_________ (1) The Company provides for income taxes in its statements of operations pursuant to Financial Accounting Standards Board Statement of Financial Accounting Standards No. ("SFAS") 109, "Accounting for Income Taxes." For further information regarding federal and foreign income taxes, see Note 7 to Consolidated Financial Statements. (2) Net Premiums written to policyholder surplus includes twelve months pro forma net premiums written for American Reliance. (3) The Company obtained permission from the Texas, Wisconsin and California insurance departments to discount its loss and loss adjustment expense reserves by 5% in connection with the preparation of the 2001 annual statutory statements for the Company's insurance subsidiaries domiciled in those states. Without this permitted statutory accounting for loss and loss adjustment expense reserves, the Company's principal insurance subsidiaries, Highlands Insurance Company, Northwestern National Casualty Company and Pacific National Insurance Company, would have reported negative surplus at December 31, 2001. The above table reflects the permitted discounting.
Property and casualty insurers are regulated by the various state insurance commissioners who coordinate their efforts through the NAIC. See Item 1: "Business--Regulation." Regulation includes rate and policy form approval, licensing of insurance agents and companies and solvency oversight.
The Company's most critical accounting policy is its estimate of incurred losses and loss adjustment expenses, including the reserve for loss and loss adjustment expenses. These estimates also directly impact the reinsurance items, primarily the receivable from reinsurers included in the consolidated financial statements.
The process of estimating loss reserves involves many variables and subjective judgments. As part of the reserving process, insurers review historical data and consider the impact of various factors such as changes in the Company's operations (such as underwriting or claims handling), trends in claim frequency and severity, emerging economic and social trends, inflation and changes in the regulatory and litigation environments. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy of reserves is affected by many factors.
As a result of a reserve analysis done in the fourth quarter of 2001 by the Company and its independent actuary, it was determined that there had been adverse development in the 2000 accident year of approximately $89 million. The 2000 accident year net loss and net loss adjustment expense ratio is 100.1%. Also, the reserve analysis demonstrated that losses incurred and loss adjustment expenses in the 2001 accident year would exceed the Company's estimates by more than 10 percentage points. For 2001, the Company recorded a 95% accident year and a 134.3% calendar year loss and loss adjustment expense ratio on $496.6 million of net earned premium. The adverse development in 2001 and 2000 came primarily from the following four lines of business--workers' compensation, general liability, commercial multiple peril and commercial auto liability. The adverse development amounts related to asbestos and environmental claims for 2001, 2000 and 1999 were $14.8 million, $7.8 million and $1.8 million, respectively.
The results of the Company's consolidated operations for the periods indicated are set forth below:
Gross premiums written for retrospectively rated policies may be adjusted up or down, subject to certain limitations contained in the policy, based on the estimated loss experience of the insured during the policy period. The Company estimates ultimate losses for retrospectively rated policies and then adjusts gross premiums written and premiums due from policyholders for changes in estimated ultimate losses and loss adjustment expenses from the date of the prior valuation. These adjustments may cause gross premiums written, net premiums written and net premiums earned to fluctuate significantly from period to period. Experience rated insurance policies reduce but do not eliminate risk to the insurer.
Net Premiums Written. Net premiums written for 2001, 2000 and 1999 were $442.0 million, $461.0 million and $333.6 million, respectively. The decrease in 2001 of $19.0 million or 4.1% and the increase in 2000 of $127.4 million or 38.4% relate to the same factors noted above for gross written premiums.
Net Premiums Earned. Net premiums earned for 2001, 2000 and 1999 were $496.6 million, $388.5 million and $325.3 million, respectively. The increase in 2001 compared to 2000 and the increase in 2000 compared to 1999 are related to the same items affecting gross and net premiums written as noted above, but also reflects the recognition of net premiums earned over the coverage period rather than when the premiums were written.
Debt Interest and Amortization Expense. Debt interest and amortization expense for 2001, 2000 and 1999 was $11.4 million, $12.4 million and $11.8 million, respectively. The decrease in debt interest and amortization expense of $1.0 million in 2001 reflects the paydown of the Company's senior bank debt and a lower variable interest rate in 2001. The increase in debt interest and amortization expense for 2000 compared to 1999 was due to the increase in the underlying variable interest rate and variable performance add-ons associated with the Company's senior bank debt.
Loss on Write-off of Subsidiary. Effective December 1999, the Company wrote- off its remaining investment in LMI which was in run-off since April 1997 when it was acquired in the purchase of American Reliance. In March 2000, the Court of Common Pleas in Franklin County, Ohio entered an Order appointing the Superintendent of Insurance of the State of Ohio as the
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.
As a result of the losses incurred by the Company's insurance subsidiaries, one or more state insurance commissioners could seek to place the Company's insurance subsidiaries that are under their jurisdiction in rehabilitation or liquidation. If an insurance subsidiary were placed in rehabilitation or liquidation, the Company would lose control of that insurance subsidiary.
Insurance Operations. The principal sources of funds for the insurance subsidiaries are premiums and amounts earned from the investment of such premiums. The principal uses of funds by these subsidiaries are loss payments and related expenses, underwriting expenses, other operating expenses and dividends and tax sharing payments to Highlands Group. As a result of the insurance subsidiaries ceasing to write any new business and not renewing existing business, premium income to the Company will be materially reduced in the future.
The following table sets forth certain information with respect to the Company's combined statutory surplus ("U.S. Insurance Subsidiaries") at the dates indicated.
The statements included in this Annual Report on Form 10-K for the year ended December 31, 2001, regarding future financial performance and results and other statements that are not historical facts are forward-looking statements. The words "expect," "project," "estimate," "predict," "anticipate," "believes" and similar expressions are also intended to identify forward-looking statements. Such statements are subject to numerous risks, uncertainties and assumptions, including but not limited to, the uncertainties relating to industry and market conditions, natural disasters and other catastrophes, and other risks and uncertainties described in this 2001 Annual Report and in the Company's other filings with the Securities and Exchange Commission. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual outcomes may vary materially from those indicated.