- -------- (1) The Company recorded a charge to pre-tax earnings during the year ended December 31, 1995 of $125 million as more fully discussed under "Management's Discussion and Analysis of Financial Condition and Results of Operation--Results of Operations."
(2) The Company provides for income taxes in its statements of operations pursuant to Financial Accounting Standards Board Statement of Financial Accounting Standards No. ("SFAS") 109, "Accounting for Income Taxes." With respect to losses for periods preceding the Distribution, no tax benefits were recorded
As discussed in Note 2 to the Consolidated Financial Statements, on April 30, 1997, Highlands Group completed the acquisition of Vik Brothers Insurance, Inc., renamed American Reliance, Inc. The acquisition was accounted for under the purchase method of accounting and, accordingly, the consolidated financial statements include the results of American Reliance's operations only from date of acquisition. The American Reliance Division consists of business managed by the Company's Lawrenceville, New Jersey office.
The 1997 underwriting loss of $50.0 million decreased $11.0 million compared to 1996. The underwriting loss for 1997 includes reductions in the underwriting loss of the Highlands Division of $19.5 million and the Discontinued Lines of $4.4 million from 1996 which is offset by the $12.9 million underwriting loss of the American Reliance Division. Also see "-- Highlands Division," "American Reliance Division" and "Discontinued Lines" for additional comments.
Net investment income for 1997, 1996 and 1995 was $74.4 million, $51.0 million and $48.5 million, respectively. Net investment income for 1997 increased from 1996 primarily due to the inclusion of the American Reliance Division. Net investment income for 1996 increased from 1995 primarily as a result of the additional
investable funds from the issuance of the Debentures and tax proceeds from the Company's former parent. The 1996 net investment income is partially offset by lower interest rates in 1996. Net realized investment gains have not been a significant portion of revenue for the Company and were $5.6 million, $1.2 million and $2.6 million for 1997, 1996 and 1995, respectively.
Debt interest and amortization expense for 1997 compared with the same period for 1996 increased $3.7 million as a result of the $65 million Credit Agreement used to finance the purchase of American Reliance. The increase between 1995 and 1996 is a result of net interest expense, amortization of debt discount and debt acquisition costs related to the Debentures.
Other expenses consist of holding company expenses offset by miscellaneous income and expense from the insurance subsidiaries. Other miscellaneous income from the American Reliance Division reduced other expenses for 1997 compared with 1996.
Gross Premiums Written. Gross premiums written for 1997, 1996 and 1995 were $129.5 million, $151.4 million and $215.2 million, respectively. The decrease of $21.9 million or 14.5% in 1997 is attributable to several factors. In March 1996, the Company began underwriting initiatives to focus on stricter underwriting standards and price increases, both of which have contributed to declines in gross premiums written in the Special
Gross premiums written for retrospectively rated policies may be adjusted up or down, subject to certain limitations contained in the policy, based on the estimated loss experience of the insured during the policy period. The Company estimates ultimate losses for retrospectively rated policies and then adjusts gross premiums written and premiums due from policyholders under retrospectively rated policies for changes in the estimated ultimate loss and loss adjustment expense from the date of the prior valuation. These adjustments may cause gross premiums written to fluctuate significantly from period to period. Experience rated contracts reduce but do not eliminate risk to the insurer.
Net Premiums Written. Net premiums written for 1997, 1996 and 1995 amounted to $117.8 million, $130.7 million and $189.4 million, respectively. The decrease of $12.9 million or 9.9% in 1997 is related to the same issues affecting gross premiums written.
Underwriting expenses for 1996 were increased by charges of $1.1 million for underaccrued premium taxes, a $1.3 million restructuring charge and $2.0 million for litigation proceedings against the Company.
American Reliance was acquired on April 30, 1997 and accounted for as a purchase. Accordingly, the above results are for the eight months ended December 31, 1997 and are included in the consolidated results of the Company.
Gross Premiums Written. Gross premiums written for the eight months ended December 31, 1997 were $214.8 million. Although prior period gross premiums written are not presented, gross premiums written have declined approximately 14% due to stricter underwriting standards, increased price competition and the temporary decline in the A.M. Best ratings for certain of the American Reliance Division's insurance subsidiaries prior to the acquisition. In addition, the September 1997 sale by the American Reliance Division of Northwestern National County Mutual (NNCM), decreased gross premiums written in 1997 by $8.9 million.
For reporting purposes, Highlands Group has three lines of business which are considered Discontinued Lines, specifically business originated by the Highlands Group's London operations, an umbrella/excess liability policy program and assumed casualty and property reinsurance contracts. The Company has ceased to write these Discontinued Lines and canceled all remaining voluntary assumed casualty and property reinsurance contracts during 1996.
The Discontinued Lines percentage of gross premiums written to the Company totals for 1997, 1996 and 1995 was 0.5%, 4.5% and 8.2%, respectively, while the percentage of underwriting losses to the Company totals for the same time periods was 19.2%, 23.0% and 55.1%, respectively.
London-Originated Business. The Company participated in the London insurance markets from 1972 until 1982 through a branch office in London (the "Highlands London Branch"). The primary business of the Highlands London Branch was the direct writing and reinsurance of general liability risks for insureds in the United States and other London market marine and aviation risks. The Highlands London Branch ceased doing business in the United Kingdom when Highlands (UK) was formed in 1982 in order to withdraw from direct writing of marine and aviation and significantly reduce the reinsurance of U.S. casualty risks through the London operations. Highlands (UK) served as an insurer and reinsurer in London markets primarily by participating in excess of loss reinsurance liability policies, which included coverage for catastrophe losses of customers in excess of policy limits of other applicable policies. Highlands (UK) ceased writing new policies in early 1993. Accordingly, the Company's continuing exposure on the business of the Highlands London Branch is generally attributable to adverse loss reserve development on asbestos and environmental claims whereas the ongoing exposure of Highlands (UK) is primarily related to adverse loss reserve development on the high levels and severity of catastrophe claims that have occurred since 1988 and have been slow to emerge in the London excess market.
Assumed Casualty and Property Reinsurance. Highlands participated in approximately 200 assumed casualty reinsurance agreements per year (primarily written from 1969 through 1974) as an excess of loss reinsurer with participation percentages that varied from contract to contract. The majority of assumed casualty treaties were nonrenewed by the end of 1976. The Company participated at levels of $50,000 to $250,000 per contract on hundreds of assumed property reinsurance contracts per year from 1969 through 1994. Loss development on the assumed casualty treaties has primarily emanated from product liability, asbestos and environmental pollution liability, particularly for accident years 1971 through 1974. Development on the assumed property reinsurance agreements has primarily related to catastrophe exposures.
Net Premiums Earned. Net premiums earned were $0.4 million, $7.1 million and $14.3 million in 1997, 1996 and 1995, respectively. The decline since 1995 is due to the cancellation of all remaining voluntary assumed reinsurance contracts in 1996. However, due to the nature of the Company's reinsurance contracts, small premium adjustments can continue long after cancellation of such agreements.
Expense Reserves" below. The decrease for 1996 compared to the same period for 1995 is primarily the result of the 1995 third quarter charge of $81.3 million. See "--1995 Third Quarter Charge" below.
During the last several years, the Company has experienced significant adverse development on prior years net ultimate loss estimates. The following table sets forth the amount of the adverse development split between lines other than Discontinued Lines and Discontinued Lines for the periods indicated.
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
On April 30, 1997, Highlands Group acquired Vik Brothers Insurance, Inc. ("VBI") and its subsidiaries. Immediately after the consummation of the acquisition, VBI was renamed American Reliance, Inc. American Reliance is a holding company and has no direct operations. American Reliance's principal assets are the capital stock of its insurance subsidiaries.
The acquisition was financed with a combination of common stock, bank debt, preferred stock and cash. In connection with the acquisition, Highlands Group paid approximately $55.4 million in cash (including $35.6 million to repay American Reliance's outstanding bank debt) and issued 1,656,700 shares of its common stock (representing approximately 12.6% of Highlands Group's then outstanding common stock) and 21,366 shares of newly issued series one preferred stock to the holders of the common stock warrants, preferred stockholders and creditors of American Reliance. The closing price of Highlands Group's Common Stock was $17.625 on April 30, 1997. The preferred stock is currently owned by a subsidiary of American Reliance and has a preference value of $1,000 per share. Simultaneously with the closing, Highlands Group contributed approximately $41.5 million to the capital of the insurance subsidiaries of American Reliance.
As a holding company, Highlands Group's principal requirements for funds are to pay operating expenses, franchise and other taxes, debt service and dividends. Operating expenses and franchise and other taxes imposed on the Company are not expected to be material. The annual cash interest requirements relating to the Debentures and the Credit Agreement are approximately $10.7 million. Highlands Group does not currently intend to pay dividends on its Common Stock. In light of the Company's corporate strategy, an additional use of funds may be to invest in other insurance companies or other insurance operations.
Highlands Group's principal sources of funds are dividends and tax sharing payments from Highlands and American Reliance, if any, and funds that may be raised from time to time from the issuance of additional debt or equity securities. The payment of dividends by the insurance subsidiaries is subject to restrictions and limitations imposed by the insurance regulatory authorities. Dividend payments to Highlands Group from its insurance subsidiaries are limited to $30.6 million in 1998 without prior regulatory approval. Both the issuance of additional debt and the issuance of additional equity securities at a price less than current market price would require the consent of the holders of a majority in interest of the Debentures pursuant to the covenants contained in the Debentures.
Statutory Surplus. Maintenance of appropriate levels of statutory surplus of the Company's United States domiciled insurance subsidiaries is a primary objective of the Company and is also important to regulatory authorities and insurance rating agencies. In addition, increased public and regulatory concerns regarding the financial stability of participants in the insurance industry have caused greater emphasis to be placed by current and potential customers upon the ratings assigned to property and casualty insurance companies. Highlands has been assigned an "A-" (Excellent) rating by A.M. Best. The principal insurance subsidiaries of American Reliance have been assigned an A.M. Best rating of "B+" (Very Good). One American Reliance insurance subsidiary has been rated "B-" (Fair) and another, LMI, which has ceased current operations, has been rated "D" (Poor).
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.
Highlands Division. The Highlands Division is creating a new processing platform for its business. A by-product of this will be a processing platform that is year 2000 compliant. The new platform will be composed of three major sub-systems: policy administration; claim administration; and management and financial reporting. The policy administration component, in part internally developed but substantially purchased, will permit the processing of year 2000 business on a new and renewal basis starting in the fourth quarter of 1998. Conversion to the new system will take approximately one year. The claim administration component will also be purchased and is planned for full conversion during the second quarter of 1999. The management and financial reporting system is made up of a series of deliverables starting with the implementation of a new general ledger in 1996 and concluding with a full reporting system in the second half of 1999.
American Reliance Division. In 1994, American Reliance, working with an outside vendor, began a project to create a single processing platform for all of its business that, among other things, would be able to process its year 2000 and subsequent business and related claims. In August 1997, Phase One of this project, covering new and renewal business for a portion of the commercial multiple peril line and the commercial automobile, general liability and personal lines, representing approximately 70% of the Division's business, began to be implemented on a new and renewal business basis. The American Reliance Division is currently processing business on this new platform. Implementation of Phase One is scheduled to be completed between August and November 1998.
Phase Two of the project, covering the balance of the commercial multiple peril line and the workers compensation and commercial umbrella lines, representing the balance of the Division's business, is expected to commence implementation in October 1998 and is scheduled to be completed by October 1999. Based on this schedule, the Company believes that the new processing platform for the American Reliance Division will be completely operational by the end of 1999.
The American Reliance Division will use the financial reporting system being implemented by the Highlands Division, once the system is operational. The cost of the above items relates to replacing the Company's legacy systems. The cost of addressing year 2000 specific issues is not expected to be material.
The Company believes that, with modifications to existing software and converting to new software, the year 2000 issue will not pose significant operational problems for the Company's computer systems as so modified and converted. However, if such modifications and conversions are not completed timely, the year 2000 issue could have a material impact on the operations of the Company.