<PAGE>

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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

                               ----------------

                                   FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
    OF 1934

                  For the Fiscal Year Ended December 31, 1997
                                      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                                 08648
      LAWRENCEVILLE, NEW JERSEY                        (ZIP CODE)
   (ADDRESS OF PRINCIPAL EXECUTIVE
              OFFICES)

                                (609) 896-1921
             (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

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

           TITLE OF EACH CLASS            NAME OF EACH EXCHANGE ON   WHICH
     Common Stock. $.01 Par Value                   REGISTERED
                                               New York Stock Exchange

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

                                     NONE.

  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]

  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

  The aggregate market value of the voting stock held by nonaffiliates of the
Registrant as of March 13, 1998, was $319,811,226 (based on $24.31 per share).
At March 13, 1998, the Registrant had outstanding 13,194,884 shares of its
Common Stock, par value $.01 per share.

                      DOCUMENTS INCORPORATED BY REFERENCE

  The registrant's definitive proxy statement to be filed with the Securities
and Exchange commission within 120 days of December 31, 1997 is incorporated
by reference in Part III of this 10-K.

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<PAGE>

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
 ITEM                                                                      PAGE
 ----                                                                      ----
                                     PART I

 <C>  <S>                                                                  <C>
  1.  Business...........................................................    1
  2.  Properties.........................................................   17
  3.  Legal Proceedings..................................................   17
  4.  Submission of Matters to a Vote of Security Holders................   17

                                    PART II

  5.  Market for Company's Common Stock and Related Stockholder Matters..   17
  6.  Selected Financial Data............................................   18
  7.  Management's Discussion and Analysis of Financial Condition and
      Results of Operations..............................................   19
  8.  Financial Statements and Supplemental Data.........................   28
  9.  Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure...............................................   29

                                    PART III

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

                                    PART IV

 14.  Financial Statements, Exhibits and Reports on Form 8-K.............   30
</TABLE>
<PAGE>

                                    PART I

ITEM 1: BUSINESS.

GENERAL

  Highlands Insurance Group, Inc. (the "Highlands Group") is an insurance
holding company that, through its subsidiaries (collectively, the "Company"),
is engaged in the property and casualty insurance business. Until January 23,
1996, the Highlands Group was a wholly-owned subsidiary of Halliburton Company
("Halliburton"). On that date, the shares of the Highlands Group's common
stock (the "Common Stock") were distributed to holders of common stock of
Halliburton in the form of a dividend (the "Distribution").

  On April 30, 1997, the Highlands Group acquired Vik Brothers Insurance, Inc.
and its subsidiaries ("VBI"). Immediately after the consummation of the
acquisition, VBI was renamed American Reliance, Inc. The acquisition was
accounted for as a purchase and, accordingly, the financial results of
American Reliance, Inc. and subsidiaries ("American Reliance") are included in
the consolidated financial statements effective April 30, 1997.

  The Company's principal product lines, shown as a percentage of gross
premiums written for 1997, are as follows:

<TABLE>
      <S>                                                                 <C>
      Commercial multiple-peril..........................................  23.1%
      Workers' compensation..............................................  20.1
      General liability..................................................  15.8
      Commercial automobile..............................................  11.6
      Homeowners multiple peril and fire.................................   8.5
      Marine.............................................................   8.1
      Personal automobile................................................   5.6
      Other..............................................................   7.2
                                                                          -----
                                                                          100.0%
                                                                          =====
</TABLE>

  The Company is licensed to write property and casualty insurance in all 50
states and is organized into two divisions--the Highlands Division and the
American Reliance Division. The Highlands Division writes property and
casualty insurance primarily for medium-sized to large commercial accounts
headquartered in Texas and Louisiana. The Highlands Division had gross
premiums written of $131.2 million in 1997. Its customers consist of entities
engaged in heavy industries, including oil and gas services, exploration and
production, construction, engineering, manufacturing and certain other smaller
but complex commercial accounts. Its largest customer is Halliburton, the
Highlands Group's former parent, which represented 13.1% of the Company's
gross premiums written in 1997. The Highlands Division also writes ocean
marine insurance, mainly on the West Coast of the United States, including
Hawaii and Alaska, and along the Gulf of Mexico, and inland marine insurance.

  Between 1976 and 1996, the Highlands Division discontinued three of its
product lines (the "Discontinued Lines"): business originated by its London
operations; an umbrella/excess liability policy program; and assumed casualty
and property reinsurance contracts. The Discontinued Lines represented an
immaterial amount of the Company's gross premiums written in 1996 and 1997.

  The American Reliance Division writes primarily property and casualty
insurance for small to medium-sized commercial customers and certain personal
lines. It had gross premiums written of $214.8 million in 1997 following the
acquisition on April 30, 1997. Its commercial policyholders consist mainly of
retailers, wholesalers, service businesses and customers in the habitational
sector. American Reliance's personal lines focus on homeowners multiple peril
and fire coverages and automobile insurance. Although the American Reliance
Division writes insurance in 35 jurisdictions in the United States, the
majority of its business is written on the East Coast and in California.
<PAGE>

  The Company's principal subsidiary, Highlands Insurance Company ("HIC"), is
rated "A-" (Excellent) by A.M. Best, and its two other principal subsidiaries,
Northwestern National Casualty Company ("NNCC") and Pacific National Insurance
Company ("PNIC") are rated "B+" (Very Good) by A.M. Best.

ACQUISITION OF AMERICAN RELIANCE

  The Highlands Group's acquisition of American Reliance, which was completed
on April 30, 1997, was financed with a combination of common stock, bank debt,
preferred stock and cash. The 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 the 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 the Highlands Group's common stock was $17.625
on April 30, 1997. The preferred stock is currently owned by a subsidiary of
American Reliance and has a preference value of $1,000 per share.
Simultaneously with the closing, the 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 transaction by utilizing the credit facility and available working
capital.

PRODUCTS

  The Company writes commercial and personal property and casualty coverage.
The commercial lines include primarily commercial multiple peril, workers'
compensation, general liability and commercial automobile insurance.
Frequently, commercial policies are sold on an account basis, including a
combination of these policy coverages. Policies written for large commercial
accounts are generally underwritten on a high deductible or retrospectively
rated basis, with significant risk retention by the insured. Policies written
for small to medium-sized accounts are generally on a fixed premium basis
where the insured has little or no retained risk. The personal lines consist
of homeowners multiple peril and dwelling fire and personal automobile
insurance. Additionally, the Company writes ocean and inland marine insurance
which is generally unrelated to the commercial or personal lines property and
casualty products.

  The following table sets forth the Company's gross premiums written by
product line for the periods indicated. Information for the American Reliance
Division is included only for the period after April 30, 1997, the date of
acquisition.

<TABLE>
<CAPTION>
                                                                 YEARS ENDED
                                                                 DECEMBER 31,
                                                              ------------------
                                                               1997  1996  1995
                                                              ------ ----- -----
                                                                (IN MILLIONS)
      <S>                                                     <C>    <C>   <C>
      Commercial multiple peril.............................. $ 80.0  16.4  25.4
      Workers' compensation..................................   69.6  60.5  76.1
      General liability......................................   54.8  21.7  46.9
      Commercial automobile..................................   40.1  23.3  28.8
      Homeowners multiple peril and fire.....................   29.5   0.9   2.1
      Marine.................................................   28.2  20.1  20.8
      Personal automobile....................................   19.5   0.6   1.4
      Other..................................................   22.6  11.8  26.3
      Discontinued lines.....................................    1.7   3.2   6.6
                                                              ------ ----- -----
        Total................................................ $346.0 158.5 234.4
                                                              ====== ===== =====
</TABLE>

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

                                       2
<PAGE>

  Commercial Multiple Peril. Commercial multiple peril policies insure
businesses and commercial dwellings against property and third party liability
exposures.

  Workers' Compensation. Workers' compensation coverage insures employers
against medical and indemnity claims resulting from injuries related to work.

  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.

  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.

  Marine. Ocean marine coverage insures business against losses related to
waterborne vessels and their cargo. Inland marine coverage primarily insures
movable property such as contractor's equipment and motor truck cargo and
builder's risk, which insures buildings under construction.

  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.

  Other. In addition to its primary product lines above, the Company also
underwrites surety bonds and property coverage.

TYPES OF POLICIES

  Approximately 82.7% of the Company's gross premiums written in 1997 related
to policies written on a traditional fixed premium basis whereby the customer
receives stated levels of coverage in return for a fixed premium over the
policy term. The balance of the Company's insurance premiums are written on
policies subject to retrospective rating or individually negotiated, high
deductible fixed premium policies.

  Premiums for retrospectively rated policies may be adjusted up or down,
subject to certain limitations contained in the policy, based on the actual
loss experience of the insured during the policy period. Loss experience rated
policies reduce but do not eliminate risk to the insurer. The Company
estimates ultimate losses for the retrospectively rated policies and then
adjusts written and earned premiums and premiums due from policyholders under
retrospectively rated policies for changes in the estimated ultimate losses
from the prior valuation.

  High deductible policies are similar to retrospectively rated policies in
terms of the level of risk retention by the insured. Under a high deductible
policy, the insured deposits an estimated deductible amount with the insurer,
which amount is generally adjusted quarterly to reflect loss payments under
the deductible. Amounts within the deductible limit are not recorded as
premiums or losses. Consequently, premiums on a high deductible policy
generally are significantly lower than on a retrospectively rated policy. In
addition, cash receipts to the Company on high deductible policies are
generally lower than for retrospectively rated policies and, thus, the
opportunity for investment income is reduced.

                                       3
<PAGE>

GEOGRAPHIC DISTRIBUTION

  The following table sets forth the geographic distribution of the Company's
gross premiums written for the periods indicated. Information for the American
Reliance Division is included for the period after April 30, 1997, the date of
acquisition.

<TABLE>
<CAPTION>
                                                                 YEARS ENDED
                                                                 DECEMBER 31,
                                                              ------------------
                                                               1997  1996  1995
                                                              ------ ----- -----
                                                                (IN MILLIONS)
      <S>                                                     <C>    <C>   <C>
      Texas.................................................. $ 79.4  95.4 121.4
      New Jersey.............................................   44.6   0.3   0.2
      California.............................................   33.4   7.9   9.0
      Pennsylvania...........................................   27.2   1.1   1.4
      North Carolina.........................................   13.0   0.4   0.2
      Louisiana..............................................   10.4  16.4  32.7
      New York...............................................   10.2   0.2   0.2
      Iowa...................................................   10.0    --    --
      Other..................................................  117.8  36.8  69.3
                                                              ------ ----- -----
                                                              $346.0 158.5 234.4
                                                              ====== ===== =====
</TABLE>

MARKETING

  Highlands Division. The Highlands Division markets its insurance products
principally through approximately 270 independent insurance agents and brokers
mainly in Texas and Louisiana. In addition, the Highlands Division provides
insurance services for Halliburton, the Division's largest customer,
representing 34.6% of the Division gross premiums written in 1997 (13.1% of
the Company's gross premiums written). No other customer of the Division
represented more than 10% of its gross premiums written in 1997. Almost all of
the Division's gross premiums written (other than the marine business) in 1997
were for customers headquartered in Texas and Louisiana. The Division's ten
largest agents and brokers wrote 11.4% of the Division's gross premiums
written (4.3% of the Company's gross premiums written) in 1997, excluding
insurance service business for Halliburton.

  The Division markets its insurance products from its office in Houston,
Texas. Its customers for commercial insurance products generally are small to
medium-sized industrial businesses. These customers consist mainly of special
trade contractors, wholesale durable goods producers, producers of retail
building materials, machine shops and tool manufacturers. The Division also
sells insurance products to a limited number of relatively large industrial
clients engaged in oil and gas services, exploration and production,
construction, engineering, manufacturing and timber and wood products where
insurance needs require specialized service capabilities and flexible
coverages. The Division markets its ocean marine products along the Gulf of
Mexico and the West Coast of the United States, including Hawaii and Alaska.
Its customers consist of commercial fishing, tug and barge, and oil field
support vessels, as well as maritime employers which purchase maritime
employer's liability insurance. Inland marine insurance is currently being
marketed in Texas and Louisiana with plans to expand into several additional
states scheduled for 1998.

  The insurance services for Halliburton are comprised mostly of workers'
compensation and general liability insurance written on a high deductible and
retrospectively rated basis. The Division considers this coverage as
substantially service-based business. In connection with the Distribution, the
Division and Halliburton negotiated a four year contract, ending December 31,
1999, covering the retention and pricing of the insurance services business.

  Because the Division's business (other than with Halliburton) is marketed
through independent insurance agents and brokers, it considers its
relationship with these agents and brokers to be critical to its success.
Accordingly, the Division seeks to establish long-term relationships with
well-established agencies and brokers

                                       4
<PAGE>

with a proven track record. In selecting agencies and brokers for appointment,
the Division considers the following criteria: a record of profitability and
financial stability; an experienced and professional staff; and the existence
of a marketing plan for future growth and a plan for succession in management.
Agents are retained under agency agreements which provide for the payment of
commissions based on a percentage of premiums written. Some agents that market
commercial insurance are also eligible to earn contingent commissions based on
achieving specified levels of premium volume with profitable underwriting
experience. The Division continually monitors the performance of its agents
and brokers and terminates relationships in the case of substandard
performance.

  In 1998, the Company plans to introduce a stock purchase plan for its
independent agents to permit them to purchase the Company's Common Stock on
favorable terms in order to encourage them to become stockholders in the
Company and thereby increase their identity of interest with the Company.

  American Reliance Division. The American Reliance Division sells its
insurance products in various regional markets through a network of
approximately 3,000 independent agents in 34 states and the District of
Columbia. The Division's ten largest agents wrote 9.3% of the Division's gross
premiums written in 1997 (5.6% of the Company's gross premiums written).

  The Division operates from its home office in Lawrenceville, New Jersey,
where two regional offices reside, and six other regional offices in Raleigh,
North Carolina; Columbus, Ohio; Brookfield, Wisconsin; Des Moines, Iowa;
Denver, Colorado; and Woodland Hills, California. Its customers for commercial
insurance consist mainly of retailers, wholesalers, service businesses,
funeral homes, office buildings, religious institutions, franchise and family
style restaurants, contractors, municipalities, golf courses, automobile
dealers and customers in the habitational sector (such as apartments,
condominiums, motels and hotels). Premiums on commercial policies range from
$2,500 to $100,000 with the average premium being $4,100. Personal lines focus
on homeowners multiple peril and fire coverages and, to a lesser extent,
personal automobile coverage. Although the Division writes insurance in 35
jurisdictions, the majority of its business is written on the East Coast and
in California.

  The Division's insurance products are marketed exclusively through
independent insurance agents. The Division utilizes several criteria in
choosing agencies to represent it, including the agency's history of
profitability, its products and marketing background, its marketing strategy
and the size of the agency. The Division's agents are primarily medium-sized
firms, generally with annual premium volume estimated at between $2 million
and $25 million. Agents are retained under agency agreements which provide for
the payment to them of commissions based on a percentage of the premiums
written and contingent commissions based on achieving specified levels of
premium volume with profitable underwriting experience. The Division reviews
its agency relationships on a regular basis and terminates agents whose
business has generated unfavorable underwriting results, which fail to make
timely payment of amounts owed to the Company or which are not achieving
acceptable premium volume levels.

  The success of the Division depends in large part on maintaining a strong
agency network. To increase its responsiveness to agents' needs, the Division
has instituted agency councils on a regional basis to deal with issues that
are important to agents. The Division has also established business unit teams
in its regions which consolidate underwriting, field marketing and agency
services into single units. Specific marketing programs have been established
to provide agents with marketing support, including an agency newsletter to
communicate product marketing information. As described above, the Company is
also introducing a stock purchase plan for agents to encourage them to become
stockholders of the Company.

UNDERWRITING

  Highlands Division. The underwriting process of risk selection and pricing
is performed independently within each business unit in the Highlands
Division. Each business unit is responsible for its own underwriting
guidelines, work process and procedures and the performance of underwriting
audits.

                                       5
<PAGE>

  American Reliance Division. Within the American Reliance Division, the
underwriting of specific risks is performed at each of the regional offices.
Underwriting guidelines and work process and procedures are developed jointly
by corporate underwriting, located in Lawrenceville, New Jersey, and the
regional offices. Underwriting audits are performed by the corporate
underwriting staff.

CLAIMS

  Highlands Division. Claims for the Highlands Division are primarily
processed in its home office in Houston, Texas, except for Louisiana claims
which are generally processed in the New Orleans service office. In addition,
the Division maintains on-site adjusters for a few of its largest accounts,
including Halliburton.

  American Reliance Division. Claims for the American Reliance Division are
processed in the regional offices where the business is written. Home office
claim support for the American Reliance Division is located in Lawrenceville,
New Jersey, which establishes claim policies and procedures for the regional
claim offices. The home office also provides support on complex claims, such
as environmental, asbestos, and construction defect claims, fraud detection
and administration, and conducts an oversight audit function for each regional
claim office. In addition, a centralized salvage and subrogation unit is
located in Raleigh, North Carolina.

  Both Divisions primarily use their own adjusters to settle claims, but also
use independent adjusters when necessary for claims in remote areas. Both
Divisions use in-house counsel for a portion of their claims litigation.

LOSS CONTROL

  The Company maintains a loss control operation in all of its offices and in
the field to provide loss prevention service to customers and to assist
underwriters in the risk selection and pricing process. Loss control services
include management consultation and recommendation, on-site inspection and
training using video, audio and written resources. Services provided to
underwriters include inspections, estimation of building replacement costs,
risk assessment and recommendations for improving the loss experience on a
risk.

DISCONTINUED LINES

  Between 1976 and 1996, the Highlands Division discontinued three lines of
business which still generate claims that affect the Company's results of
operations: (i) business generated by the Division's London operations, which
were initially conducted as a branch office and subsequently by a UK
subsidiary (together "Highlands (UK)") and which were discontinued by 1993;
(ii) certain umbrella/excess liability policies which were discontinued in
1985; and (iii) assumed casualty and property reinsurance, which was
discontinued between 1976 and 1996. The Division has outsourced the claims
handling and run-off management of Highlands (UK) to a professional run-off
company doing business in the United Kingdom. The run-off of the other
discontinued lines is being managed by Company personnel in Houston, Texas.
For additional information regarding Discontinued Lines and loss and loss
adjustment expense reserves for Discontinued Lines, see Item 7: "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

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
certified its 1997 loss and loss adjustment expense reserves for the insurance
subsidiaries, as required for their statutory filings with the various
insurance departments.

  The process of estimating loss reserves is a difficult and complex exercise
involving many variables and subjective judgments. As part of the reserving
process, insurers review historical data and consider the impact of various
factors such as changes in the Company's operations (such as underwriting or
claims handling), trends

                                       6
<PAGE>

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, its claims personnel establish a
"case reserve" for the estimated amount of the ultimate payment. This reflects
the informed judgment of such personnel based on general insurance reserving
practices and on the experience and knowledge of such personnel regarding the
nature and value of the specific types of claims. Case reserves are increased
or decreased as deemed necessary by the Company's claim department, after
evaluating, among other things, coverage, liability and the severity of
subsequent developments and periodic reviews of the cases. In addition, the
Highlands Division establishes case reserves for adjustment and litigation
expenses paid to third parties on a per claim basis. The American Reliance
Division maintains a general reserve for these expenses rather than reserving
for them on an individual case basis.

  In accordance with industry practice, the Company maintains reserves for
estimated unreported losses and associated adjustment and litigation expenses.
These reserves are established to provide for claims which have been incurred
but not yet reported ("unreported losses") and to provide for adverse
development in case reserves. A significant portion of the Company's loss
reserve is the reserve relating to unreported losses. These reserves, by
definition, are not established for specific claims. In calculating reserves
for unreported losses, therefore, the Company estimates the ultimate net
liability for losses using various techniques. Such reserves are established
based on loss experience and are grouped both by class of business and by
accident year. Reserve adjustments relating to unreported losses are also made
to take into account changes in the volume of business written, claims
frequency and severity, the mix of business, claims processing and other items
that can be expected to affect the Company's liability for losses over time.

  During the loss adjustment period, additional facts regarding individual
claims may become known. As the Company becomes aware of additional facts, it
may become necessary for it to refine and adjust liability estimates, and even
after adjustment, the ultimate net liability for claims may be less than or
greater than the revised estimates.

                                       7
<PAGE>

  The following table presents a reconciliation of total beginning and ending
reserve balances of the Company for loss and loss adjustment expense for the
periods indicated. The table includes the balances of American Reliance
effective April 30, 1997, the date of acquisition.

<TABLE>
<CAPTION>
                                                    1997      1996      1995
                                                 ---------- --------- ---------
                                                         (IN THOUSANDS)
<S>                                              <C>        <C>       <C>
Balance at January 1............................ $1,156,824 1,253,627 1,149,173
Acquisition of American Reliance................    520,719        --        --
  Less--Reinsurance recoverables................    652,449   599,558   557,096
                                                 ---------- --------- ---------
Net balance.....................................  1,025,094   654,069   592,077
                                                 ---------- --------- ---------
Incurred related to--
  Current year..................................    230,033   133,717   156,683
  Prior year--
    Asbestos and environmental..................      5,433     6,557    81,795
    All other...................................     11,013    16,315    61,775
                                                 ---------- --------- ---------
  Total prior year..............................     16,446    22,872   143,570
                                                 ---------- --------- ---------
    Total incurred..............................    246,479   156,589   300,253
                                                 ---------- --------- ---------
Paid related to--
  Current year..................................    120,705    37,020    39,846
  Prior year--
    Asbestos and environmental..................      6,812     7,855    16,630
    All other...................................    231,350   155,666   181,785
                                                 ---------- --------- ---------
  Total prior year..............................    238,162   163,521   198,415
                                                 ---------- --------- ---------
    Total paid..................................    358,867   200,541   238,261
                                                 ---------- --------- ---------
Net balance at December 31......................    912,706   610,117   654,069
  Add--Reinsurance recoverables.................    692,668   546,707   599,558
                                                 ---------- --------- ---------
Balance at December 31.......................... $1,605,374 1,156,824 1,253,627
                                                 ========== ========= =========
</TABLE>

  The loss reserve experience of the Company, as reflected on the basis of
generally accepted accounting principles, is shown in the following table,
which represents the development of balance sheet reserves (net of
reinsurance) for 1987 through 1997. The top three lines of the table reconcile
gross loss and loss adjustment expense reserves to net loss and loss
adjustment expense reserves for 1992 through 1997. The upper section of the
table shows the cumulative amount paid with respect to the previously recorded
net reserves as of the end of each succeeding period. The lower portion of the
table shows the re-estimated amount of the previously recorded net reserves
based on experience as of the end of each succeeding period. In addition, the
table also presents the gross re-estimated reserve liability as of the latest
re-estimation period. The Company did not restate data for years prior to 1992
in this table for presentation on a gross basis.

  The loss reserve estimate is increased or decreased as more information
becomes known about the frequency and severity of losses for individual years.
The cumulative (deficiency) redundancy represents the aggregate change in the
estimates over all prior periods. This table does not present accident or
policy year development data. Conditions and trends that have affected
development of the reserves in the past may not necessarily occur in the
future. Accordingly, it may not be appropriate to extrapolate deficiencies or
redundancies based on this table.


                                       8
<PAGE>

<TABLE>
<CAPTION>
                      1987      1988      1989      1990      1991       1992       1993       1994       1995       1996
                    --------  --------  --------  --------  --------  ----------  ---------  ---------  ---------  ---------
                                                                 (IN THOUSANDS)
 <S>                <C>       <C>       <C>       <C>       <C>       <C>         <C>        <C>        <C>        <C>
 Gross reserves
  for loss and
  loss adjustment
  expense........   $     --        --        --        --        --   1,393,352  1,225,242  1,149,173  1,253,627  1,156,824
 Deduct:
  reinsurance
  recoverable....         --        --        --        --        --     827,381    627,285    557,096    599,558    546,707
 Net reserves for
  loss and loss
  adjustment
  expense........    408,950   452,448   493,818   540,818   652,925     565,971    597,957    592,077    654,069    610,117
 Net paid
  (cumulative) as
  of:
 One year later..    147,950   165,380   207,948   236,070   263,755     268,072    184,586    198,415    163,521    238,162
 Two years later.    237,910   283,703   344,994   419,791   420,876     395,244    333,366    323,737    266,093
 Three years
  later..........    309,634   353,811   448,667   510,739   518,442     513,135    426,022    404,287
 Four years
  later..........    346,990   419,100   516,833   573,504   608,865     587,726    488,676
 Five years
  later..........    394,264   468,899   555,134   638,963   668,889     639,647
 Six years later.    432,624   497,568   605,691   685,578   714,843
 Seven years
  later..........    451,878   540,202   641,245   723,905
 Eight years
  later..........    486,604   569,297   670,661
 Nine years
  later..........    511,420   595,966
 Ten years later.    535,183
 Gross paid
  (cumulative) as
  of:
 One year later..                                                        583,108    405,885    284,446    279,091    183,701
 Two years later.                                                        920,199    635,683    522,680    429,250
 Three years
  later..........                                                      1,113,503    836,921    650,471
 Four years
  later..........                                                      1,296,333    945,321
 Five years
  later..........                                                      1,392,285
 Net liability
  re-estimated as
  of:
 End of year.....    408,950   452,448   493,818   540,818   652,925     565,971    597,957    592,077    654,069    610,117
 One year later..    443,859   479,617   544,574   653,379   694,248     688,811    662,841    735,647    676,940    626,563
 Two years later.    450,217   518,162   627,917   725,661   785,147     772,020    788,454    750,941    702,633
 Three years
  later..........    472,133   565,941   667,812   772,614   828,241     894,071    805,313    783,138
 Four years
  later..........    511,098   585,565   714,290   824,126   938,216     915,163    835,720
 Five years
  later..........    530,147   631,570   765,856   925,216   957,726     943,789
 Six years later.    558,648   680,821   863,909   943,067   988,466
 Seven years
  later..........    606,456   772,322   872,101   971,193
 Eight years
  later..........    692,315   776,353   897,497
 Nine years
  later..........    691,448   799,829
 Ten years later.    716,268
 Net deficiency..   (307,318) (347,381) (403,679) (430,375) (335,541)   (377,818)  (237,763)  (191,061)   (48,564)   (16,446)
 Impact of 1995
  Third Quarter
  Change.........     79,995    84,482    88,701    90,501    96,640     103,483    107,594    117,000         --         --
 Remaining net
  deficiency.....   (227,323) (262,899) (314,978) (339,874) (238,901)   (274,335)  (130,169)   (74,061)   (48,564)   (16,446)
                    ========  ========  ========  ========  ========  ==========  =========  =========  =========  =========
 Gross re-
  estimated
  liability as
  of:
 End of year.....                                                      1,393,352  1,225,242  1,149,173  1,253,627  1,156,824
 One year later..                                                      1,636,022  1,413,673  1,445,913  1,324,315  1,285,772
 Two years later.                                                      1,811,827  1,693,009  1,492,471  1,468,762
 Three years
  later..........                                                      2,102,378  1,741,108  1,644,068
 Four years
  later..........                                                      2,157,078  1,895,541
 Five years
  later..........                                                      2,307,982
 Gross cumulative
  deficiency.....                                                       (914,630)  (670,299)  (494,895)  (215,135)  (128,948)
                                                                      ==========  =========  =========  =========  =========
 Gross Re-
  Estimated
  Liability......                                                      2,307,982  1,895,541  1,644,068  1,468,762  1,285,772
 Less: re-
  estimated
  recoverable....                                                      1,364,193  1,059,821    860,930    766,129    659,209
                                                                      ----------  ---------  ---------  ---------  ---------
 Net re-estimated
  liability......                                                     $  943,789    835,720    783,138    702,633    626,563
                                                                      ==========  =========  =========  =========  =========
<CAPTION>
                      1997
                    ---------
 <S>                <C>
 Gross reserves
  for loss and
  loss adjustment
  expense........   1,605,374
 Deduct:
  reinsurance
  recoverable....     692,668
 Net reserves for
  loss and loss
  adjustment
  expense........     912,706
 Net paid
  (cumulative) as
  of:
 One year later..
 Two years later.
 Three years
  later..........
 Four years
  later..........
 Five years
  later..........
 Six years later.
 Seven years
  later..........
 Eight years
  later..........
 Nine years
  later..........
 Ten years later.
 Gross paid
  (cumulative) as
  of:
 One year later..
 Two years later.
 Three years
  later..........
 Four years
  later..........
 Five years
  later..........
 Net liability
  re-estimated as
  of:
 End of year.....     912,706
 One year later..
 Two years later.
 Three years
  later..........
 Four years
  later..........
 Five years
  later..........
 Six years later.
 Seven years
  later..........
 Eight years
  later..........
 Nine years
  later..........
 Ten years later.
 Net deficiency..
 Impact of 1995
  Third Quarter
  Change.........
 Remaining net
  deficiency.....
 Gross re-
  estimated
  liability as
  of:
 End of year.....   1,605,374
 One year later..
 Two years later.
 Three years
  later..........
 Four years
  later..........
 Five years
  later..........
 Gross cumulative
  deficiency.....
 Gross Re-
  Estimated
  Liability......
 Less: re-
  estimated
  recoverable....
 Net re-estimated
  liability......
</TABLE>

  The four components which account for the substantial majority of the
indicated historical (1987-1994) reserve deficiencies are: (i) reserving
practices prior to 1991 for unreported losses associated with retrospectively
rated policies, (ii) environmental (including asbestos) claims, (iii)
Discontinued Lines business and (iv) inadequate individual claim reserves.

As the table above illustrates, the Company's net reserves at the end of 1996
developed unfavorably in 1997 by $16.4 million. This increase is due to
reserve deficiencies on asbestos and environmental, construction defect
claims, assumed reinsurance and loss and loss adjustment expense reserves. 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."

  In 1995, the Company and its independent actuary conducted a review of its
loss and loss adjustment expense reserves to assess the Company's reserve
position. As a result of such review, the Company recorded a $117 million
charge to loss and loss adjustment expense incurred which relate to items (ii)
and (iii) in the second preceding paragraph. Loss and loss adjustment expense
reserves were increased by $117 million (net of reinsurance) as follows: (i)
asbestos and environmental reserves were increased by $59.5 million relating
to

                                       9
<PAGE>

exposures prior to 1986; (ii) assumed casualty reinsurance reserves were
increased by $13.1 million relating to risks reinsured in the early to mid-
1970's; and (iii) catastrophe loss reserves reinsured for Highlands (UK) were
increased by $12.0 million relating primarily to underwriting years 1988
through 1990. An additional $13.0 million was added to loss adjustment expense
reserves to reflect additional costs related to the settlement of claims and
run-off costs related to Highlands (UK). This reserve increase impacts the
reserve development for 1994 and all prior years. The remaining $19.4 million
reflects changes to reserves for unreported losses in order to reflect the
1995 evaluation of overall loss and loss adjustment expense reserves and
impacts development for 1994 and various other prior years.

  The Company and the property and casualty insurance industry in general have
experienced substantial adverse reserve development, particularly since 1987,
related to environmental claims. The areas of exposure for the Company are
discussed in "Management's Discussion and Analysis of Financial Condition and
Results of Operations." For 1997, 1996 and 1995, the amounts of environmental
development were $5.4 million, $6.6 million and $81.8 million, respectively.
Prior to 1993, the Company did not explicitly identify the amount of
unreported loss reserve related to environmental claims.

  Prior to the end of 1991, the Company did not establish a reserve for
unreported losses from retrospectively rated policies written for Halliburton
and its affiliated companies. The emergence of these losses was effectively
offset by collection of additional premiums under the policies and thus the
impact on the Company's income statement was minimal. For 1986 to 1990, the
total incurred loss emergence was equal to the adverse reserve development for
these policies and amounted to $181.0 million. 1991 also contained an
additional increase of $46.3 million related to the initial establishment of
unreported loss and allocated loss adjustment expense reserves for all
accident years prior to 1991.

  Although the majority of the assumed reinsurance contracts covering casualty
exposures relate to the 1969 through 1974 policy years, losses have continued
to emerge throughout the last ten years. For the calendar years 1997, 1996 and
1995, the amounts of assumed reinsurance losses recorded were $3.6 million,
$3.4 million and $22.5 million, respectively. From 1985 to 1991, this line
contributed $51.0 million of adverse reserve development averaging
approximately $7.3 million per year. Included within these amounts are losses
related to environmental claims, although enough information to identify these
losses is not always provided by the ceding companies. To the extent
information provided by ceding companies permits, the environmental losses
have been segregated for the Company's reserve analysis.

  Loss and loss adjustment expense reserves for Highlands (UK) have
demonstrated significant reserve deficiencies in prior years. Net reserve re-
estimates for 1997, 1996 and 1995 have produced increased liabilities of $1.4
million, $1.5 million and $18.6 million, respectively. There have been several
factors contributing to the adverse reserve development, including the large
number of catastrophic claims, and losses resulting from the exhaustion of
certain reinsurance coverage relating to the catastrophe claims. Finally,
Highlands (UK) established a reserve for run-off costs in 1993 in response to
the decision to cease underwriting in that year.

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.

                                      10
<PAGE>

  The Company maintained excess of loss reinsurance treaties for each of its
main property, casualty and marine coverages during 1997. On casualty risks,
including workers' compensation, the retention level was $1 million per
occurrence, with reinsurance coverage up to $30 million per occurrence.
Additional workers' compensation coverage was provided by a second catastrophe
excess of loss arrangement that provides $80 million above the $30 million for
total workers' compensation coverage of $109 million excess of $1 million. On
property risks, reinsurers assume liability for 100% of that portion of the
loss in excess of a sliding scale retention of $300,000 to $3 million, up to
$25 million per risk and per occurrence. For larger limits or whenever unusual
exposures are present, the Company purchases individual policy reinsurance
which is referred to as facultative. In addition, the Company purchased
property catastrophe reinsurance to reduce its exposure to losses resulting
from any single catastrophic event. Under this treaty, the Company retained $3
million of each loss occurrence and had protection for 95% of all losses in
excess thereof up to $100 million. On marine business, reinsurers assumed
liability on loss occurrences which exceed $250,000 per occurrence up to $22
million.

  The Company monitors the financial condition of the reinsurance companies
with which it places significant reinsurance coverage and strives to place
reinsurance coverage with financially sound reinsurance companies. In the
past, the Company has placed coverage with several hundred reinsurance
companies. It monitors the financial condition of many of such companies only
on a periodic basis. A number of such companies are in run-off or have ceased
writing reinsurance and some have become insolvent. The Company's ability to
monitor the financial condition of some formerly used foreign reinsurance
companies is limited because of the difficulty of acquiring current financial
information.

  The following table sets forth by quality of reinsurer (for those domestic
companies rated by A.M. Best) the Company's reinsurance recoverable as of
December 31, 1997.

<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
      CATEGORY                                                          1997
      --------                                                      ------------
                                                                        (IN
                                                                     MILLIONS)
      <S>                                                           <C>
      A.M. Best Rated:
        A- or better...............................................    $383.2
        B++ or less................................................      52.6
                                                                       ------
                                                                        435.8
                                                                       ------
      Non A.M. Best Rated:
        Lloyds.....................................................     129.7
        Other foreign reinsurers...................................     141.8
        Pools and associations.....................................      15.8
                                                                       ------
                                                                        287.3
                                                                       ------
          Total reinsurance recoverable............................    $723.1
                                                                       ======
</TABLE>

 Based upon its evaluations of reinsurers, the Company retains the ceded
reserves for potentially uncollectible reinsurance at such time as an
uncollectible amount is probable and the amount may be reasonably estimated.
Because of the difficulty of acquiring current financial information for
certain foreign reinsurers, including Lloyds syndicate members, the Company
believes that no meaningful range of potentially uncollectible reinsurance can
be established beyond recorded reserves. With respect to carriers that are not
authorized reinsurers as determined by an insurance subsidiary's domiciliary
department of insurance, the Company often receives collateral primarily in
the form of bank letters of credit generally securing the reinsurance
recoverable for reported losses and, in some instances, unreported losses. At
December 31, 1997, such collateral totaled approximately $20.3 million, of
which $15.7 million was received from foreign reinsurers other than Lloyds.
The Company's three largest reinsurance recoverables at December 31, 1997 were
with the underwriting syndicates at Lloyds, amounting to approximately $129.7
million of which approximately $91.7 million is carried by Highlands (UK),
$133.0 million with American Re-Insurance Company and $55.0 million with
General Reinsurance Company. See Item 7: "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Liquidity and Capital
Resources--Reinsurance Receivables."

                                      11
<PAGE>

INVESTMENTS

  The Company adheres to conservative investment practices and manages its
portfolio internally. The table below shows the carrying value and
classification of the Company's investments at the dates indicated.

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                            --------------------
                                                              1997   1996  1995
                                                            -------- ----- -----
                                                               (IN MILLIONS)
<S>                                                         <C>      <C>   <C>
Fixed maturities:
  United States Government and government agencies......... $  276.4 152.4  77.3
  States, municipalities and political subdivisions........    189.5 223.1 258.9
  Mortgage-backed securities...............................    417.6 113.4 114.5
  Corporate securities.....................................    282.5 172.7 141.1
  Foreign governments......................................       .1  12.9   2.4
  Sinking fund preferred stock.............................       .5   5.8   7.7
Equity securities..........................................      1.6  27.0  33.7
Other investments..........................................      4.1   3.8    --
Cash and cash equivalents..................................     60.7  49.5  85.2
                                                            -------- ----- -----
                                                            $1,233.0 760.6 720.8
                                                            ======== ===== =====
</TABLE>

  Fixed Maturities. Fixed maturities constituted 94.6% of the Company's
investments at December 31, 1997. The Company determines the mix of its
investment in taxable and tax-exempt securities based on its current and
projected tax position and the relationship between taxable and tax-exempt
investment yields. As of December 31, 1997, taxable bonds accounted for
approximately 83.8% of total fixed maturities. Beginning April 30, 1997, the
Company reclassified its entire fixed maturities portfolio as available-for-
sale. Fixed maturity investments classified as available-for-sale are carried
on the Company's balance sheet at estimated fair value, with unrealized gains
and losses (net of taxes) recorded in stockholders' equity. At December 31,
1997, the pre-tax unrealized gains on available-for-sale fixed maturities
totaled $34.3 million.

  The fixed maturities portfolio is managed conservatively to provide a
reasonable return while limiting exposure to risk. The following table sets
forth the composition of the Company's portfolio of fixed maturity investments
by National Association of Insurance Commissioners ("NAIC") rating and a
description of the equivalent ratings of Moody's Investor Services, Inc.
("Moody's") at the dates indicated.

<TABLE>
<CAPTION>
                      MOODY'S EQUIVALENT DECEMBER 31, DECEMBER 31, DECEMBER 31,
       NAIC RATINGS      DESCRIPTION         1997         1996         1995
       ------------   ------------------ ------------ ------------ ------------
      <S>             <C>                <C>          <C>          <C>
      1.............. AAA/AA/A               93.8%        95.7%        90.7%
      2.............. BAA                     5.0          4.3          8.5
      3.............. BA                      0.9           --          0.3
      4.............. B                       0.3           --          0.5
      5.............. CAA and lower            --           --           --
      6.............. In or near default       --           --           --
                                            -----        -----        -----
                                            100.0%       100.0%       100.0%
                                            =====        =====        =====
</TABLE>

                                      12
<PAGE>

  See Note 5 to Consolidated Financial Statements for a description of the
contractual maturities of the Company's fixed maturity portfolio at December
31, 1997 and 1996.

  Equities. Equity holdings comprised 0.1% of the Company's investments at
December 31, 1997, and consist of a diversified portfolio of unaffiliated
preferred stocks.

  Other Invested Assets. Other invested assets represent amounts invested in
limited partnerships and comprised 0.3% of total investments at December 31,
1997.

  Cash and Cash Equivalents. The Company's portfolio also includes short-term
securities and other miscellaneous investments, which in the aggregate
comprised 4.9% of total investments at December 31, 1997.

  The following table sets forth the Company's gross investment income and the
pre-tax yield of its investment portfolio (excluding investment income related
to premium notes receivable from insureds).

<TABLE>
<CAPTION>
                                          YEARS ENDED DECEMBER 31,
                         -----------------------------------------------------------
                                1997                1996                1995
                         ------------------- ------------------- -------------------
                         INVESTMENT PRE-TAX  INVESTMENT PRE-TAX  INVESTMENT PRE-TAX
                           INCOME   YIELD(1)   INCOME   YIELD(1)   INCOME   YIELD(1)
                         ---------- -------- ---------- -------- ---------- --------
                                           (DOLLARS IN THOUSANDS)
<S>                      <C>        <C>      <C>        <C>      <C>        <C>
Fixed maturity
 securities:
  Taxable...............  $53,666    6.97%    $26,815    7.06%    $23,511    7.26%
  Non-taxable(2)........   14,408    6.71%     16,743    7.14%     19,989    7.23%
Equity securities.......    2,073    9.64%      2,180    7.84%      2,441    7.89%
Short-term..............    4,997    6.71%      5,807    5.50%      3,197    5.28%
Other invested assets...      372    9.48%         54    1.35%         --       --
                          -------    -----    -------    -----    -------    -----
  Total.................  $75,516    6.95%    $51,599    6.96%    $49,138    7.16%
                          =======    =====    =======    =====    =======    =====
</TABLE>
--------
(1) Calculated as gross investment income (including dividend income in the
    case of equity securities) divided by the average of the investment
    balances at the beginning and end of each quarter. Investment balances are
    at amortized cost, except in the case of equity securities for which cost
    is used.
(2) For purposes of comparing non-taxable yields to yields on taxable
    securities, these yields are equivalent to pre-tax yields of 10.3%, 11.0%
    and 11.1% in 1997, 1996 and 1995, respectively, assuming a 35% tax rate.
    The disparity between the equivalents of pre-tax yields on non-taxable
    fixed maturity securities in comparison with the pre-tax yields on taxable
    fixed maturity securities is a function of the differing interest rate
    environments in which such securities were acquired.

COMPETITION; INDUSTRY CONDITIONS

  The property and casualty insurance business is highly competitive, mainly
on the basis of price and service. The Company estimates that there are more
than 3,000 property and casualty insurers nationwide. Many of the Company's
competitors are large national companies with greater financial and other
resources than the Company. In addition to independent insurance companies,
there is increasing competition for commercial business because of
alternatives to traditional insurance such as captive insurers and self-
insurance. Besides traditional insurance products, insurers writing commercial
lines of business now offer products for alternative forms of risk protection.
These products, including large deductible programs and other forms of self-
insurance which utilize captive insurance companies and risk retention groups,
have been instituted and marketed to attract additional business to these
companies. It is not possible to predict how continued growth in alternative
forms of risk protection will affect future operations. The Company competes
on the basis of underwriting expertise, pricing, service and product design.
Management believes its regional market knowledge, flexibility and quality
service to agents and insureds provide a competitive advantage.

                                      13
<PAGE>

YEAR 2000

  Highlands Division. The Highlands Division is creating a new processing
platform for its business. A by-product of this will be a processing platform
that is year 2000 compliant. The new platform will be composed of three major
sub-systems: policy administration; claim administration; and management and
financial reporting. The policy administration component, in part internally
developed but substantially purchased, will permit the processing of year 2000
business on a new and renewal basis starting in the fourth quarter of 1998.
Conversion to the new system will take approximately one year. The claim
administration component will also be purchased and is planned for full
conversion during the second quarter of 1999. The management and financial
reporting system is made up of a series of deliverables starting with the
implementation of a new general ledger in 1996 and concluding with a full
reporting system in the second half of 1999.

  Based on the foregoing schedule, the Company believes that the new
processing platform for the Highlands Division will be fully operational by
the end of 1999.

  American Reliance Division. In 1994, American Reliance, working with an
outside vendor, began a project to create a single processing platform for all
of its business that, among other things, would be able to process its year
2000 and subsequent business and related claims. In August 1997, Phase One of
this project, covering new and renewal business for a portion of the
commercial multiple peril line and the commercial automobile, general
liability and personal lines, representing approximately 70% of the Division's
business, began to be implemented on a new and renewal business basis. The
American Reliance Division is currently processing business on this new
platform. Implementation of Phase One is scheduled to be completed between
August and November 1998.

  Phase Two of the project, covering the balance of the commercial multiple
peril line and the workers compensation and commercial umbrella lines,
representing the balance of the Division's business, is expected to commence
implementation in October 1998 and is scheduled to be completed by October
1999. Based on this schedule, the Company believes that the new processing
platform for the American Reliance Division will be completely operational by
the end of 1999.

  The American Reliance Division will use the financial reporting system being
implemented by the Highlands Division, once the system is operational. The
cost of the above items relates to replacing the Company's legacy systems. The
cost of addressing year 2000 specific issues is not expected to be material.

  The Company believes that, with modifications to existing software and
converting to new software, the year 2000 issue will not pose significant
operational problems for the Company's computer systems as so modified and
converted. However, if such modifications and conversions are not completed
timely, the year 2000 issue could have a material impact on the operations of
the Company.

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, rate increases or other actions
that the Company might wish to take to enhance its operating results. In
addition, state regulatory examiners perform periodic examinations of
insurance companies. Such regulations are generally intended for the
protection of policyholders rather than investors.

                                      14
<PAGE>

  The Company also is subject to laws governing insurance holding companies in
states where its insurance subsidiaries are domiciled (Texas, Ohio, North
Carolina, California, Indiana and Wisconsin). These laws, among other things,
(i) require the Company to file periodic information with state regulatory
authorities including information concerning its capital structure, ownership,
financial condition and general business operations; (ii) regulate certain
transactions between the Company, its affiliates and the insurance
subsidiaries, including the amount of dividends and other distributions and
the terms of surplus notes; (iii) and restrict the ability of any one person
to acquire certain levels of the Company's voting securities without prior
regulatory approval.

  HIC and its subsidiaries, Highlands Underwriters Insurance Company,
Highlands Casualty Company and Aberdeen Insurance Company, are domiciled in
Texas. Under current Texas law, any dividend or distribution, together with
any dividend or distribution made within the preceding twelve months, is an
"extraordinary dividend" if it exceeds the greater of (a) 10% of the insurer's
surplus as regards policyholders as of the preceding December 31, or (b) the
insurer's net income for the preceding year. An extraordinary dividend may not
be paid unless the company reports the extraordinary dividend to the Texas
Insurance Commissioner at least 30 days before payment and the Texas Insurance
Commissioner does not disapprove the extraordinary dividend within that
period. The maximum dividend payable by HIC during 1998 without the prior
approval of the Texas Insurance Commissioner is approximately $19.4 million.

  NNCC and its subsidiary, NN Insurance Company ("NNI"), are domiciled in
Wisconsin. Under current Wisconsin law, any dividend or distribution of cash
or other property, together with that of other dividends paid or credited and
distributions made within the preceding twelve months, is an "extraordinary
dividend" if it exceeds the lesser of (a) 10.0% of the insurer's surplus as
regards policyholders as of the preceding December 31, or (b) the greater of:
(i) the net income (excluding realized capital gains) of the insurer for the
calendar year preceding the date of the dividend or distribution or (ii) the
aggregate of the net income of the insurer for the three calendar years
preceding the date of the dividend or distribution, minus realized capital
gains for those calendar years, and minus dividends paid or credited and
distributions made within the first two of the preceding three calendar years.
An extraordinary dividend may not be paid unless the company reports the
extraordinary dividend to the Wisconsin Insurance Commissioner at least 30
days before payment and the Wisconsin Insurance Commissioner does not
disapprove the extraordinary dividend within that period. NNCC, which paid a
$6.5 million dividend in January 1998, can pay additional dividends of $2.0
million during 1998 without the prior approval of the Wisconsin Insurance
Department.

  Pacific National Insurance Company ("PNIC") and its subsidiary, Pacific
Automobile Insurance Company ("PAIC"), are domiciled in California. Under
current California law, any payment by an insurer of a dividend or
distribution of cash or other property, whose fair market value, together with
that of other dividends or distributions made within the preceding 12 months,
exceeds the greater of (i) 10% of the insurer's surplus as regards
policyholders as of the preceding December 31, or (ii) the net income of the
insurer for the 12-month period ending on the preceding December 31 is defined
as an "extraordinary dividend." California law permits an insurer to pay
dividends only from earned surplus. An extraordinary dividend may not be paid
unless it has been approved by the insurance department or the insurance
department has not disapproved the dividend or distribution within 30 days
after notice of the declaration to the department. PNIC can pay a dividend of
$2.7 million during 1998 without prior approval of the California Insurance
Department.

  The dividend capability of LMI Insurance Company ("LMI") which is domiciled
in Ohio, State Capital Insurance Company ("SCIC"), which is domiciled in North
Carolina, and American Professionals Insurance Company and Statesman Insurance
Company, which are domiciled in Indiana, are not material to the Company.

  Insurance Regulatory Information System. The NAIC Insurance Regulatory
Information System ("IRIS") was developed to assist state Insurance
Commissioners to oversee the financial condition of insurance companies
operating in their respective states. If the review confirms that the
insurer's situation should be accorded the highest surveillance priority, the
insurer receives a "first priority" designation. The "second priority" and
"third priority" designations signify recommendations for lower levels of
increased regulatory attention. LMI and PAIC received "first priority"
designation and HIC, SCIC and PNIC received "second priority" designation as a
result of the review of each company's financial ratio results and statutory
annual statements of 1996.

                                      15
<PAGE>

Although its ratios did not fall outside the usual range, NNCC received a
"third priority" designation due to reinsurance recoverables, underwriting
results and affiliated transactions.

  Risk-Based Capital Requirement. In order to enhance the regulation of
insurer solvency, the NAIC adopted a formula and model law to implement risk-
based capital requirements for property and casualty insurance companies.
These risk-based capital requirements are designed to assess capital adequacy
and to raise the level of protection that statutory surplus provides for
policyholder obligations. The risk-based capital model for property and
casualty insurance companies measures three major areas of risk facing
property and casualty insurers: (i) underwriting, which encompasses the risk
of adverse loss developments and inadequate pricing; (ii) declines in asset
values arising from credit risk; and (iii) declines in asset values arising
from investment risks. Insurers having less statutory surplus than required by
the risk-based capital calculation are subject to varying degrees of
regulatory action, depending on the level of capital inadequacy.

  The risk-based capital model formula creates four levels of regulatory
action, (as defined in the NAIC's model law). The extent of regulatory
intervention and action increases as the level of surplus to risk-based
capital falls. The first level, Company Action Level, requires an insurer to
submit a plan of corrective actions to the regulator if surplus falls below
200% of the Authorized Control Level. The Regulatory Action Level requires an
insurer to submit a plan containing corrective actions and permits the
domiciliary insurance regulator to perform an examination or other analysis
and issue a corrective order if surplus falls below 150% of the Authorized
Control Level. The Authorized Control Level allows the regulator to
rehabilitate or liquidate an insurer in addition to the aforementioned
actions. The fourth action level, Mandatory Control Level, requires the
regulator to rehabilitate or liquidate the insurer if surplus falls below 70%
of the Authorized Control Level.

  At December 31, 1997, all of the insurance subsidiaries of Highlands Group,
other than LMI and State Capital, were above the Company Action Level. LMI's
surplus was within the Authorized Control Level at December 31, 1996. In
connection with the acquisition of American Reliance by the Highlands Group,
LMI submitted a corrective action plan to the Ohio Insurance Department, which
accepted the plan. The plan included, among other things, LMI ceasing to write
insurance and being put in run-off. At December 31, 1997, LMI's surplus was
within the Company Action Level. SCIC's surplus was within the Regulatory
Action Level at December 31, 1997. The Company is submitting a corrective
action plan to the North Carolina Insurance Department which will place SCIC
above the Company Action Level upon implementation of the plan. Management
believes that the regulatory matters concerning LMI and SCIC will not have a
material impact on the Company's results of operations or financial position.

  The business of Highlands (UK) is subject to regulation under the laws of
the United Kingdom pursuant to the Insurance Companies Act of 1982. After
incurring unacceptable underwriting results in 1991 and 1992 and reviewing the
prospects for the future, Highlands (UK) voluntarily ceased writing new
business effective April 1993. The Company received a Notification of
Requirements from the Department of Trade and Industry ("DTI") in 1993, which
included: timely reporting of certain financial information; restrictions on
certain investment activities without prior approval of the DTI; restrictions
relating to transactions with connected persons; and a provision requiring
Highlands (UK) to cease to effect contracts of insurance except where it has a
legal obligation to do so. Capital infusions for Highlands (UK) were made in
1994 and 1995. During 1994, the DTI sent an additional requirements notice to
Highlands (UK) requesting a plan for restoration of a sound financial position
because of its failure to maintain a margin of solvency required by Section 32
of the Insurance Companies Act of 1982 for a company writing premiums.
Highlands (UK) has developed such a plan. Maintaining a license to write
business in the United Kingdom is not essential and Highlands (UK) plan does
not anticipate any further capital contribution to Highlands (UK) beyond the
1995 contribution of $10 million. Management believes that the regulatory
matters concerning Highlands (UK) will not have a material impact on the
Company's results of operations or financial position.

EMPLOYEES

  The Company had 1,133 employees as of December 31, 1997. The Company
believes that its relations with its employees are satisfactory.

                                      16
<PAGE>

ITEM 2: PROPERTIES.

  The Company owns its principal executive offices in Lawrenceville, New
Jersey, which has 53,220 square feet of office space. In addition, it leases
its offices in Houston, Texas and has operating leases for its regional
offices. The Company believes that it has adequate space for its current
operations and to accommodate expansion.

ITEM 3: LEGAL PROCEEDINGS.

  None.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

  None.

                                    PART II

ITEM 5: MARKET FOR COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS.

  The Company's Common Stock is listed on the New York Stock Exchange ("NYSE")
under the trading symbol "HIC." Until January 23, 1996, Halliburton owned all
of the outstanding shares of Common Stock. In connection with the
Distribution, approximately 11.4 million shares of Common Stock were issued.
In connection with the acquisition of American Reliance, 1,656,700 shares of
Common Stock were issued and 21,366 shares of series one preferred stock were
issued. See "Business--Acquisition of American Reliance." The Company believes
that the issuance of such securities were exempt from registration under
Section 4(2) of the Securities Act of 1933 because the subject securities were
sold to a limited group of persons, each of whom was believed to have been
either an accredited investor or a sophisticated investor or had a pre-
existing business relationship with the Company and was purchasing for
investment without a view to further distribution. In addition, 63,525 shares
of Common Stock were issued in connection with a restricted stock plan offered
to certain employees. As of March 13, 1998 approximately 13,194,884 shares of
Common Stock were issued and outstanding. In addition, 1,200,000 shares of
Common Stock are reserved for issuance pursuant to restricted stock grants and
options granted or to be granted pursuant to the 1995 Stock Option Plan and
the 1995 Directors' Stock Plan. See Item 11: "Executive Compensation."

  The following table sets forth, for the calendar periods indicated, the high
and low per share sale prices of the Common Stock as reported in NYSE--
Composite Transactions.

<TABLE>
<CAPTION>
      YEAR 1997                                                      HIGH   LOW
      ---------                                                     ------ -----
      <S>                                                           <C>    <C>
      First Quarter................................................ $24.00 18.50
      Second Quarter............................................... $21.38 17.50
      Third Quarter................................................ $25.00 19.25
      Fourth Quarter............................................... $29.38 22.13
</TABLE>

  The approximate number of record holders of Common Stock as of March 13,
1998 was 6,820.

  Dividends. The Company has not previously paid any dividends and currently
does not intend to pay dividends on the Common Stock. This policy, however,
will be reconsidered from time to time by the Board of Directors of the
Company. The Company's ability to pay dividends in the future will depend upon
its financial performance and other factors not now determinable. The Credit
Agreement with its lending banks prohibits the payment of cash dividends by
the Company and the Company's 10% Convertible Subordinated Debentures due
December 31, 2005 (the "Debentures") contain covenants restricting the payment
of dividends in excess of specified amounts. As described above, the payment
of dividends to the Company by the U.S. insurance subsidiaries is subject to
certain limitations under insurance laws.

                                      17
<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,
                          ------------------------------------------------------
                             1997       1996       1995       1994       1993
                          ----------  ---------  ---------  ---------  ---------
                            (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                       <C>         <C>        <C>        <C>        <C>
STATEMENT OF OPERATIONS
 DATA:
Revenues:
  Net premiums earned...  $  311,993    152,048    201,446    241,676    275,300
  Net investment income.      74,383     50,988     48,529     46,720     46,485
  Net realized
   investment gains.....       5,585      1,199      2,618      1,910      2,702
                          ----------  ---------  ---------  ---------  ---------
    Total revenues......     391,961    204,235    252,593    290,306    324,487
Expenses:
  Loss and loss
   adjustment expense
   incurred.............     246,479    156,589    300,253    224,315    310,029
  Underwriting expenses.     115,564     56,487     73,905     65,022     56,649
  Debt interest and
   amortization expense.      10,542      6,903         --         --         --
  Other expenses
   (income), net........         857      1,697       (823)    (1,314)      (795)
                          ----------  ---------  ---------  ---------  ---------
    Total expenses......     373,442    221,676    373,335    288,023    365,883
Income (loss) before
 income tax expense
 (benefits)(1)..........      18,519    (17,441)  (120,742)     2,283    (41,396)
Income tax expense
 (benefit)(2)...........       1,683    (12,098)        --         --         --
                          ----------  ---------  ---------  ---------  ---------
Net income (loss)(1)(2).  $   16,836     (5,343)  (120,742)     2,283    (41,396)
                          ==========  =========  =========  =========  =========
Earnings (loss) per
 common share(3):
  Basic.................  $     1.34       (.47)    (10.55)       .20      (3.62)
  Diluted...............  $     1.09       (.47)    (10.55)       .20      (3.62)
BALANCE SHEET DATA (AT
 END OF PERIOD):
Investments, cash and
 cash equivalents.......  $1,232,917    760,618    720,746    683,020    673,913
Receivable from
 reinsurers.............  $  723,114    556,900    602,380    561,474    622,483
  Total assets..........  $2,366,656  1,566,031  1,636,091  1,539,418  1,625,815
Loss and loss adjustment
 expense reserves.......  $1,605,374  1,156,824  1,253,627  1,149,173  1,225,242
Stockholders' equity....  $  329,293    263,475    267,110    295,808    288,800
CERTAIN FINANCIAL RATIOS
 AND OTHER DATA:
GAAP:
  Loss ratio............        79.0%     103.0%     149.0%      92.8%     112.6%
  Expense ratio.........        37.0       37.1       36.7       26.9       20.6
                          ----------  ---------  ---------  ---------  ---------
    Combined ratio......       116.0%     140.1%     185.7%     119.7%     133.2%
                          ==========  =========  =========  =========  =========
Statutory surplus.......  $  333,141    188,527    180,020    257,953    248,673
Net premiums written to
 policyholder surplus...         0.8x       0.8x       1.1x       0.9x       0.9x
</TABLE>
--------
(1) The Company recorded a charge to pre-tax earnings during the year ended
    December 31, 1995 of $125 million as more fully discussed under
    "Management's Discussion and Analysis of Financial Condition and Results
    of Operation--Results of Operations."

(2) The Company provides for income taxes in its statements of operations
    pursuant to Financial Accounting Standards Board Statement of Financial
    Accounting Standards No. ("SFAS") 109, "Accounting for Income Taxes." With
    respect to losses for periods preceding the Distribution, no tax benefits
    were recorded

                                      18
<PAGE>

   in the statements of operations pursuant to SFAS 109 and the Company's tax-
   sharing agreement with its former parent, Halliburton. Tax receipts under
   its intercompany tax-sharing arrangements with Halliburton were recorded as
   additions to stockholders' equity for the periods preceding the
   Distribution. For further information regarding federal and foreign income
   taxes, see Note 7 to Consolidated Financial Statements.

(3) The earnings per share amounts prior to 1997 have been restated to comply
    with Statement of Financial Accounting Standards No. 128. Earnings Per
    Share. For further discussion of earnings per share and the impact of
    Statement No. 128, see the notes to the consolidated financial statements.
    Earnings (loss) per share for periods preceding the distribution has been
    computed based upon the 11,448,208 shares of Company Common Stock
    distributed on January 23, 1996.

ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

THE INDUSTRY

  The property and casualty insurance industry's profitability may be affected
significantly by the availability of insurance coverage, which varies
according to levels of surplus in the industry, volatile and unpredictable
developments, including natural and man-made disasters (such as hurricanes,
windstorms, earthquakes, blizzards, fires and explosions), fluctuations in
interest rates and other changes in the investment environment that affect
market prices of insurance companies' investments and the income from those
investments, inflationary pressures that may tend to affect the size of losses
and judicial, legislative and regulatory decisions affecting insurers'
liabilities. The demand for property and casualty insurance can also vary
significantly, generally rising as the overall level of economic activity
increases and falling as such activity decreases. Price competition has also
been enhanced by a flight of commercial insureds to alternative risk
mechanisms, often including a degree of self insurance.

  The industry has experienced the effects of a number of well publicized
catastrophic events in recent years, some of which have affected the Company.
Growth in liabilities related to asbestos and environmental risks has also
adversely affected the industry and is of significance to the Company. See "--
Results of Operations--1995 Third Quarter Charge" below.

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

COMPANY DIVISIONS

  The Company is managed in two divisions--the Highlands Division and the
American Reliance Division. The Highlands Division consists of business
managed by the Company's Houston, Texas office. In 1995, the Highlands
Division classified three of its product lines as discontinued (the
"Discontinued Lines"): business originated by its London operations; an
umbrella/excess liability policy program; and assumed casualty and property
reinsurance contracts. The Discontinued Lines are presented separately due to
their significance to the Company's total underwriting loss which amounted to
19.2%, 22.6% and 55.1% of such loss for 1997, 1996 and 1995 respectively.
Results of the Highlands Division exclude the Discontinued Lines which are
presented separately.

  As discussed in Note 2 to the Consolidated Financial Statements, on April
30, 1997, Highlands Group completed the acquisition of Vik Brothers Insurance,
Inc., renamed American Reliance, Inc. The acquisition was accounted for under
the purchase method of accounting and, accordingly, the consolidated financial
statements include the results of American Reliance's operations only from
date of acquisition. The American Reliance Division consists of business
managed by the Company's Lawrenceville, New Jersey office.

                                      19
<PAGE>

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,
                                                          ---------------------
                                                           1997   1996    1995
                                                          ------  -----  ------
                                                              (DOLLARS IN
                                                           MILLIONS, EXCEPT
                                                            PER SHARE DATA)
<S>                                                       <C>     <C>    <C>
Consolidated Results:
Gross premiums written................................... $346.0  158.5   234.3
Net premiums............................................. $277.7  135.1   201.6
                                                          ======  =====  ======
Net premiums earned:
  Highlands Division..................................... $122.8  144.9   187.2
  American Reliance Division.............................  188.8     --      --
  Discontinued Lines.....................................    0.4    7.1    14.2
                                                          ------  -----  ------
                                                          $312.0  152.0   201.4
                                                          ------  -----  ------
Underwriting loss:
  Highlands Division..................................... $(27.5) (47.0)  (77.5)
  American Reliance Division.............................  (12.9)    --      --
  Discontinued Lines.....................................   (9.6) (14.0)  (95.2)
                                                          ------  -----  ------
                                                           (50.0) (61.0) (172.7)
Net investment income....................................   74.4   51.0    48.5
Net realized investment gains............................    5.6    1.2     2.6
Debt interest and amortization expense...................  (10.6)  (6.9)     --
Other (expenses) income, net.............................   (0.9)  (1.7)     .8
                                                          ------  -----  ------
Income (loss) before income taxes........................   18.5  (17.4) (120.7)
Income tax expense (benefit).............................    1.7  (12.1)     --
                                                          ------  -----  ------
Net income (loss)........................................ $ 16.8   (5.3) (120.7)
                                                          ======  =====  ======
Earnings (loss) per share:
  Basic.................................................. $ 1.34   (.47) (10.55)
  Diluted................................................ $ 1.09   (.47) (10.55)
Ratios:
  Loss...................................................   79.0% 103.0%  149.0%
  Expense................................................   37.0   37.1    36.7
                                                          ------  -----  ------
    Combined.............................................  116.0% 140.1%  185.7%
                                                          ======  =====  ======
</TABLE>

  The results for 1995 were significantly influenced by the underwriting
results of the Discontinued Lines, including a $125 million pre-tax charge.
See "1995 Third Quarter Charge."

  Net premiums earned for 1997, 1996 and 1995 were $312.0 million, $152.0
million and $201.4 million, respectively. The increase of $160.0 million in
1997 is primarily attributable to the inclusion of the American Reliance
Division.

  The 1997 underwriting loss of $50.0 million decreased $11.0 million compared
to 1996. The underwriting loss for 1997 includes reductions in the
underwriting loss of the Highlands Division of $19.5 million and the
Discontinued Lines of $4.4 million from 1996 which is offset by the $12.9
million underwriting loss of the American Reliance Division. Also see "--
Highlands Division," "American Reliance Division" and "Discontinued Lines" for
additional comments.

  Net investment income for 1997, 1996 and 1995 was $74.4 million, $51.0
million and $48.5 million, respectively. Net investment income for 1997
increased from 1996 primarily due to the inclusion of the American Reliance
Division. Net investment income for 1996 increased from 1995 primarily as a
result of the additional

                                      20
<PAGE>

investable funds from the issuance of the Debentures and tax proceeds from the
Company's former parent. The 1996 net investment income is partially offset by
lower interest rates in 1996. Net realized investment gains have not been a
significant portion of revenue for the Company and were $5.6 million, $1.2
million and $2.6 million for 1997, 1996 and 1995, respectively.

  Debt interest and amortization expense for 1997 compared with the same
period for 1996 increased $3.7 million as a result of the $65 million Credit
Agreement used to finance the purchase of American Reliance. The increase
between 1995 and 1996 is a result of net interest expense, amortization of
debt discount and debt acquisition costs related to the Debentures.

  Other expenses consist of holding company expenses offset by miscellaneous
income and expense from the insurance subsidiaries. Other miscellaneous income
from the American Reliance Division reduced other expenses for 1997 compared
with 1996.

  The Company provides for income taxes on its statements of operations
pursuant to Statement of Financial Accounting Standards No. 109, "Accounting
for Income Taxes" (SFAS 109). Total tax expense for 1997 was $1.7 million. The
effective rate reflects the significant amount of net investment income from
tax advantaged fixed income securities and the magnitude of the underwriting
loss in relation to net taxable investment income. For 1996, the Company
recognized the benefit of its net operating loss. With respect to losses for
periods preceding the Distribution (January 23, 1996), no tax benefit was
recorded in the statements of operations pursuant to SFAS 109 and the
Company's tax-sharing arrangement with its former parent, Halliburton. Tax
receipts under its intercompany tax-sharing arrangements with Halliburton were
recorded as additions to stockholders' equity for the periods preceding the
Distribution.

HIGHLANDS DIVISION

<TABLE>
<CAPTION>
                                                         YEARS ENDED DECEMBER
                                                                 31,
                                                         ----------------------
                                                          1997    1996    1995
                                                         ------  ------  ------
                                                             (DOLLARS IN
                                                              MILLIONS)
<S>                                                      <C>     <C>     <C>
Gross premiums written.................................. $129.5   151.4   215.2
Net premiums written.................................... $117.8   130.7   189.4
                                                         ======  ======  ======
Net premiums earned..................................... $122.8   144.9   187.2
Loss and loss adjustment expense incurred............... (108.9) (139.5) (196.9)
Underwriting expenses...................................  (41.4)  (52.4)  (67.8)
                                                         ------  ------  ------
  Underwriting loss..................................... $(27.5)  (47.0)  (77.5)
                                                         ======  ======  ======
Ratios:
  Loss..................................................   88.7%   96.3%  105.2%
  Expense...............................................   33.7    36.2    36.2
                                                         ------  ------  ------
    Combined............................................  122.4%  132.5%  141.4%
                                                         ======  ======  ======
</TABLE>

  The Highlands Division underwriting results primarily consist of relatively
large commercial accounts ("Special Accounts Unit"), medium to small
commercial accounts ("Commercial Insurance Unit"), insurance for Halliburton
("Insurance Services Unit"), commercial marine products ("Marine Unit") and
surety products ("Surety Unit"). The Highlands Division excludes the
Discontinued Lines which are presented separately below.

 Period to Period Comparisons of the Highlands Division

  Gross Premiums Written. Gross premiums written for 1997, 1996 and 1995 were
$129.5 million, $151.4 million and $215.2 million, respectively. The decrease
of $21.9 million or 14.5% in 1997 is attributable to several factors. In March
1996, the Company began underwriting initiatives to focus on stricter
underwriting standards and price increases, both of which have contributed to
declines in gross premiums written in the Special

                                      21
<PAGE>

Accounts and Commercial Insurance Units. The declines have been partially
offset by premium increases in the Marine Unit and increases in
retrospectively rated policies for the Insurance Services Unit. Also
contributing to declines in gross premiums written is the continued highly
competitive pricing environment as insurers compete to retain business.

  Gross premiums written for 1996 were negatively impacted by a reduction of
$6.9 million of accrued premium adjustments and $3.1 million of improperly
classified accrued premiums due from policyholders on retrospectively rated
policies.

  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 under
retrospectively rated policies for changes in the estimated ultimate loss and
loss adjustment expense from the date of the prior valuation. These
adjustments may cause gross premiums written to fluctuate significantly from
period to period. Experience rated contracts reduce but do not eliminate risk
to the insurer.

  Net Premiums Written. Net premiums written for 1997, 1996 and 1995 amounted
to $117.8 million, $130.7 million and $189.4 million, respectively. The
decrease of $12.9 million or 9.9% in 1997 is related to the same issues
affecting gross premiums written.

  Net premiums written in 1996 were increased by an adjustment to ceded
premiums written of $3.2 million related to prior years reinsurance treaties.

  Net Premiums Earned. Net premiums earned for 1997, 1996 and 1995 were $122.8
million, $144.9 million and $187.2 million, respectively. The decrease of
$22.1 million or 15.3% in 1997 is related to the same issues affecting gross
and net premiums written.

  Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense
incurred for 1997, 1996 and 1995 amounted to $108.9 million, $139.5 million
and $196.9 million, respectively. The 1997 decrease of $30.6 million, or 21.9%
less than 1996, and the 1996 decrease of $57.4 million, or 29.2% less than
1995, can be primarily attributed to declining premium volume and stricter
underwriting criteria.

  Underwriting Expenses. Underwriting expenses for 1997, 1996 and 1995 were
$41.4 million, $52.4 million and $67.8 million, respectively. The 1997
decrease of $11.0 million is the result of lower premium related expenses due
to declining premiums and reduced operating costs. The year 1997 includes $4.0
million of expenses related to the Texas Workers' Compensation Insurance
Facility (the "Facility"). These consist of a final industry assessment and
industry litigation involving surpluses from the Facility that were previously
received by the Company and not returned to certain policyholders. The
expenses related to the Facility relate to underwriting years prior to 1995.

  Underwriting expenses for 1996 were increased by charges of $1.1 million for
underaccrued premium taxes, a $1.3 million restructuring charge and $2.0
million for litigation proceedings against the Company.

                                      22
<PAGE>

AMERICAN RELIANCE DIVISION

<TABLE>
<CAPTION>
                                                            EIGHT MONTHS ENDED
                                                             DECEMBER 31, 1997
                                                           ---------------------
                                                           (DOLLARS IN MILLIONS)
      <S>                                                  <C>
      Gross premiums written..............................        $ 214.8
      Net premiums written................................        $ 159.8
                                                                  =======
      Net premiums earned.................................        $ 188.8
      Loss and loss adjustment expense incurred...........         (129.0)
      Underwriting expenses...............................          (72.7)
                                                                  -------
          Underwriting loss...............................        $ (12.9)
                                                                  =======
      Ratios:
        Loss..............................................           68.3%
        Expense...........................................           38.5
                                                                  -------
        Combined..........................................          106.8%
                                                                  =======
</TABLE>

  American Reliance was acquired on April 30, 1997 and accounted for as a
purchase. Accordingly, the above results are for the eight months ended
December 31, 1997 and are included in the consolidated results of the Company.

 Underwriting Results of the American Reliance Division

  Gross Premiums Written. Gross premiums written for the eight months ended
December 31, 1997 were $214.8 million. Although prior period gross premiums
written are not presented, gross premiums written have declined approximately
14% due to stricter underwriting standards, increased price competition and
the temporary decline in the A.M. Best ratings for certain of the American
Reliance Division's insurance subsidiaries prior to the acquisition. In
addition, the September 1997 sale by the American Reliance Division of
Northwestern National County Mutual (NNCM), decreased gross premiums written
in 1997 by $8.9 million.

  Net Premiums Written and Earned. Net premiums written and earned for the
eight months ended December 31, 1997 were $159.8 and $188.8 million,
respectively. Net premiums written and earned have been impacted by the same
issues affecting gross premiums written. The sale of the NNCM book of business
reduced net premiums written and earned by $5.9 and $2.6 million for the eight
months ended December 31, 1997.

  Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense
incurred for the eight months ended December 31, 1997 amounted to $129.0
million. Loss and loss adjustment expense incurred was reduced by $6.0 million
of favorable development on prior years reserves.

  Underwriting Expenses. Underwriting expenses for the eight months ended
December 31, 1997 were $72.7 million.

DISCONTINUED LINES

<TABLE>
<CAPTION>
                                                              YEARS ENDED
                                                              DECEMBER 31,
                                                           --------------------
                                                           1997   1996    1995
                                                           -----  -----  ------
                                                              (DOLLARS IN
                                                               MILLIONS)
      <S>                                                  <C>    <C>    <C>
      Gross premiums written.............................. $ 1.7    7.1    19.1
      Net premiums written................................ $ 0.1    4.4    12.2
                                                           =====  =====  ======
      Net premiums earned................................. $00.4    7.1    14.3
      Loss and loss adjustment expense incurred...........  (8.5) (17.1) (103.3)
      Underwriting expenses...............................  (1.5)  (4.0)   (6.2)
                                                           -----  -----  ------
      Underwriting loss................................... $(9.6) (14.0)  (95.2)
                                                           =====  =====  ======
</TABLE>


                                      23
<PAGE>

  For reporting purposes, Highlands Group has three lines of business which
are considered Discontinued Lines, specifically business originated by the
Highlands Group's London operations, an umbrella/excess liability policy
program and assumed casualty and property reinsurance contracts. The Company
has ceased to write these Discontinued Lines and canceled all remaining
voluntary assumed casualty and property reinsurance contracts during 1996.

  The Discontinued Lines percentage of gross premiums written to the Company
totals for 1997, 1996 and 1995 was 0.5%, 4.5% and 8.2%, respectively, while
the percentage of underwriting losses to the Company totals for the same time
periods was 19.2%, 23.0% and 55.1%, respectively.

  London-Originated Business. The Company participated in the London insurance
markets from 1972 until 1982 through a branch office in London (the "Highlands
London Branch"). The primary business of the Highlands London Branch was the
direct writing and reinsurance of general liability risks for insureds in the
United States and other London market marine and aviation risks. The Highlands
London Branch ceased doing business in the United Kingdom when Highlands (UK)
was formed in 1982 in order to withdraw from direct writing of marine and
aviation and significantly reduce the reinsurance of U.S. casualty risks
through the London operations. Highlands (UK) served as an insurer and
reinsurer in London markets primarily by participating in excess of loss
reinsurance liability policies, which included coverage for catastrophe losses
of customers in excess of policy limits of other applicable policies.
Highlands (UK) ceased writing new policies in early 1993. Accordingly, the
Company's continuing exposure on the business of the Highlands London Branch
is generally attributable to adverse loss reserve development on asbestos and
environmental claims whereas the ongoing exposure of Highlands (UK) is
primarily related to adverse loss reserve development on the high levels and
severity of catastrophe claims that have occurred since 1988 and have been
slow to emerge in the London excess market.

  Umbrella/Excess Liability Program. Beginning in the early 1970s, Highlands
wrote policies that provided the customer with umbrella and excess liability
coverage with respect to losses which exceeded another insurer's primary and
excess policy coverages. The threshold at which coverage attached under such
policies underwritten by the Company varied from $300,000 to $100 million and
above. The limits of coverage under the Company's excess liability policies
were generally $5 million up to $10 million (in excess of underlying policies)
and the Company generally limited its exposure through substantial
reinsurance. The program was canceled and underwriting operations ceased
effective December 31, 1985. The Company's adverse loss experience on these
policies has primarily emanated from asbestos and environmental pollution
claims.

  Assumed Casualty and Property Reinsurance. Highlands participated in
approximately 200 assumed casualty reinsurance agreements per year (primarily
written from 1969 through 1974) as an excess of loss reinsurer with
participation percentages that varied from contract to contract. The majority
of assumed casualty treaties were nonrenewed by the end of 1976. The Company
participated at levels of $50,000 to $250,000 per contract on hundreds of
assumed property reinsurance contracts per year from 1969 through 1994. Loss
development on the assumed casualty treaties has primarily emanated from
product liability, asbestos and environmental pollution liability,
particularly for accident years 1971 through 1974. Development on the assumed
property reinsurance agreements has primarily related to catastrophe
exposures.

 Period to Period Comparisons of Underwriting Results of Discontinued Lines

  Net Premiums Earned. Net premiums earned were $0.4 million, $7.1 million and
$14.3 million in 1997, 1996 and 1995, respectively. The decline since 1995 is
due to the cancellation of all remaining voluntary assumed reinsurance
contracts in 1996. However, due to the nature of the Company's reinsurance
contracts, small premium adjustments can continue long after cancellation of
such agreements.

  Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense
incurred amounted to $8.5 million, $17.1 million and $103.3 million for 1997,
1996 and 1995, respectively. The decline for 1997 reflects the decline in
adverse loss reserve development related to years prior to 1996. See "--Loss
and Loss Adjustment

                                      24
<PAGE>

Expense Reserves" below. The decrease for 1996 compared to the same period for
1995 is primarily the result of the 1995 third quarter charge of $81.3
million. See "--1995 Third Quarter Charge" below.

 Loss and Loss Adjustment Expense Reserves

  Underwriting results of the property and casualty industry are significantly
influenced by estimates of loss and loss adjustment expense reserves. (See
Note 11 to the Consolidated Financial Statements.) These reserves are an
accumulation of the estimated amounts necessary to settle and pay all
outstanding and unreported claims including loss adjustment expenses, net of
estimated claim recoveries. The case reserve estimates for reported claims are
based upon the facts of each case and the Company's experience with similar
cases. Consideration is given to historical trends regarding reserving
patterns, changes in the Company's operations (such as underwriting and claims
handling), loss payments, and the effects of court decisions, economic
conditions and public attitudes. The process of establishing reserves is an
imprecise science involving significant judgment and assumptions. As
information develops that varies from experience, provides additional data or,
in some cases, augments data that previously were not considered sufficient
for use in determining reserves, changes in the Company's estimate of ultimate
liabilities may be required. Changes in prior year reserve estimates (net of
reinsurance), which may be material, are reflected in the results of
operations in the period such changes are determined to be required.

  During the last several years, the Company has experienced significant
adverse development on prior years net ultimate loss estimates. The following
table sets forth the amount of the adverse development split between lines
other than Discontinued Lines and Discontinued Lines for the periods
indicated.

<TABLE>
<CAPTION>
                                                                 YEARS ENDED
                                                                 DECEMBER 31,
                                                               -----------------
                                                               1997   1996 1995
                                                               -----  ---- -----
                                                                 (DOLLARS IN
                                                                  MILLIONS)
      <S>                                                      <C>    <C>  <C>
      Net reserve re-estimates due to:
       Lines other than Discontinued Lines:
        Asbestos and environmental............................ $  --   2.8  10.6
        All other.............................................  11.5   7.2  36.1
      Discontinued Lines:
        Asbestos and environmental............................   5.4   3.8  61.2
        Highlands (UK)--primarily catastrophes................   1.4   1.5  18.6
        All other.............................................  (1.9)  7.5  17.1
                                                               -----  ---- -----
          Net adverse development............................. $16.4  22.9 143.6
                                                               =====  ==== =====
</TABLE>

  As a result of changes in estimates of insured events in prior years,
primarily asbestos and environmental claims, construction defect claims and
catastrophe claims, the provision for loss and loss adjustment expense
incurred (net of reinsurance recoveries of $112.5 million, $47.8 million and
$152.9 million for 1997, 1996 and 1995, respectively) increased by $16.4
million in 1997, $22.9 million in 1996 and $143.6 million in 1995. The
emergence of environmental, asbestos and construction defect claims over the
last few years and the difficulty in accurately estimating the necessary
reserves have significantly contributed to the Company's loss reserve
development over this period. The Company's exposure to future catastrophe
claims has been significantly reduced as a result of the Company's cessation
of its Highlands (UK) business.

  The Company's loss and loss adjustment expense reserves are reviewed at each
year end by the Company's actuaries and external independent actuaries in
connection with the process to establish the Company's reserve position.

 1995 Third Quarter Charge

  In the third quarter of 1995, the Company and its external actuaries
conducted a review of its loss and loss adjustment expense reserves to assess
the Company's reserve position. As a result of such review, the Company

                                      25
<PAGE>

recorded a charge to pre-tax earnings of $125.0 million during the nine months
ended September 30, 1995. Of this amount, $117.0 million related to loss and
loss adjustment expense reserves ($242.5 million before deducting reinsurance)
and $8.0 million represented an increase in reserves related to litigation
proceedings against the Company.

LIQUIDITY AND CAPITAL RESOURCES

  Highlands Group is a holding company, the principal assets of which at
December 31, 1997 are all of the capital stock of Highlands Insurance Company
and American Reliance, Inc. The Company's property and casualty insurance
business is conducted by its direct and indirect wholly-owned insurance
subsidiaries. The liquidity and capital resource considerations for the
Highlands Group are different than those of the Company's insurance
operations.

 Holding Company

  On April 30, 1997, Highlands Group acquired Vik Brothers Insurance, Inc.
("VBI") and its subsidiaries. Immediately after the consummation of the
acquisition, VBI was renamed American Reliance, Inc. American Reliance is a
holding company and has no direct operations. American Reliance's principal
assets are the capital stock of its insurance subsidiaries.

  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. The preferred
stock is currently owned by a subsidiary of American Reliance and has a
preference value of $1,000 per share. Simultaneously with the closing,
Highlands Group contributed approximately $41.5 million to the capital of the
insurance subsidiaries of American Reliance.

  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. Highlands Group funded the cash portion of the acquisition by
utilizing the credit facility and available working capital.

  As a holding company, Highlands Group's principal requirements for funds are
to pay operating expenses, franchise and other taxes, debt service and
dividends. Operating expenses and franchise and other taxes imposed on the
Company are not expected to be material. The annual cash interest requirements
relating to the Debentures and the Credit Agreement are approximately $10.7
million. Highlands Group does not currently intend to pay dividends on its
Common Stock. In light of the Company's corporate strategy, an additional use
of funds may be to invest in other insurance companies or other insurance
operations.

  Highlands Group's principal sources of funds are dividends and tax sharing
payments from Highlands and American Reliance, if any, and funds that may be
raised from time to time from the issuance of additional debt or equity
securities. The payment of dividends by the insurance subsidiaries is subject
to restrictions and limitations imposed by the insurance regulatory
authorities. Dividend payments to Highlands Group from its insurance
subsidiaries are limited to $30.6 million in 1998 without prior regulatory
approval. Both the issuance of additional debt and the issuance of additional
equity securities at a price less than current market price would require the
consent of the holders of a majority in interest of the Debentures pursuant to
the covenants contained in the Debentures.

  Management believes that Highlands Group's liquid assets and access to the
capital markets enable it to meet its liquidity needs.

                                      26
<PAGE>

 Insurance Subsidiaries

  Insurance Operations. The principal sources of funds for the insurance
subsidiaries are premiums and amounts earned from the investment of such
premiums. The principal uses of funds by these subsidiaries are loss payments
and related expenses, underwriting expenses, other operating expenses and
dividends and tax sharing payments to Highlands Group.

  In the insurance industry, liquidity refers to the ability of an enterprise
to generate adequate amounts of cash from its operations, including its
investment portfolio, in order to meet its financial commitments, which are
principally obligations under the insurance policies it has written. Liquidity
requirements of insurance companies are influenced significantly by product
mix. Future catastrophe claims, the timing and amount of which are inherently
unpredictable, may create increased liquidity requirements for the insurance
subsidiaries. The liquidity requirements of the insurance subsidiaries are met
by that portion of the investment portfolio that is held in cash and highly
liquid securities.

  Statutory Surplus. Maintenance of appropriate levels of statutory surplus of
the Company's United States domiciled insurance subsidiaries is a primary
objective of the Company and is also important to regulatory authorities and
insurance rating agencies. In addition, increased public and regulatory
concerns regarding the financial stability of participants in the insurance
industry have caused greater emphasis to be placed by current and potential
customers upon the ratings assigned to property and casualty insurance
companies. Highlands has been assigned an "A-" (Excellent) rating by A.M.
Best. The principal insurance subsidiaries of American Reliance have been
assigned an A.M. Best rating of "B+" (Very Good). One American Reliance
insurance subsidiary has been rated "B-" (Fair) and another, LMI, which has
ceased current operations, has been rated "D" (Poor).

  For information on the Company's RBC requirements see "Business--
Regulation."

  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,
                                                             ------------------
                                                              1997  1996  1995
                                                             ------ ----- -----
                                                                (DOLLARS IN
                                                                 MILLIONS)
      <S>                                                    <C>    <C>   <C>
      Statutory surplus..................................... $333.1 188.5 180.0
      Net premiums written to surplus ratio.................   0.8x  0.8x  1.1x
</TABLE>

  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 which amounted to $2.2 million and $2.4 million as of December 31,
1997 and 1996, respectively. Additionally, the Company has retained net $18.2
million and $16.9 million of ceded reserves related to potentially
uncollectible reinsurance at December 31, 1997 and 1996. 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, 1997, such collateral totaled approximately $20.3 million. The
Company's three largest reinsurance recoverable exposures at December 31, 1997
were approximately $129.7 million with underwriting syndicates at Lloyds
(Highlands (U.K.) $91.7 million and U.S. Insurance Subsidiaries $38.0
million), $133.0 million with American

                                      27
<PAGE>

Re-Insurance Company and $55.0 million with General Reinsurance Company.
American Re-Insurance Company and General Reinsurance Company are rated by A.
M. Best "A+" and "A++", respectively.

YEAR 2000

  Highlands Division. The Highlands Division is creating a new processing
platform for its business. A by-product of this will be a processing platform
that is year 2000 compliant. The new platform will be composed of three major
sub-systems: policy administration; claim administration; and management and
financial reporting. The policy administration component, in part internally
developed but substantially purchased, will permit the processing of year 2000
business on a new and renewal basis starting in the fourth quarter of 1998.
Conversion to the new system will take approximately one year. The claim
administration component will also be purchased and is planned for full
conversion during the second quarter of 1999. The management and financial
reporting system is made up of a series of deliverables starting with the
implementation of a new general ledger in 1996 and concluding with a full
reporting system in the second half of 1999.

  Based on the foregoing schedule, the Company believes that the new
processing platform for the Highlands Division will be fully operational by
the end of 1999.

  American Reliance Division. In 1994, American Reliance, working with an
outside vendor, began a project to create a single processing platform for all
of its business that, among other things, would be able to process its year
2000 and subsequent business and related claims. In August 1997, Phase One of
this project, covering new and renewal business for a portion of the
commercial multiple peril line and the commercial automobile, general
liability and personal lines, representing approximately 70% of the Division's
business, began to be implemented on a new and renewal business basis. The
American Reliance Division is currently processing business on this new
platform. Implementation of Phase One is scheduled to be completed between
August and November 1998.

  Phase Two of the project, covering the balance of the commercial multiple
peril line and the workers compensation and commercial umbrella lines,
representing the balance of the Division's business, is expected to commence
implementation in October 1998 and is scheduled to be completed by October
1999. Based on this schedule, the Company believes that the new processing
platform for the American Reliance Division will be completely operational by
the end of 1999.

  The American Reliance Division will use the financial reporting system being
implemented by the Highlands Division, once the system is operational. The
cost of the above items relates to replacing the Company's legacy systems. The
cost of addressing year 2000 specific issues is not expected to be material.

  The Company believes that, with modifications to existing software and
converting to new software, the year 2000 issue will not pose significant
operational problems for the Company's computer systems as so modified and
converted. However, if such modifications and conversions are not completed
timely, the year 2000 issue could have a material impact on the operations of
the Company.

FORWARD LOOKING INFORMATION

  The statements included in this 1997 Annual Report regarding future
financial performance and results and the 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 1997 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.

                                      28
<PAGE>

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.

  On August 30, 1996, the Board of Directors of the Company retained KPMG Peat
Marwick LLP ("KPMG") as its principal accountant in lieu of Arthur Andersen
LLP ("Arthur Andersen"). The decision to change accountants was recommended by
the Audit Committee and approved by the Board of Directors of the Company.

  During the most recent year preceding the retention of KPMG, there were no
disagreements between the Company and Arthur Andersen on accounting and
financial disclosure matters.

  There have been no disagreements with KPMG on accounting and financial
disclosure matters since the retention of KPMG.

                                   PART III

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

  This item is omitted because a definitive proxy statement which involves the
election of directors will be filed with the Securities and Exchange
Commission not later than 120 days after the close of the fiscal year, and
which is incorporated herein by reference.

ITEM 11: EXECUTIVE COMPENSATION

  This item is omitted because a definitive proxy statement which involves the
election of directors will be filed with the Securities and Exchange
Commission not later than 120 days after the close of the fiscal year, and
which is incorporated herein by reference.

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS & MANAGEMENT

  This item is omitted because a definitive proxy statement which involves the
election of directors will be filed with the Securities and Exchange
Commission not later than 120 days after the close of the fiscal year, and
which is incorporated herein by reference.

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  This item is omitted because a definitive proxy statement which involves the
election of directors will be filed with the Securities and Exchange
Commission not later than 120 days after the close of the fiscal year, and
which is incorporated herein by reference.

                                      29
<PAGE>

                                    PART IV

ITEM 14: FINANCIAL STATEMENTS, EXHIBITS AND REPORTS ON FORM 8-K

  (a) 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.

  (b) Exhibits

<TABLE>
 <C>    <S>
  *2.1  Amended and Restated Agreement and Plan of Merger among Highlands
        Insurance Group, Inc., Highlands Acquisition Corp. and Vik Brothers
        Insurance, Inc. dated as of February 13, 1997
  *2.2  Amendment No. 1 to the Amended and Restated Plan of Merger dated March
        10, 1997
  +3.1  Amended and Restated Certificate of Incorporation of the Registrant
  +3.2  Form of Amended and Restated Bylaws of the Registrant
  +4.1  Form of Stock Certificate of Common Stock (See also Exhibits 3.1 and
        3.2)
  +4.2  Form of 10% Convertible Subordinated Debentures Due December 31, 2005
  +4.3  Form of Common Stock Subscription Warrant, Series A
  +4.4  Form of Common Stock Subscription Warrant, Series B
  +4.5  Form of 10% Convertible Subordinated Debentures Due December 31, 2005,
        Series 2
  +4.6  Form of Common Stock Subscription Warrant, Series A-2
  +4.7  Form of Common Stock Subscription Warrant, Series B-2
  *4.8  Stockholders Agreement among Highlands Insurance Group, Inc., Insurance
        Partners, L.P., Insurance Partners Offshore (Bermuda) L.P., The
        Scandinavia Company, Erik M. Vik and Manoeuvre Ltd.
  *4.9  Form of Amendment Number 1 to 10% Convertible Subordinated Debenture,
        Due December 31, 2005 of Highlands Insurance Group, Inc.
  *4.10 Form of Amendment Number 1 to 10% Convertible Subordinated Debenture,
        Series 2, Due December 31, 2005 of Highlands Insurance Group, Inc.
  *4.11 Form of Amendment Number 1 to Common Stock Subscription Warrant, Series
        A
  *4.12 Form of Amendment Number 1 to Common Stock Subscription Warrant, Series
        B
  *4.13 Form of Amendment Number 1 to Common Stock Subscription Warrant, Series
        A-2
  *4.14 Form of Amendment Number 1 to Common Stock Subscription Warrant, Series
        B-2
 +10.1  Distribution Agreement among Halliburton and the Registrant dated as of
        October 10, 1995 (exhibits omitted)
 +10.2  Investment Agreement among the Registrant, Halliburton and the
        Investors, dated as of October 10, 1995 (exhibits and schedules
        omitted)
 *10.3  Credit Agreement among Highlands Insurance Group, Inc., Various Lending
        Institutions and The Chase Manhattan Bank, as Administrative Agent,
        dated April 30, 1997
 +10.4  Form of Insurance Products and Services Agreement (schedules omitted)
 +10.5  Form of Employee Benefit Matters Agreement
 +10.6  Form of Transition Agreement
 +10.7  Form of Registration Rights Agreement to be entered into among
        Insurance Partners, L.P., Insurance Partners Offshore (Bermuda), L.P.
        and the Registrant
 +10.8  Form of 1995 Stock Option Plan
  10.9  Restricted Stock Plan
 +10.10 Form of Employment Agreement to be entered into between the Registrant
        and Richard M. Haverland
</TABLE>


                                       30
<PAGE>

<TABLE>
 <C>    <S>
 +10.11 Form of Indemnification Agreement to be entered into between the
        Registrant and each of its directors
 +10.12 Form of 1995 Directors' Stock Plan
 +10.13 Amendatory Agreement dated as of November 9, 1995 among the Company,
        Halliburton, the Investors, Robert A. Spass and Bradley E. Cooper
        (amending the Investment Agreement)
 +10.14 Form of note to be issued in consideration for the issuance by the
        Registrant of 10% Convertible Subordinated Debentures Due December 31,
        2005, Series 2, Common Stock Subscription Warrants, Series A-2, and
        Common Stock Subscription Warrants, Series B-2
 +10.15 Form of pledge agreement to secure the note filed as Exhibit 10.14
 +10.16 Form of Purchase, Redemption and Bonus Agreement to be entered into
        between the Company and the Management Investors with respect to the
        Management Securities
 *10.17 Registration Rights Agreement between Highlands Insurance Group, Inc.
        and American Re-Insurance Company dated April 30, 1997
 *10.18 Registration Rights Agreement among Highlands Insurance Group, Inc.,
        the Scandinavia Company, Inc., Erik M. Vik, Manoeuvre Ltd. and Triumph-
        Connecticut Limited Partnership and Alexander M. Vik dated April 30,
        1997
 *10.19 Registration Rights Agreement between Highlands Insurance Group, Inc.
        and Armco Financial Services Corporation dated March 26, 1997
  21.1  List of Subsidiaries
  23.1  Consent of Independent Auditors
  23.2  Consent of Independent Auditors
  27    Financial Data Schedule (included only in the electronic data filing of
        this document)
</TABLE>
--------
+ Incorporated by reference to the Company's registration statement on Form 10
  as filed with the Commission on January 4, 1996.
* Incorporated by reference to the Company's Report on Form 8-K, as amended,
  dated April 30, 1997 as filed with the Commission.

  (c) Reports on Form 8-K during the quarter ended December 31, 1997.

  None.

                                      31
<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.

                                              Highland Insurance Group, Inc.

                                                /s/ Richard M. Haverland
                                          By:__________________________________
                                             Richard M. Haverland,
                                             Chairman, President and Chief
                                             Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
             SIGNATURE                           TITLE                    DATE
             ---------                           -----                    ----

<S>                                  <C>                           <C>
   /s/ Richard M. Haverland          Chairman, President and         March 27, 1998
____________________________________ Chief Executive Officer
         Richard Haverland

     /s/ Charles J. Bachand          Vice President, Treasurer       March 27, 1998
____________________________________ and Principal Accounting
         Charles J. Bachand          Officer

      /s/  Robert A. Spass           Director                        March 27, 1998
____________________________________
          Robert A. Spass

     /s/ Bradley E. Cooper           Director                        March 27, 1998
____________________________________
         Bradley E. Cooper

     /s/ W. Bernard Pieper           Director                        March 27, 1998
____________________________________
         W. Bernard Pieper

      /s/ Kenneth S. Crews           Director                        March 27, 1998
____________________________________
         Kenneth S. Crews

       /s/ Philip J. Hawk            Director                        March 27, 1998
____________________________________
          Philip J. Hawk

      /s/ Robert W. Shower           Director                        March 27, 1998
____________________________________
         Robert W. Shower
</TABLE>

                                      32
<PAGE>

                  INDEX TO FINANCIAL STATEMENTS AND SCHEDULES

<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
<S>                                                                         <C>
Audited Financial Statements
  Reports of Independent Public Accountants................................  F-2
  Consolidated Balance Sheets as of December 31, 1997 and 1996.............  F-4
  Consolidated Statements of Operations for the Years Ended December 31,
   1997, 1996 and 1995.....................................................  F-5
  Consolidated Statements of Stockholders' Equity for the Years Ended
   December 31, 1997, 1996 and 1995........................................  F-6
  Consolidated Statements of Cash Flows for the Years Ended December 31,
   1997, 1996 and 1995.....................................................  F-7
  Notes to Consolidated Financial Statements...............................  F-8
Financial Statement Schedules
  Schedule I - Summary of Investments Other Than Investments in Related
   Parties--
   December 31, 1997....................................................... F-27
  Schedule II - Condensed Financial Information of Registrant (Parent
   Company only):
    Balance Sheets--As of December 31, 1997 and 1996....................... F-28
    Statements of Operations--For the Years Ended December 31, 1997, 1996
     and 1995.............................................................. F-29
    Statements of Cash Flows--For the Years Ended December 31, 1997, 1996
     and 1995.............................................................. F-30
  Schedule III - Supplementary Insurance Information--As of and For the
   Years Ended December 31, 1997, 1996 and 1995............................ F-31
  Schedule IV - Reinsurance--For the Years Ended December 31, 1997, 1996
   and 1995................................................................ F-32
  Schedule V - Valuation and Qualifying Accounts--For the Years Ended
   December 31, 1997, 1996 and 1995........................................ F-33
  Schedule VI - Supplemental Information Concerning Consolidated Property-
   Casualty Insurance Operations--As of and For the Years Ended December
   31, 1997, 1996 and 1995................................................. F-34
</TABLE>

                                      F-1
<PAGE>

                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors
Highlands Insurance Group, Inc.:

  We have audited the accompanying consolidated balance sheets of Highlands
Insurance Group, Inc. and subsidiaries (the Company) as of December 31, 1997
and 1996 and the related consolidated statements of operations, stockholders'
equity and cash flows for the years then ended. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Highlands
Insurance Group, Inc. and subsidiaries as of December 31, 1997 and 1996 and
the results of their operations and their cash flows for the years then ended
in conformity with generally accepted accounting principles.

  Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedules listed in the Index to
Financial Statements and Schedules that pertain to December 31, 1997 and 1996
and for the years then ended are presented for the purpose of complying with
the Securities and Exchange Commission's rules and are not part of the basic
financial statements. These schedules have been subjected to the auditing
procedures applied in the audit of the basic financial statements and, in our
opinion, fairly state in all material respects the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.

                                          KPMG Peat Marwick LLP

Houston, Texas
February 18, 1998

                                      F-2
<PAGE>

                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors
Highlands Insurance Group, Inc.:

  We have audited the accompanying consolidated statement of operations,
stockholders' equity and cash flows for the year ended December 31, 1995 of
Highlands Insurance Group, Inc. (the Company). These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audit.

  We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.

  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the Company's results of operations
and cash flows for the year ended December 31, 1995 in conformity with
generally accepted accounting principles.

  Our audit was made for the purpose of forming an opinion on the basic
financial statements taken as a whole. Schedules II, III, IV, V and VI that
pertain to December 31, 1995 and for the year then ended are presented for
purposes of complying with the Securities and Exchange Commissions rules and
are not a required part of the basic financial statements. These schedules
have been subjected to the auditing procedures applied in the audit of the
basic financial statements and, in our opinion, fairly state in all material
respects the financial data required to be set forth therein in relation to
the basic financial statements taken as a whole.

                                          ARTHUR ANDERSEN LLP

Houston, Texas
March 8, 1996

                                      F-3
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                          CONSOLIDATED BALANCE SHEETS

                           DECEMBER 31, 1997 AND 1996
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                         ASSETS                              1997       1996
                         ------                           ----------  ---------
<S>                                                       <C>         <C>
Investments:
 Fixed maturity securities:
  Available-for-sale, at fair value (amortized cost of
   $1,132,249 in 1997 and $320,909 in 1996).............. $1,166,585    324,905
  Held-to-maturity, at amortized cost (fair value of $0
   in 1997 and $367,446 in 1996).........................         --    355,492
  Equity securities, at fair value (cost of $1,410 in
   1997 and $26,293 in 1996).............................      1,554     26,967
  Other investments, at cost.............................      4,061      3,770
                                                          ----------  ---------
    Total investments....................................  1,172,200    711,134
Cash and cash equivalents................................     60,717     49,484
Premiums in course of collection, net....................     84,977     24,048
Premiums due under retrospective policies................    130,150    121,276
Receivable from reinsurers...............................    723,114    556,900
Prepaid reinsurance premiums.............................     24,451      2,829
Funds on deposit with reinsurers.........................     20,172     14,456
Net deferred tax asset...................................     64,043     37,126
Accrued investment income................................     16,459     12,600
Deferred policy acquisition costs........................     32,313      6,436
Other assets.............................................     38,060     29,742
                                                          ----------  ---------
    Total assets......................................... $2,366,656  1,566,031
                                                          ==========  =========
<CAPTION>
          LIABILITIES AND STOCKHOLDERS' EQUITY
          ------------------------------------
<S>                                                       <C>         <C>
Loss and loss adjustment expense reserves................ $1,605,374  1,156,824
Unearned premiums........................................    173,411     31,474
Senior bank debt.........................................     65,000         --
Convertible subordinated debentures......................     56,229     55,452
Funds held...............................................     24,023     16,475
Accounts payable and accrued liabilities.................    113,326     42,331
                                                          ----------  ---------
    Total liabilities....................................  2,037,363  1,302,556
                                                          ----------  ---------
Commitments and contingent liabilities
Stockholders' equity:
  Common stock, $.01 par value; 50,000,000 shares
   authorized, 13,187,273 shares issued and outstanding
   in 1997, 11,448,208 shares issued and outstanding in
   1996..................................................        132        114
  Additional paid-in capital.............................    223,460    192,273
  Net unrealized gain on investments, net of tax.........     22,278      3,036
  Deferred compensation on restricted stock..............     (1,465)        --
  Retained earnings......................................     84,888     68,052
                                                          ----------  ---------
    Total stockholders' equity...........................    329,293    263,475
                                                          ----------  ---------
    Total liabilities and stockholders' equity........... $2,366,656  1,566,031
                                                          ==========  =========
</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 OPERATIONS

              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
                  (IN THOUSANDS, EXCEPT PER COMMON SHARE DATA)

<TABLE>
<CAPTION>
                                                     1997    1996      1995
                                                   -------- -------  --------
<S>                                                <C>      <C>      <C>
Revenues:
  Net premiums earned............................. $311,993 152,048   201,446
  Net investment income...........................   74,383  50,988    48,529
  Net realized investment gains...................    5,585   1,199     2,618
                                                   -------- -------  --------
    Total revenues................................  391,961 204,235   252,593
                                                   -------- -------  --------
Expenses:
  Loss and loss adjustment expense incurred.......  246,479 156,589   300,253
  Underwriting expenses...........................  115,564  56,487    73,905
  Debt interest and amortization expense..........   10,542   6,903        --
  Other expenses (income), net....................      857   1,697      (823)
                                                   -------- -------  --------
    Total expenses................................  373,442 221,676   373,335
                                                   -------- -------  --------
Income (loss) before income taxes.................   18,519 (17,441) (120,742)
Income tax expense (benefit)......................    1,683 (12,098)       --
                                                   -------- -------  --------
    Net income (loss)............................. $ 16,836  (5,343) (120,742)
                                                   ======== =======  ========
Earnings per common share:
  Basic........................................... $   1.34    (.47)   (10.55)
  Diluted......................................... $   1.09    (.47)   (10.55)
Weighted average number of common shares
 outstanding:
  Basic...........................................   12,600  11,448    11,448
  Diluted.........................................   15,388  11,448    11,448
</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 STOCKHOLDERS EQUITY

              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                     1997     1996      1995
                                                   --------  -------  --------
<S>                                                <C>       <C>      <C>
Common Stock:
 Balance, beginning of year....................... $    114    1,000     1,000
  Change in par value of common stock.............       --     (886)       --
  Issuance of common stock, par value.............       18       --        --
                                                   --------  -------  --------
 Balance, end of year.............................      132      114     1,000
                                                   --------  -------  --------
Additional paid-in capital:
 Balance, beginning of year.......................  192,273  184,168   110,803
  Addition resulting from issuance of convertible
   subordinated debentures with detachable common
   stock warrants.................................       --    7,439        --
  Change in par value of common stock.............       --      886        --
  Contribution from former parent:
   Net current tax asset..........................       --    7,723    39,229
   Net deferred tax asset.........................       --   (7,943)   34,136
  Issuance of common stock, paid in capital.......   31,187       --        --
                                                   --------  -------  --------
 Balance, end of year.............................  223,460  192,273   184,168
                                                   --------  -------  --------
Net unrealized gain (loss) on investments:
 Balance, beginning of year.......................    3,036    8,547   (10,132)
  Changes in net unrealized gain (loss), net of
   applicable federal income tax..................   19,242   (5,511)   18,679
                                                   --------  -------  --------
 Balance, end of year.............................   22,278    3,036     8,547
                                                   --------  -------  --------
Deferred compensation on restricted stock:
 Balance, beginning of year.......................       --       --        --
  Issuance of restricted stock....................   (1,465)      --        --
                                                   --------  -------  --------
 Balance, end of year.............................   (1,465)      --        --
                                                   --------  -------  --------
Retained earnings:
 Balance, beginning of year.......................   68,052   73,395   194,137
  Net income (loss)...............................   16,836   (5,343) (120,742)
                                                   --------  -------  --------
 Balance, end of year.............................   84,888   68,052    73,395
                                                   --------  -------  --------
Total stockholders' equity........................ $329,293  263,475   267,110
                                                   ========  =======  ========
</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, 1997, 1996 AND 1995
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                     1997      1996      1995
                                                   --------  --------  --------
<S>                                                <C>       <C>       <C>
Cash flows from operating activities:
 Net income (loss)...............................  $ 16,836    (5,343) (120,742)
                                                   --------  --------  --------
 Adjustments to reconcile net income (loss) to
  net cash used in operating activities:
  Depreciation and amortization..................     2,054     1,112       455
  Net realized investment gains..................    (5,585)   (1,199)   (2,618)
  Change in:
  Premiums in course of collection...............    19,972    16,911    25,513
  Premiums due under retrospective policies......    (8,874)   13,152    (4,811)
  Receivable from reinsurers.....................      (303)   45,480   (40,906)
  Prepaid reinsurance premiums...................    19,634     4,100    (1,273)
  Funds on deposit with reinsurers...............    (5,716)      993     4,841
  Net deferred tax asset.........................     1,516   (12,098)       --
  Deferred policy acquisition costs..............     3,623     5,308       106
  Loss and loss adjustment expense reserves......   (72,170)  (96,803)  104,454
  Unearned premiums..............................   (36,019)  (21,097)    1,393
  Funds held.....................................     7,548    (6,227)    1,263
  Other operating assets and liabilities.........     2,513     3,070    22,739
                                                   --------  --------  --------
   Total adjustments.............................   (71,807)  (47,298)  111,156
                                                   --------  --------  --------
   Net cash used in operating activities.........   (54,971)  (52,641)   (9,586)
                                                   --------  --------  --------
Cash flows from investing activities:
 Proceeds from sales:
  Fixed maturity securities available-for-sale...   140,985        --     7,075
  Equity securities..............................    26,767     4,726     8,064
  Other investments..............................     1,559        --        --
 Maturities or calls:
  Fixed maturity securities available-for-sale...   163,907    27,168    19,324
  Fixed maturity securities held-to-maturity.....     5,972    40,162    45,591
 Investment purchases:
  Fixed maturity securities available-for-sale...  (306,180) (131,559)  (46,923)
  Fixed maturity securities held-to-maturity.....        --   (20,220)   (7,700)
  Equity securities..............................        --    (2,282)   (4,064)
 Net purchases of property and equipment.........    (6,793)   (1,337)     (646)
 Acquisition of subsidiary, net of cash acquired.     5,124        --        --
 Payment of acquisition expenses.................    (3,730)       --        --
 Other proceeds..................................        92        --        --
 Proceeds from disposal of subsidiary, net.......    10,000        22        --
 Cash returned by former affiliates, net.........        --     3,800       418
                                                   --------  --------  --------
   Net cash provided by (used in) investing
    activities...................................    37,703   (79,520)   21,139
                                                   --------  --------  --------
 Cash flows from financing activities:
  Proceeds from senior bank debt.................    65,000        --        --
  Repayment of acquired bank debt................   (35,638)       --        --
  Payment for debt issuance expense..............    (1,017)   (5,705)       --
  Issuance of common stock.......................       156        --        --
  Proceeds from convertible subordinated
   debentures....................................        --    60,000        --
  Contribution from former parent for net current
   tax asset.....................................        --    42,174    20,834
                                                   --------  --------  --------
   Net cash provided by financing activities.....    28,501    96,469    20,834
                                                   --------  --------  --------
Net increase (decrease) in cash and cash
 equivalents.....................................    11,233   (35,692)   32,387
Cash and cash equivalents at beginning of year...    49,484    85,176    52,789
                                                   --------  --------  --------
Cash and cash equivalents at end of year.........  $ 60,717    49,484    85,176
                                                   ========  ========  ========
Supplemental disclosure of cash flow information:
  Interest paid..................................  $  8,803     5,639        --
                                                   ========  ========  ========
  Reclassification of fixed income securities
   from held-to-maturity to available-for-sale...  $348,130        --        --
                                                   ========  ========  ========
</TABLE>

The accompanying notes to the consolidated financial statements are an integral
                           part of these statements.

                                      F-7
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

 Basis of Reporting and Operations

  The accompanying consolidated financial statements include the accounts of
Highlands Insurance Group, Inc., (Highlands Group) and its subsidiaries (the
Company). Highlands Group is an insurance holding company for Highlands
Insurance Company and its subsidiaries (Highlands), American Reliance, Inc.
and its subsidiaries (American Reliance) beginning April 30, 1997, and
Highlands Holdings (U.K.) Limited and its subsidiary (Highlands UK) (a foreign
reinsurance company located in the United Kingdom) and certain other
immaterial companies (collectively, the Insurance Subsidiaries). For reporting
purposes, the Company considers all of its property/casualty insurance
operations as one segment. All material intercompany accounts and transactions
have been eliminated.

  Highlands Group was wholly owned by Halliburton Company (Halliburton) until
January 23, 1996 when Halliburton distributed all of the outstanding shares of
common stock of Highlands Group (the Distribution) to holders of record of
common stock of Halliburton on January 4, 1996. Holders of record received one
share of common stock of Highlands Group for every ten shares of common stock
of Halliburton held on that date. Approximately 11.4 million common shares of
Highlands Group were issued in conjunction with the Distribution.

  The accompanying consolidated financial statements are presented in
accordance with generally accepted accounting principles. Certain items in the
December 31, 1996 and 1995 consolidated financial statements have been
reclassified to conform to the current years presentation. Such
reclassifications had no impact on stockholders' equity or net 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.

 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.

                                      F-8
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

 Investments

  In connection with the acquisition of Vik Brothers Insurance, Inc. (see note
2), the Company classified its entire investment portfolio as available-for-
sale effective April 30, 1997. At April 30, 1997, fixed maturity securities
with an amortized cost of $348 million and a fair value of $355 million which
were previously classified as held-to-maturity were reclassified as available-
for-sale. Investments classified as available-for-sale are carried at fair
value. Unrealized gains and losses on available-for-sale investments are
reported 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.

 Debt Issuance Costs

  Deferred financing and related costs consists of capitalized fees associated
with the issuance of $62.85 million in principal amount of 10% convertible
subordinated debentures (Debentures). These costs include underwriting, legal
and accounting fees. Debt issuance costs of $4.9 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 10 year life of the
Debentures.

 Earnings (Loss) Per Share

  In 1997, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS 128). SFAS
128 replaced the calculation of primary and fully diluted earnings per share
with basic and diluted earnings per share. Unlike primary earnings per share,
basic earnings per share excludes any dilutive effects of options, warrants
and convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings per share
amounts for all periods have been presented and, where appropriate, restated
to conform to the SFAS 128 requirements. The loss per share amounts for the
year ended December 31, 1995 are based upon the 11,448,208 shares of common
stock that were distributed and outstanding immediately following the
Distribution.

 Certain Risks and Uncertainties

  The preparation of these financial statements requires management to make
estimates and assumptions as of the date of the financial statements that
affect the reported amounts of assets and liabilities as well as disclosures
of contingent assets and liabilities. Management must make estimates and
assumptions that affect amounts of revenues and expenses for the reporting
period, primarily for loss and loss adjustment expense incurred. Management
must also make estimates and assumptions in determining reinsurance
collectibility and in determining litigation accruals. Actual results could
differ from these estimates. Future events, which could

                                      F-9
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
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 October 1995, the FASB issued Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation" (SFAS 123). SFAS 123
establishes accounting and reporting standards for stock-based employee
compensation plans. SFAS 123 recommends but does not require entities to adopt
the fair value based method of accounting for all employee stock compensation
plans, under which compensation cost is measured based on the fair value of
the award at the grant date and recognized over the vesting period. Entities
may continue to account for these plans using the intrinsic value based method
of accounting, under which compensation cost is measured as the excess, if
any, of the quoted market price of the stock at the grant date over the amount
an employee must pay to acquire the stock. Entities not adopting the fair
value based method must present proforma disclosures of net income and
earnings per share as if the fair value method of accounting had been applied.
The Company has elected to use the intrinsic value based method of accounting
for the years ended December 31, 1997 and 1996.

  In June, 1997, FASB issued Statement of Financial Accounting Standards No.
130, "Comprehensive Income" (SFAS 130). SFAS 130 establishes standards for the
reporting and disclosure of comprehensive income and its components (revenues,
expenses, gains and losses). SFAS 130 requires that all items that are
required to be recognized under accounting standards as components of
comprehensive income be reported in the statement of operations. SFAS 130
requires that an enterprise (a) classify items of other comprehensive income
by their nature in the statement of operations and (b) display the accumulated
balance of other comprehensive income separately from retained earnings and
additional paid-in capital in the equity section of the balance sheet.
Unrealized gains and losses is Highlands Group's significant item of other
comprehensive income. SFAS 130 is effective for fiscal years beginning after
December 15, 1997.

  In June, 1997, FASB issued Statement of Financial Accounting Standards
Statement No. 131, "Disclosure about Segments of an Enterprise and Related
Information" (SFAS 131). SFAS 131 establishes standards for public business
enterprises to report information about operating segments in annual financial
statements. SFAS 131 requires that those enterprises report selected
information about operating segments in interim financial reports issued to
stockholders. SFAS 131 is effective for fiscal years beginning after December
15, 1997. Management does not expect SFAS 131 to significantly change the
Company's current financial reporting.

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

                                     F-10
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

April 30, 1997. The preferred stock is currently owned by a subsidiary of
American Reliance and has a preference value of $1,000 per share.
Simultaneously with the closing, Highlands Group contributed approximately
$41.5 million to the capital of the insurance companies within the American
Reliance organization.

  In connection with the acquisition, Highlands Group obtained a $65 million
senior revolving credit facility from a consortium of banks led by The Chase
Manhattan Bank (Credit Agreement). Highlands Group funded the cash portion of
the acquisition and capital contribution by utilizing the credit facility and
available working capital.

  The acquired assets and liabilities of American Reliance were reflected in
the consolidated balance sheet as of April 30, 1997 on a fully consolidated
basis at management's best estimate of their fair values, based on information
available at that time. Evaluation and appraisal of assets and liabilities is
continuing and, therefore, allocation of the purchase price may be adjusted.

  American Reliance is an insurance holding company for the following property
and casualty insurance companies: State Capital Insurance Company (SCIC);
American Professionals Insurance Company (APIC); LMI Insurance Company (LMI);
Northwestern National Casualty Company (NNCC); NN Insurance Company (NNIC);
Statesman Insurance Company (SIC); Pacific National Insurance Company (PNIC);
and Pacific Automobile Insurance Company (PAIC) (collectively, American
Reliance ).

3. DISPOSAL OF ASSETS

  On September 29, 1997, the Company entered into an agreement to sell its
management contract, which established control over Northwestern National
Casualty Mutual (NNCM), to an independent purchaser.

  NNCM is a Texas county mutual insurance company that writes non-standard
personal automobile insurance business in Texas, which was 100% reinsured by
NNCC. Under the terms of the agreement, management and control of NNCM were
transferred to the purchaser.

  In a separate transaction, all of the existing inforce business of NNCM,
including the outstanding unearned premium reserves and outstanding loss
reserves, the renewal rights and broker agreements were transferred to an
independent purchaser. Highlands Group has provided a partial guarantee (up to
$1.3 million) of the adequacy of the loss reserves.

  Total proceeds to the Company from both transactions were $13.5 million.
Highlands Group's cost basis for the assets being sold did not exceed $2.5
million; however, these transactions resulted in a reallocation of the
purchase price of American Reliance (see Note 2).

                                     F-11
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

4. AMERICAN RELIANCE ACQUISITION--PRO FORMA RESULTS OF OPERATIONS

  The following unaudited pro forma information presents the results of
operations of the Company and American Reliance for the years ended December
31, 1997 and 1996, with pro forma adjustments as if the acquisition and
transactions related to the funding of the acquisition had been consummated as
of the beginning of the periods presented. This pro forma information is not
necessarily indicative of what would have occurred had the acquisition and
related transactions been made on the dates indicated, or of future results of
the Company.

<TABLE>
<CAPTION>
                                                                 YEARS ENDED
                                                                 DECEMBER 31,
                                                               ----------------
                                                                 1997    1996
                                                               -------- -------
                                                                (IN THOUSANDS,
                                                               EXCEPT PER SHARE
                                                                    DATA)
      <S>                                                      <C>      <C>
      Revenues................................................ $507,038 571,845
      Net income (loss)....................................... $ 18,372 (68,574)
      Basic earnings (loss) per share......................... $   1.46   (5.23)
      Diluted earnings (loss) per share....................... $   1.19   (5.23)
</TABLE>

5. INVESTMENTS AND INVESTMENT INCOME

  Net investment income for the years ended December 31, 1997, 1996 and 1995
is comprised of the following (in thousands):

<TABLE>
<CAPTION>
                                                            1997    1996   1995
                                                           ------- ------ ------
      <S>                                                  <C>     <C>    <C>
      Gross investment income:
        Fixed maturity securities......................... $68,074 43,558 43,500
        Equity securities.................................   2,073  2,180  2,441
        Cash equivalents..................................   4,997  5,807  3,197
        Other investments.................................     372     54     --
                                                           ------- ------ ------
          Gross investment income.........................  75,516 51,599 49,138
      Investment expenses.................................   1,133    611    609
                                                           ------- ------ ------
          Net investment income........................... $74,383 50,988 48,529
                                                           ======= ====== ======
</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, 1997 and available-for-sale and held-to-maturity securities as of December
31, 1996 (in thousands):

<TABLE>
<CAPTION>
                                                           GROSS
                                                        UNREALIZED
                                            AMORTIZED  -------------    FAIR
                                               COST    GAINS  LOSSES    VALUE
                                            ---------- ------ ------  ---------
<S>                                         <C>        <C>    <C>     <C>
December 31, 1997--
  Fixed maturities available-for-sale:
    United States Government and government
     agencies.............................. $  272,708  3,812   (115)   276,405
    States, municipalities and political
     subdivisions..........................    174,587 14,945     (6)   189,526
    Mortgage-backed securities.............    411,469  6,649   (563)   417,555
    Corporate securities...................    272,908  9,996   (417)   282,487
    Foreign governments....................         89     27     --        116
    Sinking fund preferred stock...........        488      8     --        496
                                            ---------- ------ ------  ---------
                                             1,132,249 35,437 (1,101) 1,166,585
Equity securities..........................      1,410    162    (18)     1,554
                                            ---------- ------ ------  ---------
                                            $1,133,659 35,599 (1,119) 1,168,139
                                            ========== ====== ======  =========
December 31, 1996--
  Fixed maturities available-for-sale:
    United States Government and government
     agencies.............................. $  141,767  1,521   (903)   142,385
    States, municipalities and political
     subdivisions..........................     31,920  1,683     (3)    33,600
    Mortgage-backed securities.............     25,742    304   (764)    25,282
    Corporate securities...................    115,914  2,647   (723)   117,838
    Sinking fund preferred stock...........      5,566    248    (14)     5,800
                                            ---------- ------ ------  ---------
                                               320,909  6,403 (2,407)   324,905
Equity securities..........................     26,293  1,015   (341)    26,967
                                            ---------- ------ ------  ---------
                                            $  347,202  7,418 (2,748)   351,872
                                            ========== ====== ======  =========
Fixed maturities held-to-maturity:
  United States Government and government
   agencies................................ $   10,041      3    (87)     9,957
  States, municipalities and political
   subdivisions............................    189,512 15,197     (1)   204,708
  Mortgage-backed securities...............     88,209    876 (2,181)    86,904
  Corporate securities.....................     54,868    212 (2,094)    52,986
  Foreign governments......................     12,862     29     --     12,891
                                            ---------- ------ ------  ---------
                                            $  355,492 16,317 (4,363)   367,446
                                            ========== ====== ======  =========
</TABLE>

  The fair value of investments is based on quoted market prices, where
available, or quotes from external pricing sources such as brokers for those
or similar investments and issues. With the exception of the securities of
United States Government and government agencies, the Company has no
investment in any one individual security issuer exceeding 10 percent of total
assets.

                                     F-13
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  The amortized cost and estimated fair value of securities as of December 31,
1997, 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.................................... $   35,878    36,028
        After one year through five years..................    198,876   205,298
        After five years through ten years.................    294,676   305,201
        After ten years....................................    191,350   202,503
        Mortgage-backed securities.........................    411,469   417,555
                                                            ---------- ---------
                                                            $1,132,249 1,166,585
                                                            ========== =========
</TABLE>

  The change in net unrealized gains and losses on investments available-for-
sale follows (in thousands):

<TABLE>
<CAPTION>
                                                        YEARS ENDED DECEMBER
                                                                 31,
                                                        -----------------------
                                                         1997     1996    1995
                                                        -------  ------  ------
      <S>                                               <C>      <C>     <C>
      Fixed maturity securities........................ $30,291  (7,420) 17,999
      Equity securities................................    (687) (1,057)  5,282
                                                        -------  ------  ------
                                                         29,604  (8,477) 23,281
      Deferred income taxes............................ (10,362)  2,966  (4,602)
                                                        -------  ------  ------
        Change in net unrealized gains
         and losses, net of tax........................ $19,242  (5,511) 18,679
                                                        =======  ======  ======
</TABLE>

 Sales of Securities

  Gross realized investment gains and losses and proceeds from the sale of
investments for the years ended December 31, 1997, 1996 and 1995 are as
follows (in thousands):

<TABLE>
<CAPTION>
                                                            1997    1996  1995
                                                          --------  ----  -----
      <S>                                                 <C>       <C>   <C>
      Fixed maturities:
        Gross realized gains............................. $  2,597  658   1,820
        Gross realized losses............................     (238)  --      (8)
                                                          --------  ---   -----
                                                          $  2,359  658   1,812
                                                          ========  ===   =====
      Equity securities:
        Gross realized gains............................. $  1,987   --     806
        Gross realized losses............................       --  (52)     --
                                                          --------  ---   -----
                                                          $  1,987  (52)    806
                                                          ========  ===   =====
      Other investments:
        Gross realized gains............................. $  1,239  593      --
        Gross realized losses............................       --   --      --
                                                          --------  ---   -----
                                                          $  1,239  593      --
                                                          ========  ===   =====
      Proceeds from sale of fixed maturity securities
       (calls and maturities excluded)................... $140,985   --   7,075
                                                          ========  ===   =====
</TABLE>

                                     F-14
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

6. DIVIDENDS FROM SUBSIDIARIES AND STATUTORY INFORMATION

  The Company's insurance subsidiaries are restricted by law as to the amount
of dividends they may pay without the approval of regulatory authorities.
During 1998, the total maximum amount of dividends which can be paid without
such approval is approximately $30.6 million.

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

<TABLE>
<CAPTION>
                                                             1997  1996   1995
                                                            ------ -----  -----
      <S>                                                   <C>    <C>    <C>
      Net income (loss).................................... $ 18.5  (2.0) (78.5)
                                                            ====== =====  =====
      Policyholders' surplus............................... $333.1 188.5  180.0
                                                            ====== =====  =====
</TABLE>

  The National Association of Insurance Commissioners (NAIC) adopted risk
based capital (RBC) requirements that require insurance companies to calculate
and report information under a risk-based formula which measures statutory
capital and surplus needs based on a regulatory definition of risk for a
company's mix of products and its balance sheet. LMI, whose surplus was within
the company action level, (as defined by the NAIC), at December 31, 1997, has
ceased writing insurance and is in runoff. During December 1997, Highlands
Group contributed $10 million to LMI to facilitate the runoff of LMI's
business. LMI previously submitted a corrective action plan to the Ohio
Insurance Department which accepted the plan. SCIC's surplus was within the
regulatory action level (as defined by the NAIC) at December 31, 1997. The
Company is submitting a corrective action plan to the North Carolina Insurance
Department which will place SCIC above the company action level upon
implementation of the plan. Management believes that the regulatory matters
concerning LMI and SCIC will not have a material impact on the Company's
results of operations or financial position. The remaining insurance
subsidiaries have an RBC amount above the company action level, as defined by
the NAIC.

  The NAIC Insurance Regulatory Information System ("IRIS") was developed to
assist state Insurance Commissioners to oversee the financial condition of
insurance companies operating in their respective states. If the review
confirms that the insurer's situation should be accorded the highest
surveillance priority, the insurer receives a "first priority" designation.
The "second priority" and "third priority" designations signify
recommendations for lower levels of increased regulatory attention. LMI
received "first priority" designation and Highlands Insurance Company (HIC)
and SCIC received "second priority" designation as a result of the review of
each company's financial ratio results and statutory annual statements for
1996. Although its ratios did not fall outside the usual range, NNCC received
a "third priority" designation due to reinsurance recoverables, underwriting
results and affiliated transactions. PAIC, which had three ratios outside the
usual range, received a "first priority" designation due to underwriting
results, affiliated transactions and change in surplus and writings. The
NAIC's review of each company's financial ratio results and statutory annual
statements for 1997 has not been completed.

7. FEDERAL AND FOREIGN INCOME TAXES

  The Company provides for income taxes on its statements of operations
pursuant to Statement of Financial Accounting Standards 109, "Accounting for
Income Taxes" (SFAS 109). With respect to losses for periods preceding the
Distribution (January 23, 1996), no tax benefit was recorded in the statements
of operations pursuant to SFAS 109 and the Company's tax-sharing arrangement
with its former parent, Halliburton. Tax receipts under its intercompany tax-
sharing arrangements with its former parent were recorded as additions to
stockholders' equity for the periods preceding the Distribution.

                                     F-15
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  The tax-sharing arrangement resulted in Halliburton acquiring the domestic
deferred tax assets and liabilities from its domestic subsidiaries. In
contemplation of Halliburton's distribution of its Highlands Group's shares,
Halliburton contributed to Highlands the net deferred tax assets attributable
to Highlands which Highlands Group recorded as a contribution to capital. The
contribution of the net deferred tax asset is considered a non-cash financing
transaction for the purposes of the statement of cash flows. Based upon the
tax-free nature of the Distribution of Highlands Group from Halliburton, the
deferred tax asset attributes are available to Highlands Group.

  The primary components of the Company's deferred tax assets and liabilities
and the related valuation allowance as of December 31, 1997 and 1996,
respectively, follow (in thousands):

<TABLE>
<CAPTION>
                                                                 1997     1996
                                                                -------  ------
      <S>                                                       <C>      <C>
      Deferred tax assets--
        Loss and loss adjustment expense reserves.............. $56,606  33,382
        Net operating loss carryforward........................  39,992  20,023
        Unearned premiums......................................   9,946   2,005
        Vacation and employee benefit reserves.................   1,518     760
        Policyholder dividends.................................     392     350
        Unearned discounts on processing fees..................   4,169      --
        Bad debt reserves......................................   2,111     788
        Other..................................................   2,684     574
                                                                -------  ------
          Gross deferred tax assets............................ 117,418  57,882
        Valuation allowance.................................... (19,567) (5,204)
                                                                -------  ------
          Net deferred tax assets..............................  97,851  52,678
                                                                -------  ------
      Deferred tax liabilities--
        Accrued retrospective premiums.........................   8,629   8,489
        Deferred acquisition costs.............................  11,310   2,253
        Net unrealized gain on investments.....................  10,998   1,636
        Other..................................................   2,871   3,174
                                                                -------  ------
          Gross deferred tax liabilities.......................  33,808  15,552
                                                                -------  ------
            Net deferred tax asset............................. $64,043  37,126
                                                                =======  ======
</TABLE>

  The realization of the net deferred tax asset is dependent upon the
Company's ability to generate sufficient taxable income in future periods. The
net deferred tax asset is net of valuation allowances of $19.6 and $5.2
million as of December 31, 1997 and 1996, respectively. The valuation
allowances are based upon management's assessment that it is more likely than
not that the portion of the deferred tax asset related to American Reliance's
and Highlands (UK)'s net operating loss carryforwards will not be realized.
Based upon the anticipated future earnings, historical profitability of
Highland's domestic operations, projected reversal of the temporary
differences, tax planning strategies available if required and all other
available evidence, both positive and negative, management has concluded it is
more likely than not that the net deferred tax asset will be realized.
Adjustments to the valuation allowance will be made if there is a change in
management's assessment of the amount of the deferred tax asset that is
realizable.

                                     F-16
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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

<TABLE>
<CAPTION>
                                                     1997     1996      1995
                                                    -------  -------  --------
<S>                                                 <C>      <C>      <C>
Income (loss) before income taxes.................. $18,519  (17,441) (120,742)
Tax rate...........................................      35%      35%       35%
                                                    -------  -------  --------
  Application of the tax rate......................   6,482   (6,104)  (42,260)
Tax effect of:
  Tax-exempt interest..............................  (4,731)  (5,889)   (6,881)
  Other............................................     (68)    (105)    1,573
                                                    -------  -------  --------
  Income tax expense (benefit) before adjustment...   1,683  (12,098)  (47,568)
  Net operating loss utilized by former affiliates,
   not recognizable by Highlands...................      --       --    47,568
                                                    -------  -------  --------
  Income tax expense (benefit)-deferred............ $ 1,683  (12,098)       --
                                                    =======  =======  ========
</TABLE>

8. EARNINGS PER SHARE

  The following table sets forth the computation of basic and diluted earnings
per share (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                       1997    1996     1995
                                                      ------- ------  --------
<S>                                                   <C>     <C>     <C>
NUMERATOR:
  Net income (loss), as reported..................... $16,836 (5,343) (120,742)
  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......................... $16,836 (5,343) (120,742)
                                                      ======= ======  ========
DENOMINATOR:
  Denominator for basic earnings (loss) per share--
   weighted average shares...........................  12,600 11,448    11,448
  Effect of dilutive securities:
    Common stock warrants and outstanding stock
     options (based on treasury stock method)........   2,788     --        --
    Convertible subordinated debentures..............      --     --        --
                                                      ------- ------  --------
  Denominator for diluted earnings per share--
   adjusted weighted average shares and assumed
   conversions.......................................  15,388 11,448    11,448
                                                      ======= ======  ========
  Basic earnings (loss) per share.................... $  1.34   (.47)   (10.55)
  Diluted earnings (loss) per share.................. $  1.09   (.47)   (10.55)
</TABLE>

  The Debentures, which are convertible into approximately 3.9 million shares,
were outstanding during 1997, but were not included in the computation of
diluted earnings per share because the assumed conversion would be
antidilutive. Earnings (loss) per share for 1995 has been computed based upon
11,448,208 shares of Company Common Stock distributed on January 23, 1996.

                                     F-17
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

9. DEBT OUTSTANDING

  On April 30, 1997, the Company entered into a $65 million Credit Agreement,
with a consortium of banks. The Credit Agreement, which contains customary
terms and restrictions, currently provides for an interest rate of LIBOR plus
75 to 150 basis points based upon a performance grid with the full principal
amount thereunder due on April 30, 2002. The Credit Agreement was used to
finance the purchase of American Reliance. The average interest rate for the
year ended December 31, 1997 was 7.2%. The Company is in compliance with the
covenants in the Credit Agreement, including various financial covenants and
restrictions.

  On January 23, 1996, Highlands Group issued $62.85 million in principal
amount of 10% convertible subordinated debentures (Debentures) due December
31, 2005, together with Series A and A-2 (collectively the "Series A
Warrants") and B and B-2 (collectively the "Series B Warrants") common stock
purchase warrants, to Insurance Partners, L.P., and Insurance Partners
Offshore (Bermuda), L.P. (collectively "IP") and certain members of the
Company's management team (Management Investors). The Company received $60
million in cash from IP and the Management Investors and individual promissory
notes (each, a "Note" and, collectively, the "Notes") in the aggregate
principal amount of $2.85 million made by the individual Management Investors
without personal liability and secured by a pledge of Debentures. The
Debentures issued in exchange for the Management Investors Notes were issued
pursuant to a Purchase, Redemption and Bonus Agreement (the "Purchase
Agreement").

  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, 1997.

  The Debentures are convertible, at the option of the holders, into Common
Stock of Highlands Group. If all of the Debentures are converted into
Highlands Group Common Stock at the conversion price of $16.16 per share, the
holders would receive approximately 3.9 million shares of Highlands Group
Common Stock and have an ownership interest in Highlands Group of
approximately 23%. Interest on the Debentures is payable semi-annually in cash
at 10% per annum. Highlands Group can redeem the Debentures at any time after
December 3, 2002. Total interest expense incurred and paid on the Debentures
was $6.0 million and $5.6 million in 1997 and 1996, respectively. The total
amortization of debt discount and acquisition costs related to the Debentures
was $1.3 million in 1997 and 1996.

  The detachable Series A Warrants enable the holders to purchase Highlands
Group Common Stock at an exercise price of $10.87 per share, equal to an
additional ownership interest in Highlands Group of approximately 19% after
giving effect to the assumed conversion of the Debentures and the exercise of
the Series A Warrants. If all of the Series A Warrants were exercised, the
holders would receive approximately 4.0 million shares of Common Stock of
Highlands Group. The exercise price of Highlands Group Common Stock into which
the Series A Warrants are exercisable is subject to adjustment related to
adverse loss reserve and uncollectible reinsurance development. Such
adjustment reduced the exercise price by $2.02 and $1.80 per share in 1997 and
1996, respectively. The detachable Series A Warrants expire on December 31,
2005.

  The detachable Series B Warrants enable the holders to purchase Highlands
Group Common Stock at an exercise price of $10.87 per share, equal to an
additional ownership interest of 5% after giving effect to the assumed
conversion of the Debentures and the exercise of the Series A and B Warrants.
The Series B Warrants become exercisable by the holders in the event that the
average closing market price of Highlands Group Common Stock exceeds 1.61
times the exercise price for any 30 consecutive trading days between January
1,

                                     F-18
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

1999 and December 31, 2000. If all of the Series B Warrants were exercised,
the holders would receive approximately 1.0 million additional shares of
Highlands Group Common Stock. The exercise price of Highlands Group Common
Stock into which the Series B Warrants are exercisable is subject to the same
adjustment as the Series A Warrants. The detachable Series B Warrants expire
on December 31, 2005.

  The Purchase Agreement further provides for a bonus to be paid to each
Management Investor on the fifth anniversary of the Purchase Agreement if the
average closing price of the Company Common Stock is equal to or greater than
prices expressed as a percentage of the exercise price of the Series A
Warrants (as adjusted from time to time) and specified in the Purchase
Agreement (the "Bonus Trigger Stock Price"). The amount of the bonus is stated
as a percentage of a maximum bonus amount separately determined for each
Management Investor and equal to the aggregate principal amount of each
Management Investor's Note. If the Bonus Trigger Stock Price is at least 1.40
times but less than 1.50 times the Series A Warrant exercise price, the bonus
is 25% of the maximum bonus amount, 50% if the Bonus Trigger Stock Price is at
least 1.50 but less than 1.61 times the Series A Warrant exercise price and
100% if the Bonus Trigger Stock Price is 1.61 times the Series A Warrant
exercise price or higher.

  If the Debentures are converted into Common Stock of Highlands Group and the
Series A and B Warrants are utilized by the holders to purchase Common Stock
of Highlands Group, IP and the Management Investors will have an ownership
interest in Highlands Group of approximately 40%.

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 ($2.2 million and $2.4 million as of
December 31, 1997 and 1996, respectively) or does not record certain contracts
as ceded business but retains these amounts ($18.2 million and $16.9 million
as of December 31, 1997 and 1996, respectively) as loss reserves for
potentially uncollectible reinsurance at such time as an uncollectible amount
is probable and the amount may be reasonably estimated. Because of the
difficulty of acquiring accurate information for certain reinsurers, including
Lloyds' syndicates and members, the Company believes that no meaningful range
of potentially uncollectible reinsurance can be established beyond recorded
reserves. With respect to its domestic book of business and reinsurers that
are not authorized reinsurers as determined by the appropriate Department of
Insurance, the Company often receives collateral primarily in the form of bank
letters of credit generally securing the reinsurance recoverable regarding
reported losses and in some instances IBNR. As of December 31, 1997, such
collateral totaled approximately $20.3 million.

  The Company's three largest recoverables as of December 31, 1997, were
approximately $129.7 million with Underwriters at Lloyds of London, $133.0
million with American Reinsurance Company and $55.0 million with General
Reinsurance Company. American Re-insurance Company and General Reinsurance
Company are rated by A. M. Best A+ and A++ rating, respectively.

                                     F-19
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  The effects of assumed and ceded reinsurance on net premiums and losses
follows (in thousands):

<TABLE>
<CAPTION>
                                             DIRECT  ASSUMED   CEDED      NET
                                            -------- -------  --------  -------
<S>                                         <C>      <C>      <C>       <C>
Year ended December 31, 1997--
  Written premiums......................... $342,414   3,631   (68,308) 277,737
  Earned premiums.......................... $367,630  (8,879)  (46,758) 311,993
  Loss and loss adjustment expense
   incurred................................ $273,114  79,269  (105,904) 246,479
                                            ======== =======  ========  =======
Year ended December 31, 1996--
  Written premiums......................... $147,474  11,072   (23,495) 135,051
  Earned premiums.......................... $160,776  13,903   (22,631) 152,048
  Loss and loss adjustment expense
   incurred................................ $159,611  53,548   (56,570) 156,589
                                            ======== =======  ========  =======
Year ended December 31, 1995--
  Written premiums......................... $210,052  24,323   (32,810) 201,565
  Earned premiums.......................... $204,508  26,991   (30,053) 201,446
  Loss and loss adjustment expense
   incurred................................ $273,488 188,089  (161,324) 300,253
                                            ======== =======  ========  =======
</TABLE>

11. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES

  The Company establishes loss reserves which are estimates of future payments
of reported and unreported claims for losses and the related expenses with
respect to insured events that have occurred. The process of establishing loss
reserves is subject to uncertainties that are normal, recurring and inherent
in the property and casualty business. The process requires reliance upon
estimates based on available data that reflect past experience, current trends
and other information and the exercise of informed judgment. As information
develops that varies from experience, provides additional data or, in some
cases, augments data that previously were not considered sufficient for use in
determining reserves, changes in the Company's estimate of ultimate
liabilities may be required. The effect of these changes, net of reinsurance,
is charged or credited to income for the periods in which they are determined.

  Reserving for asbestos, environmental-related and certain other long-term
exposure claims is subject to significant additional uncertainties that are
not generally present for other types of claims. Developed case law and
adequate claim history do not exist for such claims. Highlands and the
insurance industry dispute coverage for certain environmental, pollution and
asbestos liabilities of their policyholders. These claims differ from almost
all others in that it is not often clear that an insurable event has occurred
and which, if any, multiple policy years and insurers will be liable. These
uncertainties prevent identification of applicable policy and policy limits
until after a claim is reported and substantial time is spent (many years in
some cases) resolving contract issues and determining facts necessary to
evaluate the claim. If the courts continue in the future to expand the intent
of the policies and the scope of the coverage as they have in the past,
additional liabilities could emerge for amounts in excess of the current
reserves held.

  The Company uses methods and assumptions that are consistent with prevailing
actuarial practice and are modified periodically based on changes in
circumstance. However, estimation of loss reserves for asbestos, environmental
related and other long-term exposure claims is one of the most difficult
aspects of establishing reserves, especially given the above uncertainties.
Because of the significant uncertainties involved and the likelihood that
these uncertainties will not be resolved in the near future, the Company
believes that no meaningful range of loss and loss adjustment expense reserves
beyond recorded reserves can be established.

                                     F-20
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  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.

  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>
                                                     1997      1996      1995
                                                  ---------- --------- ---------
<S>                                               <C>        <C>       <C>
Balance at January 1............................. $1,156,824 1,253,627 1,149,173
  Acquisition of American Reliance...............    520,719        --        --
  Less--Reinsurance recoverables.................    652,449   599,558   557,096
                                                  ---------- --------- ---------
Net balance......................................  1,025,094   654,069   592,077
                                                  ---------- --------- ---------
Incurred related to--
  Current year...................................    230,033   133,717   156,683
  Prior year-
    Asbestos and environmental...................      5,433     6,557    81,795
    All other....................................     11,013    16,315    61,775
                                                  ---------- --------- ---------
  Total prior year...............................     16,446    22,872   143,570
                                                  ---------- --------- ---------
    Total incurred...............................    246,479   156,589   300,253
                                                  ---------- --------- ---------
Paid related to--
  Current year...................................    120,705    37,020    39,846
  Prior year
    Asbestos and environmental...................      6,812     7,855    16,630
    All other....................................    231,350   155,666   181,785
                                                  ---------- --------- ---------
  Total prior year...............................    238,162   163,521   198,415
                                                  ---------- --------- ---------
    Total paid...................................    358,867   200,541   238,261
                                                  ---------- --------- ---------
Net balance at December 31.......................    912,706   610,117   654,069
  Add--Reinsurance recoverables..................    692,668   546,707   599,558
                                                  ---------- --------- ---------
Balance at December 31........................... $1,605,374 1,156,824 1,253,627
                                                  ========== ========= =========
</TABLE>

  As a result of changes in estimates of insured events in prior years,
primarily environmental and pollution claims, the provision for losses and
loss adjustment expenses (net of reinsurance recoveries of $112.5 million,
$47.8 million and $152.9 million for 1997, 1996 and 1995, respectively)
increased by $16.4 million in 1997, $22.9 million in 1996 and $143.6 million
in 1995.

  As the result of an extensive review conducted in the third quarter of 1995,
the Company increased loss and loss adjustment expense reserves by $117
million in the third quarter of 1995. The review process consisted of
gathering new information and refining prior estimates, with a major focus on
assumed reinsurance and overall environmental and asbestos exposures. For
1997, 1996 and 1995, the Company recognized $5.4 million, $6.6 million and
$81.8 million, respectively, of adverse development related to environmental
and asbestos exposures.

  Losses incurred in 1995 and related to prior years for all other is
primarily related to Highlands (UK) and assumed casualty reinsurance exposures
amounted to $32.9 million.

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

                                     F-21
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

of directors. Employees, at their option, may contribute a portion of their
eligible earnings to the plan. Retirement benefits are based on the balance in
each employee's account, including the amount vested in employer
contributions. The plan may be canceled at any time at the option of the
Company. The Company's contributions to the plan for 1997, 1996 and 1995 were
approximately $1.3 million, $.6 million and $1.5 million, respectively.

13. STOCK COMPENSATION PLANS

  At December 31, 1997, the Company had two types of stock-based compensation
plans, a stock option plan and a restricted stock plan. The Company applies
APB Opinion No. 25 and related Interpretations in accounting for its plans.
Accordingly, compensation cost has been recognized for the grant of options to
acquire Company Common Stock prior to the Distribution and prior to a market
price for Company Common Stock. However, no compensation cost has been
recognized for shares issued subsequent to the Distribution which are issued
with an exercise price equal to the market value at date of grant. The
compensation cost that has been charged against income for its stock-based
plans was $500,000 and $700,000 for 1997 and 1996, respectively. Had all
compensation cost for the Company's stock-based compensation plans been
determined consistent with SFAS 123, the Company's net income (loss) and
income (loss) per share would have been the pro forma amounts indicated below
(in thousands, except per share data):

<TABLE>
<CAPTION>
                                                                  1997    1996
                                                                 ------- ------
      <S>                                            <C>         <C>     <C>
      Net income (loss)............................. As reported $16,836 (5,343)
                                                     Pro forma   $15,568 (6,609)
      Basic earnings (loss) per share............... As reported $  1.34   (.47)
                                                     Pro forma   $  1.24   (.58)
      Diluted earnings (loss) per share............. As reported $  1.09   (.47)
                                                     Pro forma   $  1.01   (.58)
</TABLE>

 Stock Option Plan

  Pursuant to the Company's 1995 Stock Option Plan, Highlands Group may grant
either incentive stock options (ISO) or non-qualified stock options (NQSO).
The exercise price for each share subject to an option will be an amount that
the Compensation Committee determines, in its good faith judgment. In the case
of ISOs, however, the exercise price per share may not be less than the amount
the Committee determines, in its good faith judgment, to be not less than 100%
of the fair value of the Company's common stock on the date the option is
granted. Options are typically exercisable over a period not in excess of ten
years. The options generally vest over three to four years, or in full upon a
change of control of the Company. The maximum number of shares that are
reserved for issuance under all option plans is 1,200,000 at December 31,
1997. A summary of the status of the Company's stock option plans at December
31, 1997 and changes during the two years then ended is presented below:

<TABLE>
<CAPTION>
                                                 1997               1996
                                           ------------------ ------------------
                                                    WEIGHTED-          WEIGHTED-
                                                     AVERAGE            AVERAGE
                                           SHARES   EXERCISE  SHARES   EXERCISE
FIXED OPTIONS                               (000)     PRICE    (000)     PRICE
-------------                              -------  --------- -------  ---------
<S>                                        <C>      <C>       <C>      <C>
Outstanding at beginning of year.......... 486,000   $15.03        --   $   --
Granted................................... 333,000   $20.31   522,000   $15.03
Exercised................................. (10,599)  $14.69        --       --
Forfeited................................. (56,418)  $17.06   (36,000)  $15.02
                                           -------   ------   -------   ------
Outstanding at end of year................ 751,983   $17.22   486,000   $15.03
                                           =======            =======
Options exercisable at year-end........... 125,589               None
                                           =======            =======
</TABLE>

                                     F-22
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

<TABLE>
<CAPTION>
                                                           1997  1997
                                                           ----- ----
      <S>                                                  <C>   <C>  <C> <C>
      Weighted-average estimated per share fair value of
       options granted:
        Issued prior to the distribution.................. $  -- 9.92
        Issued equal to market value...................... $6.80 7.88
</TABLE>

  The following table summarizes information about fixed stock options
outstanding at December 31, 1997:

<TABLE>
<CAPTION>
                                OPTIONS OUTSTANDING        OPTIONS EXERCISABLE
                          -------------------------------- --------------------
                                       WEIGHTED
                                        AVERAGE   WEIGHTED             WEIGHTED
                            NUMBER     REMAINING  AVERAGE    NUMBER    AVERAGE
                          OUTSTANDING CONTRACTUAL EXERCISE EXERCISABLE EXERCISE
RANGE OF EXERCISE PRICES  AT 12/31/97    LIFE      PRICE   AT 12/31/97  PRICE
------------------------  ----------- ----------- -------- ----------- --------
<S>                       <C>         <C>         <C>      <C>         <C>
$14.69-19.25.............   420,733      8.02      $14.71    116,925    $14.72
$19.38-23.56.............   331,250      9.27      $20.41      8,664    $20.71
                            -------                          -------
$14.69-23.56.............   751,983      8.57      $17.22    125,589    $15.13
                            =======                          =======
</TABLE>

  The fair value of stock options granted during the year ended December 31,
1997 was $2.3 million. 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 for grants in 1997 and
1996, respectively: dividend yields of -0- percent, expected volatilities of
15 percent, risk-free interest rates of 5.8 percent and 6.5 percent, and
expected terms of 6.5 years.

 Restricted Stock Plans

  In May 1997, the Company adopted a restricted stock plan (Restricted Stock
Plan) pursuant to which participants are granted an award of shares of the
Company's Common Stock (Restricted Stock) subject to restrictions. The number
of restricted shares 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 shares, which restrictions lapse on the
fifth anniversary from the date of issuance if the closing price of the
Company 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
shares 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 shares to be forfeited and transferred to the Company.

  As of December 31, 1997, the number of shares of stock reserved under the
Restricted Stock Plan is 100,000. The Company granted 63,525 shares of
Restricted Stock at a weighted average fair value of $23.20 per share during
1997. Restricted Stock is considered issued and outstanding when awarded. As
of December 31, 1997, 391 restricted shares have been forfeited to the
Company. 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
Stockholder's Equity. No amortization of the deferred expense was recorded in
1997. The deferred expense will be amortized over the remaining vesting period
once certain closing prices of the Company common stock are achieved.

                                     F-23
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

14. FAIR VALUE OF FINANCIAL INSTRUMENTS

  The Company has identified certain assets as financial instruments that
require fair value disclosure. The estimated fair value of financial
instruments has been determined by the Company using available market
information and appropriate valuation methodologies. However, considerable
judgment is necessarily required in interpreting market data to develop the
estimates of fair value. Accordingly, the Company's estimates of fair value
are not necessarily indicative of the amounts that the Company could realize
in a current market exchange. Potential taxes and other transaction costs have
not been considered in estimating fair value. As a number of the Company's
significant assets (including deferred policy acquisition costs, property and
equipment, and deferred taxes) and liabilities (loss and loss adjustment
expense reserves) are not considered financial instruments, the disclosures
that follow do not reflect the fair value of the Company as a whole.

  The carrying values and estimated fair values of financial instruments at
December 31, 1997 and 1996, were as follows (in thousands):

<TABLE>
<CAPTION>
                                                   1997               1996
                                           -------------------- ----------------
                                            CARRYING    FAIR    CARRYING  FAIR
                                           ---------- --------- -------- -------
<S>                                        <C>        <C>       <C>      <C>
Assets:
  Fixed maturity securities............... $1,166,585 1,166,585 680,397  692,351
  Equity securities....................... $    1,554     1,554  26,967   26,967
  Other investments....................... $    4,061     4,061   3,770    3,770
  Cash and cash equivalents............... $   60,717    60,717  49,484   49,484
  Premium installment receivables......... $    1,807     1,807   4,145    4,145
  Accrued investment income............... $   16,459    16,459  12,600   12,600
Liabilities:
  Convertible subordinated debentures..... $   56,229    60,000  55,452   60,000
  Senior bank debt........................ $   65,000    65,000      --       --
</TABLE>

  Fair values for fixed maturity securities are based on quoted market prices,
where available. If quoted market prices were not available, fair values were
determined by dealers specializing in those securities. Equity securities are
valued based on quoted market prices. Cash and cash equivalents, premium
installment receivables, accrued investment income and other investments are
valued at their carrying value as they are highly liquid financial assets with
maturities of less than one year. The fair value for convertible subordinated
debentures was estimated using discounted cash flow calculations based upon
Highlands Group's current incremental borrowing for similar types of borrowing
arrangements. The senior bank debt is carried at fair value.

15. CONTINGENT LIABILITIES

 Year 2000

  Highlands Division. The Highlands Division is creating a new processing
platform for its business. A by-product of this will be a processing platform
that is year 2000 compliant. The new platform will be composed of three major
sub-systems: policy administration; claim administration; and management and
financial reporting. The policy administration component, in part internally
developed but substantially purchased, will permit the processing of year 2000
business on a new and renewal basis starting in the fourth quarter of 1998.
Conversion to the new system will take approximately one year. The claim
administration component will also be purchased and is planned for full
conversion during the second quarter of 1999. The management and financial
reporting system is made up of a series of deliverables starting with the
implementation of a new general ledger in 1996 and concluding with a full
reporting system in the second half of 1999.

                                     F-24
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  Based on the foregoing schedule, the Company believes that the new
processing platform for the Highlands Division will be fully operational by
the end of 1999.

  American Reliance Division. In 1994, American Reliance, working with an
outside vendor, began a project to create a single processing platform for all
of its business that, among other things, would be able to process its year
2000 and subsequent business and related claims. In August 1997, Phase One of
this project, covering new and renewal business for a portion of the
commercial multiple peril line and the commercial automobile, general
liability and personal lines, representing approximately 70% of the Division's
business, began to be implemented on a new and renewal business basis. The
American Reliance Division is currently processing business on this new
platform. Implementation of Phase One is scheduled to be completed between
August and November 1998.

  Phase Two of the project, covering the balance of the commercial multiple
peril line and the workers compensation and commercial umbrella lines,
representing the balance of the Division's business, is expected to commence
implementation in October 1998 and is scheduled to be completed by October
1999. Based on this schedule, the Company believes that the new processing
platform for the American Reliance Division will be completely operational by
the end of 1999.

  The American Reliance Division will use the financial reporting system being
implemented by the Highlands Division, once the system is operational. The
cost of the above items relates to replacing the Company's legacy systems. The
cost of addressing year 2000 specific issues is not expected to be material.

  The Company believes that, with modifications to existing software and
converting to new software, the year 2000 issue will not pose significant
operational problems for the Company's computer systems as so modified and
converted. However, if such modifications and conversions are not completed
timely, the year 2000 issue could have a material impact on the operations of
the Company.

 Other

  The Company is a party to various claims and legal actions arising in the
ordinary course of its insurance business which, in the opinion of management,
will not have a material effect on the Company's financial position or results
of operations.

 Leases

  At December 31, 1997, the Company was obligated under noncancelable
operating leases, expiring on various dates through 2002, principally for
office space and computer software. Future aggregate minimum rentals on
noncancelable operating leases are as follows: $5.4 million in 1998, $4.4
million in 1999, $2.7 million in 2000, $1.3 million in 2001 and $.1 million
thereafter.

  The Company's gross rental expense was approximately $6.6 million, $4.5
million and $5.3 million for 1997, 1996 and 1995, respectively.

16. BUSINESS CONCENTRATION AND FOREIGN OPERATIONS

  In the normal course of business, the Company underwrites risks of
Halliburton and various subsidiaries and affiliates of Halliburton. During
1997, 1996 and 1995, net premiums earned from Halliburton aggregated
approximately $44.7 million, $30.7 million and $54.2 million, respectively.

                                     F-25
<PAGE>

  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 $85.3 million and $68.4 million at December 31, 1997 and 1996,
respectively.

  The Company's United Kingdom operations as a percentage of the Company's
consolidated revenues, loss before income taxes and identifiable assets
amounted to 2.5%, 8.5% and 16.0% and 2.5%, 22.1% and 17.2%, respectively, as
of and for the years ended December 31, 1996 and 1995. The amounts are not
material for 1997.

17. QUARTERLY FINANCIAL DATA (UNAUDITED)

  The following quarterly financial information for each of the three months
ended March 31, June 30, September 30 and December 31, 1997 and 1996 is
unaudited. However, in the opinion of management, all adjustments (consisting
of normal recurring adjustments) necessary to present fairly the results of
operations for such periods, have been made for a fair presentation of the
results shown. The earnings per share amounts for each 1996 quarter and the
first three quarters of 1997 have been restated to comply with SFAS No. 128.

<TABLE>
<CAPTION>
QUARTER ENDED                                 MARCH 31 JUNE 30  SEPT 30 DEC 31
-------------                                 -------- -------  ------- -------
                                               (DOLLARS IN THOUSANDS, EXCEPT
                                                      PER SHARE DATA)
<S>                                           <C>      <C>      <C>     <C>
1997
  Net premiums earned........................ $29,715   78,675  107,640  95,963
  Total revenues............................. $43,056   97,723  130,728 120,454
  Total expenses............................. $39,507  100,544  123,058 110,333
  Net income (loss).......................... $ 2,957   (2,268)   6,744   9,403
  Earnings (loss) per common share:
    Basic.................................... $   .26     (.18)     .51     .71
    Diluted.................................. $   .22     (.18)     .40     .52
1996
  Net premiums earned........................ $46,836   40,018   35,057  30,137
  Total revenues............................. $59,963   52,932   47,814  43,526
  Total expenses............................. $59,699   57,158   46,333  58,486
  Net income (loss).......................... $   214   (3,506)   1,233  (3,284)
  Earnings (loss) per common share:
    Basic.................................... $   .02     (.31)     .11    (.29)
    Diluted.................................. $   .02     (.31)     .11    (.29)
</TABLE>

                                     F-26
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                   SCHEDULE I

                             SUMMARY OF INVESTMENTS
                   OTHER THAN INVESTMENTS IN RELATED PARTIES

                                DECEMBER 31,1997
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                    AMOUNT AT
                                                                   WHICH SHOWN
                                             AMORTIZED    FAIR       IN THE
TYPE OF INVESTMENT                              COST      VALUE   BALANCE SHEET
------------------                           ---------- --------- -------------
<S>                                          <C>        <C>       <C>
At December 31, 1997
 Fixed maturity securities available-for-
  sale:
  United States Government and government
   agencies.................................  $ 272,708   276,405     276,405
  States, municipalities and political
   subdivisions.............................    174,587   189,526     189,526
  Mortgage-backed securities................    411,469   417,555     417,555
  Corporate securities......................    272,908   282,487     282,487
  Foreign governments.......................         89       116         116
  Sinking fund preferred stock..............        488       496         496
                                             ---------- ---------   ---------
                                              1,132,249 1,166,585   1,166,585
 Equity securities..........................      1,410     1,554       1,554
                                             ---------- ---------   ---------
    Total securities, available-for-sale....  1,133,659 1,168,139   1,168,139
                                             ---------- ---------   ---------
 Other investments..........................      4,061     4,061       4,061
                                             ---------- ---------   ---------
    Total investments....................... $1,137,720 1,172,200   1,172,200
                                             ========== =========   =========
</TABLE>


                       See accompanying auditor's report.

                                      F-27
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                  SCHEDULE II

                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                                 BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                              -----------------
                           ASSETS                               1997     1996
                           ------                             --------  -------
<S>                                                           <C>       <C>
Investment in subsidiaries................................... $464,095  263,312
Fixed maturity securities:
  Available-for-sale, at fair value..........................    5,033   24,475
  Cash and cash equivalents..................................    1,285   22,549
  Accrued investment income..................................       86      373
  Net deferred tax asset.....................................      572    2,238
  Taxes receivable from subsidiaries.........................    3,823       --
  Deferred debt expense......................................    3,984    4,482
  Other assets...............................................    3,208    3,204
                                                              --------  -------
    Total assets............................................. $482,086  320,633
                                                              ========  =======
<CAPTION>
            LIABILITIES AND STOCKHOLDERS' EQUITY
            ------------------------------------
<S>                                                           <C>       <C>
Senior bank debt............................................. $ 65,000       --
Convertible subordinated debentures..........................   56,229   55,452
Payable to subsidiaries......................................      508      196
Accounts payable and accrued liabilities.....................    9,690    1,510
                                                              --------  -------
    Total liabilities........................................  131,427   57,158
                                                              --------  -------
Stockholders' equity:
  Common stock, $.01 par value; 50,000,000 shares authorized;
   13,187,273 and 11,448,208 issued and outstanding in 1997
   and 1996, respectively....................................      132      114
  Preferred stock, $1,000 par value; 21,366 shares
   authorized, issued and outstanding in 1997................   21,366       --
  Additional paid-in capital.................................  223,460  192,273
  Net unrealized gain on investments, net of tax.............   22,278    3,036
  Deferred compensation on restricted stock..................   (1,465)      --
  Retained earnings..........................................   84,888   68,052
                                                              --------  -------
    Total stockholders' equity...............................  350,659  263,475
                                                              --------  -------
    Total liabilities and stockholders equity................ $482,086  320,633
                                                              ========  =======
</TABLE>


                      See accompanying auditor's report..

                                      F-28
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                  SCHEDULE II

                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                            STATEMENTS OF OPERATIONS
                  (IN THOUSANDS, EXCEPT PER COMMON SHARE DATA)

<TABLE>
<CAPTION>
                                                      FOR THE YEARS ENDED
                                                          DECEMBER 31,
                                                    -------------------------
                                                     1997    1996      1995
                                                    ------- -------  --------
<S>                                                 <C>     <C>      <C>
Revenues:
  Net investment income............................ $ 1,507   2,539        --
  Affiliated interest income.......................      --      --       115
                                                    ------- -------  --------
    Total revenues.................................   1,507   2,539       115
                                                    ------- -------  --------
Equity in net income (loss) of subsidiaries........  24,854  (1,186) (120,857)
                                                    ------- -------  --------
Expenses:
  Interest expense.................................  10,210   5,639        --
  Debt amortization................................   1,411   1,264        --
  Other expenses...................................   2,222   2,031        --
                                                    ------- -------  --------
    Total expenses.................................  13,843   8,934        --
                                                    ------- -------  --------
  Income (loss) before income tax benefit..........  12,518  (7,581)       --
  Income tax benefit...............................   4,318   2,238        --
                                                    ------- -------  --------
    Net income (loss).............................. $16,836 $(5,343) (120,742)
                                                    ======= =======  ========
Earnings (loss) per common share:
  Basic............................................ $  1.34    (.47)   (10.55)
  Diluted.......................................... $  1.09    (.47)   (10.55)
Weighted average number of common shares outstand-
 ing:
  Basic............................................  12,600  11,448    11,448
  Diluted..........................................  15,388  11,448    11,448
</TABLE>


                       See accompanying auditor's report.

                                      F-29
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                  SCHEDULE II

                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                            STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                      FOR THE YEARS ENDED
                                                         DECEMBER 31,
                                                   ---------------------------
                                                     1997     1996      1995
                                                   --------  -------  --------
<S>                                                <C>       <C>      <C>
Cash flow from operating activities:
  Net income (loss)............................... $ 16,836   (5,343) (120,742)
  Adjustments to reconcile net income (loss) to
   net cash provided by (used in) operating
   activities:
    Equity in net (income) loss of subsidiaries...  (24,854)   1,186   120,857
    Debt amortization.............................    1,411    1,264        --
    Dividends received from subsidiaries..........    5,000    3,000       500
    Decrease (increase) in net deferred tax asset.    1,634   (2,238)       --
    Increase in taxes receivable from
     subsidiaries.................................  (3,823)       --        --
    Changes in other operating assets and
     liabilities..................................    6,371    1,038        --
                                                   --------  -------  --------
      Total adjustments...........................  (14,261)   4,250   121,357
                                                   --------  -------  --------
    Net cash provided by (used in) operating
     activities...................................    2,575  (1,093)       615
                                                   --------  -------  --------
Cash flows from investing activities:
  Maturities or calls of fixed maturity securities
   available-for-sale.............................   34,520       --        --
  Investment purchases of fixed maturity
   securities available-for-sale..................  (14,978) (24,475)       --
  Acquisition of subsidiary, net..................  (15,000)      --        --
  Capital contributions to subsidiaries...........  (53,244) (52,174)  (20,834)
  Cash returned by (sent to) former affiliates,
   net............................................       --    3,800      (615)
  Payment of acquisition expenses.................   (3,730)      --        --
  Other proceeds..................................       92       --        --
  Proceeds from disposal of subsidiary, net.......       --       22        --
                                                   --------  -------  --------
      Net cash used in investing activities....... $(52,340) (72,827)  (21,449)
                                                   --------  -------  --------
Cash flows from financing activities:
  Proceeds from senior bank debt..................   65,000       --        --
  Proceeds from issuance of convertible
   subordinated debentures........................       --   60,000        --
  Payment for debt issuance expense...............   (1,017)  (5,705)       --
  Repayment of acquired bank debt.................  (35,638)      --        --
  Issuance of Common Stock........................      156       --        --
  Contribution from former parent of net current
   tax asset......................................       --   42,174    20,834
                                                   --------  -------  --------
      Net cash provided by financing activities...   28,501   96,469    20,834
                                                   --------  -------  --------
Net (decrease) increase in cash and cash
 equivalents...................................... (21,264)   22,549        --
Cash and cash equivalents at beginning of year....   22,549       --        --
                                                   --------  -------  --------
Cash and cash equivalents at end of year.......... $  1,285   22,549        --
                                                   ========  =======  ========
Supplemental disclosure of cash flow information:
  Interest paid................................... $  8,803    5,639        --
                                                   ========  =======  ========
</TABLE>

                       See accompanying auditor's report.

                                      F-30
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

               SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                      AS OF DECEMBER 31,
                                              ----------------------------------
                                               DEFERRED    LOSSES,
                                                POLICY     CLAIMS
                                              ACQUISITION AND LOSS  UNEARNED
PROPERTY/CASUALTY OPERATIONS                     COSTS    EXPENSES  PREMIUMS
----------------------------                  ----------- --------- --------
<S>                                           <C>         <C>       <C>      <C>
1997.........................................   $32,313   1,605,374 173,411
                                                =======   ========= =======
1996.........................................   $ 6,436   1,156,824  31,474
                                                =======   ========= =======
1995.........................................   $11,744   1,253,627  52,571
                                                =======   ========= =======
</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>
1997.................... $311,993   74,383    246,479      86,103     40,860   277,737
                         ========   ======    =======      ======     ======   =======
1996.................... $152,048   50,988    156,589      28,829     36,258   135,051
                         ========   ======    =======      ======     ======   =======
1995.................... $201,446   48,529    300,253      39,671     33,411   201,565
                         ========   ======    =======      ======     ======   =======
</TABLE>



                       See accompanying auditor's report.

                                      F-31
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                            SCHEDULE IV--REINSURANCE
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                        PERCENT
                                                       ASSUMED            OF
                                            CEDED TO    FROM            AMOUNT
                                    DIRECT    OTHER     OTHER     NET   ASSUMED
                                    AMOUNT  COMPANIES COMPANIES AMOUNT  TO NET
                                   -------- --------- --------- ------- -------
<S>                                <C>      <C>       <C>       <C>     <C>
Year ended December 31, 1997
  Property-liability insurance.... $367,630  (46,758)  (8,879)  311,993  (2.8%)
                                   ========  =======   ======   =======  ====
Year ended December 31, 1996
  Property-liability insurance.... $160,776  (22,631)  13,903   152,048   9.1%
                                   ========  =======   ======   =======  ====
Year ended December 31, 1995
  Property-liability insurance.... $204,508  (30,053)  26,991   201,446  13.4%
                                   ========  =======   ======   =======  ====
</TABLE>




                       See accompanying auditor's report.

                                      F-32
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                 SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                 ADDITIONS
                                    ------------------------------------
                         BALANCE AT  CHARGES TO                           BALANCE
                         BEGINNING     COSTS       OTHER                  AT END
                         OF PERIOD  AND EXPENSES ADDITIONS DEDUCTIONS(1) OF PERIOD
                         ---------- ------------ --------- ------------- ---------
<S>                      <C>        <C>          <C>       <C>           <C>
Year ended December 31,
 1997
  Allowance for
   uncollectible
   reinsurance.........   $ 2,410         --         --          253       2,157
                          =======       ====        ===        =====       =====
Year ended December 31,
 1996
  Allowance for
   uncollectible
   reinsurance.........   $ 4,598         --         --        2,188       2,410
                          =======       ====        ===        =====       =====
Year ended December 31,
 1995
  Allowance for
   uncollectible
   reinsurance.........   $11,903       (763)        --        6,542       4,598
                          =======       ====        ===        =====       =====
</TABLE>
--------
(1) Deductions in the allowance for uncollectible reinsurance represent write-
    offs, net of recoveries, of amounts determined to be uncollectible.


                       See accompanying auditor's report.

                                      F-33
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                  SCHEDULE VI

                SUPPLEMENTAL INFORMATION CONCERNING CONSOLIDATED
                     PROPERTY/CASUALTY INSURANCE OPERATIONS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                       AS OF DECEMBER 31,
                                                 ------------------------------
                                                    1997      1996      1995
                                                 ---------- --------- ---------
<S>                                              <C>        <C>       <C>
Deferred policy acquisition costs............... $   32,313     6,436    11,744
Loss and loss adjustment expense reserves....... $1,605,374 1,156,824 1,253,627
Unearned premiums............................... $  173,411    31,474    52,571
<CAPTION>
                                                  FOR THE YEARS ENDED DECEMBER
                                                              31,
                                                 ------------------------------
                                                    1997      1996      1995
                                                 ---------- --------- ---------
<S>                                              <C>        <C>       <C>
Net premiums earned............................. $  311,993   152,048   201,446
Net investment income........................... $   74,383    50,988    48,529
Loss and loss adjustment expense incurred
  Current year..................................    230,033   133,717   156,683
  Prior year....................................     16,446    22,872   143,570
                                                 ---------- --------- ---------
                                                 $  246,479   156,589   300,253
                                                 ========== ========= =========
Amortization of deferred policy acquisition
 costs.......................................... $   86,103    28,829    39,671
Paid loss and loss adjustment expense........... $  358,867   200,541   238,261
Net premiums written............................ $  277,737   135,051   201,565
</TABLE>


                       See accompanying auditor's report.

                                      F-34