- -------- (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 in the statements of operations pursuant to SFAS 109 and the Company's tax-sharing agreement with its
former parent, Halliburton. Tax receipts under its intercompany tax-sharing arrangements with Halliburton were recorded as additions to stockholders' equity for the periods preceding the Distribution. For further information regarding federal and foreign taxes, see Note (5) of the Notes to Consolidated Financial Statements. (3) In 1992, the Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires accrual, during the years that the employee renders the services, of the expected cost of providing postretirement benefits. As of January 1, 1992, the Company recognized a transition obligation of $439,000 which was recorded as a cumulative effect of change in accounting principle. Prior to adoption of SFAS 106, the Company expensed its contributions as paid. (4) Earnings (loss) per share has been computed based upon the 11,448,208 shares of Company Common Stock distributed on January 23, 1996. (5) In 1992, the Company adopted SFAS 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," which requires presenting loss and loss adjustment expense reserves before reinsurance recoverables and reinsurance recoverables as receivables from reinsurers. (6) Relates only to U.S. Insurance Subsidiaries.
For reporting purposes, the Company has three lines of business which are considered Discontinued Lines: (i) business originated by the Company's London reinsurance operations (Highlands (UK)), (ii) an umbrella/excess liability policy program and (iii) assumed casualty and property reinsurance contracts. The Company has ceased to write these Discontinued Lines. Although the Company has discontinued other lines of business, primarily its Florida and Texas personal lines and probate bonding business, the Company has included the financial results of those lines in underwriting results excluding Discontinued Lines for consistency purposes.
The Discontinued Lines percentage of gross premiums written to the Company totals for the years ended December 31, 1996, 1995 and 1994 were 4.5%, 8.1% and 15.4%, respectively, while the percentage of underwriting losses to the Company totals for the same time periods were 22.6%, 55.1% and 84.9%, 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 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 risks and significantly reduce the direct writing and reinsurance of U.S. general liability risks in the London market. 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 (such as the Piper Alpha explosion, the Exxon Valdez oil spill and Hurricane Hugo) that have occurred since 1988 and have been slow to emerge in the London market.
A $125 million pre-tax charge is reflected in the Company's results of operations for the year ended December 31, 1995. See "--1995 Third Quarter Charge." The Company's consolidated results have been significantly influenced by the underwriting results of the Discontinued Lines. In order to indicate the magnitude of those influences, underwriting results exclusive of the Discontinued Lines and with respect to the Discontinued Lines are presented and discussed separately below. Also see "--Discontinued Lines".
The Company provides for income taxes on its statements of operations pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). Total tax benefit for the year ended December 31, 1996 amounted to $12.1 million. With respect to losses for periods preceding the Distribution (January 23, 1996), no tax benefit was recorded in the statements of operations pursuant to SFAS 109 and the Company's tax- sharing arrangement with its former parent, Halliburton. Tax receipts under its intercompany tax-sharing arrangements with Halliburton were recorded as additions to stockholders' equity for the periods preceding the Distribution.
Gross written premiums written for 1996 were negatively impacted by a reduction of $6.9 million of accrued premium adjustments and $3.1 million of improperly classified accrued premiums on retrospectively rated policies.
to $7.1 million for the comparable 1995 period. The decrease in probate bonding gross premiums written is expected to continue in 1997.
Net Premiums Written. Net premiums written for the years ended December 31, 1996, 1995 and 1994 amounted to $130.7 million, $189.4 million and $211.9 million, respectively. The decrease of $58.7 million or 31% in 1996 is primarily related to the same issues affecting gross premiums written. However, net premiums written in 1996 were increased by an adjustment to ceded premiums written of $1.4 million related to prior years reinsurance treaties. The 1995 decrease from 1994 in net premiums written amounted to $22.5 million and was due to the cessation of California-sourced business in April 1994 and the loss of two Special Accounts customers.
The decision to exit the probate bonding business also significantly impacted net premiums written due to the ceding of 100% of the business. The year ended December 31, 1996 includes $1.0 million of probate bond net premiums written compared to $6.7 million for the comparable 1995 period.
Underwriting Expenses. Underwriting expenses for the years ended December 31, 1996, 1995 and 1994 amounted to $52.4 million, $67.8 million and $47.2 million, respectively. The 1996 decrease of $15.4 million is related to declining premium volume and lower reserve increases for litigation and administrative proceedings against the Company. The year ended December 31, 1996 includes $2 million of legal reserve increases as compared to $10.5 million recorded in the same period for 1995.
For reporting purposes, the Company has three lines of business which are considered Discontinued Lines, specifically business originated by the Company's London reinsurance operations (Highlands (UK)), an umbrella/excess liability policy program and assumed casualty and property reinsurance contracts. The Company has ceased to write these Discontinued Lines and cancelled all remaining assumed casualty and property reinsurance contracts during 1996.
Underwriting results of the property and casualty industry are significantly influenced by estimates of loss and loss adjustment expense reserves. (See Note (8) of the Notes to Consolidated Financial Statements included elsewhere herein). These reserves are an accumulation of the estimated amounts necessary to settle and pay all outstanding and unreported claims including loss adjustment expenses, net of estimated claim recoveries. The case reserve estimates for reported claims are based upon the facts of each case and the Company's experience with similar cases. Consideration is given to historical trends regarding reserving patterns, loss payments, and the effects of court decisions, economic conditions and public attitudes. The process of establishing reserves is an imprecise science involving significant judgment and assumptions. As information develops that varies from experience, provides additional data or, in some cases, augments data that previously was not considered sufficient for use in determining reserves, changes in the Company's estimate of ultimate liabilities may be required. Changes in prior year reserve estimates (net of reinsurance), which may be material, are reflected in the results of operations in the period such changes are determined to be required.
As a result of changes in estimates of insured events in prior years, primarily asbestos and environmental claims as well as catastrophe claims, the provision for losses and loss adjustment expenses incurred (net of reinsurance recoveries of $(22.0) million, $152.9 million and $123.5 million for 1996, 1995 and 1994, respectively) increased by $22.9 million in 1996, $143.6 million in 1995 and $64.9 million in 1994. The emergence of environmental and asbestos claims over the last few years and the difficulty in accurately estimating the necessary reserves have significantly contributed to the Company's loss reserve development over this period. For additional details regarding environmental claims emergence and reserves, see "--1995 Third Quarter Charge--Environmental Reserves (Including Asbestos)." The Company's exposure to future catastrophe claims has been significantly reduced as a result of curtailing the Company's cessation of its Highlands (UK) business.
this amount, $117.0 million related to loss and loss adjustment expense reserves ($242.5 million before deducting reinsurance) and $8 million represents an increase in reserves related to litigation proceedings against the Company. Of the $117 million amount for loss and loss adjustment expense reserves, adjustments of risks arising from (i) environmental claims constitute $59.5 million ($125.5 million before deducting reinsurance), (ii) assumed reinsurance claims constitute $13.1 million ($27.7 million before deducting reinsurance), and (iii) increased losses from catastrophes reinsured by Highlands (UK) constitute $12.0 million ($50.7 million before deducting reinsurance). An additional $13.0 million ($13.0 million before deducting reinsurance) was added to unallocated loss adjustment expense reserves to reflect additional costs related to the settlement of claims and run-off costs related to Highlands (UK), and the remaining $19.4 million ($25.6 million before deducting reinsurance) reflects changes to reserves for unreported losses in order to reflect the current evaluation of overall loss and loss adjustment expense reserves. Each of these is discussed in more detail below.
Environmental Reserves (Including Asbestos). Approximately $59.5 million of the increase in the net loss and loss adjustment expense reserves ($125.5 million before deducting reinsurance) of the Company is related to increased provisions for environmental claims (including asbestos claims). Environmental claims for this purpose are those claims arising from long term and other exposure to asbestos and chemicals, and those claims arising from the handling and/or disposal of pollutants such as chemicals and toxic waste. Also included in the review of environmental matters for purposes of excess liability policies was potential exposure relating to litigation over breast implants. Highlands has a dedicated environmental claims unit responsible for handling these types of claims.
Environmental claims have arisen in three of the Company's product lines, two of which are Discontinued Lines described above. The ongoing product line involving increased environmental loss exposure is the general liability policies written by the Company as primary insurance provider for its various commercial customers since 1965. The Discontinued Lines that are sources of increased environmental claim exposure are the Company's umbrella/excess liability program (as to which new underwriting activities ceased at the end of 1985) and its participation in the assumed casualty reinsurance marketplace, both in London (1972 through 1982) and the United States (most of which were nonrenewed by the end of 1976).
Umbrella Excess Liability. The Company's umbrella/excess liability program consisted of participation in the overall U.S. excess liability marketplace from 1969 through 1985. In general, larger enterprises were the purchasers of high limits of excess liability protection. Consequently, the Company insured many large industrial companies, some of which have or may become the potential primary defendants with regard to significant environmental claims. The inherent difficulty described above in estimating ultimate loss levels for environmental claims is further complicated with regard to excess of loss policies because the Company has no contractual exposure until the policy limits of the insured's underlying coverage are reached. The loss threshold at which coverage under the excess liability policies issued by the Company commences ranged from $300,000 to in excess of $100 million. Accordingly, estimation of the Company's loss exposure with regard to these policies also involves a difficult evaluation of whether aggregate claims will be made (and proven) under other insurers' policies to trigger the coverage threshold of the policies issued by the Company. The third quarter of 1995 loss review involved an evaluation of policies issued by the Company to approximately 85 insureds who were potential principal defendants for environmental claims without regard to whether any claims had been filed under these policies. Also included in the analysis was the identification of any policies for which the Company might incur losses or loss adjustment expenses related to breast implants. The resulting reserve increase on the umbrella/excess liability program related to unreported losses for environmental and breast implant claims was approximately $4.4 million ($23.0 million before deducting reinsurance).
Assumed Reinsurance--London and U.S. Markets. Net environmental reserves related to the London market were increased by approximately $11.8 million ($22.7 million before deducting reinsurance). The London market historically has demonstrated very slow claim recognition, reporting and payment. The increase in reserves stems primarily from a specific adjustment to the reserves for unreported losses relating to London market claims based on the application of asbestos payment and emergence patterns to the Company's reported losses to date. In addition, the lengthening of loss payment and emergence patterns for unreported pollution claims assumed in the loss reserve review indicated the appropriateness of an increase in the reserve for pollution claims.
loss data related to pre-1973 periods and separately analyzed the resulting treaty groups and environmental data. The treaties were divided into the two groups: those as to which the Company has been able to identify environmental claims and those as to which it has not been able to specifically identify environmental claims.
As a result of this analysis, the Company increased the reserve (net of reinsurance) for unreported losses relating to environmental claims for all of the U.S. assumed casualty reinsurance agreements by $30.3 million ($34.0 million before deducting reinsurance). Of this amount, $20.3 million relates to the group of treaties for which the Company has been able to identify environmental claims. For the treaty group that currently does not explicitly provide information to identify environmental claims, the Company has established a net provision of $10.0 million ($13.7 million before deducting reinsurance) for unreported environmental losses. This provision is based on the likelihood that a significant portion of the current payments and incurred loss emergence observed for this treaty group is related to environmental claims activity. During the Company's third quarter of 1995 reserve review of the U.S. assumed casualty reinsurance, it was noted that for contracts reporting environmental claims, approximately 80% of the current year's payments and reserve emergence were related to environmental claims. The Company believes that the treaties not identifying environmental claims have a lower exposure to these claims than the treaties that have reported environmental claims and thus has assumed that approximately 50% of the observed payments and reserve emergence on assumed casualty reinsurance contracts not identifying environmental claims are actually related to environmental claims activity. The Company has also assumed that the survival ratios (outstanding reserves to average annual payments) for the treaties not reporting environmental claims are similar to the survival ratios implied for the treaty group reporting environmental claims. These assumptions combined with the partial reliance on industry loss reporting patterns excluding environmental and asbestos claims produced the $10.0 million reserve for unreported environmental claims for this treaty group.
Due to the increases in reserve estimates for environmental claims, the Company also increased unallocated loss adjustment expense reserves by $5.0 million in recognition of additional costs related to the settlement of these claims. The 1995 Third Quarter Charge resulted in direct outstanding reserves for environmental claims increasing by $75.5 million. This increase is related to the primary general liability and the umbrella/excess liability programs. The Company utilizes a traditional industry methodology for determining unallocated loss adjustment expense reserves based on calendar year paid unallocated loss adjustment expense to direct paid loss ratios, case and incurred but not reported reserves outstanding and the 50/50 assumption (50% of the unallocated loss adjustment expense is paid when a claim is opened and 50% is paid upon closing). Since unallocated loss adjustment expense has a positive relationship with outstanding reserves, the $75.5 million reserve increase indicated an additional $5.0 million of unallocated loss adjustment expense reserve was appropriate.
The remaining $44.4 million ($89.3 million before deducting reinsurance) of the increase in reserves was spread over several lines of business. Included in this amount was $13.0 million of additional unallocated loss adjustment expense reserves, which were established primarily for additional costs related to the settlement of claims and run-off costs related to Highlands (UK). Loss reserves with regard to Highlands (UK) were increased by $12.0 million ($50.7 million before deducting reinsurance) in recognition of continuing loss realization from catastrophes occurring in the 1987 through 1990 underwriting years. The remaining reserve increases were not related to specific events, but were deemed to be appropriate adjustments to previous reserve estimates in light of the most recent available data regarding projected expected loss and loss adjustment expense from existing policies.
On May 15, 1991, Weatherford Roofing Company and other plaintiffs commenced an action against Employers National Insurance Company in the 116th Texas State District Court in Dallas County, Texas, alleging that they had been overcharged for workers' compensation insurance. On April 23, 1992, the plaintiffs amended their petition to allege a class action on behalf of all employers overcharged for workers' compensation insurance purchased between 1987 and 1992 to cover Texas employees. On April 18, 1994, Highlands and Highlands Underwriters Insurance Company were added to the action as named defendants. The lawsuit, styled Weatherford Roofing Company, et al. v. Employers National Insurance Company (Case No. 91-05637), alleges among other things that the defendants conspired to charge rates of premium for retrospectively rated insurance policies that exceeded rates then permitted under applicable Texas law and regulations. On July 2, 1996, the named plaintiffs and a group of 14 insurance company defendants, including the Company, entered into a settlement agreement (the "Settlement Agreement"), and said agreement has received preliminary approval of the court. Pursuant to the terms of the Settlement Agreement, in July of 1996, notification of the settlement was published in several Texas newspapers and mailed to all insureds within the settlement class. The insureds that have elected to opt- out of the settlement will not impact Highlands or terminate the Settlement Agreement.
In November 1988, the State of California adopted by ballot initiative Proposition 103, a comprehensive system of regulation applicable to all property and casualty insurance written in California. Proposition 103 does not apply to workers' compensation insurance or reinsurance. Proposition 103 provided, among other things, that rates for automobile and certain other insurance policies issued or renewed on or after November 8, 1988 be rolled back to levels of November 8, 1987 and then reduced by an additional 20%. In January 1995, the State of California Department of Insurance ("DOI") notified the Company that it believed that the Company had a premium rollback obligation to policyholders under Proposition 103. On April 18, 1995, the DOI issued a Notice of Hearing Re Proposition 103 Rollback Exemption Application In the Matter of the Rate Rollback Liability of Highlands and Highlands Underwriters Insurance Company. Subsequent to the issuance of the Notice of Hearing there was a Prehearing Conference Order and several motions regarding the extent and nature of discovery. On June 30, 1995, Highlands and Highlands Underwriters Insurance Company mailed a settlement offer to the Insurance Commissioner of the State of California, which was rejected by the Commissioner on July 18, 1995. In December of 1995, a decision was entered in the matter of Amwest Surety Insurance Company v. Pete Wilson, et al. In that case, the Supreme Court of the State of California determined that surety insurance would be subject to Proposition 103. There were hearings pursuant to the above-referenced Notice of Hearing during May and June of 1996 at which the DOI asserted that the rollback obligation of Highlands and Highlands Underwriters Insurance Company was $3.9 million, plus interest, for a total amount of $6.5 million. In connection with such hearing, the administrative law judge was expected to render a decision regarding the Company's rollback liability during the last quarter of 1996. Subsequent to the June of 1996 hearing, the Company re-evaluated its legal reserves, and such reserves were increased in the third quarter of 1996 by $1 million to reflect the Company's current estimate of its most probable loss. Settlement negotiations occurred during the fourth quarter of 1996, and as a result of the status of such negotiations, legal reserves were increased $1 million in the fourth quarter of 1996.
Immediately following the Distribution, the Company issued $62.85 million in principal amount of Debentures for $60.0 million in cash and $2.85 million of notes. Of such proceeds, the Company invested $10.0 million in the U.S. Insurance subsidiaries as a contribution to surplus, paid approximately $5.7 million in transactions fees and for reimbursement of out-of-pocket expenses incurred in connection with the issuance of the Debentures and Warrants and retained the remaining approximately $44.4 million for general corporate purposes.
The Company's other principal sources of funds are dividend and tax sharing payments from Highlands, 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 Highlands is subject to restrictions and limitations imposed by the insurance laws of the State of Texas. The maximum dividend payable by Highlands in 1997 without approval is approximately $18.0 million. 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.
On June 21, 1996, the Company entered into an agreement to acquire Vik Brothers Insurance, Inc. ("VBII"). VBII is an insurance holding company that primarily writes commercial property and casualty business for small to medium sized companies and, to a lesser extent, personal lines business.
Following completion of the acquisition, the Company intends to contribute up to a maximum of $42 million of capital to the VBII insurance subsidiaries, which will be funded by $25 million of additional debt and $17 million in cash. The Company is currently negotiating a $65 million revolving credit facility in connection with this acquisition.
The liquidity requirements of the Insurance Subsidiaries are met by that portion of the investment portfolio that is held in cash and highly liquid short-and intermediate-term securities. Prior to the Distribution, liquidity requirements of the Insurance Subsidiaries were also provided for by the payments made by Halliburton to the Company and the Insurance Subsidiaries under the income tax sharing arrangements for losses generated by the Company and its subsidiaries. These tax sharing arrangements were terminated in connection with the Distribution and resulted in the Insurance Subsidiaries receiving $42.2 million from Halliburton in 1996.
In 1994, Highlands (UK) had a liability of $21.5 million for cash advances received from an affiliate of Halliburton. During 1994, this liability was exchanged for a capital contribution to Highlands (UK). Accordingly, the Company recorded additional paid-in capital of $21.5 million in 1994.
Statutory Surplus. Maintenance of appropriate levels of statutory surplus of the Company's U.S. Insurance Subsidiaries is a primary objective of the Company and is also important to regulatory authorities and 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. Each of the U.S. Insurance Subsidiaries and Highlands have been assigned an "A-" (Excellent) rating by A.M. Best.
An annual range of ratio results has been established from studies of the ratios for companies that have become insolvent or have experienced financial difficulties falling outside the usual range. The analytical phase is a review of annual statements and the financial ratios. Companies that receive financial ratio values outside the usual range generally are analyzed in order to identify those companies that appear to require immediate regulatory attention. A more comprehensive review of the ratio results in an insurer's annual statement is performed later to confirm that an insurer's situation in fact calls for increased and closer regulatory attention. If the review confirms that the insurer's situation should be accorded the highest priority in the Insurance Commissioner's surveillance process, the insurer receives a "first priority" designation. Highlands received "first priority" designation as a result of the review of its financial ratio results and statutory annual statements for 1995. The primary reason Highlands received a "first priority" designation was due to the large reserve increase it recorded in 1995. Highlands' statutory surplus decreased by $75.4 million in 1995, principally as a result of a third quarter charge (see "1995 Third Quarter Charge"), and was $178.7 million as of December 31, 1995.
The following table sets forth certain information with respect to the Company's statutory surplus (U.S. Insurance Subsidiaries) at the dates indicated.
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 run-off 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 information.
Based on the Company's evaluation of the financial condition of its reinsurers, the Company has established reserves for potentially uncollectible reinsurance which amounted to $2.4 million and $4.6 million as of December 31, 1996 and 1995, respectively. Additionally, the Company has retained net $20.1 million and $18.6 million of ceded reserves related to potentially uncollectible reinsurance at December 31, 1996 and 1995. With respect to carriers that are not authorized reinsurers as determined by the Texas 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, 1996 such collateral totaled approximately $14.8 million. The Company's three largest reinsurance recoverable exposures at December 31, 1996 were approximately $111.2 million with underwriting syndicates at Lloyds (Highlands (U.K.) $90.2 million and U.S. Insurance Subsidiaries $21.0 million), $84.2 million with American Re-insurance Company and $55.0 million with General Reinsurance Company. American Re-insurance Company and General Reinsurance Company are rated by A. M. Best and carry "A+" and "A++" ratings, respectively.