<PAGE>

                       SECURITIES AND EXCHANGE COMMISSION

                             Washington, D.C. 20549

                                 --------------
                                    FORM 10-K

                  |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR
                     15(d) OF THE SECURITIES EXCHANGE ACT OF
                     1934 For the Fiscal Year Ended December
                                    31, 2000

                                       OR

|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934
                                 --------------
                         HIGHLANDS INSURANCE GROUP, INC.
             (Exact Name of Registrant as Specified in its Charter)
                                     1-14028
                            (Commission File Number)

           Delaware                                         75-2370945
(State or Other Jurisdiction                           (I.R.S. Employer
of Incorporation or Organization)                    Identification Number)

       1000 Lenox Drive
    Lawrenceville, New Jersey                                  08648
(Address of Principal Executive Offices)                     (Zip Code)

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

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

                 Title of each          Name of each exchange on
                    class                   which registered
          --------------------------  -----------------------------
         Common Stock $.01 Par Value     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 30, 2001, was $40,920,669 (based on $3.30 per share). At
March 30, 2001, the Registrant had outstanding 13,248,879 shares of its Common
Stock, par value $.01 per share.
<PAGE>

                                TABLE OF CONTENTS

<TABLE>
<CAPTION>

  Item                                                                                             Page
<S>                                                                                               <C>
                                                 PART I
    1.Business...................................................................................  1
    2.Properties................................................................................. 17
    3.Legal Proceedings.......................................................................... 17
    4.Submission of Matters to a Vote of Security Holders........................................ 18

                                                PART II

    5.Market for Company's Common Stock and Related Stockholder Matters.......................... 19
    6.Selected Financial Data.................................................................... 20
    7.Management's Discussion and Analysis of Financial Condition and Results of Operations...... 21
   7A.Quantitative and Qualitative Disclosures about Market Risk................................. 27
    8.Financial Statements and Supplemental Data................................................. 28
    9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure....... 28

                                                PART III

   10.Directors and Executive Officers of the Registrant......................................... 28
   11.Executive Compensation..................................................................... 30
   12.Security Ownership of Certain Beneficial Owners and Management............................. 37
   13.Certain Relationships and Related Transactions............................................. 40

                                                PART IV

   14.Exhibits, Financial Statement Schedules, and Reports on Form 8-K........................... 40

</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"). In April 1997, the Highlands
Group acquired Vik Brothers Insurance, Inc. and its subsidiaries which was
renamed American Reliance, Inc. The acquisition was accounted for as a purchase
and, accordingly, the financial results of American Reliance, Inc. and its
subsidiaries ("American Reliance") are included in the consolidated financial
statements effective as of the date of acquisition.

     The Company's home office is in Lawrenceville, New Jersey, where it has one
of its regional offices. It maintains eight other regional offices in Texas,
North Carolina, Ohio, Wisconsin, Iowa, Colorado, Tennessee and California. A
major accounts business unit is located in Lawrenceville to service larger or
specialized accounts. The Company's principal subsidiaries are Highlands
Insurance Company, Northwestern National Casualty Company and Pacific National
Insurance Company.

     In 2000, the Company incurred a pre-tax loss of $38.5 million and, due to
the write-off of deferred tax assets, a net after tax loss of $106 million. The
Company incurred a net loss of $13.5 million in 1999. As a result of these
losses, the Company would have been in default of covenants under its senior
bank debt. These defaults have been eliminated through amendments to the Credit
Agreement for the senior bank debt. The Company has retained two investment
banking firms to explore strategic and other alternatives for the Company. See
"Risk Factors" in this Item 1 and Item 7. "Management's Discussion and Analysis
of Financial Condition and Results of Operations."

     The Company's principal product lines, shown as a percentage of gross
premiums written for 2000, are as follows:

            Commercial multiple-peril..............     26.5
            Workers' compensation..................     24.7
            Commercial automobile..................     22.3
            Homeowners multiple peril and fire.....     10.2
            General liability......................      9.3
            Personal automobile....................      5.1
            Inland Marine..........................       .2
            Other..................................      1.7
                                                     ----------
                                                       100.0%

The Company, which is licensed in all 50 states and the District of Columbia,
writes primarily property and casualty insurance for commercial customers and
certain personal lines. Its commercial policyholders consist of small to medium-
sized customers, such as retailers, wholesalers, contractors and service
businesses. In addition, the Company writes insurance through its major accounts
unit for medium to large commercial accounts and program groups, including risk
purchasing groups. The Company's personal lines focus on homeowners multiple
peril, dwelling fire and automobile insurance, primarily on the East Coast.

                                       1
<PAGE>

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 can be
underwritten on a high deductible or retrospectively rated basis, with
significant risk retention by the insured. Policies written for small to
medium-sized accounts are generally on a fixed premium basis where the insured
has little or no retained risk, although certain workers' compensation policies
provide for profit sharing participation to the insured in the form of
dividends. The personal lines consist of homeowners multiple peril and dwelling
fire and personal automobile insurance. Additionally, the Company writes inland
marine insurance which is generally unrelated to the commercial or personal
lines property and casualty products. The Company discontinued writing ocean
marine business at the end of 1999.

     The following table sets forth the Company's gross premiums written by
product line for the periods indicated.

                                                            Years Ended
                                                           December 31,

                                                       2000     1999    1998
                                                       ----     ----    ----
                                                           (in millions)
 Commercial multiple peril..............              $137.2   101.4    96.6
 Workers' compensation..................               128.0    70.8    90.0
 Commercial automobile..................               115.2    50.5    47.5
 Homeowners multiple peril and fire.....                52.6    49.0    40.2
 General liability......................                48.2    42.4    26.7
 Personal automobile....................                26.6    29.9    27.5
 Inland Marine..........................                 1.1     7.2     7.2
 Discontinued lines.....................                 1.6     1.3     1.0
 Ocean Marine...........................                  --     8.6    10.9
 Other .................................                 6.1     3.0    30.5
                                                      ------   -----   -----
      Total.............................              $517.1   364.1   378.1
                                                      ======   =====   =====

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

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

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

     Commercial Automobile. Commercial automobile coverage insures businesses
against losses incurred from personal bodily injury, bodily injury to third
parties and property damage to an insured's vehicle, other vehicles and other
property. This product line is primarily offered in connection with the
Company's other primary insurance products.

     Homeowners Multiple Peril and Fire. Homeowners multiple peril coverage
insures individuals for losses to their residences and personal property and
against third party liability exposures.

     General Liability. General liability coverage insures businesses against
third-party liability from accidents occurring on their premises or arising out
of their operations, such as injuries sustained from products sold.

     Personal Automobile. Personal automobile insurance insures individuals
against losses incurred from personal bodily injury, bodily injury to third
parties and property damage to the insured's vehicle, other vehicles and other
property.

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

                                       2
<PAGE>
underwrites surety bonds and property coverage.


Types of Policies

     Approximately 98% of the Company's gross premiums written in 2000 related
to policies written on a traditional fixed premium basis whereby the customer
receives stated levels of coverage in return for a fixed premium over the policy
term, including certain workers' compensation policies which provide for
participating dividends. The balance of the Company's insurance premiums are
written on policies subject to retrospective rating or individually negotiated,
high deductible, fixed premium policies.

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

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

Geographic Distribution

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

                                       Years Ended
                                      December 31,
                                  2000     1999    1998
                                  ----     ----    ----
                                      (in millions)
            California.........  $81.2     53.0     47.1
            Texas..............   67.7     46.7     52.4
            New York...........   47.5     13.3     11.3
            New Jersey.........   44.6     39.1     51.3
            Pennsylvania.......   40.2     32.2     31.4
            North Carolina.....   23.3     23.6     18.3
            Wisconsin..........   16.0     10.2      9.4
            Iowa...............   15.7     14.9     14.4
            Indiana............   11.3     11.7     10.5
            South Carolina.....    9.4     10.5     11.0
            Other..............  160.2    108.9    121.0
                                ------    -----    -----
                                $517.1    364.1    378.1
                                ======    =====    =====

                                       3
<PAGE>

Marketing

     The Company sells its insurance products in various regional markets
through a network of approximately 2,500 independent agents. Its ten largest
agents wrote 7.1% of the Company's gross premiums written in 2000.

     The Company markets small to medium-sized commercial and personal insurance
through nine regional offices in Lawrenceville, New Jersey; Houston, Texas;
Raleigh, North Carolina; Columbus, Ohio; Brookfield, Wisconsin; Des Moines,
Iowa; Denver, Colorado; Nashville, Tennessee; and Woodland Hills and Tustin,
California. The Company has new business offices in Dallas, Texas and
Sacramento, California.

     The Company's small to medium-sized commercial customers (with premium on
policies ranging from $2,500 to $500,000) consist mainly of retailers,
wholesalers, service businesses, funeral homes, office buildings, religious
institutions, franchise and family style restaurants, municipalities, golf
courses, automobile dealers, contractors, wholesale durable goods producers,
producers of retail building materials, machine shops and tool manufacturers.

     The personal lines unit, which is headquartered in Raleigh, North Carolina,
focuses on homeowners multiple peril, dwelling fire and, to a lesser extent,
personal automobile coverage, primarily along the East Coast.

     The Company sells insurance products, through its major accounts unit in
Lawrenceville, New Jersey. This unit focuses on program groups, including risk
purchasing groups and other larger accounts with a premium size of $1 million or
greater.

     Because the Company's business is marketed through independent insurance
agents and brokers, it considers its relationship with these agents and brokers
to be critical to its success. Accordingly, the Company seeks to establish
long-term relationships with well-established agencies and brokers with a proven
track record. In selecting agencies and brokers for appointment, the Company
considers the following criteria: a record of profitability and financial
stability; an experienced and professional staff; the existence of a marketing
plan for future growth; and a plan for succession in management. The Company's
agents are primarily medium-sized firms, generally with annual premium volume
estimated at between $2 million and $40 million. Agents are retained under
agency agreements which provide for the payment of commissions based on a
percentage of premiums written by line of business. Some agents are also
eligible to earn contingent commissions based on achieving specified levels of
premium volume with profitable underwriting experience. The Company continually
monitors the performance of its agents and brokers and terminates relationships
in the case of substandard performance.

     The success of the Company depends in large part on maintaining a strong
agency network. To increase its responsiveness to agents' needs, the Company has
instituted agency councils on a regional basis to deal with issues that are
important to agents. The Company has also established teams in its regions which
consolidate 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.

Underwriting

     The underwriting and risk selection process is performed at each of the
regional offices, new business offices and business units. Underwriting
guidelines and criteria are established by corporate underwriting, located in
Lawrenceville, New Jersey. Underwriting audits are performed periodically by the
regional, corporate underwriting and executive personnel to ensure compliance
with underwriting and pricing directives.

Claim

     Claims are processed in five regional claim offices located in
Lawrenceville, New Jersey; Raleigh, North Carolina; Des Moines, Iowa; Houston,
Texas; and Woodland Hills, California. Home office claim support is located in
Lawrenceville, New Jersey, which establishes claim policies and procedures for
the regional claim offices. The home office also provides support on complex
claims, such as environmental/mass tort, asbestos, and construction defect
claims, fraud detection and administration, and conducts an oversight audit
function for each regional claim office. In addition, a centralized salvage and
subrogation unit is located in Raleigh, North Carolina. The Company primarily
uses its own adjusters to settle claims, but

                                       4
<PAGE>

also uses independent adjusters when necessary for claims in remote areas. The
Company uses in-house counsel for a portion of its claims litigation.

Loss Control

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

Discontinued Lines

     Between 1976 and 1996, the Company discontinued three lines of business
("Discontinued Lines") which still generate claims that affect the Company's
results of operations: (i) business generated by the Company's London
operations, which were initially conducted as a branch office and subsequently
by a UK subsidiary (together "Highlands (UK)") and which were discontinued in
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. In 1999, the Company discontinued writing
ocean marine business. The Company has outsourced the claims handling and
run-off management of Highlands (UK) to a professional run-off company doing
business in the United Kingdom. The run-off of the other discontinued lines is
being managed directly by Company personnel in Houston, Texas and Lawrenceville,
New Jersey.

Loss and Loss Adjustment Expense Reserves

     Significant periods of time often elapse between the occurrence of an
insured loss, the reporting of the loss to the insurer and the insurer's payment
of that loss. To recognize liabilities for unpaid losses, insurers establish
reserves as balance sheet liabilities representing estimates of amounts needed
to pay reported and unreported losses and the related loss adjustment expense.
The Company's loss and loss adjustment expense reserves are reviewed quarterly
by the Company's internal actuaries and at year end by the Company's independent
actuaries. The Company's independent actuaries issued opinions on the 2000 loss
and loss adjustment expense reserves for the insurance subsidiaries, as required
for their statutory filings with the various insurance departments.

     The process of estimating loss reserves is a difficult and complex exercise
involving many variables and subjective judgments. As part of the reserving
process, insurers review historical data and consider the impact of various
factors such as changes in the Company's operations (such as underwriting or
claims handling), trends in claim frequency and severity, emerging economic and
social trends, inflation and changes in the regulatory and litigation
environments. This process assumes that past experience, adjusted for the
effects of current developments and anticipated trends, is an appropriate basis
for predicting future events. There is no precise method, however, for
evaluating the impact of any specific factor on the adequacy of reserves,
because the eventual deficiency or redundancy of reserves is affected by many
factors.

     When a claim is reported to the Company, claim personnel establish a "case
reserve" for the estimated amount of the ultimate liability. This reflects the
informed judgment of such personnel based on general insurance reserving
practices and on the experience and knowledge of such personnel regarding the
nature and value of the specific types of claims. Case reserves are increased or
decreased as deemed necessary by the Company's claim department, after
evaluating, among other things, coverage, liability and the severity of
subsequent developments.

     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

                                       5
<PAGE>

in the volume of business written, claims frequency and severity, the mix of
business, claims processing and other items that can be expected to affect the
Company's liability for losses over time.

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

                                       6
<PAGE>

     The following table presents a reconciliation of total beginning and ending
reserve balances of the Company for loss and loss adjustment expense for the
periods indicated.

<TABLE>
<CAPTION>


                                                                     2000           1999          1998
                                                                    -------       --------      --------
<S>                                                              <C>          <C>           <C>

                                                                             (in thousands)
Balance at January 1............................................   $1,353,524    1,603,548    1,605,374
     Less--Reinsurance recoverables..............................     614,208      732,567      692,668
                                                                   ----------   ----------    ---------
Net balance at January 1........................................      739,316      870,981      912,706
                                                                   ----------   ----------    ---------
Incurred related to--
     Current year...............................................      321,181      247,027      256,528
     Commutation of Aggregate Excess of Loss Reinsurance
        Agreement...............................................           --           --       50,000
     Prior year--
          Asbestos and environmental............................        7,762        1,795       19,119

          All other.............................................       17,194       (9,882)       2,753
                                                                   ----------   ----------    ---------

     Total prior year...........................................       24,956       (8,087)      21,872
                                                                   ----------   ----------    ---------
          Total incurred........................................      346,137      238,940      328,400
                                                                   ----------   ----------    ---------
Paid related to--
     Current year...............................................      136,565      101,294       90,635
     Prior year--
          Asbestos and environmental............................       11,041       15,038        9,712
          All other.............................................      171,997      230,240      269,778
                                                                   ----------   ----------    ---------
     Total prior year...........................................      183,083      245,278      279,490
                                                                   ----------   ----------    ---------
          Total paid............................................      319,603      346,572      370,125
                                                                   ----------   ----------    ---------
Elimination of LMI reserves(1)..................................          --        24,033           --
                                                                   ----------   ----------    ---------
Net balance at December 31......................................      765,850      739,316      870,981
     Add--Reinsurance recoverables...............................     626,647      614,208      732,567
                                                                   ----------   ----------    ---------
Balance at December 31..........................................   $1,392,497    1,353,524    1,603,548
                                                                   ==========   ==========    =========
</TABLE>
------------------
(1)  The Company wrote off its investment in LMI Insurance Company("LMI").  See
     Item 7:  "Management's Discussion and Analysis of Financial Condition and
     Results of Operations."

     The loss reserve experience of the Company, as reflected on the basis of
generally accepted accounting principles, is shown in the following table, which
represents the development of balance sheet reserves for 1990 through 2000. 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 2000.
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 of
reinsurance basis for 1990 and 1991.

                                       7
<PAGE>

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

<TABLE>
<CAPTION>
<S>                                             <C>         <C>         <C>          <C>         <C>         <C>
                                                     1990        1991         1992        1993        1994        1995
                                                ---------   ---------   ----------   ---------   ---------   ---------
Gross reserves for loss and adjustment
expense  ......................................        --          --    1,393,352   1,225,242   1,149,173   1,253,627
Deduct: reinsurance recoverable  ..............        --          --      827,381     627,285     557,096     599,558
Net reserves for loss and loss adjustment
expense  ......................................   540,818     652,925      565,971     597,957     592,077     654,069
Net paid (cumulative) as of:
One year later  ...............................   236,070     263,755      268,072     184,586     198,415     163,521
Two years later  ..............................   419,791     420,876      395,244     333,366     323,737     266,093
Three years later  ............................   510,739     518,442      513,135     426,022     404,287     348,713
Four years later  .............................   573,504     608,865      587,726     488,676     473,059     424,307
Five years later  .............................   638,963     668,889      639,647     548,333     542,484     456,108
Six years later  ..............................   685,578     714,843      692,851     612,998     570,475
Seven years later  ............................   723,905     763,008      753,462     636,731
Eight years later  ............................   764,543     820,177      773,148
Nine years later  .............................   822,346     836,369
Ten years later  ..............................   834,515
Gross paid (cumulative) as of:
One year later  ...............................                            583,180     405,885     284,446     279,091
Two years later  ..............................                            920,199     635,683     522,680     429,250
Three years later  ............................                          1,113,503     836,921     650,471     556,177
Four years later  .............................                          1,296,333     945,321     762,957     674,906
Five years later  .............................                          1,392,285   1,047,819     875,842     763,058
Six years later  ..............................                          1,486,879   1,155,295     959,651
Seven years later  ............................                          1,587,715   1,231,710
Eight years later  ............................                          1,657,188
Net liability re-estimated as of:
End of year  ..................................   540,818     652,925      565,971     597,957     592,077     654,069
One year later  ...............................   653,379     694,248      688,811     662,841     735,647     676,940
Two years later  ..............................   725,661     785,147      772,020     788,454     750,941     702,633
Three years later  ............................   772,614     828,241      894,071     805,313     783,138     765,168
Four years later  .............................   824,126     938,216      915,163     835,720     863,781     753,158
Five years later  .............................   925,216     957,726      943,789     913,664     850,726     792,861
Six years later  ..............................   943,067     988,466    1,035,577     900,015     894,614
Seven years later  ............................   971,193   1,084,762    1,023,488     948,416
Eight years later  ............................ 1,060,151   1,073,281    1,069,581
Nine years later  ............................. 1,053,600   1,127,817
Ten years later  .............................. 1,108,671
Net (deficiency) redundancy  ..................  (567,853)   (474,892)    (503,610)   (350,459)   (302,537)   (138,792)
Impact of 1995 Third Quarter Change  ..........    90,501      96,640      103,483     107,594     117,000          --
Aggregate Stop Loss Adjustment.  ..............    50,000      50,000       50,000      50,000      50,000      50,000
Remaining net (deficiency) redundancy  ........  (427,352)   (328,252)    (350,127)   (192,865)   (135,537)    (88,792)
                                                =========   =========   ==========   =========   =========   =========
Gross re-estimated liability as of:
End of year  ..................................                          1,393,352   1,225,242   1,149,173   1,253,627
One year later  ...............................                          1,636,022   1,413,673   1,445,913   1,324,315
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   1,644,067
Four years later  .............................                          2,157,078   1,895,541   1,820,250   1,601,476
Five years later  .............................                          2,307,982   2,071,815   1,777,438   1,661,484
Six years later  ..............................                          2,472,233   2,031,628   1,832,012
Seven years later  ............................                          2,437,690   2,079,767
Eight years later  ............................                          2,476,651
Gross cumulative (deficiency) redundancy  .....                         (1,083,299)   (854,525)   (682,839)   (407,857)
                                                                        ==========   =========   =========   =========
Gross re-estimated liability  .................                          2,476,651   2,079,767   1,832,012   1,661,484
Less: re-estimated recoverable  ...............                          1,407,070   1,131,350     937,398     868,623
                                                                        ----------   ---------   ---------   ---------
Net re-estimated liability  ...................                          1,069,581     948,416     894,614     792,861
                                                                        ==========   =========   =========   =========
LMI Gross Reserves  ...........................
LMI Net Reserves  .............................
Gross re-estimated liability excluding LMI
reserves(1)  ..................................

Net re-estimated liability excluding LMI
reserves(1)  ..................................



                                                      1996        1997        1998       1999       2000
                                                 ---------   ---------   ---------  ---------  ---------
Gross reserves for loss and adjustment
expense  ......................................  1,156,824   1,605,374   1,603,548  1,353,524  1,392,497
Deduct: reinsurance recoverable  ..............    546,707     692,668     732,567    614,208    626,647
Net reserves for loss and loss adjustment
expense  ......................................    610,117     912,706     870,981    739,316    765,850
Net paid (cumulative) as of:
One year later  ...............................    135,747     279,490     245,278    183,038
Two years later  ..............................    231,409     459,712     364,188
Three years later  ............................    316,905     545,261
Four years later  .............................    358,041
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  ...............................    183,701     338,120     333,982    240,167
Two years later  ..............................    324,859     590,529     504,850
Three years later  ............................    453,634     729,053
Four years later  .............................    551,313
Five years later  .............................
Six years later  ..............................
Seven years later  ............................
Net liability re-estimated as of:
End of year  ..................................    610,117     912,706     870,951    739,316    765,850
One year later  ...............................    626,563     984,578     862,894    764,272
Two years later  ..............................    689,107     971,903     866,204
Three years later  ............................    676,970     987,611
Four years later  .............................    711,769
Five years later  .............................
Six years later  ..............................
Seven years later  ............................
Eight years later  ............................
Nine years later  .............................
Ten years later  ..............................
Net (deficiency) redundancy  ..................   (101,652)   (74,905)      4,777     (24,956)
Impact of 1995 Third Quarter Change  ..........         --          --          --
Aggregate Stop Loss Adjustment.  ..............     50,000      50,000
Remaining net (deficiency) redundancy  ........    (51,652)    (24,905)     54,777     25,044
                                                 =========   =========   =========  =========
Gross re-estimated liability as of:
End of year  ..................................  1,156,824   1,605,374   1,603,548  1,353,524  1,392,497
One year later  ...............................  1,285,772   1,746,580   1,574,814  1,413,887
Two years later  ..............................  1,457,923   1,693,237   1,579,515
Three years later  ............................  1,414,284   1,732,603
Four years later  .............................  1,486,184
Five years later  .............................
Six years later  ..............................
Seven years later  ............................
Eight years later  ............................
Gross cumulative (deficiency) redundancy  .....   (329,360)   (127,229)     24,033    (60,363)
                                                 =========   =========   =========  =========
Gross re-estimated liability  .................  1,486,184   1,732,603   1,579,515  1,413,887
Less: re-estimated recoverable  ...............    774,415     744,992     713,311    649,615
                                                 ---------   ---------   ---------  ---------
Net re-estimated liability  ...................    711,769     987,611     866,204    764,272
                                                 =========   =========   =========
LMI Gross Reserves  ...........................                 52,759      60,284
LMI Net Reserves  .............................                 23,626      24,033
Gross re-estimated liability excluding LMI
reserves(1)  ..................................              1,640,478   1,514,530
                                                             ---------   ---------
Net re-estimated liability excluding LMI
reserves(1)  ..................................                948,277     960,545

</TABLE>
  ___________
(1) The Company wrote off its investment in LMI.  See Item 7: ``Management's
    Discussion and Analysis of Financial Condition and Results of Operations.''

                                       8
<PAGE>

  As the above table illustrates, the Company's net reserves at the end of 1999
developed unfavorably in 2000 by $25.0 million.


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.''

  As a result of an analysis made in the fourth quarter of 2000 by the Company
and its independent actuary, it was determined that there had been adverse
development in the commercial multiple peril and workers' compensation lines of
business. Following the results of this analysis, loss and loss adjustment
expense reserves were increased at the end of 2000. The reserve increase covered
the commerical multiple peril and workers' compensation lines as well as
increases and decreases in other lines. The increase in reserves affected
current year business as well as business written in prior years and added
approximately 12.1 points to the 2000 year loss ratio of 89.1%. In addition,
the Company and the property and casualty insurance industry in general has
experienced substantial adverse development related to asbestos and
environmental claims. For 2000, 1999 and 1998, the amounts of adverse reserve
development related to asbestos and environmental claims were $7.8 million, $1.8
million and $19.1 million, respectively.


                                       9
<PAGE>

Reinsurance

  The Company utilizes reinsurance arrangements to limit its maximum loss, to
provide greater diversification of risks and to minimize exposures on larger
risks. Reinsurance involves an insurance company transferring or ceding all or a
portion of its exposure on insurance policies to a reinsurer. The reinsurer
assumes the exposure in exchange for a portion of the premiums received by the
ceding insurance company. Generally, reinsurance coverage is on an excess of
loss basis, which means that reinsurance coverage commences after losses exceed
a specified dollar amount. Additionally, the Company has catastrophe coverage
for certain types of losses over stipulated aggregate amounts arising from any
one occurrence. Although reinsurance does not legally discharge an insurer from
its primary liability for the full amount of the policies, it does make the
assuming reinsurer liable to the reinsured to the extent of the reinsurance
ceded.

  The Company maintained excess of loss reinsurance treaties for each of its
main property, casualty and marine coverages during 2000. On casualty risks,
including workers' compensation, the retention level was $500,000 per
occurrence, with reinsurance coverage up to $30 million per occurrence.
Additional workers' compensation coverage was provided by a second catastrophe
excess of loss arrangement that provides $80 million in addition to the $30
million for total workers' compensation coverage of $109.5 million in excess of
$500,000. On property risks, reinsurers assume liability for 100% in excess of a
retention of $500,000 up to $25 million per risk subject. For larger limits or
whenever unusual exposures are present, the Company purchases individual policy
reinsurance which is referred to as facultative. In addition, the Company
purchased property catastrophe reinsurance to reduce its exposure to losses
resulting from any single catastrophic event. Under this treaty, which is
effective from July 1, 2000 through June 30, 2001, the Company retains $5
million of a loss occurrence and there are four layers of coverage above the $5
million retention.  The first layer, which is 55.44% placed, covers $5 million
of losses in excess of $5 million and the Company retains 5%; the second layer
covers $10 million of losses in excess of $10 million and the Company retains
2.5%; the third layer covers $20 million of losses in excess of $20 million with
no retention by the Company; and the fourth layer covers $30 million in losses
in excess of $40 million with no retention by the Company.  The Company intends
to renew this treaty for an additional year when it expires. On marine business,
reinsurers assumed liability on loss occurrences which exceed $125,000 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, 2000.

<TABLE>
<CAPTION>
<S>                                                     <C>
                                                        December 31,
                                                        ------------
      Category                                              2000
      --------                                          ------------
                                                        (in millions)
      A.M. Best Rated:
         B++ or better  ..............................       312.5
         B+ or less  .................................       100.2
      Non A.M. Best Rated:
         Equitas/Lloyds  .............................       141.1
         Other foreign reinsurers  ...................       117.0
         Pools and associations  .....................        12.8
                                                        ------------
            Total reinsurance recoverable  ...........       683.6
                                                        ============
</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. In
addition, there are instances where the Company and one or more of its
reinsurers disagree on the terms or extent of reinsurance coverage with respect
to particular losses. In those situations, the Company attempts to negotiate an
acceptable settlement of the disagreement or, failing to reach a settlement,
takes the matter to arbitration. The largest such disagreement, in the amount of
$20 million of reinsurance recoverable (net of a valuation allowance), concerns
reinsurance on California construction defect claims.

  Because of the difficulty of acquiring current financial information for
certain foreign reinsurers, including Lloyds syndicate members, the Company
believes that no meaningful range of potentially uncollectible reinsurance can
be established beyond recorded reserves. With respect to certain carriers,
including those that are not authorized reinsurers as determined by an insurance
subsidiary's domiciliary department of insurance, the Company sometimes receives
collateral primarily in the form of bank letters of credit generally securing
the reinsurance recoverable for reported losses and, in some instances,
unreported losses.

                                       10
<PAGE>

At December 31, 2000, such collateral totaled approximately $22.8 million, of
which $12.2 million was received from other foreign reinsurers above. The
Company's three largest reinsurance recoverables at December 31, 2000 were with
Lloyds of London/Equitas, amounting to approximately $141.1 million, $84.1
million with American Reinsurance Company and $55.8 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."


Investments

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

<TABLE>
<CAPTION>
                                                                       December 31,
                                                              -------------------------------
<S>                                                           <C>        <C>        <C>
                                                                   2000       1999       1998
                                                                  -----      -----    -------
                                                                       (in millions)
Fixed maturities:
  United States Government and government agencies  ........     $138.3      116.0      205.5
  States, municipalities and political subdivisions  .......       15.9       41.3       61.2
  Asset-backed and collateralized securities  ..............      345.0      336.6      415.0
  Corporate securities  ....................................      277.2      268.6      318.4
  Other  ...................................................         --         --        1.1
Equity securities  .........................................       32.1       26.6       21.1
Other investments  .........................................        2.0        3.1        3.1
Cash and cash equivalents  .................................      109.8       78.3       70.7
                                                                 ------      -----    -------
                                                                 $920.3      870.5    1,096.1
                                                                 ======      =====    =======
</TABLE>

  Fixed Maturities. Fixed maturities constituted 84.4% of the Company's cash and
investments at December 31, 2000. Fixed maturity investments are classified as
available-for-sale and carried on the Company's balance sheet at estimated fair
value, with unrealized gains and losses (net of taxes) recorded in stockholders'
equity as accumulated other comprehensive income (loss). At December 31, 2000,
the pre-tax net unrealized losses on available-for-sale fixed maturities totaled
$20.6 million.

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

<TABLE>
<CAPTION>
                              Moody's
                            Description
      NAIC Ratings          Equivalent      December 31,     December 31,     December 31,
------------------------  -------------    --------------   --------------   --------------
                                               2000             1999             1998
                                               -----            -----            -----
<C>                       <S>            <C>              <C>              <C>
           1              AAA/AA/A              88.3%            90.9%            91.1%
           2              BAA                   10.9%             8.8              8.2
           3              BA                      .8%             0.3              0.5
           4              B                       --               --              0.2
                                               -----            -----            -----
                                               100.0%           100.0%           100.0%
                                               =====            =====            =====
</TABLE>

                                       11
<PAGE>

  See Notes to Consolidated Financial Statements for a description of the
contractual maturities of the Company's fixed maturities portfolio at December
31, 2000.

  Equity Securities. Equity holdings comprised 3.5% of the Company's investments
at December 31, 2000, and consist of a diversified portfolio of unaffiliated
preferred stocks.

  Other Investments. Other investments represent amounts invested in limited
partnerships and comprised .2% of total investments at December 31, 2000.

  Cash and Cash Equivalents. The Company's portfolio also includes short-term
securities and other miscellaneous investments, which in the aggregate comprised
11.9% of total investments at December 31, 2000.

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

<TABLE>
<CAPTION>
                                                          Years ended December 31,
                                         2000                      1999                     1998
                                ---------------------    ----------------------    ----------------------
                                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       $55,729       7.33%          $62,981       6.76%       $74,075       6.81%
Equity securities  ..........     2,469       8.33             1,973       7.21            517       5.68
Short-term  .................     5,237       5.82             3,343       4.45          3,993       6.48
Other invested assets   .....        41       1.59               113       3.76             57       2.82
                                -------       ----           -------       ----        -------       ----
   Total  ...................   $63,476       7.19           $68,410       6.60%       $78,642       6.75%
                                =======       ====           =======       ====        =======       ====
</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.


Competition; Industry Conditions

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


Regulation



                                       12
<PAGE>

  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.

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

  Highlands Insurance Company (``HIC'') and its subsidiaries, Highlands
Underwriters Insurance Company, Highlands Casualty Company and Aberdeen
Insurance Company and Highlands Lloyds, a controlled affiliate, are domiciled in
Texas. Under current Texas law, any dividend or distribution, together with any
dividend or distribution made within the preceding twelve months, is an
``extraordinary dividend'' if it exceeds the greater of (a) 10.0% of the
insurer's surplus as regards policyholders as of the preceding December 31, or
(b) the insurer's net income for the preceding year. An extraordinary dividend
may not be paid unless the company reports the extraordinary dividend to the
Texas Insurance Commissioner at least 30 days before payment and the Texas
Insurance Commissioner does not disapprove the extraordinary dividend within
that period. The maximum dividend payable by HIC during 2001 without the prior
approval of the Texas Insurance Commissioner is approximately $12.7 million.

  Northwestern National Casualty Company (``NNCC'') and its subsidiary, NN
Insurance Company (``NNI''), are domiciled in Wisconsin. Under current Wisconsin
law, any dividend or distribution of cash or other property, together with that
of other dividends paid or credited and distributions made within the preceding
twelve months, is an ``extraordinary dividend'' if it exceeds the lesser of (a)
10.0% of the insurer's surplus as regards policyholders as of the preceding
December 31, or (b) the greater of: (i) the net income (excluding realized
capital gains) of the insurer for the calendar year preceding the date of the
dividend or distribution or (ii) the aggregate of the net income of the insurer
for the three calendar years preceding the date of the dividend or distribution,
minus realized capital gains for those calendar years, and minus dividends paid
or credited and distributions made within the first two of the preceding three
calendar years. An extraordinary dividend may not be paid unless the company
reports the extraordinary dividend to the Wisconsin Insurance Commissioner at
least 30 days before payment and the Wisconsin Insurance Commissioner does not
disapprove the extraordinary dividend within that period. During 2001, NNCC must
receive the prior approval of the Wisconsin Insurance Department to pay any
dividends.

  Pacific National Insurance Company (``PNIC'') and its subsidiary, Pacific
Automobile Insurance Company (``PAIC''), are domiciled in California. Under
current California law, any payment by an insurer of a dividend or distribution
of cash or other property, whose fair market value, together with that of other
dividends or distributions made within the preceding 12 months, exceeds the
greater of (i) 10.0% of the insurer's surplus as regards policyholders as of the
preceding December 31, or (ii) the net income of the insurer for the 12-month
period ending on the preceding December 31 is defined as an ``extraordinary
dividend.'' California law permits an insurer to pay dividends only from earned
surplus. An extraordinary dividend may not be paid unless it has been approved
by the insurance department or the insurance department has not disapproved the
dividend or distribution within 30 days after notice of the declaration to the
department. PNIC must receive the prior approval of the California Insurance
Department to pay any dividends in 2001.

                                       13
<PAGE>

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

  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. All of the insurance subsidiaries of
Highlands Group are above the Company Action Level.

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

                                       14
<PAGE>

Employees

  The Company had 912 employees as of December 31, 2000. The Company believes
that its relations with its employees are satisfactory.

Risk Factors

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

  The Company regularly reviews its reserving techniques and its overall amount
of reserves. It also reviews: information regarding each claim for losses; its
loss history and the industry's loss history; legislative enactments, judicial
decisions and legal developments regarding damages; changes in political
attitudes; and trends in general economic conditions, including inflation. As a
result of an analysis made at the end of 2000, it was determined that there had
been adverse development in the commercial multiple peril and workers'
compensation lines of business. At the end of 2000, a reserve increase was made
covering those two lines as well as increases and decreases in other lines.

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

  The Company, from time to time on an opportunistic basis, assumes
reinsurance from other insurers and reinsurers.  This assumed reinsurance
business produced an underwriting profit for the Company in 2000, but there is
no guarantee that it will produce future profits.

  Debt Obligations.  The Company has outstanding $49 million in senior bank debt
and $62.85 million principal amount of convertible subordinated debentures.  The
bank debt matures on April 30, 2002, and is collaterized by the stock of the
Company's principal insurance subsidiaries. The Company was in default of
certain covenants in the Credit Agreement for the bank debt at the end of 1999.
Effective December 31, 1999, the Company and its lender banks entered into an
amendment to the Credit Agreement, which had the effect of eliminating these
defaults. The Company was again in default of certain covenants in the Credit
Agreement at the end of 2000. Effective December 31, 2000, the Company and the
lender banks entered into an Amendment and Waiver Agreement, further amending
the covenants in the Credit Agreement, which had the effect of eliminating the
defaults. There can be no assurance that the Company will be able to comply with
the amended covenants in the Credit Agreement. A default under the Credit
Agreement which is not cured or waived gives the lending banks the right to
declare the senior bank debt in default, accelerate the maturity of the debt and
seek repayment, including seeking to execute on the collateral for the debt. The
convertible subordinated debentures, which are subordinated to the senior bank
debt, are due December 31, 2005; however, by virtue of the cross default
provisions of the debentures, if the senior bank debt is in default and the
maturity of the debt is accellerated, the holders of the debentures have the
right to declare the debentures in default and accelerate their maturity.

  Even if there are no future defaults, the senior bank debt is due and payable
on April 30, 2002, at which time the Company must either pay or refinance it.
There is no assurance that the Company will have the resources to pay the debt
when it is due or that the lending banks or any other source would be willing to
provide the resources to refinance the debt.

  Continuing Losses. In 2000, the Company incurred a pre-tax loss of $38.5
million and an after tax loss of $106.5 million. In connection with the
computation of its after tax loss, the Company wrote off deferred tax assets due
to

                                       15
<PAGE>

their doubtful recoverability. The Company incurred a net loss of $13.5 million
in 1999. The Company's ability to continue as a viable business is dependent on
its ability to achieve profitable operations.

  Halliburton. From 1958 until 1986, the Company issued fixed premium insurance
policies to Brown & Root, a subsidiary of Halliburton. From 1987 on, the
Company's insurance policies with Halliburton and its subsidiary companies have
been written on a retrospectively rated or high-deductible basis. Since the mid-
1990's, Halliburton has received a substantial number of asbestos claims.
Through December 31, 2000, the Company paid $1.2 million on behalf of
Halliburton under the fixed premium policies on account of the asbestos claims,
and billed Halliburton $8.5 million under the retrospectively rated and high-
deductible policies on account of asbestos claims. Halliburton has not paid this
billed amount.  The Company and Halliburton are currently litigating liability
for the asbestos claims under the insurance policies.  See Item 3:  "Legal
Proceedings" for a description of the litigation.  If the Company is not
successful in the litigation, it could have a material adverse impact on the
Company.

  Catastrophes. Property and casualty insurance companies frequently experience
losses from catastrophes. Catastrophes may have a material adverse effect on the
Company's operations. Catastrophes include windstorms, hurricanes, earthquakes,
tornadoes, hail, severe winter weather and fires. The Company cannot predict how
severe a particular catastrophe may be until after it occurs. The extent of the
Company's losses from catastrophes is a function of the total amount of losses
its clients incur, the number of its clients affected, the frequency of the
events and the severity of the particular catastrophe. Most catastrophes occur
in small geographic areas. However, windstorms, hurricanes and earthquakes may
produce significant damage in large, heavily populated areas.

  Importance of Rating Agencies. Rating agencies rate insurance companies based
on financial stability and an ability to pay claims, factors more relevant to
policyholders than investors. Ratings are not recommendations to buy, hold or
sell the Company's Common Stock.  Currently, A.M. Best rates the Company's
principal insurance subsidiaries as ``B++'' (Very Good), however, A.M. Best has
placed the rating of the Company's insurance subsidiaries under review with
negative implications. Ratings by A.M. Best in the insurance industry range from
``A++'' (Superior) to ``F'' (in Liquidation). According to A.M. Best, an insurer
with a ``B++'' rating has demonstrated very good financial strength and
operating performance and is considered to be secure.  A rating below ``B+''
indicates that a company is not considered secure. The Company's business could
be adversely affected if A.M. Best downgrades its rating, and will be adversely
affected if its rating were downgraded below ``B+.''

  Reliance on Independent Insurance Agents. The Company markets and sells almost
all of its insurance products through independent, non-exclusive insurance
agencies and brokers. The agencies and brokers also sell competitors' insurance
products. The Company's business depends in part on the marketing efforts of
those agencies and brokers and the Company must offer insurance products that
meet the requirements of their customers. If those agencies and brokers fail to
market the Company's products successfully, the Company's business may be
adversely impacted.

  Significant Influence of Investors. Insurance Partners, L.P. and Insurance
Partners Offshore (Bermuda) L.P. own 10% Convertible Subordinated Debentures
together with Common Stock warrants in the Company. The debentures and warrants
represent significant equity ownership potential. If Insurance Partners and
Insurance Partners (Bermuda) convert the debentures and exercise the warrants,
they would own approximately 41.6% of the Company's Common Stock, although such
conversion and exercise is considered to be highly unlikely in view of the
Company's operating results. In addition, by contract Insurance Partners
designates 28% of the members of the Board of Directors.

  Competition. The Company competes with regional and national insurance
companies, including direct writers of insurance coverage. Many of these
competitors are larger and have greater financial, technical and operating
resources. The property and casualty insurance industry is highly competitive on
the basis of both price and service. There are many companies competing for the
same insurance customers in the geographic areas in which the Company operates.
If the Company's competitors price their premiums more aggressively and the
Company meets their pricing, this may adversely affect the Company's
underwriting results. In addition, because the Company's insurance products are
marketed through independent insurance agencies, which represent more than one
insurance company, the Company faces competition within each agency.

  The Company also faces competition from the implementation of self-insurance
in the commercial insurance area. Many of the Company's customers and potential
customers are examining the risks of self-insuring as an alternative to
traditional insurance. The Company also faces potential competition from banks.
Recent changes in laws permit banks to

                                       16
<PAGE>

engage in non-banking, financial service businesses, such as the underwriting of
insurance. These changes allow banks to compete directly with the Company by
selling insurance through their own insurance agencies.

  Regulation. The Company is subject to extensive supervision and regulation in
the states in which it operates. The supervision and regulation relate to
numerous aspects of its business and financial condition. The primary purpose of
the supervision and regulation is the protection of the Company's insurance
policyholders, and not the Company's shareholders or other investors. The extent
of regulation varies, but generally is derived from state statutes. These
statutes delegate regulatory, supervisory and administrative authority to state
insurance departments. The regulations or the state insurance departments may
impede the Company from obtaining rate increases or taking other actions the
Company might wish to take to increase its profitability. State insurance laws
require prior approval by state insurance departments of any acquisition of
control of a domestic insurance company or of any company which controls a
domestic insurance company. ``Control'' is generally presumed to exist through
the ownership of 10% or more of the voting securities of a domestic insurance
company or of any company which controls a domestic insurance company. Any
purchaser of 10% or more of the outstanding shares of the Company's Common Stock
will be presumed to have acquired control of its subsidiaries unless the
relevant insurance commissioner determines otherwise. Accordingly, any purchase
of 10% or more of the Company's outstanding Common Stock would require prior
action by all or some of the insurance commissioners in the home states of the
Company's insurance subsidiaries.

  Restrictions on Dividends. As an insurance holding company, the Company's
principal assets consist of the capital stock of its insurance subsidiaries. The
Company cannot declare cash dividends on the Common Stock unless its insurance
subsidiaries can pay cash dividends. The Company's insurance subsidiaries may
only pay dividends if they are permitted to do so under the insurance
regulations of their domiciliary states. All of the domiciliary states of the
Company's insurance subsidiaries regulate the payment of dividends. In addition,
these regulations may adversely affect the Company's ability to pay its expenses
and debts.  Due to the losses incurred by the Company in 1999 and 2000, the
ability of the Company's insurance subsidiaries to pay cash dividends without
regulatory approval is severely limited.

  Industry. Historically, the property and casualty insurance industry has been
cyclical. Except for certain segments of the industry that have recently shown
signs of a hardening market, the industry generally has been in a downturn for
years, which resulted in a decline in premium rates. The decline in premium
rates adversely affected the Company's underwriting results. Furthermore,
unpredictable developments affect the industry's profitability. These
developments include natural disasters, fluctuations in interest rates and other
changes in the investment environment that affect returns on the Company's
investments, inflationary pressures that affect the size of losses, and judicial
decisions that affect insurers' liabilities. The demand for property and
casualty insurance, particularly commercial lines, can also vary with the
overall level of economic activity.

  Certain Anti-takeover Effects. Certain provisions of the Company's
organizational documents may discourage, delay or prevent a change of control of
the Company. These include, among others, provisions in the Company's Amended
and Restated Certificate of Incorporation and Bylaws relating to staggered terms
for directors, notice requirements for stockholders proposing director
nominations or bringing business before stockholder meetings and the ability of
the Board of Directors to issue ``blank check'' preferred stock without
stockholder approval. These provisions could have the effect of depriving
stockholders of an opportunity to receive a premium over the prevailing market
price in the event of an attempted hostile takeover.


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.

  From 1958 to 1986, the Company issued fixed premium, guaranteed cost (not
retrospectively rated) insurance policies to Brown & Root, a subsidiary of
Halliburton Company.  Beginning in 1987, the Company's insurance policies with
Halliburton (including Brown & Root) were written on a retrospectively rated or
high-deductible basis.  Since the mid-

                                       17
<PAGE>

1990's, over 20,000 third party asbestos claims have been made against
Halliburton. Through December 31, 2000, the Company paid $1.2 million on behalf
of Halliburton under the fixed premium policies on asbestos claims, and billed
Halliburton $8.5 million under the retrospectively rated and high-deductible
policies on asbestos claims. Halliburton has not paid this billed amount and has
questioned the proper allocation of the asbestos claims between the fixed
premium and the retrospectively rated and high-deductible policies.

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

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

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

  If the Company is not ultimately successful in the litigation described above,
it could have a material adverse impact on the Company.  The Company believes,
however, that the positions it has taken in the Delaware Action and Texas Action
are meritorious, and that, ultimately, the Company will not be responsible for a
material amount, if any, of Halliburton's asbestos liability.


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

  None.

                                       18
<PAGE>

                                    PART II

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

  The Company's Common Stock is listed on the New York Stock Exchange (``NYSE'')
under the trading symbol ``HIC.'' As of March 30, 2001, approximately 13,248,879
shares of Common Stock were issued and outstanding, 445,900 of which are held by
subsidiaries of the Company. In addition, 1,700,000 shares of Common Stock are
reserved for issuance pursuant to restricted stock grants and options granted or
to be granted pursuant to the 1995 Stock Option Plan and the 1995 Directors'
Stock Plan. See Item 11: ``Executive Compensation.''

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

<TABLE>
<CAPTION>
Period                                  High      Low
------------------------------------  --------  -------
<S>                                   <C>       <C>
      1999 First Quarter  ..........    $14.94    10.56
      1999 Second Quarter  .........    $13.25    10.25
      1999 Third Quarter  ..........    $10.94     8.25
      1999 Fourth Quarter  .........    $ 9.69     6.75
      2000 First Quarter  ..........    $10.63     6.81
      2000 Second Quarter  .........    $ 9.38     7.06
      2000 Third Quarter  ..........    $ 9.63     8.38
      2000 Fourth Quarter  .........    $ 9.63     8.69
</TABLE>

The approximate number of stockholders of record of Common Stock as of March 30,
2001 was 11,404.

  The NYSE Listed Company Manual requires the Company to obtain shareholder
approval prior to the issuance of Common Stock or securities convertible into or
exercisable for Common Stock to certain persons including a substantial security
holder of the Company unless an exception to obtaining such approval applies. On
April 13, 2001, Insurance Partners, L.P., Insurance Partners Offshore (Bermuda),
L.P. (collectively ``IP'') and the Company executed a Summary of Terms pursuant
to which IP waived the Company's obligation to pay cash interest on the 10%
Convertible Subordinated Debentures due on June 30, 2001 and December 31, 2001,
held by IP and, instead, IP will receive new 12.5% convertible subordinated
debentures in an amount equal to the interest due as payment of the interest.
The Company believes that its issuance of the new convertible subordinated
debentures will qualify for an exception to the NYSE shareholder approval rule.
The Company has notified the NYSE of the issuance of the new convertible
subordinated debentures and intends to comply with the requirements for an
exception to the shareholder approval rule.

  Dividends. The Company has not previously paid any dividends and currently
does not intend to pay dividends on the Common Stock. The Company's ability to
pay dividends in the future will depend upon its financial performance and other
factors that are not presently determinable. The Company's 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 its U.S. insurance subsidiaries is subject to certain limitations
under insurance laws.

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

                                       19
<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,
                                                  -------------------------------------------------------------
<S>                                                <C>           <C>         <C>         <C>        <C>
                                                      2000        1999        1998        1997         1996
                                                   ---------     -------     -------     -------      -------
                                                          (dollars  n thousands, except per share data)
Statement of Operations Data:
Revenues:
  Net premiums earned  ........................    $ 388,505     325,305     388,813     311,993       152,048
  Net investment income  ......................       62,453      67,684      77,969      74,383        50,988
  Net realized investment gains  ..............          974          22      16,874       5,585         1,199
                                                   ---------     -------     -------     -------       -------
     Total revenues  ..........................      451,932     393,011     483,656     391,961       204,235
Expenses:
  Loss and loss adjustment expense
    incurred  .................................      346,137     238,940     328,400     246,479       156,589
  Underwriting expenses  ......................      134,470     130,121     141,788     115,564        56,487
  Debt interest and amortization expense  .....       12,392      11,753      12,258      10,542         6,903
  Loss on write-off of subsidiary  ............           --      10,452          --          --            --
  Other expenses (income), net  ...............       (2,538)      2,210       2,000         857         1,697
                                                   ---------     -------     -------     -------       -------
     Total expenses  ..........................      490,461     393,476     484,446     373,442       221,676
Income (loss) before taxes  ...................      (38,529)       (465)       (790)     18,519       (17,441)
Income tax expense (benefit)(1)  ..............       67,747      12,984      (3,887)      1,683       (12,098)
                                                   ---------     -------     -------     -------       -------
Net income (loss)  ............................     (106,276)    (13,449)      3,097      16,836        (5,343)
Dividends paid on mandatorily redeemable
  preferred stock..............................          289          --          --          --            --
                                                   ---------     -------     -------     -------       -------
Net income (loss) attributable to common
  stockholders.................................    $(106,565)    (13,449)      3,097      16,836        (5,343)
                                                   =========     =======     =======     =======       =======
Earnings (loss) per common share(2):
  Basic  ......................................       $(8.06)      (1.04)        .24        1.34          (.47)
  Diluted  ....................................       $(8.06)      (1.04)        .20        1.09          (.47)

Balance Sheet Data (at end of period):
Investments, cash and cash equivalents  .........  $  920,259    870,455   1,096,147   1,232,917       760,618
Receivable from reinsurers  .....................  $  683,439    684,525     787,344     723,114       556,900
  Total assets  .................................  $2,001,150  1,961,287   2,265,043   2,366,656     1,566,031
Loss and loss adjustment expense reserves  ......  $1,392,497  1,353,524   1,603,548   1,605,374     1,156,824
Mandatorily redeemable preferred stock  .........  $    4,930      4,641          --          --            --
Stockholders' equity  ...........................  $  174,549    264,401     318,554     329,293       263,475


Certain Financial Ratios and Other Data:
GAAP:
  Loss ratio  ...................................        89.1%      73.5%       84.4%       79.0%        103.0%
  Expense ratio  ................................        34.6%      40.0        36.5        37.0          37.1
                                                   ----------  ---------   ---------   ---------     ---------
     Combined ratio  ............................       123.7%     113.5%      120.9%      116.0%        140.1%
                                                   ==========  =========   =========   =========     =========
Statutory surplus  ..............................  $  204,042    270,783     313,542     333,141       188,527
Net premiums written to policyholder surplus  ...        2.2x       1.2x        1.2x        1.2x(3)       0.8x
</TABLE>
_________
(1) The Company provides for income taxes in its statements of operations
    pursuant to Financial Accounting Standards Board Statement of Financial
    Accounting Standards No. (``SFAS'') 109, ``Accounting for Income Taxes.''
    For further information regarding federal and foreign income taxes, see
    Note 7 to Consolidated Financial Statements.

(2) The earnings (loss) per share amounts for 1996 have been restated to comply
    with SFAS No. 128, ``Earnings Per Share.''


                                       20

<PAGE>

(3) Net Premiums written to policyholder surplus includes twelve months pro
    forma net premiums written for American Reliance.


ITEM 7: Management's Discussion and Analysis of Financial Condition and Results
      of Operations.

The Industry

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

  The industry has experienced the effects of a number of well publicized
catastrophic events in recent years, some of which have affected the Company.
Growth in liabilities related to asbestos and environmental risks has also
adversely affected the industry and is of significance to the Company.

  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.

                                       21
<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,
                                                        -------------------------------------
<S>                                                     <C>          <C>          <C>
                                                              2000         1999         1998
                                                            ------       ------       ------
                                                            (dollars in millions, except
                                                                  per share data)
      Consolidated Results:
      Gross premiums written  ......................       $ 517.1        364.1        378.1
      Net premiums written  ........................       $ 461.0        333.6        374.8
                                                           =======       ======       ======
      Net premiums earned  .........................       $ 388.5        325.3        388.8
      Loss and loss adjustment expense  ............        (346.1)      (238.9)      (328.4)
      Underwriting expenses  .......................        (134.5)      (130.1)      (141.8)
                                                           -------       ------       ------
      Underwriting loss  ...........................         (92.1)       (43.7)       (81.4)
      Net investment income  .......................          62.5         67.7         78.0
      Net realized investment gains  ...............           1.0           --         16.9
      Debt interest and amortization expense  ......         (12.4)       (11.8)       (12.3)
      Loss on write-off of subsidiary  .............            --        (10.5)          --
      Other income (expenses), net  ................           2.5         (2.2)        (2.0)
                                                           -------       ------       ------
      Loss before income taxes  ....................         (38.5)        (0.5)        (0.8)
      Income tax expense (benefit)  ................          67.8         12.9         (3.9)
                                                           -------       ------       ------
      Net income (loss)  ...........................       $(106.3)       (13.4)         3.1
                                                           =======       ======       ======
      Earnings (loss) per share:
         Basic  ....................................       $ (8.06)       (1.04)         .24
         Diluted  ..................................       $ (8.06)       (1.04)         .20
      Ratios:
         Loss  .....................................          89.1%        73.5%        84.4%
         Expense  ..................................          34.6         40.0         36.5
                                                            ------       ------       ------
         Combined  .................................         123.7%       113.5%       120.9%
                                                            ======       ======       ======
</TABLE>

Period to Period Comparisons

Gross Premiums Written. Gross premiums written for 2000, 1999 and 1998 were
$517.1 million, $364.1 million and $378.1 million, respectively. The increase in
gross premiums written of $153.0 million or 42.0% in 2000 is primarily due to
increases in premium volume from the Company's regional offices as well as new
programs introduced in 2000, principally the golf course program ($15.3 million)
and a livery program ($27.5 million). In addition, the Company increased prices
on its commercial lines in 2000, reflecting the hardening commercial insurance
market. The gross premiums written decrease of $14.0 million or 3.7% in 1999
compared to 1998 is due primarily to three factors. First, in 1999 the Company
focused on underwriting standards and adequate pricing during a period of
competitive pricing in both commercial and personal lines. Second, service
disruptions in early 1998 associated with the implementation of a new policy
issuance system at the end of 1997 negatively impacted new and renewal policy
processing and agents' willingness in 1999 to place business with the Company.
Finally, the reduction in the A.M. Best rating of Highlands to B++ from A-,
announced by A.M. Best in June 1998, caused a decline in premium production as
certain agents were unwilling to use a B++ market.

  Gross premiums written for retrospectively rated policies may be adjusted up
or down, subject to certain limitations contained in the policy, based on the
estimated loss experience of the insured during the policy period. The Company
estimates ultimate losses for retrospectively rated policies and then adjusts
gross premiums written and premiums due from policyholders for changes in
estimated ultimate losses and loss adjustment expenses from the date of the
prior valuation. These adjustments may cause gross premiums written, net
premiums written and net premiums earned to fluctuate significantly from period
to period. Experience rated insurance policies reduce but do not eliminate risk
to the insurer.

                                       22
<PAGE>

  Net Premiums Written. Net premiums written for 2000, 1999 and 1998 were $461.0
million, $333.6 million and $374.8 million, respectively. The increase in 2000
of $127.4 million or 38.4% relates to the same factors noted above for gross
written premiums. Net premiums written for the golf course program and livery
program were $11.1 million and $9.0 million, respectively, reflecting the
reinsurance on these programs. The decrease in 1999 compared to 1998 is
primarily related to a non-recurring additional premium in 1998 of $34.6 million
associated with the Company's termination of an Aggregate Excess of Loss
Reinsurance Agreement (``Stop Loss Agreement''). The remaining decrease of $6.6
million in 1999 is related to the same issues affecting gross premiums written.

  Net Premiums Earned. Net premiums earned for 2000, 1999 and 1998 were $388.5
million, $325.3 million and $388.8 million, respectively. The increase in 2000
compared to 1999 is related to the same items affecting gross and net premiums
written as noted above, but also reflects the recognition of net premiums earned
over the coverage period rather than when the premiums were written.
Additionally, the Company reestimated the premiums due under retrospective
policies, reducing such assets by $11.0 million. The decrease in 1999 compared
to 1998 is related to the same items affecting gross and net premiums written as
noted above including the 1998 termination of the Stop Loss Agreement, which
increased reported net earned premiums in 1998 by $34.6 million.

  Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense
incurred for 2000, 1999 and 1998 was $346.1 million, $238.9 million and $328.4
million, respectively. The loss and loss adjustment expense ratios for 2000,
1999, and 1998 were 89.1%, 73.5% and 84.4%, respectively. During the fourth
quarter of 2000, the Company, along with its independent actuary, determined
that there had been adverse development in the commercial multiple peril and
workers' compensation lines. Following this analysis, loss and loss adjustment
expense reserves were increased at the end of 2000 by approximately $48.0
million, covering those lines as well as increases and decreases in other lines.
The increase in reserves affected current as well as prior year business, and
increased the 2000 calendar year loss ratio by approximately 12.1 points,
excluding the affects of certain reserve adjustments on retrospective rated
policies which were off-set by increases in net premiums earned. The decrease in
1999 of $89.5 million compared to 1998 was primarily attributable to three
factors. First, the 1998 termination of the Stop Loss Agreement noted above had
the effect of increasing loss and loss adjustment expenses reported in 1998 by
$50.0 million. Second, in 1999, the Company experienced a decrease in loss and
loss adjustment expenses of $19.1 million related to California construction
defect claims because, in 1999, the Company recorded additional reinsurance
recoverables for previously unbilled paid losses of $11.1 million related to
California construction defect claims, while in 1998, the Company had $8.0
million of unfavorable reserve development for these claims. Third, the Company
experienced a decrease in loss and loss adjustment expenses of approximately
$4.1 million related to weather related catastrophe losses. Finally, in 1998,
there were higher incurred losses subject to retrospectively rated policies.

  Underwriting Expenses. Underwriting expenses for 2000, 1999 and 1998 were
$134.5 million, $130.1 million and $141.8 million, respectively. The
underwriting expense ratios for 2000, 1999 and 1998 were 34.6%, 40.0% and 36.5%
respectively. The decline in the 2000 underwriting expense ratio, compared to
the 1999 expense ratio, of 5.4 points to 34.6%, resulted from expense savings
initiatives instituted in 1999, principally reducing systems out-sourcing costs
by $5.1 million and reducing salary and benefits by $3.5 million. Additionally,
lower fixed costs were spread over higher premium volume in 2000. The decline in
the 1999 underwriting expense ratio, compared to the adjusted 1998 expense
ratio, is the result of the Company's 1999 expense saving initiatives. During
1999, the Company realized expense savings of $2.4 million due to the 1998
termination of the Stop Loss Agreement and $1.6 million related to restructuring
a system vendor agreement. These savings were partially offset by a
restructuring charge in the amount of $780,000 and additional expenses
associated with the Company's 1999 system integration projects. Elimination of
the 1998 non-recurring additional premium related to the Stop Loss Agreement and
certain unusually large 1998 retrospectively rated policy adjustments resulted
in an adjusted expense ratio of 41.8% for 1998.

  Investment Results. Net investment income for 2000, 1999 and 1998 was $62.5
million, $67.7 million and $78.0 million, respectively. Net investment income
decreased $5.2 million in 2000 compared to 1999 primarily due to a reduction in
the investment portfolio's average amortized cost. Net investment income
decreased $10.3 million in 1999 compared to 1998 due to declining premium volume
in 1999 and 1998, continued reduction of the investment portfolio's average
amortized cost due to the payment of older loss reserves, and the 1998
repurchase of Company Common Stock.

  Debt Interest and Amortization Expense. Debt interest and amortization expense
for 2000 compared to 1999 increased approximately $600,000 due to the increase
in the underlying variable interest rate (LIBOR) and variable performance add-
ons associated with the Company's senior bank debt. Debt interest and
amortization expense for 1999 compared to 1998 decreased approximately $500,000
due to the mid-year paydown of $6.0 million of senior bank debt offset somewhat
by higher interest rates.

  Loss on Write-off of Subsidiary. Effective December 1999, the Company wrote-
off its remaining investment in LMI which was in run-off since April 1997 when
it was acquired in the purchase of American Reliance. In March 2000, the Court
of Common Pleas in Franklin County, Ohio entered an Order appointing the
Superintendent of Insurance of the State of Ohio as the Rehabilitator of LMI. As
Rehabilitator, the Superintendent is by operation of law vested with control of
LMI, including title to all of LMI's assets.

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


  Income Taxes. During 2000, the Company increased its valuation allowance for
deferred tax assets by $82.8 million. Based on the results of operations,
management does not currently believe that it is more likely than not that the
tax benefits for which it increased the valuation allowance will be realized in
the near future. Total tax expense for 2000 was $67.7 million and reflects the
increase in valuation allowance. The total tax expense for 1999 was $13.0
million. In 1999, the Company recorded a charge totaling

                                       23



<PAGE>

$11.6 million of deferred taxes related to the write-off of LMI because it was
determined that deferred tax assets associated with LMI would not be recoverable
by the Company.

Liquidity and Capital Resources

Highlands Group is a holding company, the principal assets of which at December
31, 2000 are all of the capital stock of Highlands Holding Company, Inc. and
American Reliance, Inc. The Company's property and casualty insurance business
is conducted by its 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.

                                       24
<PAGE>

 Holding Company

  As a holding company, Highlands Group's principal requirements for funds are
to pay operating expenses, franchise and other taxes and debt service. Operating
expenses and franchise and other taxes imposed on the Company are not expected
to be material. The annual cash interest requirements relating to the Company's
outstanding 10% convertible subordinated debentures (the "Debentures") and the
loan under the Credit Agreement are approximately $10.0 million. At the end of
2000, the Company was in default of certain covenants, including financial
covenants, in the Credit Agreement. Effective December 31, 2000, the Company and
the lenders entered into an Amendment and Waiver Agreement which amended the
Credit Agreement thereby eliminating the defaults. There can be no assurance
that the Company will be able to comply with the amended covenants in the Credit
Agreement. A default under the Credit Agreement which is not cured or waived
gives the lenders the right to declare the entire loan under the Credit
Agreement, $49 million at December 31, 2000, in default, accelerate the maturity
of the loan and seek repayment, including seeking to execute on the collateral
for the loan, i.e., the stock of the Company's principal insurance subsidiaries.
The Debentures in the principal amount of $62.85 million are due December 31,
2005; however, by virtue of the cross-default provisions of the Debentures, if
the loan under the Credit Agreement is in default and the payment of the debt is
accelerated, the holders of the Debentures have the right to declare the
Debentures in default and accelerate their maturity. Also, at the end of 1999,
the Company was in default under certain financial covenants in the Credit
Agreement. Effective December 31, 1999, the Company and its lenders amended the
Credit Agreement to revise those financial covenants and to provide for the
payment of $10.0 million in principal during 2000.

  As stated above, annual cash interest payments under the Credit Agreement and
the Debentures approximate $10 million. Furthermore, even in the absence of
defaults, the loan under the Credit Agreement is due and payable on April 30,
2002. The Company is taking a number of steps to deal with these requirements.

  First, as required under the December 31, 2000 Amendment and Waiver to the
Credit Agreement, the terms of the Debentures have been amended so that only
payment in kind ("PIK") interest may be made under the Debentures until the loan
under the Credit Agreement is paid. The PIK interest will be paid in the form of
a new 12.5% convertible subordinated debenture due December 31, 2005 (the "New
Debentures"). The New Debentures will be in the same form and have the same
terms as the Debentures, except that interest is at the rate of 12.5% per annum
and the New Debenture are convertible into Common Stock at a conversion price of
$6.00 per share. Cash interest on the New Debentures may not be paid until the
loan under the Credit Agreement is paid. Secondly, the Company has retained two
investment advisors to explore strategic and other alternatives available to the
Company, and to advise the Special Committee described below on proposal
transactions. These alternatives include sale or merger of the entire Company,
sale of certain lines of business or assets of the Company, obtaining an
investment in the Company, and entering into a joint venture or other joint
endeavor. There can be no assurance that the Company will be successful in
pursuing any of these alternatives. If the Company is not successful, it will
need to pay or refinance the loan under the Credit Agreement by April 2002.
There is no assurance that the Company will have the resources to pay the loan
or that it will be able to find a source of refinancing.

  A Special Committee was formed by the Board of Directors of the Company on
March 29, 2001 in connection with the Company's exploration of engaging in one
or more transactions, including without limitation one or more of the following:
a merger, consolidation or sale of all or a portion of its business or assets;
an acquisition of another company or business; obtaining an investment in the
Company; a joint venture or other joint endeavor (including creating a new
entity to effect any such venture or endeavor); a strategic or other transaction
(a ``Transaction''). The Special Committee was formed to avoid potential
conflicts of interest. The Company may not take any action with respect to a
proposed Transaction unless such proposed Transaction is recommended for
approval to the full Board of Directors of the Company by the Special Committee
evidenced by a resolution duly adopted by the Special Committee. The powers and
authorities of the Special Committee include to retain independent legal,
accounting, actuarial or other advisors to advise the Special Committee in
connection with any proposed Transaction; to obtain reports (including without
limitation one or more fairness opinions) concerning proposals for one or more
Transactions; to cause its financial advisors to solicit indications of interest
from one or more persons or entities with respect to engaging in a Transaction;
to negotiate the form, terms and provisions of any proposed Transaction; to
consider and approve or disapprove any and all agreements (subject to the
ultimate authority of the full Board of Directors of the Company, upon
recommendation of the Special Committee, to approve any definitive agreement in
connection with any Transaction) related to a proposed Transaction; and to
recommend to the full Board of Directors of the Company the approval or
disapproval of any proposed Transaction. The Company has retained two
independent investment advisors to advise the Special Committee in connection
with any proposed Transaction. The Special Committee consists of four Non-
Employee Directors: Messrs. Hawk, Pieper, Williams and Shower. See Part III,
Item 10. "Directors and Executive Officers of the Registrant."

                                       25
<PAGE>

  Highlands Group's principal sources of funds are dividends and tax sharing
payments from its subsidiaries, if any, and funds that may be raised from time
to time from the issuance of additional debt or equity securities. The payment
of dividends by the insurance subsidiaries is subject to restrictions and
limitations imposed by the insurance regulatory authorities. Due to the
Company's operating losses, dividend payments to Highlands Group from its
insurance subsidiaries are limited to approximately $12.7 million in 2001
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.


 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 and the
profitability of the products.  Continuing operating losses, including those
from future catastrophe claims, the timing and amount of which are inherently
unpredictable, may create increased liquidity requirements for the insurance
subsidiaries. The liquidity requirements of the insurance subsidiaries are met
by that portion of the investment portfolio that is held in cash and highly
liquid securities.

  Statutory Surplus. Maintenance of appropriate levels of statutory surplus of
the Company's United States domiciled insurance subsidiaries is a primary
objective of the Company and is also important to regulatory authorities and
insurance rating agencies. As a result of operating losses, the statutory
surplus of the Company's insurance subsidiaries has declined from $270.8 million
at December 31, 1999, to $204.0 million at December 31, 2000. In addition,
increased public and regulatory concerns regarding the financial stability of
participants in the insurance industry have caused greater emphasis to be placed
by current and potential customers upon the ratings assigned to property and
casualty insurance companies. The Company's principal insurance subsidiaries
have been assigned an A.M. Best secure rating of ``B++'' (Very Good). However,
A.M. Best has placed this rating under review with negative implications.

  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,
                                                       ---------------------
<S>                                                    <C>         <C>
                                                             2000       1999
                                                             ----      -----
                                                       (dollars in millions)
      Statutory surplus  .............................      $204.0      270.8
      Net premiums written to surplus ratio  .........        2.2x       1.2x
</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 of $7.4 million and $2.2 million as of December 31, 2000 and 1999,
respectively. Additionally, the Company has retained $25.1 million and $25.6
million of ceded reserves related to potentially uncollectible reinsurance at
December 31, 2000 and 1999. 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, 2000, such collateral totaled
approximately $22.8 million. The Company's three largest reinsurance recoverable
exposures at December 31, 2000 were approximately $141.1 million with Lloyds of
London/Equitas, $84.1 million with American Reinsurance Company and $55.8
million with General Reinsurance Company. American Reinsurance Company and
General Reinsurance Company are rated by A. M. Best ``A+'' and ``A++'',
respectively.

                                       26


<PAGE>

Forward Looking Information

  The statements included in this Annual Report on Form 10-K for the fiscal year
end December 31, 2000, regarding future financial performance and results and
other statements that are not historical facts are forward-looking statements.
The words ``expect,'' ``project,'' ``estimate,'' ``predict,'' ``anticipate,''
``believes'' and similar expressions are also intended to identify forward-
looking statements. Such statements are subject to numerous risks, uncertainties
and assumptions, including but not limited to, the uncertainties relating to
industry and market conditions, natural disasters and other catastrophes, and
other risks and uncertainties described in this 2000 Annual Report and in the
Company's other filings with the Securities and Exchange Commission. Should one
or more of these risks or uncertainties materialize, or should underlying
assumptions prove incorrect, actual outcomes may vary materially from those
indicated.


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

Market Risk

  Market risk is the risk of lower securities and portfolio values resulting
from adverse changes in interest rates, foreign currency exchange rates and
other relevant market rate or price changes. The Company's investment strategy
is to maximize income and total return by investing in a diverse portfolio of
high-quality investment grade securities. The carrying value of the Company's
investment portfolio as of December 31, 2000 and 1999 was $810.5 million and
$792.2 million, respectively. The primary market risk to the investment
portfolio is interest rate risk associated with investments in fixed maturity
securities. The Company's exposure to equity price risk and foreign exchange
risk is not material. The Company has no direct commodity risk.

  The Company has exposure to market price declines resulting from increases in
interest rates. The Company attempts to mitigate its exposure to interest rate
risk through active portfolio management including limiting average portfolio
duration to approximately four and one-half years. Market prices for all
securities held are updated and reviewed monthly including estimates of cash
flows as well as the impact of interest rate fluctuations relating to the
Company's investment portfolio. For the Company's investment portfolio, there
were no significant changes in the Company's primary risk exposures or in how
those exposures are managed for 2000 compared to 1999. The Company does not
currently anticipate significant changes in its primary market risk exposures or
in how those exposures are managed in future reporting periods based upon what
is known or expected to be in effect in future reporting periods.

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

  The rates should not be considered a prediction by the Company of future
events. This analysis is not intended to provide a precise forecast of the
effect of changes in interest rates on the Company's income, cash flow and
stockholders' equity.

  The sensitivity analysis model used by the Company produces a loss in fair
value of market sensitive instruments of $37.8 million and $37.4 million based
on a 100 basis point increase in interest rates as of December 31, 2000 and
1999,

                                       27
<PAGE>

respectively. This loss value only reflects the impact of an interest rate
increase on the fair value of the Company's financial instruments, which
constitute approximately 45.9% of total assets and approximately 50.4% of total
liabilities as of December 31, 2000 and approximately 40.4% of total assets and
approximately 46.8% of total liabilities as of December 31, 1999. As a result,
the loss value excludes a significant portion of the Company's consolidated
balance sheet which would materially mitigate the impact of the loss in fair
value.

  In addition to the above, the Company's Credit Agreement is also subject to
interest rate fluctuations. An increase in interest rates of 100 basis points
(1%) would result in additional annual interest expense of $.5 million.


ITEM 8: Financial Statements and Supplemental Data.

  The Consolidated Financial Statements are set forth herein beginning on page
F-1 of this Report.


ITEM 9: Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure.

  None.

                                    PART III

ITEM 10: Directors and Executive Officers of the Registrant.

Board of Directors

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

<TABLE>
<CAPTION>
Class III Directors With Terms of Office Expiring at the 2001 Annual Meeting of Stockholders

           Name of Class III Directors              Age    Business Experience During Past Five Years and Other Information
-------------------------------------------------  ------  ----------------------------------------------------------------
<S>                                                <C>     <C>
Robert A. Spass (1)..............................      45  Deputy Chairman of the Board of Capital Z Management,
                                                           LLC and Capital Z Partners, Ltd., 1998 to present;
                                                           Managing Partner of Insurance Partners Advisors, L.P.,
                                                           1994 to present; President and Chief Executive Officer of
                                                           International Insurance Advisors, Inc., 1990-1994.  In
                                                           addition to holding directorships in non-public companies, Mr.
                                                           Spass is a director of Superior National Insurance Group,
                                                           Inc., Ceres Group, Inc., Aames Financial Corporation and
                                                           Universal American Financial Corporation. Mr. Spass is currently
                                                           a director of the Company.
Bradley E. Cooper (1)............................      34  Senior Vice President of Capital Z Management, LLC and
                                                           Capital Z Partners, Ltd., 1998 to present; Partner of
                                                           Insurance Partners Advisors, L.P., 1994 to present; Vice President of
                                                           International Insurance Advisors, Inc., 1990-1994. In addition to holding
                                                           directorships in non-public companies, Mr. Cooper is a director of
                                                           Superior National Insurance Group, Inc., Ceres Group, Inc. and Universal
                                                           American Financial Corporation. Mr. Cooper is currently a director of the
                                                           Company.
Rufus J. Williams, III...........................      53  Private investor, 1999 to present; Chairman of Montgomery &
                                                           Collins, 1998 to 1999; Director of Johnson & Higgins/Marsh &
                                                           McLennan, 1967 to 1997.  Mr. Williams is currently a director
                                                           of the Company, having been elected by the Board in July 2000
                                                           to fill the vacancy resulting from the resignation of Kenneth
                                                           Crews.
</TABLE>

                                       28
<PAGE>

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

<TABLE>
<CAPTION>
            Name of Class I Directors               Age    Business Experience During Past Five Years and Other Information
-------------------------------------------------  ------  ----------------------------------------------------------------
<S>                                                <C>     <C>
W. Bernard Pieper................................      68  Self-employed investor, 1996 to present; Vice Chairman of
                                                           Halliburton Co., 1992 to 1996; Mr. Pieper is a director of
                                                           NCI Building Systems, Inc. and OSCA, Inc.
Philip J. Hawk...................................      47  Chairman and Chief Executive Officer of Team, Inc., 1998
                                                           to present; President and Chief Executive Officer of
                                                           EOTT Energy Partners, L.P., 1993 to 1998.  Mr. Hawk is a
                                                           director of Team, Inc.
</TABLE>

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

<TABLE>
<CAPTION>
           Name of Class II Directors               Age    Business Experience During Past Five Years and Other Information
-------------------------------------------------  ------  ----------------------------------------------------------------
<S>                                                <C>     <C>
Willis T. King, Jr...............................      57  Chairman and Chief Executive Officer of the Company,
                                                           June 1, 1999 to present; Vice Chairman, Guy Carpenter
                                                           & Co., Inc., March 1997 to May 1999; Chairman
                                                           & Chief Executive Officer, Willcox Inc. Reinsurance,
                                                           March 1984 to March 1997. Mr. King is a director of SCPIE
                                                           Holdings, Inc.
Richard M. Haverland (1).........................      60  Retired, 1999 to present; Insurance Consultant, December 1994
                                                           to present; Chairman, President and Chief Executive Officer
                                                           of the Company, January 1996 to June 1, 1999.
Robert W. Shower.................................      63  Retired, 1996 to present; Executive Vice President and Chief
                                                           Financial Officer, Seagull Energy Corporation, 1994 to April
                                                           1996. Mr. Shower is a director of Lear Corporation, Edge
                                                           Petroleum Corporation and Nuevo Energy Company.
</TABLE>
________
(1) The Debentures obligate the Company to nominate, and recommend the election
    of, persons designated by a majority in interest of the holders of the
    Debentures so that the number of persons so designated will at all times
    constitute, if elected, at least 28% of the Board of Directors. Messrs.
    Haverland, Spass and Cooper were so elected to the Board of Directors of the
    Company.

Executive Officers

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

<TABLE>
<CAPTION>
          Name              Age      Title and Business Experience During Past Five Years
-------------------------  -----  ----------------------------------------------------------
<S>                        <C>    <C>
Willis T. King, Jr.......     57  Chairman, President (until May 2000) and Chief Executive
                                  Officer of the Company, June 1, 1999 to Present; see also
                                  ``Election of Directors--Names of Class II Directors'' for
                                  additional information regarding his business experience.
John W. Cowley...........     54  President and Chief Operating Officer of the Company and
                                  its subsidiaries, May 2000 to present;  Executive Vice
                                  President, Operations of the subsidiaries of the Company,
                                  January 2000 to April 2000; President, Residual Market
                                  Division, National Council on Compensation Insurance,
                                  Inc., January 1999 to January 2000; Owner/Insurance
                                  Consultant, Cowley & Associates, Inc., July 1998 to
                                  present; Vice President, Guy Carpenter & Company,
                                  April 1994 to July 1998.
Charles J. Bachand.......     48  Vice President and Treasurer of the Company, November
                                  1993 to present; Senior Vice President and Chief
                                  Financial Officer of the Subsidiaries of the Company,
                                  November 1993 to present.
</TABLE>

                                       29
<PAGE>

<TABLE>
<CAPTION>
<S>                        <C>    <C>
Stephen L. Kibblehouse        45  Vice President, General Counsel and Secretary of the
                                  Company, May 2000 to present; Senior Vice President,
                                  General Counsel and Secretary of the subsidiaries of the
                                  Company, May 2000 to present; Senior Vice President,
                                  Assistant General Counsel and Assistant Secretary of the
                                  subsidiaries of the Company, May 1997 to April 2000;
                                  Senior Vice President, Assistant General Counsel and
                                  Assistant Secretary of American Reliance, Inc. (formerly
                                  Vik Brothers Insurance, Inc.), June 1995 to April 2000.
Stephen J. Greenberg.....     59  Vice President and Secretary of the Company, May 1997
                                  to April 2000 (Mr. Greenberg retired from the Company on
                                  April 30, 2000); Executive Vice President and General
                                  Counsel of the subsidiaries of the Company, May 1997 to
                                  April 2000; Executive Vice President, General Counsel
                                  and Assistant Secretary of American Reliance, Inc.
                                  (formerly Vik Brothers Insurance, Inc.), January 1993 to
                                  April 1997.
</TABLE>



Section 16(a) Beneficial Ownership Reporting Compliance

  Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our
directors and executive officers, and persons who own more than 10% of a
registered class of our equity securities, to file with the Securities and
Exchange Commission reports of ownership and reports of changes in ownership of
our common stock and other equity securities of the Company. The Company
believes that all such reports required to be filed during 2000 were timely
filed.

ITEM 11: Executive Compensation.

  Summary Compensation Table. The following table sets forth information
concerning compensation for services in all capacities to the Company and its
subsidiaries during each of the last three years of those persons who were the
Company's Chief Executive Officer and its other executive officers during 2000
(collectively, the ``named executive officers''):

                           Summary Compensation Table

<TABLE>
<CAPTION>
                                                                                                      Long-Term
                                                                                  --------------------------------------------------
                                                   Annual Compensation                               Compensation
                                         ---------------------------------------  --------------------------------------------------
                                                                                    Restricted     Securities
                                                                                  --------------  -------------       All Other
                                                                  Other Annual        Stock        Underlying    ------------------
                                                                 ---------------  --------------  -------------     Compensation
  Name and Principal Position     Years  Salary ($)  Bonus ($)    Compensation      Award ($)      Options (#)          ($)(1)
--------------------------------  -----  ----------  ----------  ---------------  --------------  ------------- -------------------
<S>                               <C>    <C>         <C>         <C>              <C>             <C>            <C>
Willis T. King, Jr.                2000   $455,230    $210,000             --              --        120,000             $ 5,100
 Director, Chairman and Chief      1999   $254,692    $210,000             --      $2,750,000(2)     150,000                  --
 Executive Officer of the
  Company

John W. Cowley                     2000   $282,212          --       $116,506(3)           --         60,000             $ 4,875
 President and Chief Operating
 Officer of the Company

Charles J. Bachand                 2000   $240,615          --       $    663(3)           --             --             $ 5,100
 Vice President and Treasurer      1999   $188,500          --       $ 85,436(3)           --          6,000             $ 3,360
 of the Company                    1998   $182,500    $ 10,000             --              --             --             $14,325

Stephen L. Kibblehouse             2000   $199,707    $  6,500             --              --          7,500             $ 5,100
 Vice President, General Counsel
 and Secretary of the Company

Stephen J. Greenberg(5)            2000   $119,620          --             --              --             --             $ 4,151
 Vice President and Secretary      1999   $300,000          --             --      $   85,608(2)      24,000(4)          $ 5,000
 of the Company                    1998   $300,000    $  5,000             --              --             --             $11,400
</TABLE>

                                       30
<PAGE>

----------------
(1) The amounts shown for Messrs. King, Cowley, Bachand, Greenberg and
    Kibblehouse are matching and profit sharing contributions under 401(k) plan.
(2) Represents the market price of shares issued under the Restricted Stock Plan
    at time of issuance, see ``Restricted Stock Plan.'' The Restricted Stock
    award to Mr. Greenberg in 1999 was in exchange for the Restricted Shares
    issued to them in 1997. The value of Mr. King's 250,000 Restricted Shares at
    December 31, 2000 was $2,250,000; and the value of Mr. Greenberg's 6,461
    Restricted Shares at December 31, 2000 was $58,149.
(3) Amounts paid to Messrs. Cowley and Bachand represent reimbursement of
    relocation expenses.
(4) Represents options to purchase 22,500 shares of Common Stock issued in
    exchange for options to purchase 30,000 shares, pursuant to an exchange
    offer conducted in 1999, and options to purchase an additional 1,500 shares
    issued in 1999.
(5)  Mr. Greenberg retired from the Company on April 30, 2000.

  Stock Option Grants in the Last Fiscal Year. The following table sets forth
certain information with respect to stock options to purchase shares of the
Company's Common Stock that were granted to each of the named executive officers
during the fiscal year ended December 31, 2000.


                       Option Grants in Last Fiscal Year

<TABLE>
<CAPTION>
                                                                           Potential Realizable Value
                                                                           --------------------------
                                                                               of Assumed Annual
                                                                           --------------------------
                                                                            Appreciation for Option
                                                                           --------------------------
                            Individual Grants                                      Term(2)
-------------------------------------------------------------------------  --------------------------
         (a)                (b)           (c)         (d)         (e)          (f)          (g)
                                      % of Total
                       Number of      ----------
                       ----------      Options
                       Securities     ----------   Exercise
                       ----------     Granted to   --------
                       Underlying     ----------   or Base
                       ----------     Employees    --------
                        Options       ----------    Price    Expiration
                       ----------     in Fiscal    --------  ----------
         Name          Granted(1)        Year      ($/Sh.)      Date          5% ($)      10% ($)
---------------------  ----------     ----------   --------  ----------    ----------   -----------
<S>                    <C>            <C>          <C>        <C>          <C>          <C>
Willis T. King, Jr...     120,000           39.7       8.13       5/9/10      613,550     1,554,885
John W. Cowley.......      50,000           16.6       8.13      2/28/10      295,646       647,857
                           10,000            3.3       8.13       5/9/10       51,129       129,571
Stephen L.
 Kibblehouse.........       7,500            2.5       8.13       5/9/10       38,347        97,178

</TABLE>

(1) These options were granted at an exercise price equal to the per share
    market value of the Common Stock on the grant date. The options become
    exercisable 33percent each year beginning one year after the date of grant.
(2) The potential realizable value is calculated based on the term of the option
    (ten years) at its date of grant. It is calculated by assuming that the
    stock price on the date of grant appreciates at the indicated annual rate
    compounded annually for the entire term of the option; however, the optionee
    will not actually realize any benefit from the option unless the market
    value of the Company's Common Stock in fact increases over the option price.

  Option Exercises and Year-End Option Holdings. The following table summarizes
the number and value of the unexercised options to purchase Common Stock held by
the named executive officers at December 31, 2000. None of the named executive
officers exercised options during 2000.

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

<TABLE>
<CAPTION>
                                                          Number of Shares of
                                                      ---------------------------
                                                             Common Stock            Value of Unexercised In-
                                                      ---------------------------  ----------------------------
                                                        Underlying Unexercised      The-Money Options Held at
                                                      ---------------------------  ----------------------------
                                                            Options Held at             December 31, 2000
                                                      ---------------------------  ----------------------------
                                                           December 31, 2000
                                                      ---------------------------
                        Name                          Exercisable   Unexercisable   Exercisable   Unexercisable
----------------------------------------------------  ------------  -------------  -------------  -------------
<S>                                                   <C>           <C>            <C>            <C>
Willis T. King, Jr.                                         49,500        220,500             $0       $104,400
John W. Cowley                                                   0         60,000             $0         52,300
Charles J. Bachand                                          22,000          4,000             $0              0
Stephen L. Kibblehouse                                       1,441         17,059             $0          6,525
Stephen J. Greenberg                                           664         23,336             $0              0
</TABLE>

                                       31
<PAGE>

Compensation of Directors

  Directors who are employees of the Company are not paid any fees or additional
compensation for service as members of the Board or any committee thereof.
Directors who are not employees of the Company (``Non-Employee Directors''),
other than Messrs. Spass, Haverland and Cooper, receive a retainer fee of
$10,000, payable annually, as well as a fee of $1,000 per day for attendance at
meetings of the Board and any committee meetings held on the same day as a Board
meeting and a fee of $750 per day for attendance at committee meetings not held
on the same day as a Board meeting. In addition, all Directors are reimbursed
for reasonable out-of-pocket expenses incurred in connection with traveling to
any Board or committee meeting. Pursuant to an agreement described below,
Insurance Partners designated directors do not receive compensation as Directors
in the form of cash or stock and, accordingly, although they are not employees
of the Company, the term Non-Employee Directors defined above is deemed not to
include them. Each Non-Employee Director of the Company as of January 1996 was
granted an option to purchase 10,000 shares of Common Stock under the 1995
Directors' Stock Plan (the ``Directors Plan''). Moreover, under the Directors
Plan, commencing with the first annual meeting of the Board of Directors of the
Company after January 1996, and at each annual meeting thereafter, each Non-
Employee Director is automatically granted shares of Common Stock having a fair
market value at the time of grant of $10,000.

  During 2000, the Company conducted a survey of director compensation.  The
results of the survey indicated that the Company's compensation of its Non-
Employee Directors (which had not been adjusted since 1996) was below average
for public companies of similar size.  At its October 31, 2000 meeting, the
Board voted to increase the compensation of directors to the following amounts:
$10,000 retainer fee; $12,500 common stock award; $1,100 per day Board meeting
fee and $800 per day committee meeting fee (if not on same day as a Board
meeting); and reimbursement of reasonable out-of-pocket expenses incurred in
connection with traveling to any Board or committee meeting.

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

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

  Pursuant to the Directors Plan, Mr. King was issued an option to purchase
150,000 shares of Common Stock during 1999. The exercise price of Mr. King's
Options is $11.00 per share. Except for Options granted to Mr. Haverland in
1996, Options granted under the Directors Plan vest and become exercisable as to
33 1/3%, 66 2/3% and 100% of the shares of Common Stock subject thereto on each
of the first, second and third anniversaries of the option grant. Options
granted under the Directors Plan to Mr. Haverland vested and became exercisable
as to 25%, 50%, 75% and 100% of the shares of Common Stock subject thereto on
each of the first, second, third and fourth anniversaries, respectively, of the
Option grant. Each Option is evidenced by a stock option agreement which may
contain such terms and conditions as may be determined by the Committee and are
not inconsistent with the Directors Plan. The term of an Option is ten years
from the date of grant. During a Director's lifetime, an Option granted pursuant
to the Directors Plan will be exercisable only by the Director. The Option will
not be transferable by a Director other than by will or the laws of descent and
distribution. Messrs. Hawk, Pieper and Shower were each issued 1,230 shares of
Common Stock and Mr. Williams was issued 1,143 shares of Common Stock under the
Directors Plan in 2000.

Employment Contracts and Retention Agreements

  Employment Contracts. During 1999, the Company entered into an Employment
Agreement with Willis T. King, Jr., under which Mr. King became and serves as
Chairman and Chief Executive Officer of the Company.  The period of Mr. King's
employment will end pursuant to the Employment Agreement, as amended, no earlier
than June 1, 2003, unless his employment is terminated prior to such date
pursuant to the terms of his Employment Agreement.  Under the terms of the
Employment Agreement, as amended, Mr. King is paid an annual salary which is
$480,000 for 2001, and an annual bonus of up to 150% of annual salary but no
less than $210,000 for 1999 and 2000, to be determined by the Board of Directors
of the

                                       32
<PAGE>

Company. The Company also granted Mr. King options to purchase 150,000 shares of
Common Stock at an exercise price of $11.00 per share, which was the closing
price of the Common Stock on the New York Stock Exchange on the date of the
Employment Agreement. Mr. King purchased $5 million of Common Stock of the
Company at a price of $11.00 per share. Mr. King also received 250,000 shares of
Restricted Shares under the Restricted Stock Plan, with a base price of $11.00
per share.

  In 2000, the Company entered into an Employment Agreement with John W. Cowley,
under which Mr. Cowley became and serves as President and Chief Operating
Officer of the Company. The period of Mr. Cowley's employment will end pursuant
to the Employment Agreement, as amended, no earlier than January 1, 2004, unless
his employment is terminated prior to such date pursuant to the terms of his
Employment Agreement. Under the terms of the Employment Agreement, Mr. Cowley is
paid an annual salary which is $350,000 for 2001, and an annual bonus of up to
75% of annual salary based on the performance of the Company as measured by the
achievement of specified performance objectives determined by the Chief
Executive Officer of the Company in his sole discretion. The Company also
granted Mr. Cowley options to purchase 50,000 shares of Common Stock at an
exercise price of $8.13 per share, which was the closing price of the Common
Stock on the New York Stock Exchange on the date the options were issued.

In 1996, the Company entered into a three-year Employment Agreement with Richard
M. Haverland, an investor in and consultant to IP, under which Mr. Haverland
served as Chairman and Chief Executive Officer of the Company. Under the terms
of the Employment Agreement, Mr. Haverland was paid an annual salary of
$525,000, and for 1996 and 1997, an annual bonus of no less than $250,000, to be
determined by the Board of Directors of the Company. Pursuant to the Employment
Agreement, the Company granted Mr. Haverland options to purchase 300,000 shares
of Common Stock at an exercise price of $14.69 per share. Pursuant to the
Employment Agreement, the Company sold to Mr. Haverland (i) $2,100,000 in
principal amount of the Company's 10% Convertible Subordinated Debentures due
December 31, 2005, together with Series A and Series B Common Stock Warrants and
(ii) Management Debentures, together with Common Stock Subscription Warrants,
Series A-2 and Common Stock Subscription Warrants, Series B-2 in exchange for a
promissory note in the principal amount of $2,100,000. Such promissory note is
without personal recourse and is secured by a pledge of the Management
Securities purchased thereby. See Item 13: ``Certain Relationships and Related
Transactions.''

  Retention Agreements. In 2001, the Board of Directors, with the recommendation
of the Special Committee, approved the Company's offer of Retention Agreements
to the Company's executive officers and certain key employees (each an
``Executive''). The purpose of the Retention Agreements is to provide an
incentive to Executives to continue to manage the business of the Company and
represent and protect the interests of the Company's shareholders during and in
connection with the Company's exploration of the possibility of engaging in a
Transaction. The Company has entered into Retention Agreements with Messrs.
King, Cowley, Bachand and Kibblehouse, among others.  Under the terms of the
Retention Agreements, each Executive will be paid on each of September 30, 2001,
March 31, 2002, the closing date of a qualifying Transaction and the date 180
days after the closing date of a qualifying Transaction an amount equal to 25%
of a multiple of the sum of their 2001 base annual compensation and the average
of their annual cash bonuses paid in 1999 and 2000 (the ``Base Amount''),
provided the Executive is employed by the Company on the payment date.  The
employment condition does not apply to the payment due 180 days after the
closing date of a qualifying Transaction if the Executive is discharged (other
than for cause) or resigns for good reason after the closing date of a
qualifying Transaction.  If the Executive is discharged (other than for cause)
or resigns for good reason after the Company enters an agreement, or announces
an intention, to participate in a qualifying Transaction, the Company is
required to pay the Executive all payments provided for in the Retention
Agreement.  The payments due on September 30, 2001 and March 31, 2002 will be
accelerated to the closing date of a qualifying Transaction if the closing date
occurs before such payment dates.  In addition, if the Executive is discharged
(other than for cause) or resigns for good reason within 180 days after the
Company closes a qualifying Transaction or enters an agreement, or announces an
intention, to participate in a qualifying Transaction, the Company is required
to continue for a number of years equal to the Executive's Retention Agreement
multiple the Executive's life, medical, dental, health, accident and disability
insurance and other benefits, including retirement plan benefits, vest
Executive's interest under all of the Company's long-term incentive plans and
options to purchase the Company's Common Stock and Restricted Shares, and remove
any restrictions on Restricted Shares.  The Base Amount and multiple under the
Retention Agreement offered to Willis T. King, Jr. are $585,000 and 2.5
respectively, under the Retention Agreement offered to John W. Cowley are
$350,000 and 1.9 respectively, under the Retention Agreement offered to Charles
J. Bachand are $269,002 and 1.9 respectively, and under the Retention Agreement
offered to Stephen L. Kibblehouse are $225,878 and 1.9 respectively.

  Restricted Stock Plan. In 1997, the Company adopted the 1997 Restricted Stock
Plan (the ``Restricted Stock Plan''), which authorized grants of up to 100,000
shares of restricted Common Stock (the ``Restricted Shares'') to officers of the
Company's subsidiaries selected by the Compensation Committee. In 1999, the
Restricted Stock Plan was amended (i) to

                                       33
<PAGE>

permit participants to have a one-time opportunity to exchange restricted stock
for new restricted stock equal to 75% of the number of shares surrendered for
exchange and (ii) to allow for the issuance of an additional 250,000 shares. In
order to be issued Restricted Shares, a grantee must purchase an equal number of
shares of Common Stock at market price (``Qualifying Shares''). Restricted
Shares vest five years after the date of grant, provided the following
conditions are satisfied: (i) the grantee remains employed by the Company or one
of its subsidiaries until at least three years from the date of grant; (ii) the
grantee does not resign from the Company and its subsidiaries, and is not
terminated for cause, before the vesting date; and (iii) the market price of the
Common Stock on the vesting date is at least 40% greater than on the date of
grant. If the market price has increased at least 40% but less than 50%, 25% of
the Restricted Shares vest, if the increase is at least 50% but less than 61%,
50% vest, and if the market price increases at least 61%, 100% vest. In 1997,
Mr. Greenberg was issued 8,615 Restricted Shares at a base price of $23.22. In
1999, Mr. Greenberg exchanged 8,615 Restricted Shares for 6,461 Restricted
Shares pursuant to the exchange offer described above with a vesting base price
of $13.25 per share. Pursuant to his employment agreement, Mr. King purchased
250,000 Qualifying Shares at $11.00 per share and was issued 250,000 Restricted
Shares in 1999.

  Employees' Retirement and Savings Plan. The Company makes annual contributions
to the Highlands Insurance Group Employees' Retirement and Savings Plan (the
``Retirement Plan'') for the benefit of qualified employees. The amount of each
year's contribution, if any, is determined by the Board of Directors of the
Company in its discretion. Before-tax contributions up to 6% of compensation are
matched by the Company at a 50% rate under the Retirement Plan. Matching
contributions by the Company to executive officers under the Retirement Plan for
2000, 1999 and 1998 are set forth in the Summary Compensation Table. It is not
possible to estimate the amount of benefits payable at retirement under the
Retirement Plan to Messrs. King, Cowley, Bachand, Kibblehouse and Greenberg
because of some or all of the following: (i) amounts contributed in the future
will be contingent on future discretionary contributions by the Company as well
as contribution levels of the participant; (ii) earnings on trust fund assets
will vary; (iii) trust fund assets may appreciate or depreciate in value; (iv)
the compensation of the individual may vary; (v) age at date of retirement may
vary; and (vi) the Retirement Plan may be changed or discontinued.

Compensation Committee Interlocks and Insider Participation in Compensation
Decisions

  The Compensation Committee consists of Messrs. Hawk, Pieper, Williams and
Spass (Chairman).  No member of the committee was an officer or employee of the
Company or any of its subsidiaries during fiscal year 2000, nor was any member
formerly an officer of the Company or any of its subsidiaries.

Compensation Committee Report on Executive Compensation

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

  The goals of the compensation program are to align compensation with business
objectives and performance, and to enable the Company to attract, retain and
reward executive officers whose contributions are critical to the long-term
success of the Company. The Company's compensation program for executive
officers is based on the same two principles applicable to compensation
decisions for all employees of the Company.

  .  The Company pays competitively.
  .  The Company pays for sustained performance.

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

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

                                       34
<PAGE>

  Compensation Vehicles. The Company's compensation program consists of cash and
equity based compensation. The Company believes that having such a compensation
program allows the Company to attract and retain key employees, which in turn
permits the Company to provide useful products and services to customers,
enhance stockholder value, motivate technological innovation, foster teamwork
and adequately reward employees.  The Company's principal compensation vehicles
are as follows:

  Cash-based Compensation-Salary and Bonus. The Company establishes salary
ranges for employees by reviewing the aggregate of base salary and annual bonus
for competitive positions in the market. The Company performs an assessment of
individual positions in an effort to identify appropriate market salary ranges
for all positions. Ranges for officer positions are established based on
competitive market data. These ranges allow an officer to be placed above or
below the midpoint according to that officer's overall performance. As described
above, overall individual performance is measured against the achievement of
specific goals, including profitability goals for those individuals controlling
key profit centers.

  Equity-based Compensation Stock Option Program. The purpose of this program is
to provide additional incentives to employees to work to maximize stockholder
value. The Company also recognizes that a stock incentive program is a necessary
element of a competitive compensation package for its employees. The program
utilizes vesting periods to encourage key employees to continue in the employ of
the Company and thereby acts as a retention device for key employees. The
Company believes that the program encourages employees to maintain a long-term
perspective. The Company grants stock options to a broad-based group. As of
March 30, 2001, almost all Company employees had been granted options.

  In determining the size of an option award for an executive officer, the
Compensation Committee's primary considerations are the ``grant value'' of the
award and the expected or actual performance of the officer measured against the
same performance criteria described above under ``Cash-based Compensation''
which is used to determine salary and bonus. In addition to considering the
grant value and the officer's performance, the Compensation Committee also
considers the number of outstanding unvested options which the officer holds and
the size of previous option awards to that officer. The Compensation Committee
does not assign specific weights to these items.

  On February 22, 1999, the Stock Option Plan was amended so that each employee
was given the one-time opportunity to exchange his or her stock options for
Performance-Based Stock Options exercisable for 75% of the number of shares
covered by the options surrendered for exchange. The Performance-Based Stock
Options will fully vest three years after issuance, with intermediate vesting
subject to the Company's meeting certain combined ratio goals. The exercise
price of Performance-Based Stock Options was 100% of the fair market value of
the Company's Common Stock on the date the options were issued. The Committee
amended the Plan to allow for the exchange because it believed that the options
of many employees prior to the exchange did not provide meaningful incentives.

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

  Other Considerations

  Certain Limitations on Deductibility of Executive Compensation. Section 162(m)
of the Internal Revenue Code, enacted in 1993, generally disallows a tax
deduction to public companies for compensation over $1 million paid to the
Company's Chief Executive Officer or any of the four other most highly
compensated executive officers. Certain performance-based compensation, however,
is specifically exempt for the deduction limit. The Company does not have a
policy that requires or encourages the Compensation Committee to qualify stock
options or restricted stock awarded to executive officers for deductibility
under Section 162(m) of the Internal Revenue Code (the ``Code'').

  CEO Compensation.   Willis T. King has been Chief Executive Officer and
Chairman of the Company since June 1, 1999. The Compensation Committee used the
same compensation policy described above for all employees to determine Mr.
King's 2000 compensation. In setting both the cash-based and the equity based
elements of Mr. King's overall compensation, the Compensation Committee made an
overall assessment of Mr. King's ability to lead the Company in reaching its
long-term strategic and business goals.

                                    COMPENSATION COMMITTEE


                                    Robert A. Spass (Chairman)
                                    Phillip J. Hawk
                                    W. Bernard Pieper
                                    Rufus J. Williams, III

                                       35
<PAGE>

                                Performance Graph

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

     Set forth below is a line graph comparing cumulative stockholder return
from January 12, 1996 to December 31, 2000 on the Common Stock, based on the
market price of the Common Stock, with the cumulative total return on the
Standard & Poor's 500 Stock Index and the Standard & Poor's Insurance
(Property-Casualty) Index:

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



                                  January 12,           December 31,
                                             -----------------------------------
                                     1996*   1996     1997    1998   1999   2000
                                   --------  ----     ----    ----   ----   ----
Highlands Insurance Group, Inc.....   100     96      134      62     45     43
                                      ---
S&P 500............................   100    123      164     211    255    132
                                      ---
S&P Insurance (Property-Casualty)..   100    122      177     164    123    191
                                      ---
_________

*  Total assumes $100 invested on January 12, 1996 in Common Stock, the Standard
   & Poor's 500 Index and the Standard & Poor's Insurance (Property-Casualty)
   Index, including reinvestment of dividends with respect to the two indices.
   The Company has not paid dividends on common stock since January 1996.

                                       36
<PAGE>

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

     The following table sets forth information with respect to persons or
groups who, to the Company's knowledge, beneficially own, or have the right to
acquire within 60 days of March 30, 2001, more than five percent of the Common
Stock:

<TABLE>
<CAPTION>

                                                         Amount and
                                                         Nature of
                                                         Beneficial       Percent of
Name and Address of Beneficial Owner                    Ownership(1)(2)   Class(1)(2)
------------------------------------                    --------------- --------------
<S>                                                     <C>             <C>

Insurance Partners, L.P. (3)........................       4,568,759(4)       25.6%
   201 Main Street
   Fort Worth, TX 76102
Insurance Partners Offshore (Bermuda), L.P. (5).....       2,518,009(6)       16.0%
   Cedar House
   41 Cedar Avenue
   P.O. Box HM1179
   Hamilton, Bermuda
Waveland Partners (7)...............................       1,353,700          10.2%
   227 West Monroe, Suite 4800
   Chicago, IL 60606
FMR Corp. (8).......................................       1,343,390          10.1%
   82 Devonshire Street
   Boston, MA 02109
Dimensional Fund Advisors Inc. (9)..................         941,510           7.1%
   1299 Ocean Avenue, 11th Floor
   Santa Monica, CA 90401
Willis T. King, Jr. (10) ...........................         926,774           6.9%
    1000 Lenox Drive
    Lawrenceville, NJ 08648
Richard M. Haverland (11) ..........................         825,285           5.9%
   160 Coquille Way
   Vero Beach, FL  32963
Royce & Associates, Inc. (12) ......................         818,600           6.2%
    1414 Avenue of the Americas
    New York, NY 10019
Clayton Management Company (13) ....................         800,000           6.0%
    John D. Weil
    200 N. Broadway, Suite 825
    St. Louis, MO  6310
David L. Babson & Co. Inc. (14).....................         791,200           6.0%
   One Memorial Drive
    Cambridge, MA 02142
Blavin & Company, Inc. (15).........................         693,161           5.2%
   8800 North Gainey Center Drive, Suite 260
   Scottsdale, AZ 85258
</TABLE>
---------------------------
(1)    Calculated pursuant to Rule 13d-3(d) of the Exchange Act. Unless
       otherwise stated below, each such person has sole voting and investment
       power with respect to all such shares.
(2)    Based on 13,248,879 shares of Common Stock outstanding at the close of
       business on March 30, 2001.
(3)    The general partner of Insurance Partners, L.P. is Insurance GenPar L.P.,
       a Delaware limited partnership; the general partner of the latter is
       Insurance GenPar MGP, L.P., a Delaware limited partnership; and the
       general partner of the latter is Insurance GenPar MGP, Inc., a Delaware
       corporation. Robert A. Spass (a director of the Company) owns 40% of the
       voting stock of Insurance GenPar MGP, Inc., and Steven Gruber and Daniel
       Doctoroff each owns 30% of such voting stock.

                                       37
<PAGE>

(4)    Represents the number of shares of Common Stock issuable upon conversion
       of the Company's 10% Convertible Subordinated Debentures due December 31,
       2005 (the "Debentures") and exercise of the Company's Common Stock
       Subscription Warrants, Series A (the "Series A Warrants") owned of record
       by Insurance Partners, L.P.
(5)    The general partner of Insurance Partners Offshore (Bermuda), L.P.
       ("IP Bermuda") is Insurance GenPar (Bermuda), L.P., a Bermuda limited
       partnership; the general partner of the latter is Insurance GenPar
       (Bermuda) MGP, L.P.; and the general partner of the latter is Insurance
       GenPar (Bermuda) MGP, Ltd., a Bermuda corporation. Robert A. Spass
       (a director of the Company) owns 40% of the voting stock of Insurance
       GenPar (Bermuda) MGP, Ltd., and Steven Gruber and Daniel Doctoroff each
       owns 30% of such voting stock.
(6)    Represents the number of shares of Common Stock issuable upon conversion
       of the Debentures and exercise of the Series A Warrants owned of record
       by IP Bermuda. Shares acquirable by IP Bermuda upon conversion or
       exercise of Debentures or Series A Warrants will be Series B Common
       Stock, which have reduced voting rights until such shares are transferred
       by IP Bermuda or the occurrence of certain events.
(7)    Represents  shared  beneficial  ownership by the following related
       entities:  Waveland  International,  Ltd., a Cayman Island exempted
       company,  Waveland  Partners L.P., an Illinois  limited  partnership,
       Waveland  Capital Management,  L.P., an Illinois limited  partnership,
       Clincher  Capital  Corporation,  an Illinois  corporation, Waveland
       Capital  Management,  LLC, an Illinois limited liability company and
       Waveland Partners,  Ltd., a Cayman Islands exempted company.
(8)    Fidelity Management & Research Company ("Fidelity"), a wholly-owned
       subsidiary of FMR Corp. and an investment advisor is the beneficial owner
       of 1,329,060 shares or 9.726% of the Common Stock outstanding of the
       Company as a result of acting as investment adviser to various investment
       companies (the "Fidelity Funds"). The ownership of one investment
       company, Fidelity Equity-Income Fund, amounted to 787,590 shares or
       5.763% of the Common Stock outstanding. Edward C. Johnson 3d, FMR Corp.,
       through its control of Fidelity and the funds each has sole power to
       dispose of the 1,329,060 shares owned by the Fidelity Funds. Neither FMR
       Corp. nor Edward C. Johnson 3d, Chairman of FMR Corp., has the sole power
       to vote or direct the voting of the shares owned directly by the Fidelity
       Funds, which power resides with the Fidelity Funds' Boards of Trustees.
       Fidelity carries out the voting of the shares under written guidelines
       established by the Fidelity Funds' Boards of Trustees. Fidelity
       Management Trust Company, a wholly-owned subsidiary of FMR Corp., is the
       beneficial owner of 14,330 shares or 0.104% of the Common Stock
       outstanding of the Company as a result of its serving as investment
       manager of the institutional account(s). Edward C. Johnson 3d and FMR
       Corp., through its control of Fidelity Management Trust Company, each has
       sole dispositive power over 14,330 shares and sole power to vote or to
       direct the voting of 14,330 shares. Strategic Advisers, Inc., a
       wholly-owned subsidiary of FMR Corp. and an investment adviser, provides
       investment advisory services to individuals. It does not have sole power
       to vote or direct the voting of shares of certain securities held for
       clients and has sole dispositive power over such securities. As such, FMR
       Corp.'s beneficial ownership may include shares beneficially owned
       through Strategic Advisers, Inc.
(9)    Dimensional Fund Advisors, Inc., an investment advisor registered under
       Section 203 of the Investment Advisors Act of 1940, furnishes investment
       advice to four investment companies registered under the Investment
       Company Act of 1940, and serves as investment manager to certain other
       commingled group trusts and separate accounts. In its role as investment
       adviser or manager, Dimensional possesses voting and/or investment power
       over the securities of the Company that are owned by such funds. All
       securities are owned by such funds. Dimensional Fund Advisors Inc.
       disclaims beneficial ownership of such securities.
(10)   Mr. King is the Chairman and Chief Executive Officer of the Company and
       its subsidiaries. The shares beneficially owned were acquired as follows:
       534,546 shares privately purchased; 250,000 shares granted pursuant to
       the Company's 1997 Restricted Stock Plan; 140,000 shares issuable
       pursuant to stock options; and 2,228 shares acquired through
       participation in the Company's 401(k) Plan.
(11)   Mr. Haverland is a Director of the Company. The shares beneficially owned
       were acquired as follows: 259,003 issuable pursuant to warrants; 254,712
       shares issuable pursuant to the Debentures; 300,000 shares issuable
       pursuant to stock options; and 12,570 shares acquired through the
       Employee Stock Purchase Plan.
(12)   Royce & Associates, Inc. ("Royce") and Royce Management Company ("RMC")
       are investment advisors registered under Section 203 of the Investment
       Advisors Act of 1940. Royce is the beneficial owner of 814,800 shares of
       the Common Stock outstanding of the Company; RMC beneficially owns 3,800
       shares of the Common Stock outstanding of the Company. Charles M. Royce
       may be deemed to be a controlling person of Royce and RMC, and, as such,
       may be deemed to beneficially own the shares of Common Stock of the
       Company beneficially owned by Royce and RMC. Mr. Royce does not own any
       shares of Common Stock of the Company outside of Royce and RMC, and
       disclaims all beneficial ownership of the shares held by Royce and RMC.

                                       38
<PAGE>

(13)   Based on a Schedule 13G filed on February 16, 2001, these shares are held
       as follows: 760,000 shares held by Woodbourne Partners, L.P.
       ("Woodbourne"), a Missouri Limited Partnership; 40,000 shares held by
       Forsyth Joint Venture ("Forsyth"), a joint venture among three charitable
       foundations governed under Missouri Law. Clayton Management Company
       ("Clayton") is the general partner of Woodbourne and the manager of
       Forsyth and has authority to vote, direct the vote, dispose or direct the
       disposition of shares held by Woodbourne and Forsyth. John D. Weil
       ("Weil") is the sole director and sole shareholder of Clayton. Weil and
       certain of his family members are the Trustees of the charitable
       foundations that formed Forsyth. As such, Weil has authority to vote,
       direct the vote, dispose or direct the disposition of shares held by
       Woodbourne and Forsyth.
(14)   David L. Babson & Co., Inc. ( "DLB "), in its capacity as investment
       adviser, may be deemed the beneficial owner of 791,200 shares of Common
       Stock of the Company which are owned by several investment clients.
(15)   Shares reported are beneficially owned by investment adviser Blavin &
       Company,  Inc.  ( "BCI "),  Paul W. Blavin as principal, and four
       institutional clients for which BCI acts as investment advisor.

     The following table sets forth information with respect to the numbers of
shares of Common Stock that the following persons beneficially own, or have the
right to acquire within 60 days of March 30, 2001: (i) each director of the
Company, (ii) each executive officer of the Company named in the table entitled
"Summary Compensation Table" and (iii) all executive officers and directors of
the Company as a group at March 30, 2001:

<TABLE>
<CAPTION>

                                                                       Amount and
                                                                       Nature of
                                                                       Beneficial      Percent of
Name                                                                   Ownership(1)      Class(1)
----                                                                 --------------    -----------
<S>                                                                   <C>                <C>

Willis T. King, Jr.............................................        926,774(2)(6)          6.9%
Richard M. Haverland...........................................        825,285(3)(5)          5.9%
Robert A. Spass................................................            ---(4)               *
Bradley E. Cooper..............................................          3,000(4)               *
W. Bernard Pieper..............................................         19,586                  *
Kenneth S. Crews...............................................         12,326                  *
Philip J. Hawk.................................................         14,056                  *
Robert W. Shower...............................................         13,556                  *
Rufus J. Williams, III.........................................          6,143                  *
Charles J. Bachand.............................................         72,590(3)(5)(6)         *
John W. Cowley.................................................         28,531(5)(6)            *
Stephen J. Greenberg...........................................         15,576(2)(5)            *
Stephen L. Kibblehouse.........................................          6,036(2)(5)(6)         *
All Directors and executive officers as a group (13 persons)...      1,943,459(2)(3)(5)(6)   13.5%
---------
* Less than 1%.
</TABLE>


(1) Based on 13,248,879 shares of Common Stock outstanding at the close of
    business on March 30, 2001.
(2) Includes 250,000 shares issued to Mr. King, 6,461 shares issued to Mr.
    Greenberg and 641 shares issued to Mr. Kibblehouse under the 1997 Restricted
    Stock Plan. See "Executive Officers--Executive Compensation."
(3) Includes the following  numbers of shares of Common Stock  issuable upon
    exercise of the Series A Warrants and the Company's Common Stock
    Subscription Warrants, Series A-2 Warrants and conversion of the Debentures
    and the Company's 10% Convertible Subordinated Debentures due December 31,
    2005, Series 2, respectively, held by: Richard M. Haverland--126,343,
    132,660, 123,762 and 129,950 shares; and Charles J. Bachand--12,003, 12,003,
    11,757 and 11,757 shares.
(4) Does not include shares owned beneficially by Insurance Partners, L.P. and
    IP Bermuda. See the prior table under "Stock Ownership of Certain Beneficial
    Owners and Management."
(5) Includes the following shares issuable pursuant to stock options currently
    exercisable or exercisable within 60 days: Mr. King--140,000; Mr. Haverland
    --300,000; Mr. Bachand--23,667; Mr. Greenberg--500; Mr. Cowley--20,000; and
    Mr. Kibblehouse--4,000 shares.
(6) Includes shares beneficially owned as a result of participation in the
    Company's 401(k) Plan.

                                       39
<PAGE>

ITEM 13: Certain Relationships and Related Transactions.

     In January 1996, when the Company's shares were distributed as a dividend
to the shareholders of its then parent, Halliburton Company, Richard M.
Haverland and Charles J. Bachand acquired, respectively, $2.1 million and
$190,000 in principal amount of the Debentures, together with Warrants.

     In addition, the Company issued to Mr. Haverland and Mr. Bachand,
respectively, an additional $2.1 million and $190,000 in principal amount of the
Company's 10% Convertible Subordinated Debentures due December 31, 2005, Series
2 (the "Management Debentures") together with detachable Common Stock
Subscription Warrants, Series A-2 and Series B-2 (the "Management Warrants," and
collectively with the Management Debentures, the "Management Securities"). The
Series B-2 Warrants, which are not exercisable since the market price of the
Company's common stock did not meet required levels, expire on December 31,
2005.

     The Management Securities contain terms and provisions substantially
similar to the Debentures and the Warrants.

     The Management Securities were issued pursuant to a Purchase, Redemption
and Bonus Agreement (the "Purchase Agreement") among the Company, Messrs.
Haverland and Bachand and members of the then management of the Company. The
consideration paid by Messrs. Haverland and Bachand for the Management
Securities consists of individual promissory notes (each, a "Note" and,
collectively, the "Notes") in the principal amounts of $2.1 million and
$190,000, respectively, made by Messrs. Haverland and Bachand, without personal
liability and secured by a pledge of the Management Securities. The Notes have a
term of five years and bear interest at a rate of 10%, payable annually on the
anniversary date of their issuance. The Notes may be prepaid at any time without
penalty. As of March 30, 2001, the principal amount outstanding of Mr.
Haverland's Note was $2.0 million and of Mr. Bachand's Note was $190,000.

     Assuming conversion and exercise of the Debentures, Management Debentures,
Warrants and Management Warrants, Messrs. Haverland and Bachand will own,
respectively, 825,285 and 72,590 shares of Common Stock, representing on a fully
diluted basis, respectively 5.9% and 0.5% of the outstanding Common Stock.

                                     PART IV

ITEM 14: Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

     (a) (1) and (2) Financial Statements. The Consolidated Financial Statements
and Schedules are listed in the Index to Financial Statements on page F-1 and
are filed as part of this Report.

     (a) (3) Exhibits.

     *2.1    Amended and Restated Agreement and Plan of Merger among Highlands
             Insurance Group, Inc., Highlands Acquisition Corp. and Vik Brothers
             Insurance, Inc. dated as of February 13, 1997

     *2.2    Amendment No. 1 to the Amended and Restated Plan of Merger dated
             March 10, 1997

     +3.1    Amended and Restated Certificate of Incorporation of the Registrant

     +3.2    Form of Amended and Restated Bylaws of the Registrant

     +4.1    Form of Stock Certificate of Common Stock (See also Exhibits 3.1
             and 3.2)

     +4.2    Form of 10% Convertible Subordinated Debentures Due December 31,
             2005

     +4.3    Form of Common Stock Subscription Warrant, Series A

     +4.4    Form of Common Stock Subscription Warrant, Series B

     +4.5    Form of 10% Convertible Subordinated Debentures Due December 31,
             2005, Series 2

     +4.6    Form of Common Stock Subscription Warrant, Series A-2

                                       40
<PAGE>

     +4.7    Form of Common Stock Subscription Warrant, Series B-2

     *4.8    Stockholders Agreement among Highlands Insurance Group, Inc.,
             Insurance Partners, L.P., Insurance Partners Offshore (Bermuda)
             L.P., The Scandinavia Company, Erik M. Vik and Manoeuvre Ltd.

     *4.9    Form of Amendment Number 1 to 10% Convertible Subordinated
             Debenture, Due December 31, 2005 of Highlands Insurance Group, Inc.

     *4.10   Form of Amendment Number 1 to 10% Convertible Subordinated
             Debenture, Series 2, Due December 31, 2005 of Highlands Insurance
             Group, Inc.

    *4.11    Form of Amendment Number 1 to Common Stock Subscription Warrant,
             Series A

    *4.12    Form of Amendment Number 1 to Common Stock Subscription Warrant,
             Series B

    *4.13    Form of Amendment Number 1 to Common Stock Subscription Warrant,
             Series A-2

    *4.14    Form of Amendment Number 1 to Common Stock Subscription Warrant,
             Series B-2

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

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

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

    +10.3    Form of 1995 Stock Option Plan

  +++10.4    Restricted Stock Plan

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

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

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

    +10.8    Form of 1995 Directors' Stock Plan

    +10.9    Amendatory Agreement dated as of November 9, 1995 among the
             Company, Halliburton, the Investors, Robert A. Spass and Bradley E.
             Cooper (amending the Investment Agreement)

    +10.10   Form of note issued in consideration for the issuance by the
             Registrant of 10% Convertible Subordinated Debentures Due December
             31, 2005, Series 2, Common Stock Subscription Warrants, Series A-2,
             and Common Stock Subscription Warrants, Series B-2

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

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

  ***10.13   Agency Stock Purchase Plan

   ++10.14   Employee Stock Purchase Plan

                                       41
<PAGE>

   ++10.15   Employees' Retirement And Savings Plan

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

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

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

     10.19   Employment Agreement between the Registrant and John W. Cowley

     10.20   Form of Retention Agreement

     10.21   Seventh Amendment and Waiver to Credit Agreement dated as of April
             13, 2001, among the Registrant, Various Lending Institutions and
             The Chase Manhattan Bank, as Administrative Agent

        21   List of Subsidiaries

        23   Consent of Independent Auditors

----------
   + Incorporated by reference to the Company's registration statement on Form
     10 as filed with the Commission on January 4, 1996.

   * Incorporated by reference to the Company's Report on Form 8-K, as amended,
     dated April 30, 1997 as filed with the Commission.

  ** Incorporated by reference to the Company's Report on Form 10-K, for the
     fiscal year ended December 31, 1998 as filed with the Commission.

 *** Incorporated by reference to the Company's registration statement on Form
     S-3 as filed with the Commission on May 1, 1998.

  ++ Incorporated by reference to the Company's registration statement on Form
     S-8 as filed with the Commission on June 1, 1998

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

*    The Company has offered  Retention  Agreements to Willis T. King, Jr.,
     John W. Cowley,  Charles L. Bachand and Stephen J.  Kibblehouse  the
     particular  terms of which are  specified in   "Employment  Contracts  and
     Retention Agreements"  under Item 11:  "Executive Compensation."

     (b) Reports on Form 8-K during the quarter ended December 31, 2000.

     None.

                                       42
<PAGE>

                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized on the 17th day of
April, 2001.

                                  Highlands Insurance Group, Inc.

                                  By:     /s/   WILLIS T. KING, JR.
                                     ------------------------------------------
                                         Willis T. King, Jr.
                                         Chairman 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/ WILLIS T. KING, JR.     Chairman and Chief Executive      April 17, 2001
-----------------------------    Officer
       Willis T. King, Jr.

     /s/ CHARLES J. BACHAND      Vice President, Treasurer and     April 17, 2001
-----------------------------    Principal Financial and
       Charles J. Bachand        Accounting Officer

       /s/ ROBERT A. SPASS       Director                          April 17, 2001
-----------------------------
         Robert A. Spass

      /s/ BRADLEY E. COOPER      Director                          April 17, 2001
-----------------------------
        Bradley E. Cooper

      /s/ W. BERNARD PIEPER      Director                          April 17, 2001
-----------------------------
        W. Bernard Pieper

       /s/ PHILIP J. HAWK        Director                          April 17, 2001
-----------------------------
         Philip J. Hawk

      /s/ ROBERT W. SHOWER       Director                          April 17, 2001
-----------------------------
        Robert W. Shower

    /s/ RICHARD M. HAVERLAND     Director                          April 17, 2001
-----------------------------
      Richard M. Haverland

   /s/ RUFUS J. WILLIAMS, III    Director                          April 17, 2001
-----------------------------
     Rufus J. Williams, III
</TABLE>

                                       43
<PAGE>

                  INDEX TO FINANCIAL STATEMENTS AND SCHEDULES

<TABLE>
<CAPTION>
                                                                                                          PAGE
                                                                                                         ------
<S>                                                                                                      <C>
Audited Financial Statements
  Independent Auditors' Report                                                                              F-2
  Consolidated Balance Sheets as of December 31, 2000 and 1999                                              F-3
  Consolidated Statements of Operations for the Years Ended December 31, 2000,                              F-4
     1999 and 1998
  Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2000,
     1999 and 1998                                                                                          F-5
  Consolidated Statements of Comprehensive Loss for the Years Ended December 31, 2000,
     1999 and 1998                                                                                          F-6
  Consolidated Statements of Cash Flows for the Years Ended December 31, 2000, 1999 and 1998                F-7
  Notes to Consolidated Financial Statements                                                                F-9

Financial Statement Schedules
  Schedule I - Summary of Investments Other Than Investments in Related Parties--
     December 31, 2000                                                                                     F-31
  Schedule II - Condensed Financial Information of Registrant (Parent Company only):
     Balance Sheets--As of December 31, 2000 and 1999                                                      F-32
     Statements of Operations--For the Years Ended December 31, 2000, 1999 and 1998                        F-33
     Statements of Cash Flows--For the Years Ended December 31, 2000, 1999 and 1998                        F-34
  Schedule III - Supplementary Insurance Information--As of and For the Years Ended
     December 31, 2000, 1999 and 1998                                                                      F-35
  Schedule IV - Reinsurance--For the Years Ended December 31, 2000, 1999 and 1998                          F-36
  Schedule V - Valuation and Qualifying Accounts--For the Years Ended December 31, 2000, 1999
     and 1998                                                                                              F-37
  Schedule VI - Supplemental Information Concerning Consolidated Property/Casualty Insurance
  Operations--As of and For the Years Ended December 31, 2000, 1999 and 1998                               F-38
</TABLE>

                                      F-1
<PAGE>

                         INDEPENDENT AUDITORS' REPORT

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

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

  We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our 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, 2000 and 1999 and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2000 in conformity with accounting
principles generally accepted in the United States of America. Also in our
opinion, the related financial statement schedules, when considered in relation
to the basic consolidated financial statements taken as a whole, present fairly,
in all material respects, the information set forth therein.


                                  KPMG LLP

Houston, Texas
April 13, 2001

                                      F-2
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                          CONSOLIDATED BALANCE SHEETS

                           DECEMBER 31, 2000 AND 1999
                                 (in thousands)


<TABLE>
<CAPTION>
                                       ASSETS                                                  2000               1999
------------------------------------------------------------------------------------       -----------          ---------
<S>                                                                                   <C>                    <C>
Investments:
  Fixed maturity securities available-for-sale, at fair value (amortized cost of
     $797,092 in 2000 and $802,594 in 1999)                                                $   776,453            762,478
  Equity securities, at fair value (cost of $30,686 in 2000 and $31,376 in 1999)                32,091             26,594
  Other investments, at cost                                                                     1,952              3,100
                                                                                           -----------          ---------
     Total investments                                                                         810,496            792,172
Cash and cash equivalents                                                                      109,763             78,283
Premiums in course of collection, net                                                          126,719             56,574
Premiums due under retrospective policies                                                      138,119            142,849
Receivable from reinsurers                                                                     683,439            684,525
Prepaid reinsurance premiums                                                                     8,576              3,777
Funds on deposit with reinsurers                                                                 9,019             17,534
Net deferred tax asset                                                                           6,732             82,536
Accrued investment income                                                                       11,084             11,396
Deferred policy acquisition costs                                                               49,622             33,556
Other assets                                                                                    47,581             58,085
                                                                                           -----------          ---------
     Total assets                                                                          $ 2,001,150          1,961,287
                                                                                           ===========          =========

                     LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------------------------------------------------------
Loss and loss adjustment expense reserves                                                    1,392,497          1,353,524
Unearned premiums                                                                              224,120            146,832
Senior bank debt                                                                                49,004             59,004
Convertible subordinated debentures                                                             58,626             57,816
Accounts payable and accrued liabilities                                                        97,424             75,069
                                                                                           -----------          ---------
     Total liabilities                                                                       1,821,671          1,692,245
                                                                                           -----------          ---------

Mandatorily redeemable preferred stock                                                           4,930              4,641
                                                                                           -----------          ---------

Stockholders' equity:
  Common stock, $.01 par value; 50,000,000 shares authorized, 13,225,411 shares
  issued and outstanding in 2000, 13,217,903 shares issued and outstanding in 1999                 140                140
  Additional paid-in capital                                                                   231,566            231,515
  Accumulated other comprehensive loss                                                         (12,572)           (29,184)
  Treasury stock, at cost (739,400 shares in 2000 and 1999, including 445,900
     shares held by subsidiaries in 2000 and 1999)                                              (9,459)            (9,459)
  Deferred compensation on restricted stock                                                     (3,097)            (3,147)
  Retained (loss) earnings                                                                     (32,029)            74,536
                                                                                           -----------          ---------
     Total stockholders' equity                                                                174,549            264,401
                                                                                           -----------          ---------
     Total liabilities, mandatorily redeemable preferred stock and stockholders'
       equity                                                                              $ 2,001,150          1,961,287
                                                                                           ===========          =========
</TABLE>

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



                                      F-3
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS

              FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
                  (in thousands, except per common share data)

<TABLE>
<CAPTION>
                                                                     2000          1999          1998
                                                                ---------       -------       -------
<S>                                                         <C>             <C>           <C>
Revenues:
  Net premiums earned                                           $ 388,505       325,305       388,813
  Net investment income                                            62,453        67,684        77,969
  Net realized investment gains                                       974            22        16,874
                                                                ---------       -------       -------
     Total revenues                                               451,932       393,011       483,656
                                                                ---------       -------       -------

Expenses:
  Loss and loss adjustment expense incurred                       346,137       238,940       328,400
  Underwriting expenses                                           134,470       130,121       141,788
  Debt interest and amortization expense                           12,392        11,753        12,258
  Loss on write-off of subsidiary                                      --        10,452            --
  Other expenses (income), net                                     (2,538)        2,210         2,000
                                                                ---------       -------       -------
     Total expenses                                               490,461       393,476       484,446
                                                                ---------       -------       -------
Loss before income taxes                                          (38,529)         (465)         (790)
Income tax expense (benefit)                                       67,747        12,984        (3,887)
                                                                ---------       -------       -------
     Net income (loss)                                           (106,276)      (13,449)        3,097
Dividends paid on mandatorily redeemable preferred stock              289            --            --
                                                                ---------       -------       -------
     Net income (loss) attributable to common
       stockholders                                             $(106,565)      (13,449)        3,097
                                                                =========       =======       =======

Earnings (loss) per common share:
  Basic                                                            $(8.06)        (1.04)          .24
  Diluted                                                          $(8.06)        (1.04)          .20
Weighted average number of common shares outstanding:
  Basic                                                            13,221        12,956        13,095
  Diluted                                                          13,221        12,956        15,811
</TABLE>



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

                                      F-4
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

              FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                        2000               1999               1998
                                                                                   ---------            -------            -------
<S>                                                                            <C>                 <C>                <C>
Common stock:
  Balance, beginning of year                                                       $     140                132                132
     Issuance of common stock, par value                                                  --                  8                 --
                                                                                   ---------            -------            -------
  Balance, end of year                                                                   140                140                132
                                                                                   ---------            -------            -------

Additional paid-in capital:
  Balance, beginning of year                                                         231,515            223,976            223,460
     Net issuance of common stock                                                         51              7,539                516
                                                                                   ---------            -------            -------
  Balance, end of year                                                               231,566            231,515            223,976
                                                                                   ---------            -------            -------

Accumulated other comprehensive income (loss):
  Balance, beginning of year                                                         (29,184)            16,803             22,278
     Changes in net unrealized investment gains (losses), net of tax                  16,682            (46,138)            (5,475)
     Net unrealized investment losses of written-off subsidiary, net of tax               --                151                 --
     Other                                                                               (70)                --                 --
                                                                                   ---------            -------            -------
  Balance, end of year                                                               (12,572)           (29,184)            16,803
                                                                                   ---------            -------            -------

Treasury stock, at cost:
  Balance, beginning of year                                                          (9,459)            (9,268)                --
     Acquisition of treasury stock                                                        --               (191)            (9,268)
                                                                                   ---------            -------            -------
  Balance, end of period                                                              (9,459)            (9,459)            (9,268)
                                                                                   ---------            -------            -------

Deferred compensation on restricted stock:
  Balance, beginning of year                                                          (3,147)            (1,074)            (1,465)
     Net retirement (issuance) of restricted stock                                        50             (2,073)               391
                                                                                   ---------            -------            -------
  Balance, end of year                                                                (3,097)            (3,147)            (1,074)
                                                                                   ---------            -------            -------

Retained (loss) earnings:
  Balance, beginning of year                                                          74,536             87,985             84,888
     Net income (loss) attributable to common stockholders                          (106,565)           (13,449)             3,097
                                                                                   ---------            -------            -------
  Balance, end of period                                                             (32,029)            74,536             87,985
                                                                                   ---------            -------            -------

Total stockholders' equity                                                         $ 174,549            264,401            318,554
                                                                                   =========            =======            =======
</TABLE>



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

                                      F-5
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                 CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

              FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                        2000          1999          1998
                                                                   ---------       -------       -------
<S>                                                             <C>            <C>           <C>
Net income (loss) attributable to common stockholders              $(106,565)      (13,449)        3,097
                                                                   ---------       -------       -------

Other comprehensive income (loss), net of taxes:
  Increase (decrease) in unrealized gains (losses) on
     investments net of taxes of $9,248; $(24,836); and
     $2,958                                                           17,175       (46,124)        5,493
  Reclassification adjustments for realized gains in net
     income (loss) net of taxes of $341, $8; and $5,906                 (633)          (14)      (10,968)
  Net unrealized investment losses of written-off subsidiary,
     net of taxes of $0; $81; and $0                                      --           151            --
  Other                                                                  70             --            --
                                                                   ---------       -------       -------
  Other comprehensive income (loss), net of taxes                     16,612       (45,987)       (5,475)
                                                                   ---------       -------       -------

  Comprehensive loss                                               $ (89,953)      (59,436)       (2,378)
                                                                   =========       =======       =======
</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, 2000, 1999 AND 1998
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                        2000             1999           1998
                                                                                     ---------        ---------       --------
<S>                                                                              <C>                 <C>                 <C>
Cash flows from operating activities:
  Net income (loss)                                                                  $(106,276)         (13,449)         3,097
                                                                                     ---------        ---------       --------
  Adjustments to reconcile net income (loss) to net
   cash provided by (used in) activities:
     operating activities:
     Depreciation and amortization                                                       5,162            3,768          3,453
     Net realized investment gains                                                        (974)             (22)       (16,874)
     Write-off of subsidiary                                                                --           10,452             --
     Deferred tax expense (benefit)                                                     66,957           12,659         (3,443)
     Change in:
       Premiums in course of collection                                                (70,145)          (2,771)        33,839
       Premiums due under retrospective policies                                         4,730            1,764        (14,463)
       Receivable from reinsurers                                                        1,086           60,407        (64,230)
       Prepaid reinsurance premiums                                                     (4,799)          (1,254)        21,928
       Funds on deposit with reinsurers                                                  8,515              339          2,299
       Deferred policy acquisition costs                                               (16,066)          (2,019)           776
       Loss and loss adjustment expense reserves                                        38,973         (189,740)        (1,826)
       Unearned premiums                                                                77,288            9,554        (36,058)
       Other operating assets and liabilities                                           30,459           (2,679)       (59,679)
                                                                                     ---------        ---------       --------
          Total adjustments                                                            141,186          (99,542)      (134,278)
                                                                                     ---------        ---------       --------
          Net cash provided by (used in) operating activities                           34,910         (112,991)      (131,181)
                                                                                     ---------        ---------       --------
Cash flows from investing activities:
  Proceeds from sales:
     Fixed maturity securities available-for-sale                                       87,714          184,817        409,954
     Equity securities                                                                   1,721            8,311            986
     Other investments                                                                   1,720               --            842
  Maturities or calls:
     Fixed maturity securities available-for-sale                                       56,713          149,610        155,698
  Investment purchases:
     Fixed maturity securities available-for-sale                                     (138,348)        (180,269)      (392,686)
     Equity securities                                                                  (1,000)         (18,940)       (18,337)
  Net purchases of property and equipment                                               (2,011)         (10,313)        (6,134)
  Cash and cash equivalents of written-off subsidiary                                       --          (12,843)            --
  Other proceeds                                                                            --              867             --
                                                                                     ---------        ---------       --------
     Net cash provided by investing activities                                           6,509          121,240        150,323
                                                                                     ---------        ---------       --------

  Cash flows from financing activities:
     Repayment of senior bank debt                                                     (10,000)          (5,996)            --
     Payment for debt issuance expense                                                      --               --           (675)
     Issuance of common stock                                                               61            5,474            831
     Acquisition of treasury stock                                                          --             (191)        (9,268)
                                                                                     ---------        ---------       --------
       Net cash used in financing activities                                            (9,939)            (713)        (9,112)
                                                                                     ---------        ---------       --------
Net increase in cash and cash equivalents                                               31,480            7,536         10,030
Cash and cash equivalents at beginning of year                                          78,283           70,747         60,717
                                                                                     ---------        ---------       --------
Cash and cash equivalents at end of year                                             $ 109,763           78,283         70,747
                                                                                     =========        =========       ========

Supplemental disclosure of cash flow information:
     Interest paid                                                                   $  10,700        $  10,163         10,603
                                                                                     =========        =========       ========
</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), and Highlands Holdings (U.K.) Limited and
its subsidiary (Highlands UK) (a foreign reinsurance company located in the
United Kingdom) and certain other immaterial companies (collectively, the
Insurance Subsidiaries). For reporting purposes, the Company considers all of
its property and casualty insurance operations as one segment. All material
intercompany accounts and transactions have been eliminated.

  As discussed in Note 4, the Company wrote-off in December 1999 its remaining
investment in and deferred taxes associated with LMI Insurance Company (LMI).
The assets and liabilities of LMI were not included in the accompanying balance
sheet as of December 31, 1999.  The 1998 consolidated financial statements have
not been restated.

  The accompanying consolidated financial statements are presented in accordance
with accounting principles generally accepted in the United States of America.
Certain items in the December 31, 1999 and 1998 consolidated financial
statements have been reclassified to conform to the current years presentation.
Such reclassifications had no impact on stockholders' equity or net income
(loss) as previously reported.


 Net Premiums Earned

  Insurance premiums on property/casualty insurance contracts are earned ratably
over the terms of the policies after estimated adjustments for retrospectively
rated policies and a deduction for ceded insurance.


 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.  Amortization of deferred acquisition costs was
$89.9 million, $65.3 million and $71.5 million for the years ended December 31,
2000, 1999 and 1998, respectively.

                                      F-8
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Investments

  Investments classified as available-for-sale are carried at fair value.
Unrealized gains and losses on available-for-sale investments are reported
within accumulated other comprehensive loss as a separate component of
stockholders' equity, net of applicable deferred taxes.  Fixed income securities
may be sold to take advantage of investment opportunities generated by changing
interest rates, prepayments and tax and credit considerations, as part of the
Company's asset/liability strategy, or for similar factors. As a result, the
Company considers all of its fixed income securities (bonds and redeemable
preferred stocks) and all equity securities as available-for-sale. The amortized
cost of debt securities is adjusted for amortization of premiums and accretion
of discounts to expected maturity. Such amortization and accretion are included
in net investment income.

  The cost of each security sold was specifically identified in computing the
related gain or loss. The Company continually monitors the difference between
the cost and estimated fair value of the investments. When impairment of the
value of an investment is considered other than temporary, the decrease in value
is reported in earnings as a realized investment loss and a new cost basis is
established.


 Cash and Cash Equivalents

  The Company defines cash equivalents as short-term, highly liquid investments
that are readily convertible to known amounts of cash. In general, only
investments with original maturities of three months or less qualify as cash
equivalents.


 Debt Issuance Costs

  Deferred financing and related costs consist of capitalized fees associated
with the issuance of $62.85 million in principal amount of 10% convertible
subordinated debentures (Debentures) and the $65 million senior revolving credit
facility. These costs include underwriting, legal and accounting fees. Debt
issuance costs of $5.6 million were capitalized in connection with the issuance
of the Debentures and are being amortized on the straight line basis and charged
to income over the remaining life of each instrument.


 Certain Risks and Uncertainties

  The preparation of these financial statements requires management to make
estimates and assumptions as of the date of the financial statements that affect
the reported amounts of assets and liabilities as well as disclosures of
contingent assets and liabilities. Management must make estimates and
assumptions that affect amounts of revenues and expenses for the reporting
period, primarily for loss and loss adjustment expense incurred. Management
makes estimates and assumptions in determining reinsurance and retrospective
premium collectibility, deferred tax asset utilization and in determining
litigation accruals. Actual results could differ from these estimates. Future
events, which could impact the estimates used in these financial statements,
include inflationary pressures that may tend to affect the amount of loss;
judicial, legislative and regulatory decisions affecting insurers' liabilities;
and fluctuations in interest rates.

                                      F-10
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Accounting Standards

  In June 1998, the Financial Accounting Standards Board (FASB) issued Statement
No. 133, "Accounting For Derivative Instruments and Hedging Activities"
(Statement 133). Statement 133 addresses the accounting for and disclosure of
derivative instruments, including certain derivative instruments embedded in
other contracts, and hedging activities. This Statement standardizes the
accounting for derivative instruments by requiring that an entity recognize
those items as assets or liabilities in the statement of financial position and
measure them at fair value. This Statement, as amended by FASB Statement No.
137, is effective for all fiscal quarters of fiscal years beginning after June
15, 2000. The Company has reviewed the investment portfolio and various risk
management techniques used to hedge all exposures. The Company has determined
that none of the Instruments held at December 31, 2000, currently meets the
definition of a derivative as defined in Statement 133 or have only nominal
value; therefore, implementation of the Statement will not have any significant
impact on the Company's financial statements as of January 1, 2001. The Company
will continue to evaluate all current and future instruments and apply the
requirements of Statement 133 as necessary.

  In September 2000, the FASB issued Statement No. 140, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities"
(Statement 140). Statement 140 supersedes and replaces the guidance in FASB
issued Statement 125, "Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities" Statement 140 provides guidance on
securitization transactions involving financial assets, sales of financial
assets such as receivables, loans and securities, collateralized borrowing
arrangements, securities lending transactions, and repurchase agreements.
Disclosure requirements under this Statement become effective for financial
statements for fiscal years ending after December 15, 2000. The Company has no
arrangements requiring disclosure at December 31, 2000.

                                      F-10
<PAGE>


                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


2. Business Acquisition

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

  The acquisition was financed with a combination of common stock, bank debt,
preferred stock and cash. In connection with the acquisition, Highlands Group
paid approximately $55.4 million in cash (including $35.6 million to repay
American Reliance's outstanding bank debt) and issued 1,656,700 shares of its
common stock (representing approximately 12.6% of Highlands Group's then
outstanding common stock) and 21,366 shares of newly issued series one preferred
stock to the holders of the common stock warrants, preferred stockholders and
creditors of American Reliance. The closing price of Highlands Group's common
stock was $17.625 on April 30, 1997.  Simultaneously with the closing, Highlands
Group contributed approximately $41.5 million to the capital of the insurance
companies within the American Reliance organization.

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

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

                                      F-11
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

3. Disposal of Assets

  In December 1997, the Company sold to an independent purchaser a management
contract which established control over Northwestern National Casualty Mutual
(NNCM).  NNCM, a Texas county mutual insurance company, which wrote non-standard
personal automobile insurance business in Texas and was 100% reinsured by NNCC.
In a separate transaction, all of the existing in force business of NNCM,
including the outstanding unearned premium reserves and outstanding loss
reserves, the renewal rights and broker agreements, were transferred to an
independent purchaser.  Highlands Group has provided a partial guarantee (up to
$1.3 million) of the adequacy of the loss reserves.  The guarantee was finalized
in 2000 and Highlands recognized other income of approximately $1.3 million.

  Total proceeds to the Company from both transactions were $13.5 million.
NNCC's historical cost basis for the assets being sold did not exceed $2.5
million.  These transactions were part of the fair value allocation of the
purchase price of American Reliance.


4. Write-off Of Subsidiary

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

                                      F-12
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Following is a summary of net assets and results of operations of LMI as of
December 31, 1999 (the date of disposal) and for the years ended December 31,
1999 and 1998 (in thousands):

<TABLE>
<CAPTION>
                                                        December 31,
                                                                1999
                                                        ------------
<S>                                                     <C>
  Fixed maturity securities, at fair value                   $18,686
  Highlands Group preferred stock                              4,641
                                                             -------
     Total investments                                        23,327
  Cash and cash equivalents                                   12,843
  Receivable from reinsurers                                  42,412
  Other assets                                                 2,247
                                                             -------
  Total Assets                                               $80,829
                                                             =======

  Loss and loss adjustment expense reserves                   60,284
  Other liabilities                                           10,093
                                                             -------
  Total liabilities                                          $70,377
                                                             =======

  Net Assets                                                 $10,452
                                                             =======
</TABLE>

<TABLE>
<CAPTION>
                                                                     Years ended
                                                                     December 31,
                                                           -----------------------------
                                                                 1999               1998
                                                           ----------          ---------
<S>                                                        <C>                 <C>
Total revenues                                               $ 3,396              3,882
Total expenses                                                 3,099              9,913
                                                             -------             ------
     Net income (loss) before taxes                              297             (6,031)

Income tax expense (benefit)                                   2,604             (2,531)
                                                             -------             ------
  Net loss                                                   $(2,307)            (3,500)
                                                             =======             ======
</TABLE>

  The 1998 consolidated financial statements have not been restated to reflect
the write-off of LMI.  LMI stand alone financial statements were not prepared
and issued in accordance with generally accepted accounting principles for 1999
or 1998.  The 1998 LMI stand alone financial statements prepared in accordance
with statutory accounting practices received an adverse audit opinion due to a
deficiency in loss reserves with an explanatory paragraph regarding LMI's
ability to continue as a going concern.

                                      F-13
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


5. Investments and Investment Income

  Net investment income for the years ended December 31, 2000, 1999 and 1998 is
comprised of the following (in thousands):

<TABLE>
<CAPTION>
                                                          2000           1999          1998
                                                       -------         ------        ------
<S>                                                <C>            <C>            <C>
Gross investment income:
  Fixed maturity securities                            $55,697         62,981        74,075
  Equity securities                                      2,469          1,973           517
  Cash equivalents and other investments                 5,309          3,456         4,050
                                                       -------         ------        ------
     Gross investment income                            63,475         68,410        78,642
  Investment expenses                                    1,022            726           673
                                                       -------         ------        ------
     Net investment income                             $62,453         67,684        77,969
                                                       =======         ======        ======
</TABLE>

  The following is a summary of available-for-sale securities as of December 31,
2000 and 1999 (in thousands):

<TABLE>
<CAPTION>
                                                                 Amortized            Gross Unrealized
                                                               -------------    ----------------------------
                                                                   Cost             Gains           Losses     Fair Value
                                                               -------------    -------------    -----------  -------------

December 31, 2000--
Fixed maturities available-for-sale:
<S>                                                            <C>            <C>            <C>            <C>
     United States Government and government agencies               $137,800          1,252          (733)        138,319
     States, municipalities and political subdivisions                16,015            201          (275)         15,941
     Mortgage-backed securities                                      346,124          2,340        (3,444)        345,020
     Corporate securities                                            297,153          1,946       (21,926)        277,173
                                                                    --------          -----       -------         -------
                                                                     797,092          5,739       (26,378)        776,453
  Equity securities                                                   30,686          2,690        (1,285)         32,091
                                                                    --------          -----       -------         -------
                                                                    $827,778          8,429       (27,663)        808,544
                                                                    ========          =====       =======         =======
December 31, 1999--
  Fixed maturities available-for-sale:
     United States Government and government agencies               $119,510             63        (3,615)        115,958
     States, municipalities and political subdivisions                41,735          1,064        (1,460)         41,339
     Mortgage-backed securities                                      351,297            436       (15,137)        336,596
     Corporate securities                                            290,052            328       (21,795)        268,585
                                                                    --------          -----       -------         -------
                                                                     802,594          1,891       (42,007)        762,478
  Equity securities                                                   31,376            375        (5,157)         26,594
                                                                    --------          -----       -------         -------
                                                                    $833,970          2,266       (47,164)        789,072
                                                                    ========          =====       =======         =======
</TABLE>

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

                                      F-14
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The amortized cost and estimated fair value of fixed maturity securities as of
December 31, 2000, 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                                        $ 31,378           31,488
  After one year through five years                       149,701          149,798
  After five years through ten years                      109,168          105,025
  After ten years                                         160,721          145,122
  Mortgage-backed securities                              346,124          345,020
                                                         --------          -------
                                                         $797,092          776,453
                                                         ========          =======
</TABLE>

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

<TABLE>
<CAPTION>
                                                               Years Ended December 31,
                                                     ---------------------------------------------
<S>                                                  <C>              <C>              <C>
                                                            2000             1999            1998
                                                         -------          -------          ------
  Fixed maturity securities                              $19,477          (65,889)         (8,751)
  Equity securities                                        6,187           (5,092)            328
  Write-off of subsidiary net unrealized loss                 --              232              --
                                                         -------          -------          ------
                                                          25,664          (70,749)         (8,423)
  Deferred income taxes                                   (8,982)          24,762           2,948
                                                         -------          -------          ------
     Change in net unrealized gains and losses,
       net of tax                                        $16,682          (45,987)         (5,475)
                                                         =======          =======          ======
</TABLE>

                                      F-15
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Sales of Securities

  Gross realized investment gains and losses and proceeds from the sale of
investments for the years ended December 31, 2000, 1999 and 1998 are as follows
(in thousands):

<TABLE>
<CAPTION>
                                                                             2000              1999             1998
                                                                          -------           -------          -------
<S>                                                                  <C>               <C>               <C>
Fixed maturities:
  Gross realized gains                                                    $ 1,096             3,967           18,975
  Gross realized losses                                                      (692)           (4,866)          (3,050)
                                                                          -------           -------          -------
                                                                          $   404              (899)          15,925
                                                                          =======           =======          =======
Equity securities:
  Gross realized gains                                                    $    --                --              387
  Gross realized losses                                                        --                --             (385)
                                                                          -------           -------          -------
                                                                          $    --                --                2
                                                                          =======           =======          =======
Other investments:
  Gross realized gains                                                    $   570               921              999
  Gross realized losses                                                        --                --              (52)
                                                                          -------           -------          -------
                                                                          $   570               921              947
                                                                          =======           =======          =======
Proceeds from sale of fixed maturity securities (calls and
 maturities excluded)                                                     $87,714           184,817          409,954
                                                                          =======           =======          =======

</TABLE>

6. Dividends from Subsidiaries and Statutory Information

  The Company's insurance subsidiaries are restricted by law as to the amount of
dividends they may pay without the approval of regulatory authorities. During
2001, the total maximum amount of dividends which can be paid without such
approval is approximately $12.7 million.

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

<TABLE>
<CAPTION>
                                             2000            1999           1998
                                           ------           -----          -----
<S>                                    <C>             <C>            <C>
  Net income (loss)                        $(42.2)            6.5           13.4
                                           ======           =====          =====
Policyholders' surplus                     $204.0           270.8          313.5
                                           ======           =====          =====
</TABLE>


   The above combined statutory financial information of the Company's insurance
subsidiaries was prepared in accordance with accounting practices prescribed or
permitted by the various insurance departments of the insurance subsidiaries'
states of domicile. The statutory surplus at December 31, 2000 for Highlands
Insurance Company was $127.4 million and for Northwestern National Casualty was
$49.8 million. "Prescribed" statutory accounting practices include state laws,
regulations and general administrative rules, as well as a variety of
publications of the National Association of Insurance Commissioners (NAIC).
"Permitted" statutory accounting practices encompass all accounting practices
that are not prescribed; such practices may differ from state to state, may
differ from company to company within a state, and may change in the future. In
1999, the Company's insurance subsidiaries obtained permission from certain
insurance departments to write-off directly to policyholder surplus certain
computer software amounts that were previously non-admitted under prescribed
statutory accounting practices. There was no impact on surplus at December 31,
1999 due to this permitted accounting. The Company's insurance subsidiaries did
not have any other material permitted statutory accounting practices in 2000,
1999 and 1998.

                                      F-16
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   In March 1998, the NAIC adopted the Codification of Statutory Accounting
Principles (the Codification).  The implementation of the Codification and the
date thereof will be ultimately dependent on an insurer's state of domicile.
Implementation of the Codification is effective for the Company's insurance
subsidiaries January 1, 2001.

  The 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.  The insurance
subsidiaries of the Company have an RBC amount above the company action level,
as defined by the NAIC at December 31, 2000. At December 31, 2000, the RBC ratio
for Highlands Insurance Company was 217%. RBC for all the other subject
insurance companies was in excess of 300%.

  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.  The NAIC's review of each company's
financial ratio results and statutory annual statements for 2000 has not been
completed, however, based on the Company's review of the 2000 IRIS ratios,
certain insurance subsidiaries may receive a first priority designation.


7. Federal and Foreign Income Taxes

  The Company provides for income taxes on its statements of operations pursuant
to Statement of Financial Accounting Standards 109, "Accounting for Income
Taxes" (SFAS 109).

  The primary components of the Company's deferred tax assets and liabilities
and the related valuation allowance as of December 31, 2000 and 1999,
respectively, follow (in thousands):

<TABLE>
<CAPTION>
                                                                       2000           1999
                                                                   --------        -------
<S>                                                            <C>            <C>
Deferred tax assets--
  Net operating loss carryforward                                  $ 54,545         43,304
  Loss and loss adjustment expense reserves                          44,926         45,281
  Unearned premiums                                                  15,088         10,014
  Deferred credits for processing fees                                2,089          2,726
  Bad debts                                                           2,712          1,185
  Unrealized loss on investments                                      6,732         15,714
  Other                                                               8,691          5,422
                                                                   --------        -------
     Deferred tax assets before valuation allowance                 134,783        123,646
  Valuation allowance                                               (95,619)       (12,791)
                                                                   --------        -------
     Deferred tax assets after valuation allowance                   39,164        110,855
                                                                   --------        -------

Deferred tax liabilities--
  Deferred acquisition costs                                         17,368         11,745
  Accrued retrospective premiums                                      7,500          9,999
  Depreciation & amortization                                         6,468          3,218
  Other                                                               1,096          3,357
                                                                   --------        -------
     Deferred tax liabilities                                        32,432         28,319
                                                                   --------        -------
       Net deferred tax asset                                      $  6,732         82,536
                                                                   ========        =======
</TABLE>

                                      F-17
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The net deferred tax asset is net of valuation allowances of $95.6 and $12.8
million as of December 31, 2000 and 1999, respectively.  During 2000, the
Company increased its valuation allowance to approximately $95.6 million related
to its $134.8 million of deferred tax assets. Based on the results of
operations, management does not currently believe that it is more likely than
not that the tax benefits for which it created a valuation allowance will all be
realized in the near future. The remaining net deferred tax asset of
approximately $6.7 million represents the tax affect of unrealized losses on
investments. By employing available tax planning strategies management believes
it is more likely than not that the Company will be able to realize, in the
future, the tax benefits of the unrecorded losses on the investments.

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

<TABLE>
<CAPTION>
                                                                                       2000             1999            1998
                                                                                   --------           ------          ------
<S>                                                                            <C>               <C>              <C>
Loss before income taxes                                                           $(38,529)            (465)           (790)
Tax rate                                                                                 35%              35%             35%
                                                                                   --------           ------          ------
  Application of the tax rate                                                       (13,485)            (163)           (277)
Tax effect of:
  Tax-exempt income                                                                    (793)          (1,102)         (2,547)
  Write-off of subsidiary                                                                --            3,657              --
  Write-off net deferred tax assets of subsidiary                                        --           11,618              --
  Other                                                                                (803)           5,177            (490)
                                                                                   --------           ------          ------
     Income tax (benefit) expense before valuation allowance                        (15,081)          19,187          (3,314)
  Change in valuation allowance                                                     (82,828)          (6,203)           (573)
                                                                                   --------           ------          ------
     Income tax expense (benefit)                                                  $ 67,747           12,984          (3,887)
                                                                                   ========           ======          ======
</TABLE>

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

<TABLE>
<CAPTION>
                                                                                       2000            1999           1998
                                                                                    -------          ------         ------
<S>                                                                            <C>              <C>             <C>
Current expense (benefit)                                                           $   790             325           (444)
Deferred expense (benefit)                                                           66,957          12,659         (3,443)
                                                                                    -------          ------         ------
  Income tax expense (benefit)                                                      $67,747          12,984         (3,887)
                                                                                    =======          ======         ======
</TABLE>

8. Debt and Preferred Stock Outstanding

  On April 30, 1997, the Company entered into a $65 million Credit Agreement,
with a consortium of banks. The Credit Agreement, which contains customary terms
and restrictions, including a security interest in the Company's principal
insurance subsidiaries, currently provides for an interest rate of LIBOR plus
150 to 225 basis points based upon a performance grid with the full principal
amount thereunder due on April 30, 2002. The Credit Agreement was used to
finance the purchase of American Reliance.  During 2000, the Company repaid
$10.0 million of the loan.  This payment permanently reduced the senior
revolving credit facility from $59.0 million to $49.0 million.  The average
interest rate for the year ended December 31, 2000 was 8.8%.  Effective
December 31, 1999, the Company and its lenders amended the Credit Agreement to
revise certain financial covenants and to provide for the payment of $10.0
million in principal during 2000.  Effective December 31, 2000, the Company and
its lenders further amended the Credit Agreement to again revise those covenants
(see note 19). The Company is in compliance with the revised covenants in the
Credit Agreement.

                                      F-18
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  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, 2000.

   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, except that
for 2001, interest is payable in kind in the form of new 12.5% convertible
subordinated debentures ("New Debentures"). See note 19 regarding subsequent
event to provide for payment of interest in 2001 by issuance of New Debentures.
The New Debentures have the same terms and conditions as the Debentures except
that the interest rate on the New Debentures is 12.5% per annum and their
conversion price is $6 per share. Highlands Group can redeem the Debentures at
any time after December 31, 2002. Total interest expense incurred and paid on
the Debentures was $6.0 million in 2000, 1999 and 1998. The total amortization
of debt discount and acquisition costs incurred related to the Debentures was
approximately $1.3 million in 2000, 1999 and 1998.

  The detachable Series A Warrants enable the holders to purchase Highlands
Group Common Stock at an exercise price of $9.77 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
increased the exercise price by $0.94 per share in 1999 and reduced the exercise
price by $2.04 per share in 1998. The adjustment of 2000, if any, has not yet
been determined. 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 $9.77 per share, equal to an
additional ownership interest of 5% after giving effect to the assumed
conversion of the Debentures and the exercise of the Series A and B Warrants.
The Series B Warrants become exercisable by the holders in the event that the
average closing market price of Highlands Group Common Stock exceeds 1.61 times
the exercise price for any 30 consecutive trading days between January 1, 1999
and December 31, 2000.  Because this test was not satisfied, the Series B
Warrants are not exercisable.   The Series B Warrants exercise price is subject
to the same adjustment as the Series A Warrants. The detachable Series B
Warrants expire on December 31, 2005.

                                      F-19
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  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.  The minimum Bonus Trigger Stock Price was not achieved and, therefore,
no bonus is payable to the Management Investors.

  If the Debentures are converted into Common Stock of Highlands Group and the
Series A Warrants are utilized by the holders to purchase Common Stock of
Highlands Group, the holders will have an ownership interest in Highlands Group
of approximately 41.6%.

  In 1997, the Company authorized the designation of a series of Preferred Stock
(the "Series One Preferred Stock") for use in transactions related to the
acquisition of American Reliance.  The Company is authorized to issue up to
50,000 shares of non-voting shares of the Series One Preferred Stock.  At the
time of the stock issuance 100% of the outstanding shares were held by the
subsidiaries of Highlands Group and eliminated in consolidation.  At December
31, 2000, there were 15,940.82 shares issued and outstanding of which 4,930.28
shares were held by LMI. As a result of the Company's write-off of LMI the
shares held by LMI are reflected as outstanding in consolidated balance sheets
of the Company as of December 31, 2000 and 1999. The Series One Preferred Stock
have cumulative dividends payable quarterly at 6% and can be in the form of cash
or paid-in-kind ("PIK") dividends with PIK dividends being elected to date. The
Series One Preferred Stock is mandatorily redeemable on January 1, 2004. The
liquidation preference amount is $1,000 per share plus cumulative unpaid
dividends.

                                      F-20
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


9. Earnings Per Share

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

<TABLE>
<CAPTION>
                                                                                          2000              1999            1998
                                                                                     ---------          --------          ------
<S>                                                                              <C>                <C>              <C>
NUMERATOR:
  Net income (loss) attributable to common stockholders, as reported and for
     basic earnings (loss) per share                                                 $(106,565)          (13,449)          3,097
  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                                $(106,565)          (13,449)          3,097
                                                                                     =========          ========          ======
DENOMINATOR:
  Denominator for basic earnings (loss) per share--weighted average shares              13,221            12,956          13,095
  Effect of dilutive securities:
     Common stock warrants and outstanding stock options (based on
       treasury stock method)                                                               --                --           2,716
     Convertible subordinated debentures                                                    --                --              --
                                                                                     ---------          --------          ------
  Denominator for diluted earnings per share--adjusted weighted average
     shares and assumed conversions                                                  $  13,221            12,956          15,811
                                                                                     =========          ========          ======

  Basic earnings (loss) per share                                                    $   (8.06)            (1.04)            .24
  Diluted earnings (loss) per share                                                  $   (8.06)            (1.04)            .20
</TABLE>

  The Debentures, which are convertible into approximately 3.9 million shares,
were outstanding during 2000, 1999 and 1998, but were not included in the
computation of diluted earnings per share because the assumed conversion would
be antidilutive. Common stock warrants attached to the Debentures for
approximately 5 million shares for 2000, 1999 and 1998, respectively, were not
included in earnings per share calculations as they were antidilutive.

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

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.

                                      F-21
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Based upon its evaluations of reinsurers, the Company has established an
allowance for uncollectible reinsurance ($7.4 million and $2.2 million as of
December 31, 2000 and 1999, respectively) or does not record certain contracts
as ceded business but retains these amounts ($25.1 million and $25.6 million as
of December 31, 2000 and 1999, respectively) as loss reserves for uncollectible
reinsurance at such time as an uncollectible amount is probable and the amount
may be reasonably estimated. Because of the difficulty of acquiring accurate
information for certain reinsurers, including Lloyds' syndicates and members,
the Company believes that no meaningful range of uncollectible reinsurance can
be established beyond recorded reserves. With respect to certain carriers and
reinsurers that are not authorized reinsurers as determined by the appropriate
Department of Insurance, the Company often receives collateral primarily in the
form of bank letters of credit generally securing the reinsurance recoverable
regarding reported losses and in some instances IBNR. As of December 31, 2000,
such collateral totaled approximately $22.8 million.

  The Company's six largest recoverables as of December 31, 2000, were
approximately $141.1 million with Underwriters at Lloyds of London/Equitas,
$84.1 million with American Reinsurance Company, $55.8 million with General
Reinsurance Company, $48.1 million with New England Reinsurance Corporation,
$24.9 million with Ace Property and Casualty Insurance Company and $21.4 million
with Employers Reinsurance Company, American Reinsurance Company and General
Reinsurance Company are rated by A. M. Best A+ and A++ rating, respectively.

  There are instances where the Company and one or more of its reinsurers
disagree on the terms or extent of reinsurance coverage with respect to
particular losses. In these situations, the Company attempts to negotiate an
acceptable settlement of the disagreement or, failing to reach such a
settlement, takes the matter to arbitration. The largest such disagreement, in
the amount of $20 million of reinsurance recoverable (net of a valuation
allowance), concerns reinsurance on California construction defect claims.

                                      F-22
<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
                                                    -------------  -----------  -------------  -----------
Year ended December 31, 2000--
<S>                                                 <C>            <C>          <C>            <C>
  Written premiums                                       $495,103       22,015        56,125       460,993
  Earned premiums                                        $427,268       12,194        50,957       388,505
  Loss and loss adjustment expense incurred              $401,574       20,601        76,038       346,137
                                                         ========       ======       =======       =======

Year ended December 31, 1999--
  Written premiums                                       $355,313        8,816        30,524       333,605
  Earned premiums                                        $345,885        9,181        29,761       325,305
  Loss and loss adjustment expense incurred              $257,024       21,973        40,057       238,940
                                                         ========       ======       =======       =======

Year ended December 31, 1998--
  Written premiums                                       $370,210        7,874         3,268       374,816
  Earned premiums                                        $406,028        8,464        25,679       388,813
  Loss and loss adjustment expense incurred              $321,033       27,573        20,206       328,400
                                                         ========       ======       =======       =======
</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 reflects past experience, current trends and other
information and the exercise of informed judgment. As information develops that
varies from experience, provides additional data or, in some cases, augments
data that previously were not considered sufficient for use in determining
reserves, changes in the Company's estimate of ultimate liabilities may be
required. The effect of these changes, net of reinsurance, is charged or
credited to income for the periods in which they are determined.

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

  The Company uses methods and assumptions that are consistent with prevailing
actuarial practice and are modified periodically based on changes in
circumstances. However, estimation of loss reserves for asbestos, environmental
related and other long-term exposure claims is one of the most difficult aspects
of establishing reserves, especially given the above uncertainties. The Company
has recorded its best estimate of loss and loss adjustment expense reserves;
however because of the significant uncertainties involved and the likelihood
that these uncertainties will not be resolved in the near future, the ultimate
amounts paid upon settlement of these matters may be more or less than the
current estimate.

                                      F-23
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  As a result of an analysis made during the fourth quarter of 2000, it was
determined that there had been adverse development in the commercial multi-peril
and the workers' compensation lines.  Following the results of this analysis,
reserves were increased at the end of 2000 to cover those lines as well as
increases and decreases in other lines.

  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>
                                                                     2000             1999              1998
                                                           --------------        ---------         ---------
<S>                                                        <C>                <C>               <C>
Balance at January 1                                           $1,353,524        1,603,548         1,605,374
  Less--Reinsurance recoverables                                  614,208          732,567           692,668
                                                               ----------        ---------         ---------
Net balance at January 1                                          739,316          870,981           912,706
                                                               ----------        ---------         ---------
Incurred related to--
  Current year                                                    321,187          247,027           256,528
  Commutation of Aggregate Excess of Loss
     Reinsurance Agreement                                             --               --            50,000
  Prior year-
     Asbestos and environmental                                     7,762            1,795            19,119
     All other                                                     17,194           (9,882)            2,753
                                                               ----------        ---------         ---------
  Total prior year                                                 24,956           (8,087)           21,872
                                                               ----------        ---------         ---------
     Total incurred                                               346,137          238,940           328,400
                                                               ----------        ---------         ---------
Paid related to--
  Current year                                                    136,565          101,294            90,635
  Prior year
     Asbestos and environmental                                    11,041           15,038             9,712
     All other                                                    171,997          230,240           269,778
                                                               ----------        ---------         ---------
  Total prior year                                                183,038          245,278           279,490
                                                               ----------        ---------         ---------
     Total paid                                                   319,603          346,572           370,125
                                                               ----------        ---------         ---------
Elimination of reserves of written-off subsidiary                      --           24,033                --
                                                               ----------        ---------         ---------
Net balance at December 31                                        765,850          739,316           870,981
     Add--Reinsurance recoverables                                626,647          614,208           732,567
                                                               ----------        ---------         ---------
Balance at December 31                                         $1,392,497        1,353,524         1,603,548
                                                               ==========        =========         =========
</TABLE>

[Update]

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

<TABLE>
<CAPTION>
                                        2000    1999
                                       ------  ------
<S>                                    <C>     <C>
       Asbestos                       $ 72,286     74,604
       Environmental                    41,145     42,106
                                       -------    -------
                                      $113,431    116,710
                                       =======    =======
</TABLE>


12. Employee Benefits

  The Company has a retirement and savings plan (defined contribution plan) for
which all employees are eligible to participate. The Company's contributions are
restricted to amounts authorized annually by the board of directors. Employees,
at their option, may contribute a portion of their eligible earnings to the
plan. Retirement benefits are based on the balance in each employee's account,
including the amount vested in employer contributions. The plan may be canceled
at any time at the option of the Company. The Company's net contributions to the
plan for 2000, 1999 and 1998 were approximately $1.9 million, $1.2 million, and
$1.1 million, respectively.

                                      F-24

<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


13. Stock Compensation Plans

  At December 31, 2000, the Company had two types of stock-based compensation
plans, a stock option plan and a restricted stock plan. The Company applies APB
Opinion No. 25 and related Interpretations in accounting for its plans.
Accordingly, compensation cost is being recognized for the grant of options to
acquire Company Common Stock prior to a market price (January 23, 1996) for
Company Common Stock. The compensation cost that has been charged against income
for its stock-based plans was $(93,500), $321,000 and $472,000 for 2000, 1999
and 1998, respectively.  However, no compensation cost has been recognized for
shares issued with an exercise price equal to the market value at date of grant.
Had all compensation cost for the Company's stock-based compensation plans been
determined consistent with Statement of Financial Accounting Standards No. 123,
the Company's net income (loss) and income (loss) per share would have been the
pro forma amounts indicated below (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                                                 2000             1999          1998
                                                                            ---------          -------         -----
<S>                                                      <C>              <C>              <C>           <C>
  Net income (loss) attributable to common
  stockholders                                           As reported        $(106,565)         (13,449)        3,097
                                                         Pro forma          $(107,589)         (13,974)        1,915
  Basic earnings (loss) per share                        As reported        $   (8.06)           (1.04)          .24
                                                         Pro forma          $   (8.14)           (1.08)          .15
  Diluted earnings (loss) per share                      As reported        $   (8.06)           (1.04)          .20
                                                         Pro forma          $   (8.14)           (1.08)          .12
</TABLE>


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

  Stock Option Plan

  Pursuant to the Company's 1995 Stock Option Plan, Highlands Group may grant
either incentive stock options (ISO) or non-qualified stock options (NQSO). The
exercise price for each share subject to an option will be an amount that the
Compensation Committee of the Board of Directors determines, in its good faith
judgment. In the case of ISOs, however, the exercise price per share may not be
less than the amount the Committee determines, in its good faith judgment, to be
not less than 100% of the fair value of the Company's Common Stock on the date
the option is granted. Options are typically exercisable over a period not in
excess of ten years. The options generally vest over three to four years, or in
full upon a change of control of the Company. The maximum number of shares that
were reserved for issuance under all option plans was 1,350,000 at December 31,
2000.

                                      F-25
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  A summary of the status of the Company's stock option plans at December 31,
2000 and changes during the three years then ended is presented below:

<TABLE>
<CAPTION>
                                                   2000                        1999                       1998
                                          ----------------------      ----------------------      ----------------------
                                                       Weighted-                   Weighted-                  Weighted-
                                                        Average                     Average                    Average
                                            Shares      Exercise        Shares      Exercise        Shares     Exercise
Fixed Options                                (000)       Price           (000)       Price           (000)      Price
-------------------------------------     ---------    ---------        --------   ---------       --------   --------
<S>                                    <C>            <C>           <C>           <C>           <C>           <C>
Outstanding at beginning of year            978,309         $14.48      841,920         $18.35      751,983       $17.22
Granted                                     302,075         $ 8.42      448,201         $11.91      233,150       $23.78
Exercised                                        --   $       --             --   $       --         (8,375)      $17.31
Forfeited                                  (137,102)        $15.14     (311,812)        $21.31     (134,838)      $21.47
                                          ---------         ------     --------         ------     --------       ------
Outstanding at end of year                1,143,282         $12.76      978,309         $14.48      841,920       $18.35
                                          =========                    ========                    ========
Options exercisable at year-end             544,303                     389,679                     299,757
                                          =========                    ========                    ========
</TABLE>

  The following table summarizes information about stock options outstanding at
December 31, 2000:


<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 12/31/00       Life        Price      At 12/31/00      Price
-----------------------------------  -------------  ------------  ----------  -------------  ------------
<S>                                  <C>            <C>           <C>         <C>            <C>
$8.13-9.31                                 289,275          9.41      $ 8.37             --  $       --
$9.44-13.25                                380,225          8.32      $11.64         92,788        $11.02
$14.69-14.69                               378,333          5.01      $14.69        378,333        $14.69
$14.88-28.38                                95,449          6.92      $22.87         73,182        $22.50
                                         ---------                                  -------
$8.13-28.38                              1,143,282          7.38      $12.76        544,303        $15.11
                                         =========                                  =======
</TABLE>

  The fair value of stock options granted during the years ended December 31,
2000, 1999 and 1998 was $1.5 million, $3.4 million and $3.1 million,
respectively.  The weighted average estimated per share fair value of options
granted during the years ended December 31, 2000, 1999 and 1998 was $5.00, $7.61
and $13.25, respectively.  The fair value of each option is estimated on the
date of the grant using the Black-Scholes option-pricing model.  The following
weighted average assumptions were used in the Black-Scholes option pricing model
for grants in 2000, 1999 and 1998, respectively: dividend yields of -0- percent,
expected volatilities of 45 percent, 46 percent and 48 percent, risk-free
interest rates of 5.2 percent, 6.5 percent and 5.9 percent, and expected terms
of 6.5 years.

                                      F-26
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Employee Stock Purchase Plan

  In May 1998, the Company adopted a tax-qualified employee stock purchase plan
(the Purchase Plan).  An aggregate of 300,000 shares of the Common Stock has
been reserved for issuance under the Purchase Plan.  All employees of the
Company with at least three months of service can purchase Common Stock on the
annual offering date at a price equal to 85% of its fair market value at the
time of purchase.  Employees can authorize payroll deductions in order to
accumulate funds for any offering during the year prior to any offering.  At
December 31, 2000, 35,573 shares were issued under the Purchase Plan.

  Restricted Stock Plans

  In May 1997, the Company adopted a restricted stock plan ("Restricted Stock
Plan") pursuant to which participants are granted an award of shares of the
Company's Common Stock (Restricted Stock) subject to restrictions. The number of
shares of Restricted Stock granted to each participant is equal to the number of
shares of Common Stock of the Company, if any, that the participant purchases
under the Restricted Stock Plan. There are restrictions as to the
transferability of the Restricted Stock, which restrictions lapse on the fifth
anniversary from the date of issuance if the closing price of the Company's
Common Stock is equal to or greater than the prices expressed as a percentage of
the price on the date of issuance (the "Restricted Stock Trigger Price"). If
the Restricted Stock Trigger Price is at least 1.40 times but less than 1.50
times the price on the date of issuance, 75% of the Restricted Stock shall be
forfeited and transferred to the Company, 50% if the Restricted Stock Trigger
Price is at least 1.50 times but less than 1.61 times the price on the date of
issuance and 0% if the Restricted Stock Trigger Price is 1.61 times the price on
date of issuance or higher. Termination of employment with the Company during
the restricted period will also cause the Restricted Stock to be forfeited and
transferred to the Company.

  As of December 31, 2000, the number of shares of stock reserved under the
Restricted Stock Plan was 350,000. The Company granted 276,158 and 10,695 shares
of Restricted Stock at weighted average fair values of $11.21 and $18.20 per
share during 1999 and 1998, respectively. The Company did not grant any shares
of Restricted Stock in 2000. Restricted Stock is considered issued and
outstanding when awarded. As of December 31, 2000, 38,682 restricted shares have
been forfeited to the Company and 276,824 shares are outstanding under the plan.
The fair market value of Restricted Stock on the date of issuance has been
recorded as a deferred expense and included as a component of stockholders'
equity. No amortization of the deferred expense was recorded in 2000, 1999 or
1998. The deferred expense will be amortized over the remaining vesting period
once certain closing prices of the Company's Common Stock are achieved.


15. Fair Value of Financial Instruments

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

                                      F-27
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The carrying values and estimated fair values of financial instruments at
December 31, 2000 and 1999, were as follows (in thousands):

<TABLE>
<CAPTION>
                                                         2000                      1999
                                              -------------------------  ------------------------
                                                Carrying       Fair        Carrying       Fair
                                              ------------  -----------  ------------  ----------
<S>                                           <C>           <C>          <C>           <C>
Assets:
  Fixed maturity securities                       $776,453      776,453      $762,478     762,478
  Equity securities                               $ 32,091       32,091      $ 26,594      26,594
  Other investments                               $  1,952        1,952      $  3,100       3,100
  Cash and cash equivalents                       $109,763      109,763      $ 78,283      78,283
  Premium installment receivables                 $  3,525        3,525      $  1,388       1,388
  Accrued investment income                       $ 11,084       11,084      $ 11,396      11,396
Liabilities:
  Convertible subordinated debentures             $ 58,626       60,000      $ 57,816      60,000
  Senior bank debt                                $ 49,004       49,004      $ 59,004      59,004
</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 Debentures, for which there
is no market, was estimated using the principal (face) amount of the Debentures.
The senior bank debt is floating rate and considered to approximate fair value.


16. Contingent Liabilities

 Legal Action

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

  From 1958 to 1986, the Company issued fixed premium, guaranteed cost (not
retrospectively rated) insurance policies to Brown & Root, a subsidiary of
Halliburton Company.  Beginning in 1987, the Company's insurance policies with
Halliburton (including Brown & Root) were written on a retrospectively rated or
high-deductible basis.  Since the mid-1990's, over 20,000 third party asbestos
claims have been made against Halliburton.  Through December 31, 2000, the
Company paid $1.2 million on behalf of Halliburton under the fixed premium
policies on asbestos claims, and billed Halliburton $8.5 million under the
retrospectively rated and high-deductible policies on asbestos claims.
Halliburton has not paid this billed amount and has questioned the proper
allocation of the asbestos claims between the fixed premium and the
retrospectively rated and high-deductible policies.

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

                                      F-28
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



rated and high-deductible policies; and (iv) a declaration estopping Brown &
Root from invoking insurance under the fixed premium policies.

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

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

  If the Company is not ultimately successful in the litigation described above,
it could have a material adverse impact on the Company.  The Company believes,
however, that the positions it has taken in the Delaware Action and Texas Action
are meritorious, and that, ultimately, the Company will not be responsible for a
material amount, if any, of Halliburton's asbestos liability.


 Leases

  At December 31, 2000, the Company was obligated under noncancelable operating
leases, expiring on various dates through 2004, principally for office space and
computer software. Future aggregate minimum rentals on noncancelable operating
leases are as follows: $2.4 million in 2001, $1.7 million in 2002, $1.5 million
in 2003, $1.5 million in 2004 and $.1 million thereafter.

  The Company's gross rental expense was approximately $4.0 million, $3.1
million, and $4.3 million for 2000, 1999 and 1998, respectively.

                                      F-29
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


17. Business Concentration and Foreign Operations

  In the normal course of business, the Company has underwritten risks of its
former parent, Halliburton, and various subsidiaries and affiliates of
Halliburton.  However, the agreement between Halliburton and the Company under
which the Company underwrote Halliburton business expired in January 2000.
During 2000, 1999 and 1998, net premiums earned from Halliburton aggregated
approximately $8.4 million, $22.9 million, and $53.9 million, respectively.

  A portion of this business is retrospectively rated, meaning that ultimate
premiums will approximate ultimate losses plus certain expenses. Future premiums
due from Halliburton under these retrospective arrangements approximate $114.4
million and $108.6 million at December 31, 2000 and 1999, respectively.

  The Company's United Kingdom operations as a percentage of the Company's
consolidated revenues, loss before income taxes and identifiable assets as of
and for the years ended December 31, 2000, 1999 and 1998 are not significant.

                                      F-30
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

          NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


18. Quarterly Financial Data (Unaudited)

  The following quarterly financial information for each of the three months
ended March 31, June 30, September 30 and December 31, 2000 and 1999 is
unaudited. However, in the opinion of management, all adjustments (consisting of
normal recurring adjustments) necessary to present fairly the results of
operations for such periods, have been made for a fair presentation of the
results shown.  The financial information for the quarter ended December 31,
2000 reflects the reserve strengthening at the end of 2000 (see note 11) and the
increase in the valuation allowance for net deferred tax assets (see note 7).

<TABLE>
<CAPTION>
Quarter Ended                                March 31      June 30      Sept 30       Dec 31
-------------                              -------------  ----------  ------------  -----------
                                              (Dollars in thousands, except per share data)
<S>                                        <C>            <C>         <C>           <C>
2000
  Net premiums earned                            $81,398      90,510      102,912      113,685
  Total revenues                                 $97,599     106,350      118,419      129,564
  Total expenses                                 $95,078     101,778      114,445      179,160
  Net income (loss) attributable to
     common stockholders                         $ 1,966       3,566        2,994     (115,091)
  Earnings (loss) per common share:
     Basic                                       $   .15         .27          .23        (8.70)
     Diluted                                     $   .15         .27          .23        (8.70)

1999
  Net premiums earned                            $81,705      78,158       78,091       87,351
  Total revenues                                 $99,964      96,634       95,942      100,471
  Total expenses                                 $96,377      93,034      101,333      102,732
  Net income (loss)                              $ 2,752       2,799       (3,323)     (15,677)
  Earnings (loss) per common share:
     Basic                                       $   .22         .22         (.25)       (1.19)
     Diluted                                     $   .20         .20         (.25)       (1.19)
</TABLE>

19. Subsequent Events

  On April 13 2001, the Company and the lenders of the Senior Bank Debt (see
note 8) amended the Credit Agreement, effective as of December 31, 2000, to
revise the financial covenant requirements under the Credit Agreement for
December 31, 2000 and 2001 as well as for the quarterly periods of 2001. The
Company is in compliance with the new financial covenant requirements as
calculated for December 31, 2000. The lenders furthermore waived the events of
default resulting from the Company's failure to provide certain financial
statements and other reports within the time-frame specified in the Credit
Agreement for the period ended December 31, 2000.

  Among other financial covenant requirements, the Credit Agreement, as amended,
requires the Company to maintain a leverage ratio (as defined) of no less than
0.4:1 at December 31, 2000, no less than 0.45:1 at December 31, 2001, and no
less than 0.31:1 beginning in 2002. The interest coverage ratio (as defined) may
be no less than 2.5:1 for the period ending December 31, 2000, no less than
2.0:1 at December 31, 2001, and no less than 2.5:1 thereafter. Minimum statutory
capital and surplus of Highlands must be greater than $125,000,000 at December
31, 2000 and 2001, after which it must be $185,000,000. Minimum statutory
capital and surplus for American Reliance's insurance subsidiaries must be no
less than $65,000,000 at December 31, 2000 and $70,000,000 at December 31, 2001,
after which it must be $100,000,000. Most of these finanical covenant
requirements also have certain measurement thresholds on a quarterly basis.

  The Company and the holders of the Debentures also entered into an agreement
dated April 13, 2001, whereby the interest payments due on the Debentures in
June 2001 and December 2001 will be paid by the Company by issuing New
Debentures with interest at 12.5% accruing from the date of issuance and payable
semi-annually in cash beginning May 1, 2002. The New Debentures are due in 2005
and are convertible into Company Common Stock with a conversion price of $6.00
per share.

                                      F-31
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                   SCHEDULE I

                             SUMMARY OF INVESTMENTS
                   OTHER THAN INVESTMENTS IN RELATED PARTIES

                               DECEMBER 31, 2000
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                           Amount at
                                                                                        ---------------
                                                                                          which Shown
                                                                                        ---------------
                                                              Amortized                      in the
                                                             ------------               ---------------
Type of Investment                                               Cost       Fair Value    Balance Sheet
------------------                                           ------------  ------------ ---------------
<S>                                                          <C>           <C>           <C>
At December 31, 2000
Fixed maturity securities available-for-sale:
     United States Government and government agencies            $137,800       138,319       138,319
     States, municipalities and political subdivisions             16,015        15,941        15,941
     Mortgage-backed securities                                   346,124       345,020       345,020
     Corporate securities                                         297,153       277,173       277,173
                                                                 --------       -------       -------
                                                                  797,092       776,453       776,453
  Equity securities                                                30,686        32,091        32,091
                                                                 --------       -------       -------
     Total securities available-for-sale                          827,778       808,544       808,544
                                                                 --------       -------       -------
  Other investments                                                 1,952         1,952         1,952
                                                                 --------       -------       -------
    Total investments                                            $829,730       810,496       810,496
                                                                 ========       =======       =======
</TABLE>




                See accompanying independent auditors' report.

                                      F-32
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                  SCHEDULE II

                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                                 BALANCE SHEETS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                                    December 31,
                                                                                            -----------------------------
                                         ASSETS                                                 2000              1999
                                         ------                                             ------------        --------
<S>                                                                                         <C>            <C>
Investments in subsidiaries                                                                 $    275,318         350,085
Cash and cash equivalents                                                                          7,103          12,731
Accrued investment income                                                                            --               60
Net deferred tax asset                                                                             6,732          29,318
Taxes receivable from subsidiaries                                                                   --            3,022
Deferred debt expense                                                                              2,490           3,475
Other assets                                                                                       3,634           3,045
                                                                                            ------------        --------
     Total assets                                                                           $    295,277         401,736
                                                                                            ============        ========

                        LIABILITIES AND STOCKHOLDERS' EQUITY
                        ------------------------------------
Senior bank debt                                                                            $     49,004          59,004
Convertible subordinated debentures                                                               58,626          57,816
Taxes payable to subsidiaries                                                                      2,526             --
Payable to subsidiaries                                                                            1,002              94
Accounts payable and accrued liabilities                                                           4,640          15,780
                                                                                             -----------        --------
     Total liabilities                                                                           115,798         132,694
                                                                                             -----------        --------

Mandatorily redeemable preferred stock                                                             4,930           4,641
                                                                                             -----------        --------

Stockholders' equity:
  Common stock, $.01 par value; 50,000,000 shares authorized; 13,225,411 shares
     issued and outstanding in 2000, 13,217,903 shares issues and outstanding in 1999                140             140
  Additional paid-in capital                                                                     231,566         231,515
  Accumulated other comprehensive income                                                         (12,572)        (29,184)
  Treasury stock, at cost (739,400 shares in 2000 and in 1999, including 445,900 shares
     held by subsidiaries in 2000 and 1999)                                                       (9,459)         (9,459)
  Deferred compensation on restricted stock                                                       (3,097)         (3,147)
  Retained earnings                                                                              (32,029)         74,536
                                                                                            ------------        --------
     Total stockholders' equity                                                                  174,549         264,401
                                                                                            ------------        --------
     Total liabilities, mandatorialy redeemable preferred securities and stockholders'
       equity                                                                               $    295,277        $401,736
                                                                                            ============        ========
</TABLE>




                See accompanying independent auditors' report.

                                      F-33
<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,
                                                              ---------------------------------------
                                                                 2000           1999          1998
                                                              ----------      --------       -------
<S>                                                           <C>         <C>            <C>
Revenues:
  Net investment income                                       $      254           594           595
  Net realized investment gains                                       --            28            --
                                                              ----------      --------       -------
     Total revenues                                                  254           622           595
                                                              ----------      --------       -------

Equity in net income (loss) of subsidiaries                      (81,714)       (4,257)       11,890
                                                              ----------      --------       -------

Expenses:
  Interest expense                                                11,233        11,952        12,291
  Debt amortization                                                1,511         1,297         1,286
  Other expenses                                                  (1,617)        1,151         3,041
                                                              ----------      --------       -------
     Total expenses                                               11,127        14,400        16,618
                                                              ----------      --------       -------
  Loss before income tax benefit                                 (92,587)      (18,035)       (4,133)
  Income tax expense (benefit)                                    13,689        (4,586)       (7,230)
                                                              ----------      --------       -------
     Net income (loss)                                        $ (106,276)      (13,449)        3,097
Dividends paid on manditorily redeemable preferred stock             289            --            --
                                                              ----------      --------       -------
Net income (loss) attributable to common stockholders         $ (106,565)      (13,449)        3,097
                                                              ==========      ========       =======
Earnings (loss) per common share:
  Basic                                                       $    (8.06)        (1.04)          .24
  Diluted                                                     $    (8.06)        (1.04)          .20
Weighted average number of common shares outstanding:
  Basic                                                           13,221        12,956        13,095
  Diluted                                                         13,221        12,956        15,811
</TABLE>




                 See accompanying independent auditors' report.

                                      F-34
<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,
                                                                                  ----------------------------------------
                                                                                         2000         1999           1998
                                                                                  -----------      -------        -------
<S>                                                                               <C>          <C>           <C>
Cash flow from operating activities:
  Net income (loss)                                                               $  (106,276)     (13,449)         3,097
  Adjustments to reconcile net income (loss) to net cash provided by
   operating activities:
     Equity in net (income) loss of subsidiaries                                       81,714        4,257        (11,890)
     Deferred tax expense (benefit)                                                    13,604       (1,747)        (5,765)
     Debt amortization                                                                  1,308        1,297          1,286
     Dividends received from subsidiaries                                              18,700       17,000         17,500
     Decrease in taxes receivable from subsidiaries                                     5,548          517            284
     Changes in other operating assets and liabilities                                (10,287)       1,541          2,031
                                                                                  -----------      -------        -------
       Total adjustments                                                              110,587       22,865          3,446
                                                                                  -----------      -------        -------
     Net cash provided by operating activities                                          4,311        9,416          6,543
                                                                                 ------------      -------        -------

Cash flows from financing activities:
  Payment for debt issuance expense                                                        --         (147)          (675)
  Repayment of senior bank debt                                                       (10,000)      (5,996)            --
  Issuance of Common Stock                                                                 61        5,474            831
  Acquisition of treasury stock                                                            --         (191)        (3,809)
                                                                                  -----------      -------        -------
     Net cash used in financing activities                                             (9,939)        (860)        (3,653)
                                                                                  -----------      -------        -------
Net increase (decrease) in cash and cash equivalents                                   (5,628)       8,556          2,890
Cash and cash equivalents at beginning of year                                         12,731        4,175          1,285
                                                                                  -----------      -------        -------
Cash and cash equivalents at end of year                                          $     7,103       12,731          4,175
                                                                                  ===========      =======        =======

Supplemental disclosure of cash flow information:
     Interest paid                                                                $    10,700       10,163         10,603
                                                                                  ===========      =======        =======

Noncash financing activities:
  Parent company stock acquired by subsidiaries and held in treasury              $        --           --          5,268
                                                                                  ===========      =======        =======
</TABLE>
                See accompanying independent auditors' report.

                                      F-35
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

               SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                            As of December 31,
                                                              --------------------------------------------
                                                                 Deferred         Losses,
                                                                  Policy        Claims And
                                                                Acquisition        Loss          Unearned
Property/casualty Operations                                       Costs     Expenses/Reserves   Premiums
----------------------------                                    -----------  -----------------  ----------
<S>                                                             <C>          <C>              <C>
2000                                                                $49,622      1,392,497       224,120
                                                                    =======      =========       =======
1999                                                                $33,556      1,353,524       146,832
                                                                    =======      =========       =======
1998                                                                $31,537      1,603,548       137,353
                                                                    =======      =========       =======
</TABLE>


<TABLE>
<CAPTION>
                                                   For the Years Ended December 31,
                            -----------------------------------------------------------------------------
                                                                    Amortization
                                                         Loss And   of Deferred
                                               Net         Loss        Policy        Other        Net
                                Premium     Investment  Adjustment  Acquisition    Operating    Premiums
Property/casualty Operations    Revenue       Income     Expense       Costs       Expenses     Written
----------------------------  ------------  ----------  ----------  ------------  -----------  ----------
<S>                           <C>           <C>         <C>         <C>           <C>          <C>
2000                              $388,505      62,453     346,137        89,962      118,404     460,993
                                  ========      ======     =======        ======      =======     =======

1999                              $325,305      67,684     238,940        65,308      132,140     333,605
                                  ========      ======     =======        ======      =======     =======

1998                              $388,813      77,969     328,400        71,538      141,012     374,816
                                  ========      ======     =======        ======      =======     =======
</TABLE>




                See accompanying independent auditors' report.

                                      F-36
<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>
Premiums Earned:

Year ended December 31, 2000
  Property-liability insurance           $427,268       (50,957)       12,194      388,505          3.1%
                                     ============  ============   ===========  ===========  ===========

Year ended December 31, 1999
  Property-liability insurance           $345,885       (29,761)        9,181      325,305          2.8%
                                     ============  ============   ===========  ===========  ===========

Year ended December 31, 1998
  Property-liability insurance           $406,028       (25,679)        8,464      388,813          2.2%
                                     ============  ============   ===========  ===========  ===========
</TABLE>







                 See accompanying independent auditors' report.

                                      F-37
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

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

<TABLE>
<CAPTION>
                                                                       Additions
                                                             ---------------------------
                                                  Balance at    Charges to                               Balance
                                                  Beginning      Cost And       Other                     At End
                                                  of Period      Expenses     Additions   Deductions    Of Period
                                                 ------------  ------------  -----------  -----------  ------------
<S>                                              <C>           <C>           <C>          <C>          <C>
Year ended December 31, 2000
  Allowance for uncollectible reinsurance(1)     $      2,157         5,220           --           --         7,377
                                                 ============  ============  ===========  ===========  ============
  Allowance for bad debts                               6,680            --           --        1,367         5,313
                                                 ------------  ------------  -----------  -----------  ------------
  Deferred tax asset valuation allowance         $     12,791        82,828           --           --        95,619
                                                 ============  ============  ===========  ===========  ============

Year ended December 31, 1999
  Allowance for uncollectible reinsurance(1)     $      1,702            --          455           --         2,157
                                                 ============  ============  ===========  ===========  ============
  Allowance for bad debts(2)                            9,128            --           --        2,448         6,680
                                                 ------------  ------------  -----------  -----------  ------------
  Deferred tax asset valuation allowance(3)      $     18,994            --           --        6,203        12,791
                                                 ============  ============  ===========  ===========  ============

Year ended December 31, 1998
  Allowance for uncollectible reinsurance(1)     $      2,157            --           --          455         1,702
                                                 ============  ============  ===========  ===========  ============
  Allowance for bad debts                               7,662         1,466           --           --         9,128
                                                 ------------  ------------  -----------  -----------  ------------
  Deferred tax asset valuation allowance         $     19,567            --           --          573        18,994
                                                 ============  ============  ===========  ===========  ============
</TABLE>
--------------
(1)  Deductions in the allowance for uncollectible reinsurance represent
     write-offs, net of recoveries, of amounts determined to be uncollectible.
(2)  $1.2 million of the deduction relates to the write-off of LMI.
(3)  $5.6 million of the deduction relates to the write-off of LMI.





                See accompanying independent auditors' report.

                                      F-38
<PAGE>

                        HIGHLANDS INSURANCE GROUP, INC.

                                  SCHEDULE VI

                SUPPLEMENTAL INFORMATION CONCERNING CONSOLIDATED
                     PROPERTY/CASUALTY INSURANCE OPERATIONS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                        As of December 31,
                                                            -------------------------------------------
                                                                 2000             1999           1998
                                                            --------------     ---------      ---------
<S>                                                         <C>             <C>            <C>
Deferred policy acquisition costs                               $   49,622        33,556         31,537
Loss and loss adjustment expense reserves                       $1,392,497     1,353,524      1,603,548
Unearned premiums                                               $  224,120       146,832        137,353

                                                                 For the Years Ended December 31,
                                                            -------------------------------------------
                                                                      2000          1999           1998
                                                                -----------     ---------      ---------
Net premiums earned                                             $  388,505       325,305        388,813
Net investment income                                               62,453        67,684         77,969
Net loss and loss adjustment expense incurred:
  Current year                                                     321,181       247,027        256,528
  Commutation of Aggregate Excess of Loss Reinsurance                   --            --         50,000
  Prior year                                                        24,956        (8,087)        21,872
                                                                ----------     ---------      ---------
                                                                $  346,137       238,940        328,400
                                                                ==========     =========      =========

Amortization of deferred policy acquisition costs               $   89,962        65,308         71,538
Net paid loss and loss adjustment expense                       $  319,603       346,572        370,125
Net premiums written                                            $  460,993       333,605        374,816
</TABLE>



                See accompanying independent auditors' report.

                                      F-39