The Company leases its principal executive offices in Houston, Texas. The Company also leases offices in Dallas, El Paso and San Antonio, Texas and Metairie, Louisiana. The Company has three leased offices in California, two of which have been sublet and one of which the Company is currently attempting to sublet. The Company believes that it has adequate space for its current operations and to accommodate expansion.
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 (primarily through its curtailed assumed reinsurance operations). Growth in liabilities related to asbestos and environmental risks has also adversely affected the industry and are of significance to the Company. See "--Results of Operations--1995 Third Quarter Charge--Environmental Reserves (Including Asbestos)" below.
Property and casualty insurers are regulated by the various state insurance departments that coordinate their efforts through the National Association of Insurance Commissioners ("NAIC"). Regulation includes rate and policy form approval, licensing of insurance agents and companies and solvency oversight. As a result of recent legislative changes in the Texas insurance market, beginning with Senate Bill 1 aimed at workers' compensation reform, which became effective January 1, 1991, the Texas insurance climate has become more attractive to insurers.
Umbrella/Excess Liability Program. Beginning in the early 1970s, Highlands wrote policies that provided the customer with umbrella and excess liability coverage with respect to losses which exceeded another insurer's primary and excess policy coverages. The threshold at which coverage commenced under such policies underwritten by the Company varied from $300,000 to $100 million and above. The limits of coverage under the Company's excess liability policies were generally up to $10 million (in excess of underlying policies) and the Company generally limited its exposure through substantial reinsurance. The program was canceled and underwriting operations ceased effective December 31, 1985. The Company's adverse loss experience on these policies has primarily emanated from asbestos and environmental pollution claims.
Assumed Casualty and Property Reinsurance. Highlands participated in approximately 200 assumed casualty reinsurance agreements per year (primarily written from 1969 through 1974) as an excess of loss reinsurer with participation percentages that varied from contract to contract. A majority of assumed casualty treaties were nonrenewed by the end of 1976. All remaining casualty contracts were canceled by December 31, 1996. The Company participated at levels of $50,000 to $250,000 per contract on hundreds of assumed property reinsurance contracts per year from 1969 through 1994. Loss development on the assumed casualty treaties has primarily emanated from product liability, asbestos and environmental pollution liability, particularly for accident years 1971 through 1974. Development on the assumed property reinsurance agreements has primarily related to catastrophe exposures. For 1992 and prior periods, Highlands was a direct writer of Florida commercial and personal homeowners lines and acted as a fronting company for the Southern Underwriters Inc. Quota Share Facility (the "Southern Underwriters Facility"), which reinsured substantially all of this risk. Due to Highlands' participation (approximately 6.5%) as a reinsurer of the Southern Underwriters Facility, this business was managed as and included with the assumed property reinsurance business. Subsequent to the termination of the Southern Underwriters Facility in 1993, the Company's Florida direct business has been (and will continue to be) managed as and included with the assumed property reinsurance business. In 1996, as permitted by the laws of the State of Florida, the Company ceased writing the Florida personal homeowners line of business.
Net investment income for the years ended December 31, 1996, 1995 and 1994 amounted to $51.0 million, $48.5 million and $46.7 million, respectively. Net investment income for 1996 increased from 1995 primarily as a result of the additional investable funds from the issuance of the Debentures and tax proceeds from the Company's former parent. The income is partially offset by lower investment rates in 1996. The increase between 1994 and 1995 reflects an increase in average invested assets and a higher investment yield during 1995 as a result of moving to taxable investments. Net realized investment gains have not been a significant portion of revenue for the Company and amount to $1.2 million, $2.6 million and $1.9 million for the years ended December 31, 1996, 1995 and 1994, respectively.
Other expenses for the year ended December 31, 1996 compared with the same period for 1995 increased due to additional expenses associated with being a public company.
Gross premiums written and net premiums written have been redefined for all periods presented to include the effects of changes in premiums due under retrospective policies. Such changes were previously recorded only as net premiums earned.
The underwriting results excluding Discontinued Lines primarily consist of relatively large commercial accounts (Special Accounts), medium to small commercial accounts (Commercial Insurance), insurance for Halliburton (Insurance Services), commercial marine products (Marine Division) and surety products (Surety Division).
Gross Premiums Written. Gross premiums written for the years ended December 31, 1996, 1995 and 1994 amounted to $151.4 million, $215.2 million and $247.6 million, respectively. The decrease of $63.8 million or 29.6% in 1996 is attributable to several factors. The Company began its underwriting initiatives in March 1996 and continues to focus on stricter underwriting standards and price increases both of which have contributed to declines in gross premiums written. Also contributing to declines in gross premiums written is the highly competitive market conditions for Special Accounts customers. In this highly competitive market, Special Accounts has become more selective in its initial underwriting as well as renewal activity. Finally, Insurance Services' mix of business continues to change from retrospectively rated policies to high deductible policies which produce lower gross premiums.
Gross premiums written for 1996 were also impacted by the decision to exit the probate bonding business. On March 1, 1996, the Company reinsured 100% of its inforce policies, subject to a profit sharing arrangement. The year ended December 31, 1996 includes $6.2 million of probate bonding gross premiums written compared
Gross premiums written for retrospectively rated policies may be adjusted up or down, subject to certain limitations contained in the policy, based on the estimated loss experience of the insured during the policy period. The Company estimates ultimate losses for retrospectively rated policies and then adjusts gross premiums written and premiums due from policyholders under retrospectively rated policies for changes in the estimated ultimate loss and loss adjustment expense from the date of the prior valuation. These adjustments may cause gross premiums written to fluctuate significantly from period to period. Gross premiums written for the year ended December 31, 1996 compared to the like period in 1995 were also impacted by a $4.9 million decrease in written premium on Insurance Services retrospectively rated policies. Experience rated contracts reduce but do not eliminate risk to the insurer.
Net Premiums Earned. Net premiums earned for the years ended December 31, 1996, 1995 and 1994 amounted to $144.9 million, $187.2 million and $208.6 million, respectively. The decrease of $42.3 million or 23% in 1996 is related to the same issues affecting gross and net premiums written. The decline of $21.4 million or 10% in 1995 reflects the cessation of California-sourced business and the loss of two Special Accounts customers.
Additionally, the year ended December 31, 1996 reflects the lower incurred losses subject to retrospectively rated policies and the impact of declining premium volume. See Item 1: "Business--Loss and Loss Adjustment Expense Reserves" for a discussion of the process of estimating loss reserves.
The year ended December 31, 1996 underwriting expenses included two other unusual items of significance amounting to $2.4 million. The Company implemented a plan under which it recorded a $1.3 million restructuring charge as part of its strategic and financial assessment of the Company's business. Additionally, a charge of $1.1 million was recorded for underaccrued premium taxes.
The 1995 increase in underwriting expenses from 1994 amounted to $20.6 million and was due largely to $10.5 million of legal reserve increases, of which $8.0 million was included in the 1995 Third Quarter Charge. See "--1995 Third Quarter Charge". Additionally, 1994 underwriting expenses were reduced by the receipt of an $8.4 million refund from the Texas Workers' Compensation Insurance Facility.
Net Premiums Earned. Net premiums earned were $7.1 million, $14.3 million and $33.1 million in 1996, 1995 and 1994, respectively. The decline is due to the runoff of canceled assumed reinsurance and the declining premiums from Highlands (UK), which ceased writing new business in 1993. However, due to the nature of the Company's policies and reinsurance contracts, small premium adjustments can continue subsequent to cancellation.
Losses and Loss Adjustment Expenses Incurred. Losses and loss adjustment expenses amounted to $17.1 million, $103.3 million and $55.7 million for the years ended December 31, 1996, 1995 and 1994, respectively. The decrease for the year ended December 31, 1996 compared to the same period for 1995 is primarily the result of the 1995 third quarter loss and loss adjustment expense charge of $81.3 million. See "--Loss and Loss Adjustment Expense Reserves" and "--1995 Third Quarter Charge". The decline for 1996 also reflects the decline in premium volume offset by development on prior year loss reserve. The prior year reserve strengthening in 1996 related to: asbestos, environmental and other toxic torts of $3.8 million; assumed reinsurance workers' compensation of $3.0 million; and all other of $6.1 million. In addition, the Company's participation in an assumed reinsurance contract resulted in a $.5 million loss from the ValuJet catastrophe and a $.5 million loss from the TWA flight 800. Losses and loss adjustment expenses incurred in 1994 reflect loss development on the significant catastrophe losses that have plagued the industry since 1988 and incurred losses related to asbestos and environmental exposures. The Company's catastrophe losses for 1994 were primarily experienced through Highlands (UK) and the assumed property reinsurance business. Losses and loss adjustment expenses incurred for Highlands (UK) amounted to $13.6 million in 1994 and included net loss development of approximately $9.3 million ($44.5 million before deducting reinsurance) related to catastrophe claims. The catastrophe claims include Hurricane Andrew, European Storms, Pan Am Lockerbie and Kuwait Airlines.
In the third quarter of 1995, the Company and its external actuaries conducted a review of its loss and loss adjustment expense reserves to assess the Company's reserve position. As a result of such review, the Company recorded a charge to pre-tax earnings during the nine months ended September 30, 1995 of $125.0 million. Of
The third quarter of 1995 reserve review reevaluated the Company's potential environmental exposure, including a review of possible exposure under policies provided to specific high-profile or "target" potential defendants (companies identified as being primarily involved in the creation of environmental risks, such as asbestos manufacturers), without regard to whether claims have been reported under such policies; the segmentation of environmental and asbestos data on the U.S. portion of assumed reinsurance; and the review and discussion of the conclusions of the examination with the Company's external independent actuaries.
The difficulties inherent in the establishment of loss and loss adjustment expense reserves for property and casualty companies are magnified when estimating exposure from environmental claims. Estimation of exposure in regard to such claims involves a large number of variables which are difficult to establish with precision, including determining the actual scope of coverage under existing policies, fixing the date of an occurrence of a covered loss, estimating the ultimate proportion of pollution clean-up costs that will be borne by liable parties, evaluating the potential for and nature of legislative relief and other similar items. The Company's historical estimates of reserves for environmental claims for two of the Discontinued Lines and the primary general liability line have relied primarily upon loss payment and emergence patterns without regard to the year of occurrence separated between asbestos and pollution claims. The assumptions employed in the recent loss review involved lengthening the assumed loss payment and emergence patterns for pollution claims, which resulted in increased indicated reserves related to these claims across all three business product lines affected by environmental risks.
In the U.S. market, the Company participated in approximately 200 assumed casualty reinsurance contracts per year between 1969 and 1974 before the product line was substantially discontinued. As a participant with other reinsurers, the Company generally assumed a small percentage of each reinsurance placement. The majority of the Company's exposure for environmental claims on these agreements relates to risks reinsured in the early to mid-1970s.
Non-Environmental Exposure on Assumed Reinsurance, Catastrophe Losses and Other Insurance Related Reserves. The Company also established an additional reserve of $13.1 million ($27.7 million before deducting reinsurance) for unreported losses relating to the non-environmental exposures for the two assumed reinsurance treaty groups described above. This estimate was developed in reliance upon historical emergence patterns for Highlands' assumed reinsurance treaties, reported development patterns compiled by the Reinsurance Association of America, actuarial estimates provided by the ceding companies and management's judgment as to the likely effects of these factors on the Company's loss exposure.
Litigation Reserves. As indicated above, the Company increased its reserves for litigation and administrative proceedings against the Company by $8.0 million during the third quarter of 1995 and by an additional $2.5 million in the fourth quarter of 1995. In addition, litigation reserves were increased by $2.0 million in 1996. See Item 3: "Legal Proceedings."
On February 3, 1997, this matter was settled for $5.7 million and such amount is not in excess of current legal reserves and is not expected to have a material adverse effect on the financial condition of the Company. The settlement will be submitted to the Administrative Law Judge and the Commissioner of Insurance for their approval, and the Company has no reason to believe at this time that the settlement will not be approved. In the event the settlement is not approved, the Company will continue to defend this matter vigorously.
The remaining portion of the legal reserves relates to various claims and legal actions arising in the ordinary course of the Company's business.
The Company is a holding company, the principal assets of which are all of the capital stock of Highlands and $47.0 million of fixed maturities and cash and cash equivalent investments at December 31, 1996. The Company's property and casualty insurance business is conducted by Highlands and the other Insurance Subsidiaries. The liquidity and capital resource considerations for the Company and its Insurance Subsidiaries are different.
Prior to the Distribution, the Company was included in the Halliburton consolidated U.S. federal tax return. An intercompany tax-sharing arrangement between the Company and Halliburton resulted in the Company receiving from or paying to Halliburton a cash payment for U.S. federal income taxes based on financial reporting (book) income rates that were determined by Halliburton. The Company was not charged more U.S. federal income tax than it would have paid on a separate return basis. Pursuant to SFAS 109, the Company provided for income taxes on its statements of operations as if it had filed separate tax returns in each taxing jurisdiction (separate return method). Differences between income tax provisions calculated using the separate return method and amounts calculated under the intercompany tax-sharing arrangements are reflected as additions or reductions to stockholders' equity, as appropriate. In 1996 the Company received from Halliburton and forwarded to its Insurance Subsidiaries approximately $42.2 million in cash related to the tax benefit of the significant tax losses incurred in 1995 which are utilizable by Halliburton.
The tax-sharing agreement resulted in Halliburton acquiring the domestic deferred tax assets and liabilities from its U.S. subsidiaries. In contemplation of Halliburton's distribution of the Company's shares, Halliburton contributed to the Company in 1995 the net deferred tax assets attributable to the Company which the Company recorded as a contribution to capital. Based on the tax-free nature of the spin off, the deferred tax asset attributes are available to the Company.
As a holding company, the Company's principal requirements for funds are to pay operating expenses, to pay franchise and other taxes, to pay debt service and to pay dividends. Operating expenses and franchise and other taxes imposed on the Company are not expected to be material. The annual cash interest requirements relating to the debentures will be approximately $6.0 million. The Company does not currently intend to pay dividends on the Company Common Stock. In light of the Company's corporate strategy, an additional use of funds may be to invest in other insurance companies or other insurance operations.
On February 13, 1997, the Company signed an amended and restated agreement and plan of merger which revised the terms of the agreement originally entered into June 21, 1996. On March 10, 1997, the Company entered into an amendment to the February 13, 1997 agreement. Under the revised terms, the Company will acquire VBII for aggregate consideration of approximately $97 million consisting of the issuance of 1.4 million shares of Company Common Stock valued at $21.50 per share representing 12.5% of the then outstanding Company Common Stock, the refinancing of $40 million in debt, the issuance of $21.4 million of preferred stock and $4 million of cash.
Consummation of the acquisition is subject to certain consents, waivers or other agreements from certain securityholders of VBII and other third parties, as well as regulatory approval. The transaction is expected to be completed in the second quarter of 1997.
The NAIC has 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 with respect to a company's mix of products and its balance sheet. Highlands' authorized control level RBC, as defined by the NAIC, was $56.6 million on December 31, 1996 which was substantially below Highlands' existing capital of $187.0 million. The other U.S. Insurance Subsidiaries have an RBC amount above the authorized control level RBC as defined by the NAIC.
The NAIC's Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators primarily to assist state insurance departments in executing their statutory mandate to oversee the financial condition of insurance companies operating in their respective states. IRIS helps to identify those companies that merit the highest priority in the allocation of the regulators' resources on the basis of eleven financial ratios which are calculated annually from financial information obtained from insurers' statutory annual statements. A "usual range" of results for each ratio is used as a benchmark. The ratios and benchmark comparisons are calculated within defined parameters and are not intended to replace the Insurance Commissioners' own in-depth financial analysis or on-site examinations. Departure from the usual range on four or more of the ratios could lead to inquiries from individual Commissioners.
The Consolidated Financial Statements are set forth herein beginning on page 43 of this Report.