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.
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 2001 loss and loss adjustment expense reserves for the insurance subsidiaries, as required for their statutory filings with the various insurance departments.
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 on reported losses. A significant portion of the Company's loss reserves are the reserves relating to unreported losses. These reserves, by definition, are not established for specific claims. In calculating reserves for unreported losses, therefore, the Company estimates the ultimate net liability for losses using various techniques. Such reserves are established based on loss experience and are grouped both by class of business and by accident year. Reserve adjustments relating to unreported losses are also made to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing and other items that can be expected to affect the Company's liability for losses over time.
During the loss adjustment period, additional facts regarding individual claims may become known. As the Company becomes aware of additional facts, it may become necessary for it to refine and adjust liability estimates, and even after adjustment, the ultimate net liability for claims may be less than or greater than the revised estimates.
Gross Premiums Written. Gross premiums written for 2001, 2000 and 1999 were $499.0 million, $517.1 million and $364.1 million, respectively. The decrease in gross premiums written of $18.1 million or 3.5% in 2001 is primarily due to the implementation of the Company's financial plan to reduce premiums and operating expenses. 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 a 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.
Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense incurred for 2001, 2000 and 1999 were $667.2 million, $346.1 million and $238.9 million, respectively. The loss and loss adjustment expense ratios for 2001, 2000 and 1999 were 134.3%, 89.1% and 73.5%, respectively. During the fourth quarter of 2001, the Company, along with its independent actuary, determined that there had been adverse development in the Company's major lines of business. Following this analysis, loss and loss adjustment expense reserves were increased at the end of 2001 by approximately $190 million. The increase in reserves affected current as well as prior year business, and increased the 2001 calendar year loss ratio by approximately 10 percentage points, excluding the effects of certain reserve adjustments on retrospectively rated policies which were offset by net premiums earned. 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.
Investment Results. Net investment income for 2001, 2000 and 1999 was $58.8 million, $62.5 million and $67.7 million, respectively. Net investment income decreased $3.7 million in 2001 compared to 2000 and $5.2 million in 2000 compared to 1999 primarily due to reductions in the investment portfolio's average amortized cost.
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 $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. Total tax expense for 2001 was $744,000, for state income taxes.
Highlands Group is a holding company, the principal assets of which at December 31, 2001 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 wholly-owned insurance subsidiaries. The liquidity and capital resource considerations for the Highlands Group are different than those of the Company's insurance operations. As described more fully below, due to the Company's current financial condition, see Item 6: "Selected Financial Data," Highlands Group is currently investigating the possibility of filing a petition for reorganization under Chapter 11 of the United States Bankruptcy Code.
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 material. The Company has outstanding $47.5 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 a first lien on the stock of the Company's principal insurance subsidiaries. The Company is currently in default under the terms of the Credit Agreement for the senior bank debt. The convertible subordinated debentures are due December 31, 2005; however, by virtue of the cross default provisions of the debentures, if either the senior bank debt becomes due and is not paid or is in default and the maturity of the debt is accelerated, the holders of the debentures have the right to declare the debentures in default and accelerate their maturity.
Highlands Group's only significant sources of funds are dividends and tax sharing payments from its subsidiaries. As a result of orders issued by state insurance regulators and losses incurred by the Company's insurance subsidiaries, no further payments from the insurance subsidiaries are likely to be made. As a result, Highlands Group is currently investigating the possibility of filing a petition for reorganization under Chapter 11 of the United States Bankruptcy Code.
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 $204.0 million at December 31, 2000, to $41.2 million at December 31, 2001. In November 2001, the Company's principal insurance subsidiaries were downgraded to an A.M. Best rating of "C-" (Weak). On March 25, 2002, the Company was rated NR-4 (not rated at Company's request) by A.M. Best.
Based on the Company's evaluation of the financial condition of its reinsurers, the Company has established reserves for potentially uncollectible reinsurance of $10.4 million and $7.4 million as of December 31, 2001 and 2000, respectively. Additionally, the Company has retained $26.4 million and $25.1 million of ceded reserves related to potentially uncollectible reinsurance at December 31, 2001 and 2000. 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, 2001, such collateral totaled approximately $60.8 million. The Company's three largest reinsurance recoverable exposures at December 31, 2001 were approximately $135.2 million with Lloyds of London/Equitas, $72.1 million with American Re-Insurance Company and $52.5 million with General Reinsurance Company. American Re-Insurance Company and General Reinsurance Corporation are both rated "A++" by A. M. Best.