                                                      2001         2000         1999
                                                                    --------     --------     --------
     <S>                                                            <C>          <C>          <C>
     Fixed maturities:
           Gross realized gains...................................  $  4,574      $ 1,096        3,967
           Gross realized losses..................................      (270)        (692)      (4,866)
                                                                    --------      -------      -------
                                                                    $  4,304      $   404         (899)
                                                                    ========      =======      =======
     Equity securities:
           Gross realized gains...................................  $  5,984      $    --           --
           Gross realized losses..................................        --           --           --
                                                                    --------      -------      -------
                                                                    $  5,984      $    --           --
                                                                    ========      =======      =======
     Other investments:
           Gross realized gains...................................  $  1,535      $   570          921
           Gross realized losses..................................        --           --           --
                                                                    --------      -------      -------
                                                                    $  1,535      $   570          921
                                                                    ========      =======      =======
     Proceeds from sale of fixed maturity securities
         (calls and maturities excluded)..........................  $156,836      $87,714      184,817
                                                                    ========      =======      =======
</TABLE>

6.   Dividends from Subsidiaries and Statutory Information

     The insurance subsidiaries are restricted by law as to the amount of
dividends they may pay without the approval of regulatory authorities. During
2002, no dividends can be paid without such approval.

     Combined net income (loss) and policyholders' surplus of the Company's
combined insurance subsidiaries, as determined in accordance with statutory
accounting practices, follows (in millions):

<TABLE>
<CAPTION>
                                              2001       2000      1999
                                            --------    ------    ------
     <S>                                    <C>         <C>       <C>
     Net income (loss)....................  $(282.1)    (42.2)      6.5
                                            =======     =====     =====
     Policyholders' surplus...............  $  41.2     204.0     270.8
                                            =======     =====     =====
</TABLE>


                                      F-14
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


     The above combined statutory financial information of the insurance
subsidiaries was prepared in accordance with accounting practices prescribed or
permitted by the various insurance departments of the insurance subsidiaries'
states of domicile. The statutory surplus at December 31, 2001 for Highlands
Insurance Company was $25.5 million and for NNCC was $5.2 million. "Prescribed"
statutory accounting practices include state laws, regulations and general
administrative rules, as well as a variety of publications of the National
Association of Insurance Commissioners (NAIC). "Permitted" statutory accounting
practices encompass all accounting practices that are not prescribed; such
practices may differ from state to state, may differ from company to company
within a state, and may change in the future. For 2001, the Company obtained
permission from the Texas, Wisconsin and California insurance departments to
discount its loss and loss adjustment expense reserves by 5% in connection with
the preparation of the annual 2001 statutory statements for the insurance
subsidiaries domiciled in those states. Without this permitted statutory
accounting for loss and loss adjustment expense reserves, the Company's
principal insurance subsidiaries, Highlands Insurance Company, NNCC and PNIC,
would have reported negative surplus at December 31, 2001. The above table
reflects the permitted discounting. As discussed in Note 16, the insurance
subsidiaries of the Company are subject to supervisory orders. In 1999, the
Company's insurance subsidiaries obtained permission from certain insurance
departments to write-off directly to policyholder surplus certain computer
software amounts that were previously non-admitted under prescribed statutory
accounting practices. There was no impact on surplus at December 31, 1999 due to
this permitted accounting. The insurance subsidiaries did not have any other
material permitted statutory accounting practices in 2001, 2000 and 1999.

     In March 1998, the NAIC adopted the Codification of Statutory Accounting
Principles (the Codification). The implementation of the Codification was
effective for the Company's insurance subsidiaries January 1, 2001. The adoption
of the Codification did not have a significant impact on policyholder surplus at
December 31, 2001.

                                     F-15
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


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).

     The primary components of the Company's deferred tax assets and liabilities
and the related valuation allowance as of December 31, 2001 and 2000,
respectively, follow (in thousands):

<TABLE>
                                                                                     2001            2000
                                                                                  ---------        --------
     <S>                                                                          <C>              <C>
     Deferred tax assets--
         Net operating loss carryforward...................................       $ 148,663         54,545
         Loss and loss adjustment expense reserves.........................          57,199         44,926
         Unearned premiums.................................................          11,193         15,088
         Deferred credits for processing fees..............................           1,545          2,089
         Bad debts  .......................................................             905          2,712
         Unrealized loss on investments....................................           2,955          6,732
         Other.............................................................           5,002          8,691
                                                                                  ---------       --------
          Deferred tax assets before valuation allowance...................         227,462        134,783
         Valuation allowance...............................................        (218,018)       (95,619)
                                                                                  ---------       --------
          Deferred tax assets after valuation allowance....................           9,444         39,164
                                                                                  ---------       --------
     Deferred tax liabilities--
         Deferred acquisition costs........................................              --         17,368
         Accrued retrospective premiums....................................           5,087          7,500
         Depreciation & amortization.......................................           3,649          6,468
         Other.............................................................             708          1,096
                                                                                  ---------       --------
          Deferred tax liabilities.........................................           9,444         32,432
                                                                                  ---------       --------
            Net deferred tax asset.........................................       $      --          6,732
                                                                                  =========       ========
</TABLE>

     The net deferred tax asset is net of valuation allowances of $218.0 and
$95.6 million as of December 31, 2001 and 2000, respectively. During 2001, the
Company increased its valuation allowance to $218.0 million related to its
$227.5 million of deferred tax assets. In assessing whether the deferred taxes
are realizable assets, management considers whether it is more likely than not,
that some portion of all of the deferred tax assets will not be realized. The
ultimate realization of deferred tax assets is dependent upon generation of
future taxable income during periods in which those temporary differences become
deductible. Based upon the level of historical taxable income and expectations
for future taxable income, management believes it is more likely than not that
the Company will not realize the benefits of these deductible differences and,
therefore, has established a valuation allowance for 100% of the net deferred
tax assets.

                                      F-16
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

     At December 31, 2001 and 2000, the Company had the following net operating
losses (NOL's), foreign net operating losses (foreign NOL's), alternative
minimum tax operating losses (AMTOL's), capital losses and alternative minimum
tax credits (AMT credits) (in thousands) available to be carried to future
periods.

<TABLE>
<CAPTION>
                                                  2001              2000
                                                --------          --------
               <S>                              <C>               <C>
               NOL's                            $414,974          144,440
               Foreign NOL's                       9,778           11,403
               AMTOL's                           382,091          121,831
               Capital Losses                          0              443
               AMT Credits                           556              556
</TABLE>

     The NOL's and AMTOL's begin to expire in 2004 and expire completely by
2021. Of the total NOL carryforward at December 31, 2001, $26.2 million is
subject to an annual Section 382 limitation of $2.8 million attributable to the
1997 acquisition of American Reliance by the Company. As of December 31, 2001,
none of the Section 382 limitation has been used.

     The income tax expense (benefit) was different from the amount computed by
applying the federal income tax rate to loss before income taxes for the
following reasons (in thousands):

<TABLE>
<CAPTION>
                                                                                  2001          2000          1999
                                                                                ---------     --------      --------
     <S>                                                                        <C>           <C>           <C>
     Loss before income taxes....................................               $(340,859)     (38,529)        (465)
     Tax rate....................................................                      35%          35%          35%
                                                                                ---------      -------      -------
        Application of the tax rate..............................                (119,301)     (13,485)        (163)
     Tax effect of:
        Tax-exempt income........................................                    (659)        (793)      (1,102)
        Write-off of subsidiary..................................                      --           --        3,657
        Write-off net deferred tax assets of subsidiary..........                      --           --       11,618
        Other....................................................                   1,260         (803)       5,177
                                                                                ---------      -------      -------
          Income tax (benefit) expense before valuation
            allowance............................................                (118,700)     (15,081)      19,187
     Change in valuation allowance...............................                (119,444)     (82,828)      (6,203)
                                                                                ---------      -------      -------
          Income tax expense.....................................               $     744       67,747       12,984
                                                                                =========      =======      =======
</TABLE>

     The income tax expense (benefit) consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                       2001      2000      1999
                                                      ------    ------    ------
  <S>                                                  <C>      <C>       <C>
  Current expense (benefit)........................    $ 744       790       325
  Deferred expense (benefit).......................       --    66,957    12,659
                                                       -----    ------    ------
        Income tax expense (benefit)...............    $ 744    67,747    12,984
                                                       =====    ======    ======
</TABLE>


                                      F-17
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


8.   Debt and Preferred Stock 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, including a security interest in the Company's principal
insurance subsidiaries, currently provides for an interest rate of LIBOR plus
150 to 225 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. During 2000, the Company repaid $10.0
million of the loan. This payment permanently reduced the senior revolving
credit facility from $59.0 million to $49.0 million. The credit facility was
further reduced in March 2002 to $47.5 million through a repayment of $1.5
million. The average interest rate for the year ended December 31, 2001 was
7.3%.

     Since December 31, 2001, the Company has been in default under the terms of
the Credit Agreement for noncompliance with certain financial ratios. The
Company does not have sufficient funds to satisfy the $47.5 million principal
due on April 30, 2002. Representatives of the Company and the senior lenders
have been in discussions regarding the notes.

     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
Notes were issued pursuant to a Purchase, Redemption and Bonus Agreement (the
"Purchase Agreement").

     By virtue of cross default provisions in the Debentures, if either the
indebtedness under the Credit Agreement, as described above, becomes due and is
not paid or is in default and the maturity of the debt is accelerated, the
holders of the Debentures have the right to declare the Debentures in default
and accelerate their maturity.

     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, 2001.

     Interest on the Debentures is payable semi-annually in cash at 10% per
annum, except that for 2001, interest is payable in kind in the form of new
12.5% convertible subordinated debentures ("New Debentures"). The New Debentures
have the same terms and conditions as the Debentures except that the interest
rate on the New Debentures is 12.5% 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 $5.9 million in 2001 and $6.0 million in 2000 and
1999. The total amortization of debt discount and acquisition costs incurred
related to the Debentures was approximately $1.3 million in 2001, 2000 and 1999.

                                      F-18
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


     In 1997, the Company authorized the designation of a series of Preferred
Stock (the Series One Preferred Stock) for use in transactions related to the
acquisition of American Reliance. The Company is authorized to issue up to
50,000 shares of non-voting shares of the Series One Preferred Stock. At the
time of the issuance of the Series One Preferred Stock, 100% of the outstanding
shares were held by the subsidiaries of Highlands Group and were eliminated in
consolidation. At December 31, 2001, there were 16,922 shares of Series One
Preferred Stock issued and outstanding, of which 5,235 shares were held by LMI.
As a result of the Company's write-off of LMI, the shares held by LMI are
reflected as outstanding in consolidated balance sheets of the Company as of
December 31, 2001 and 2000. The Series One Preferred Stock has cumulative
dividends payable quarterly at 6% which can be in the form of cash or paid-in-
kind (PIK) dividends with PIK dividends being elected to date. The Series One
Preferred Stock is mandatorily redeemable on January 1, 2004. The liquidation
preference amount is $1,000 per share plus cumulative unpaid dividends.


9.   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>
                                                                                             2001          2000         1999
                                                                                           ---------     ---------     -------
     <S>                                                                                   <C>           <C>           <C>
     NUMERATOR:
       Net income (loss) attributable to common stockholders, as reported and for
         basic earnings (loss) per share...............................................    $(341,908)     (106,565)    (13,449)
       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....................    $(341,908)     (106,565)    (13,449)
                                                                                           =========     =========     =======
     DENOMINATOR:
       Denominator for basic earnings (loss) per share--weighted average
         shares........................................................................       13,207        13,221      12,956
       Effect of dilutive securities:
          Common stock warrants and outstanding stock options (based on
            treasury stock method).....................................................           --            --          --
          Convertible subordinated debentures..........................................           --            --          --
                                                                                           ---------     ---------     -------
       Denominator for diluted earnings per share--adjusted weighted average
         shares and assumed conversions................................................       13,207        13,221      12,956
                                                                                           =========     =========     =======
       Basic earnings (loss) per share.................................................    $  (25.89)        (8.06)      (1.04)
       Diluted earnings (loss) per share...............................................    $  (25.89)        (8.06)      (1.04)
</TABLE>

     The Debentures, which are convertible into approximately 3.7 million
shares, were outstanding during 2001, 2000 and 1999, but were not included in
the computation of diluted earnings per share because the assumed conversion
would be antidilutive. Common stock warrants attached to the Debentures for
approximately 3.8 million shares for 2001 and 5 million shares for 2000 and
1999, respectively, were not included in earnings per share calculations as they
were antidilutive.

     Stock options for 1,086,498, 1,143,282 and 978,309 weighted shares for
2001, 2000 and 1999, respectively, were not included in earnings per share
calculations as they were antidilutive.

                                      F-19
<PAGE>

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 reinsurance 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 ($10.4 million and $7.4 million as of
December 31, 2001 and 2000, respectively) or does not record certain contracts
as ceded business but retains these amounts ($26.4 million and $25.1 million as
of December 31, 2001 and 2000, respectively) as loss reserves for 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 uncollectible reinsurance can
be established beyond recorded reserves. With respect to certain carriers 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, 2001,
such collateral totaled approximately $60.8 million.

     The Company's three largest recoverables as of December 31, 2001 were
approximately $135.2 million with Underwriters at Lloyds of London/Equitas,
$72.1 million with American Reinsurance Company and $52.5 million with General
Reinsurance Company. American Reinsurance Company and General Reinsurance
Company are both rated by A++ by A. M. Best.

     There are instances where the Company and one or more of its reinsurers
disagree on the terms or extent of reinsurance coverage with respect to
particular losses. In these situations, the Company attempts to negotiate an
acceptable settlement of the disagreement or, failing to reach such a
settlement, takes the matter to arbitration. The largest such disagreement, in
the amount of $12 million of reinsurance recoverable (net of a valuation
allowance), concerns reinsurance on California construction defect claims.

     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, 2001--
     Written premiums...............................    $441,550    57,455    57,033    441,972
     Earned premiums................................    $509,263    45,330    58,034    496,559
     Loss and loss adjustment expense incurred......    $679,032    52,976    64,891    667,118
                                                        ========    ======    ======    =======
Year ended December 31, 2000--
     Written premiums...............................    $495,103    22,015    56,125    460,993
     Earned premiums................................    $427,268    12,194    50,957    388,505
     Loss and loss adjustment expense incurred......    $401,574    20,601    76,038    346,137
                                                        ========    ======    ======    =======
Year ended December 31, 1999--
     Written premiums...............................    $355,313     8,816    30,524    333,605
     Earned premiums................................    $345,885     9,181    29,761    325,305
     Loss and loss adjustment expense incurred......    $257,024    21,973    40,057    238,940
                                                        ========    ======    ======    =======
</TABLE>

                                      F-20
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


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. The Company and the insurance
industry generally 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
circumstances. 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.

     As a result of a reserve analysis done in the fourth quarter of 2001 by the
Company and its independent actuary, it was determined that there had been
adverse development in the 2000 accident year of approximately $89 million.
Also, the reserve analysis demonstrated that losses incurred and loss adjustment
expenses in the 2001 accident year would exceed the Company's estimates by more
than 10 percentage points.  For the 2001 accident year, the Company recorded a
95% and a 134.3% calendar year loss and loss adjustment expense ratio on $496.6
million of net earned premium.  The adverse development in 2001 and 2000 came
primarily from the following four lines of business--workers' compensation,
general liability, commercial multiple peril and commercial auto liability.  The
adverse development amounts related to asbestos and environmental claims for
2001, 2000 and 1999 were $14.8 million, $7.8 million and $1.8 million,
respectively.

     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-21
<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>
                                                                      2001          2000         1999
                                                                   ----------    ----------    ---------
<S>                                                                <C>           <C>           <C>
Balance at January 1...........................................    $1,392,497    $1,353,524    1,603,548
  Less--Reinsurance recoverables...............................       626,647       614,208      732,567
                                                                   ----------    ----------    ---------
Net balance at January 1.......................................       765,850       739,316      870,981
                                                                   ----------    ----------    ---------
Incurred related to--
  Current year.................................................       470,038       321,181      247,027
  Prior year--
     Asbestos and environmental................................        14,748         7,762        1,795
     All other.................................................       182,332        17,194       (9,882)
                                                                   ----------    ----------    ---------
  Total prior year.............................................       197,080        24,956       (8,087)
                                                                   ----------    ----------    ---------
     Total incurred............................................       667,118       346,137      238,940
                                                                   ----------    ----------    ---------
Paid related to--
  Current year.................................................       163,428       136,565      101,294
  Prior year
     Asbestos and environmental................................         7,258        11,041       15,038
     All other.................................................       272,032       171,997      230,240
                                                                   ----------    ----------    ---------
  Total prior year.............................................       279,290       183,038      245,278
                                                                   ----------    ----------    ---------
     Total paid................................................       442,718       319,603      346,572
                                                                   ----------    ----------    ---------
Elimination of reserves of written-off subsidiary..............            --            --       24,033
                                                                   ----------    ----------    ---------
Net balance at December 31.....................................       990,250       765,850      739,316
Add--Reinsurance recoverables..................................       608,877       626,647      614,208
                                                                   ----------    ----------    ---------
Balance at December 31.........................................    $1,599,127    $1,392,497    1,353,524
                                                                   ==========    ==========    =========
</TABLE>


     The following table summarizes the Company's net reserves for asbestos and
environmental reserves as of December 31 (in thousands):

<TABLE>
<CAPTION>
                                        2001       2000
                                      --------   --------
     <S>                             <C>          <C>
     Asbestos....................     $ 96,852   $ 77,843
     Environmental...............       30,001     41,520
                                      --------   --------
                                      $126,853   $119,363
                                      ========   ========
</TABLE>


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 contributions. The plan may be canceled
at any time at the option of the Company. The Company's net contributions to the
plan for 2001, 2000 and 1999 were approximately $.2 million, $1.9 million, and
$1.2 million, respectively.

                                      F-22
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


13.  Stock Compensation Plans

     At December 31, 2001, 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 is being recognized for the grant of options to
acquire Company Common Stock prior to a market price (January 23, 1996) for
Company Common Stock. The compensation cost that has been charged against income
for its stock-based plans was $(157,500), $(93,500) and $321,000 for 2001, 2000
and 1999, respectively. However, no compensation cost has been recognized for
shares issued 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 Statement of Financial Accounting Standards No. 123,
the Company's net income (loss) and income (loss) per share would have been the
pro forma amounts indicated below (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                                               2001        2000       1999
                                                                            ---------    --------    -------
<S>                                                         <C>             <C>          <C>         <C>
Net income (loss) attributable to common stockholders.....  As reported     $(341,908)   (106,565)   (13,449)
                                                            Pro forma       $(342,172)   (107,589)   (13,974)
Basic earnings (loss) per share...........................  As reported     $  (25.89)      (8.06)     (1.04)
                                                            Pro forma       $  (25.91)      (8.14)     (1.08)
Diluted earnings (loss) per share.........................  As reported     $  (25.89)      (8.06)     (1.04)
                                                            Pro forma       $  (25.91)      (8.14)     (1.08)
</TABLE>

     During 1999, the Company gave its employees the opportunity to exchange
stock options and restricted stock for new stock options and restricted stock
with a current market price ($13.25 per share on March 12, 1999). Employees
taking advantage of this opportunity forfeited all vesting to date and 25% of
their shares subject to option. The newly issued stock options fully vest after
three years with the opportunity for accelerated vesting if certain performance
measures are met. The vesting of the restricted stock is based on performance
measures, but in any event vest at the end of three years.


  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
were reserved for issuance under all option plans was 1,350,000 at December 31,
2001.

                                      F-23
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  A summary of the status of the Company's stock option plans at December 31,
2001 and changes during the three years then ended is presented below:

<TABLE>
<CAPTION>
                                                   2001                     2000                     1999
                                           -------------------      -------------------      -------------------
                                                     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.......  1,143,282     $ 12.76      978,309     $ 14.48      841,920     $ 18.35
Granted................................     14,400     $  8.94      302,075     $  8.42      448,201     $ 11.91
Exercised..............................         --     $    --           --     $    --           --     $    --
Forfeited..............................   (307,198)    $ 12.06     (137,102)    $ 15.14     (311,812)    $ 21.31
                                         ---------     -------    ---------     -------     --------     -------
Outstanding at end of year.............    850,484     $ 12.95    1,143,282     $ 12.76      978,309     $ 14.48
                                         ---------                =========                 ========
Options exercisable at year-end........    647,395                  544,303                  389,679
                                         =========                =========                 ========
</TABLE>


  The following table summarizes information about stock options outstanding at
December 31, 2001:

<TABLE>
<CAPTION>
                                    Options Outstanding                     Options Exercisable
                      -----------------------------------------------  -----------------------------
                        Number     Weighted Average                      Number
      Range Of        Outstanding     Remaining      Weighted Average  Exercisable  Weighted Average
  Exercise Prices     At 12/31/01  Contractual Life   Exercise Price   At 12/31/01   Exercise Price
  ---------------     -----------  ----------------   --------------   -----------   --------------
<S>                   <C>          <C>               <C>               <C>          <C>
  $ 8.13 -  9.31          183,856              8.43       $     8.42        86,627       $     8.32
  $ 9.44 - 13.25          267,095              7.32       $    11.67       161,235       $    10.97
  $14.69 - 14.69          346,833              4.01       $    14.69       346,833       $    14.69
  $14.88 - 28.38           52,700              5.84       $    23.75        52,700       $    23.75
                          -------              ----       ----------       -------       ----------
  $ 8.13 - 28.38          850,484              6.12       $    12.95       647,395       $    13.65
                          =======                                          =======
</TABLE>

  The fair value of stock options granted during the years ended December 31,
2001, 2000 and 1999 was $.1 million, $1.5 million and $3.4 million,
respectively. The weighted average estimated per share fair value of options
granted during the years ended December 31, 2001, 2000 and 1999 was $8.16, $5.00
and $7.61, 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 2001, 2000 and 1999, respectively: dividend yields of -0- percent,
expected volatilities of 111 percent, 45 percent and 46 percent, risk-free
interest rates of 5.0 percent, 5.2 percent and 6.5 percent, 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,
2001, 35,573 shares were issued under the Purchase Plan.

                                      F-24
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Restricted Stock Plan

     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, 2001, the number of shares of stock reserved under the
Restricted Stock Plan was 350,000.  The Company did not grant any shares of
Restricted Stock in 2001 or 2000. Restricted Stock is considered issued and
outstanding when awarded. As of December 31, 2001, 291,225 restricted shares
have been forfeited to the Company and 24,281 shares are outstanding under the
plan. The fair market value of Restricted Stock on the date of issuance has been
recorded as a deferred expense and included as a component of stockholders'
equity. No amortization of the deferred expense was recorded in 2001, 2000 or
1999. The deferred expense will be amortized over the remaining vesting period
if certain closing prices of the Company's Common Stock are achieved.


15.  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, 2001 and 2000, were as follows (in thousands):

<TABLE>
<CAPTION>
                                                            2001                       2000
                                                 -------------------------    ----------------------
                                                   Carrying          Fair      Carrying       Fair
                                                 ------------      -------    ----------   ---------
<S>                                              <C>               <C>        <C>          <C>
Assets:
     Fixed maturity securities................   $    714,243      714,243      776,453      776,453
     Equity securities........................   $     29,665       29,665       32,091       32,091
     Other investments........................   $         54           54        1,952        1,952
     Cash and cash equivalents................   $    109,634      109,634      109,763      109,763
     Premium installment receivables..........   $        189          189        3,525        3,525
     Accrued investment income................   $      9,723        9,723       11,084       11,084
Liabilities:
     Convertible subordinated debentures......   $     62,297       65,804       58,626       60,000
     Senior bank debt.........................   $     49,004       49,004       49,004       49,004
</TABLE>

                                      F-25
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


     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 Debentures, for which there
is no market, was estimated using the principal (face) amount of the Debentures.
The senior bank debt is floating rate and considered to approximate fair value.


16.  Contingent Liabilities

 Legal Action

     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.

     Halliburton. From 1958 to 1986, the Company issued fixed premium,
guaranteed cost (not retrospectively rated) insurance policies to Brown & Root,
a subsidiary of Halliburton Company. Beginning in 1987, the Company's insurance
policies with Halliburton (including Brown & Root) were written on a
retrospectively rated or high-deductible basis. Based on the Form 10-K filed by
Halliburton on March 12, 2002, as of December 31, 2001, there were approximately
32,000 open and unresolved third party asbestos claims which have been made
against Halliburton's Engineering and Construction Group. Through December 31,
2000, the Company paid $1.2 million on behalf of Halliburton under the fixed
premium policies on asbestos claims, and billed Halliburton $8.5 million under
the retrospectively rated and high-deductible policies on asbestos claims.
Halliburton has not paid this billed amount and has questioned the proper
allocation of the asbestos claims between the fixed premium and the
retrospectively rated and high-deductible policies.

     On April 5, 2000, the Company filed an action in the Delaware Court of
Chancery (Delaware Action) asserting that indemnification obligations exist
pursuant to the Distribution Agreement dated October 10, 1995 between the
Company and Halliburton, which was executed as part of the distribution by
Halliburton of the shares of the Company's Common Stock to Halliburton's
stockholders and the public. The action is seeking (i) a declaratory judgment
that Halliburton is responsible for indemnifying the Company for losses and
expenses incurred on the Halliburton/Brown & Root policies; (ii) an injunction
ordering Halliburton to assume responsibility for such losses and expenses;
(iii) a judgment against Halliburton for non-payment of the amounts billed under
the retrospectively rated and high-deductible policies; and (iv) a declaration
estopping Brown & Root from invoking insurance under the fixed premium policies.

                                      F-26
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


     On July 13, 2000, the Company amended its complaint in the Delaware Action,
adding a count seeking a declaratory judgment that the Company is not liable
under the fixed premium policies because those policies were terminated pursuant
to the Investment Agreement dated October 10, 1995 among the Company,
Halliburton, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda)
L.P. The Company also filed a motion for a preliminary injunction enjoining
Halliburton from instituting, continuing or prosecuting any action in any other
jurisdiction arising out of or related to the subject matter of the Delaware
Action. On July 26, 2000, Halliburton filed motions to dismiss the Delaware
Action on the grounds of forum non conveniens and failure to state a claim upon
which relief can be granted. On September 8, 2000, the Company filed a motion
for judgment on the pleadings in the Delaware Action. Oral argument on
Halliburton's motions to dismiss and the Company's motion for judgment on the
pleadings in the Delaware Action was held on November 30, 2000. On March 21,
2001, the Chancery Court in the Delaware Action issued its decision in favor of
the Company, finding that the fixed premium policies had been terminated
pursuant to the Investment Agreement. An order was issued to that effect on
April 3, 2001. Halliburton appealed the decision of the Chancery Court to the
Delaware Supreme Court and on March 13, 2002, the Delaware Supreme Court issued
an Order affirming the decision of the Chancery Court.  On March 28, 2002,
Halliburton filed a motion with the Delaware Supreme Court requesting
reargument.

     On April 24, 2000, Halliburton filed an action in the District Court of
Harris County, Texas (Texas Action) seeking (i) a declaratory judgment that the
Company is liable for costs and expenses under the fixed premium policies; (ii)
a declaratory judgment that Halliburton has the right to select the policy under
which such coverage is to be paid; and (iii) damages. The Company filed its
answer in the Texas Action on July 26, 2000 denying the allegations in
Halliburton's complaint. On July 27, 2000, Halliburton filed an amended petition
in the Texas Action adding Brown & Root as plaintiff. On November 6, 2000,
Halliburton filed a second amended petition in the Texas Action adding Highlands
Group as a defendant. Proceedings in the Texas Action have largely been held in
abeyance by the parties pending the resolution of the Delaware Action, although
there is no assurance that Halliburton will not attempt to activate the Texas
Action in the future. Following the decision of the Delaware Supreme Court on
March 13, 2002, Halliburton announced that it is "reviewing its options."

     Regulatory Proceedings. In February 2002, the Texas Department of Insurance
issued Supervisory Orders to the Company's Texas insurance subsidiaries,
including Highlands Insurance Company, the Company's principal insurance
subsidiary. By their terms, the orders are also binding on all the companies'
affiliates. A Supervisory Order for another of the insurance subsidiaries, SCIC,
was issued by the North Carolina Department of Insurance in December 2001, and
in October 2001, the Wisconsin Commissioner of Insurance issued a Stipulation
and Order covering NNCC, the Company's second largest insurance subsidiary and
NNIC, another of the Company's insurance subsidiaries. In addition to these
orders, the Company's insurance subsidiaries have had their licenses to transact
business suspended in Florida, Illinois, Kansas, Kentucky, Minnesota, Missouri,
New Mexico, Ohio and Rhode Island, and by the U.S. Department of Treasury and
the U.S. Department of Labor with respect to federal surety and workers'
compensation programs. The licenses in Connecticut and North Carolina have been
amended to allow the companies to service existing business only. The Company
has also agreed to cease writing new and renewal business in Colorado, Maine,
Michigan and South Carolina and has been removed from the list of eligible
surplus lines insurers in New Mexico, Texas and Virginia. Except where
prohibited by regulation or where withdrawal plans have been filed and are
pending, the Company is not renewing any business upon policy term expiration.

                                      F-27
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Leases

     At December 31, 2001, the Company was obligated under noncancelable
operating leases, expiring on various dates through 2004, principally for office
space and computer software. Future aggregate minimum rentals on noncancelable
operating leases are as follows: $2.9 million in 2002, $2.7 million in 2003,
$2.1 million in 2004, $1.7 million in 2005 and $1.0 million thereafter.

     The Company's gross rental expense was approximately $3.7 million, $4.0
million, and $3.1 million for 2001, 2000 and 1999, respectively.


17.  Business Concentration and Foreign Operations

     In the normal course of business, the Company has underwritten risks of its
former parent, Halliburton, and various subsidiaries and affiliates of
Halliburton. However, the agreement between Halliburton and the Company under
which the Company underwrote Halliburton business expired in January 2000.
During 2001, 2000 and 1999, net premiums earned from Halliburton aggregated
approximately $(26.4) million, $8.4 million, and $22.9 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 $81.9
million and $114.4 million at December 31, 2001 and 2000, respectively.

     The Company's United Kingdom operations as a percentage of the Company's
consolidated revenues, loss before income taxes and identifiable assets as of
and for the years ended December 31, 2001, 2000 and 1999 are not significant.

                                      F-28
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


18.  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, 2001 and 2000 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 financial information for the quarter ended December 31, 2001
reflects the reserve strengthening at the end of 2001 (see note 11) and the
write-off of deferred acquisition costs (see note 1).

<TABLE>
<CAPTION>
Quarter Ended                                                         March 31       June 30      Sept 30         Dec 31
-------------                                                         --------       -------      -------         ------
                                                                       (Dollars in thousands, except per share data)
<S>                                                              <C>              <C>          <C>           <C>
2001
     Net premiums earned.......................................     $   127,053      144,646       131,666         93,194
     Total revenues............................................     $   143,910      159,459       149,341        114,454
     Total expenses............................................     $   158,514      179,081       179,802        390,626
     Net income (loss) attributable to common stockholders.....     $   (14,685)     (19,819)      (30,540)      (276,864)
     Earnings (loss) per common share:
        Basic..................................................     $     (1.11)       (1.50)        (2.31)        (21.07)
        Diluted................................................     $     (1.11)       (1.50)        (2.31)        (21.07)
2000
     Net premiums earned.......................................     $    81,398       90,510       102,912        113,685
     Total revenues............................................     $    97,599      106,350       118,419        129,564
     Total expenses............................................     $    95,078      101,778       114,445        179,160
     Net income (loss).........................................     $     1,966        3,566         2,994       (115,091)
     Earnings (loss) per common share:
        Basic..................................................     $       .15          .27           .23          (8.70)
        Diluted................................................     $       .15          .27           .23          (8.70)
</TABLE>

19.  Subsequent Events

     The Company has outstanding $47.5 million in senior bank debt and $62.85
million principal amount of Debentures. The bank debt matures on April 30, 2002,
and is collaterized by a first lien on the stock of the Company's principal
insurance subsidiaries. The Company is currently in default under the terms of
the Credit Agreement for the senior bank debt. The Debentures are due December
31, 2005; however, by virtue of the cross default provisions of the Debentures,
if either the senior bank debt becomes due and is not paid or is in default and
the maturity of the debt is accelerated, the holders of the debentures have the
right to declare the debentures in default and accelerate their maturity. Due to
the Company's current financial condition, Highlands Group is currently
investigating the possibility of filing a petition for reorganization under
Chapter 11 of the United States Bankruptcy Code.

     On November 19, 2001, A.M. Best Company downgraded the financial rating of
the Company from B (Fair) to C- (Weak). As a result of the downgrade in November
2001 and continuing financial losses, on December 7, 2001, the Company announced
its intention to cease writing new and renewal business and to "run-off"
existing claims and business. On March 25, 2002, the Company was rated NR-4 (not
rated at Company's request) by A.M. Best.

                                     F-29
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                  SCHEDULE II

                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                                BALANCE SHEETS
                                (in thousands)

<TABLE>
<CAPTION>
                                                                                                  December 31,
                                                                                             ----------------------
                                          ASSETS                                                2001         2000
                                          ------                                             ---------     --------
<S>                                                                                         <C>           <C>
Investments in subsidiaries..............................................................    $ (44,204)     275,318
Cash and cash equivalents................................................................        3,878        7,103
Net deferred tax asset...................................................................           --        6,732
Deferred debt expense....................................................................        1,992        2,490
Receivable from subsidiaries.............................................................          135           --
Other assets                                                                                       416        3,634
                                                                                             ---------     --------
     Total assets........................................................................    $ (37,783)     295,277
                                                                                             =========     ========


                          LIABILITIES AND STOCKHOLDERS' EQUITY
                          ------------------------------------
Senior bank debt.........................................................................    $  49,004       49,004
Convertible subordinated debentures......................................................       62,297       58,626
Taxes payable to subsidiaries............................................................        4,410        2,526
Payable to subsidiaries..................................................................           --        1,002
Accounts payable and accrued liabilities.................................................        4,553        4,640
                                                                                             ---------     --------
     Total liabilities...................................................................      120,264      115,798
                                                                                             ---------     --------
Mandatorily redeemable preferred stock...................................................        5,235        4,930
                                                                                             ---------     --------
Stockholders' equity (deficit):
  Common stock, $.01 par value; 50,000,000 shares authorized; 12,978,533 shares
    issued and outstanding in 2001, 13,225,411 shares issues and outstanding in 2000.....          137          140
  Additional paid-in capital.............................................................      228,872      231,566
  Accumulated other comprehensive income.................................................       (8,582)     (12,572)
  Treasury stock, at cost (739,400 shares in 2001 and in 2000, including 445,900
    shares held by subsidiaries in 2001 and 2000)........................................       (9,459)      (9,459)
  Deferred compensation on restricted stock..............................................         (313)      (3,097)
  Retained earnings......................................................................     (373,937)     (32,029)
                                                                                             ---------     --------
     Total stockholders' equity (deficit)................................................     (163,282)     174,549
                                                                                             ---------     --------
     Total liabilities, mandatorily redeemable preferred securities and stockholders'
       equity............................................................................    $ (37,783)     295,277
                                                                                             =========     ========
</TABLE>

                See accompanying independent auditors' report.

                                      F-30
<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,
                                                                     --------------------------------
                                                                      2001          2000        1999
                                                                    --------      --------     -------
<S>                                                                <C>            <C>          <C>
Revenues:
  Net investment income......................................      $     130           254         594
  Net realized investment gains..............................             --            --          28
                                                                   ---------      --------     -------
     Total revenues..........................................            130           254         622
                                                                   ---------      --------     -------
Equity in net income (loss) of subsidiaries..................       (328,869)      (81,714)     (4,257)
                                                                   ---------      --------     -------
Expenses:
  Interest expense...........................................          9,969        11,233      11,952
  Debt amortization..........................................          1,795         1,511       1,297
  Other expenses.............................................           (631)       (1,617)      1,151
                                                                   ---------      --------     -------
     Total expenses..........................................         11,133        11,127      14,400
                                                                   ---------      --------     -------
  Loss before income tax benefit.............................       (339,872)      (92,587)    (18,035)
  Income tax expense (benefit)...............................          1,731        13,689      (4,586)
                                                                   ---------      --------     -------
     Net income (loss).......................................       (341,603)     (106,276)    (13,449)
Dividends paid on mandatorily redeemable preferred stock.....            305           289          --
                                                                   ---------      --------     -------
Net income (loss) attributable to common stockholders........      $(341,908)     (106,565)    (13,449)
                                                                   =========      ========     =======
Earnings (loss) per common share:
  Basic......................................................      $  (25.89)        (8.06)      (1.04)
  Diluted....................................................      $  (25.89)        (8.06)      (1.04)
Weighted average number of common shares outstanding:
  Basic......................................................         13,207        13,221      12,956
  Diluted....................................................         13,207        13,221      12,956
</TABLE>

                See accompanying independent auditors' report.

                                      F-31
<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,
                                                                             --------------------------------------
                                                                                  2001          2000         1999
                                                                               ---------      --------      -------
<S>                                                                          <C>           <C>           <C>
Cash flow from operating activities:
  Net income (loss)........................................................    $(341,603)     (106,276)     (13,449)
  Adjustments to reconcile net income (loss) to net cash provided by
    operating activities:
     Equity in net (income) loss of subsidiaries...........................      328,869        81,714        4,257
     Deferred tax expense (benefit)........................................           --        13,604       (1,747)
     Debt amortization.....................................................        1,795         1,511        1,297
     Dividends received from subsidiaries..................................           --        18,700       17,000
     Decrease in taxes receivable from subsidiaries........................        1,884         5,548          517
     Changes in other operating assets and liabilities.....................        5,830       (10,490)       1,541
                                                                               ---------      --------      -------
        Total adjustments..................................................      338,378       110,587       22,865
                                                                               ---------      --------      -------
     Net cash provided by (used in) operating activities...................       (3,225)        4,311        9,416
                                                                               ---------      --------      -------
Cash flows from financing activities:
  Payment for debt issuance expense........................................           --            --         (147)
  Repayment of senior bank debt............................................           --       (10,000)      (5,996)
  Issuance of Common Stock.................................................           --            61        5,474
  Acquisition of treasury stock............................................           --            --         (191)
                                                                               ---------      --------      -------
        Net cash used in financing activities..............................           --        (9,939)        (860)
                                                                               ---------      --------      -------
Net increase (decrease) in cash and cash equivalents.......................       (3,225)       (5,628)       8,556
Cash and cash equivalents at beginning of year.............................        7,103        12,731        4,175
                                                                               ---------      --------      -------
Cash and cash equivalents at end of year...................................    $   3,878         7,103       12,731
                                                                               =========      ========      =======
Supplemental disclosure of cash flow information:
  Interest paid............................................................    $   3,933        10,700       10,163
                                                                               =========      ========      =======
</TABLE>

                See accompanying independent auditors' report.

                                      F-32
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

               SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
                                (in thousands)

<TABLE>
<CAPTION>
                                                               As of December 31,
                                                       --------------------------------
                                          Deferred
                                           Policy                 Losses,
                                         Acquisition          Claims And Loss         Unearned
Property/Casualty Operations               Costs            Expenses/Reserves         Premiums
----------------------------               -----            -----------------         --------
<S>                                    <C>                  <C>                       <C>
2001...............................     $       --               1,599,127            168,480
                                        ==========               =========            -------
2000...............................     $   49,622               1,392,497            224,120
                                        ==========               =========            =======
1999...............................     $   33,556               1,353,524            146,832
                                        ==========               =========            =======
</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>
2001.....................   $ 496,559      58,782     667,118     133,035      177,576    441,972
                            =========      ======     =======     =======      -------    -------
2000.....................   $ 388,505      62,453     346,137      89,962      118,404    460,993
                            =========      ======     =======     =======      =======    =======
1999.....................   $ 325,305      67,684     238,940      65,308      132,140    333,605
                            =========      ======     =======     =======      =======    =======
</TABLE>

                See accompanying independent auditors' report.

                                      F-33
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                 SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS
                                (in thousands)

<TABLE>
<CAPTION>
                                                                                      Additions
                                                                              -------------------------
                                                         Balance at     Charges to                                 Balance at
                                                          Beginning      Cost And        Other                       End of
                                                          of Period      Expenses      Additions    Deductions       Period
                                                          ---------      --------      ---------    ----------       ------
<S>                                                      <C>          <C>             <C>          <C>           <C>
Year ended December 31, 2001
     Allowance for uncollectible reinsurance(1).....      $    7,377         3,000             --            --          10,377
                                                          ==========      ========       ========       =======      ==========
     Allowance for bad debts........................      $    5,313            --             --            33           5,280
                                                          ==========      ========       ========       =======      ==========
     Deferred tax asset valuation allowance.........      $   95,619       119,444          2,955            --         218,018
                                                          ==========      ========       ========       =======      ==========
Year ended December 31, 2000
     Allowance for uncollectible reinsurance(1).....      $    2,157         5,220             --            --           7,377
                                                          ==========      ========       ========       =======      ==========
     Allowance for bad debts........................      $    6,680            --             --         1,367           5,313
                                                          ==========      ========       ========       =======      ==========
     Deferred tax asset valuation allowance.........      $   12,791        82,828             --            --          95,619
                                                          ==========      ========       ========       =======      ==========
Year ended December 31, 1999
     Allowance for uncollectible reinsurance(1).....      $    1,702            --            455            --           2,157
                                                          ==========      ========       ========       =======      ==========
     Allowance for bad debts(2).....................      $    9,128            --             --         2,448           6,680
                                                          ==========      ========       ========       =======      ==========
     Deferred tax asset valuation allowance(3)......      $   18,994            --             --         6,203          12,791
                                                          ==========      ========       ========       =======      ==========
</TABLE>

___________
(1)  Deductions in the allowance for uncollectible reinsurance represent write-
     offs, net of recoveries, of amounts determined to be uncollectible.

(2)  $1.2 million of the deduction relates to the write-off of LMI.

(3)  $5.6 million of the deduction relates to the write-off of LMI.



                See accompanying independent auditors' report.

                                      F-34