- -------- (1) The Company recorded a charge to pre-tax earnings during the year ended December 31, 1995 of $125 million for loss and loss adjustment expenses and other legal accruals.
(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 due to 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 income taxes, see Note 7 to Consolidated Financial Statements.
(3) The earnings per share amounts prior to 1997 have been restated to comply with SFAS No. 128, "Earnings Per Share." Earnings (loss) per share for periods preceding the Distribution have been computed based upon the 11,448,208 shares of Company Common Stock distributed on January 23, 1996.
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. See "-- Results of Operations--Loss and Loss Adjustment Expense Reserves" below.
Gross premiums written for 1998 increased $32.1 million compared to 1997. The 1998 amount includes an additional $63.4 million of gross premiums written because the 1997 American Reliance acquisition was accounted for as a purchase and 1997 included only eight months of its gross premiums written. Using full year 1997 gross premiums written for American Reliance produces a decline in 1998 of approximately 19.7% due primarily to the same issues impacting the decline in 1999 gross premiums written, as noted above. The declines were partially offset by approximately $15.3 million of unusually large increases in premiums under retrospectively rated policies.
Net Premiums Earned. Net premiums earned for 1999, 1998 and 1997 were $325.3 million, $388.8 million and $312.0 million, respectively. The decrease in 1999 compared to 1998 is related to the same items affecting gross and net premiums written as noted above including the 1998 termination of the Stop Loss Agreement, which increased reported net earned premiums in 1998 by $34.6 million. Net premiums earned increased in 1998 compared to 1997 due to the premium associated with the termination of the Stop Loss Agreement and the inclusion of American Reliance for the full year 1998.
Loss and Loss Adjustment Expense Incurred. Loss and loss adjustment expense incurred for 1999, 1998 and 1997 were $238.9 million, $328.4 million and $246.5 million, respectively. The loss and loss adjustment expense ratios for 1999, 1998, and 1997 were 73.5%, 84.4% and 79.0%, respectively. The decrease in 1999 of $89.5 million compared to 1998 was primarily attributable to three factors. First, the 1998 termination of the Stop Loss Agreement noted above had the effect of increasing loss and loss adjustment expenses reported in 1998 by $50.0 million. Second, in 1999, the Company experienced a decrease in loss and loss adjustment expenses of $19.1 million related to California construction defect claims because, in 1999, the Company recorded additional reinsurance recoverables for previously unbilled paid losses of $11.1 million related to California construction defect claims, while in 1998, the Company had $8.0 million of unfavorable reserve development for these claims. Third, the Company experienced a decrease in loss and loss adjustment expenses of approximately $4.1 million related to weather related catastrophe losses. Finally, in 1998, there were higher incurred losses subject to retrospectively rated policies.
Underwriting Expenses. Underwriting expenses for 1999, 1998 and 1997 were $130.1 million, $141.8 million and $115.6 million, respectively. The underwriting expense ratio for 1999, 1998 and 1997 was 40.0%, 36.5% and 37.0%, respectively. Elimination of the 1998 non-recurring additional premium related to the Stop Loss Agreement and certain unusually large 1998 retrospectively rated policy adjustments resulted in an adjusted expense ratio of 41.8% for 1998.
The decline in the 1999 underwriting expense ratio, compared to the adjusted 1998 expense ratio, is the result of the Company's 1999 expense saving initiatives. During 1999, the Company realized expense savings of $2.4 million due to the 1998 termination of the Stop Loss Agreement and $1.6 million related to restructuring a system vendor agreement. These savings were partially offset by a restructuring charge in the amount of $780,000 and additional expenses associated with the Company's 1999 system integration projects.
The underwriting expense ratio for 1998 increased compared to 1997 (adjusted 41.8% compared to 37%) due to the higher costs associated with problems relating to the implementation of a policy issuance system and the resulting decrease in premium volume.
Debt Interest and Amortization Expense. Debt interest and amortization expense for 1999 compared to 1998 decreased approximately $500,000 due to the mid-year paydown of $6.0 million of senior bank debt offset somewhat by higher interest rates. Debt and amortization expense increased in 1998 compared to 1997 as a result of the senior bank debt being outstanding for the full year in 1998 versus eight months in 1997.
Loss on Write-off of Subsidiary. The Company wrote-off its remaining investment in LMI which has been 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.
Other Expenses, Net. Other expenses consist of parent company expenses and miscellaneous expenses from the insurance subsidiaries offset by miscellaneous income.
Income Taxes. The total tax expense for 1999 was $13.0 million. The Company recorded a charge totaling $11.6 million of deferred taxes related to the write-off of LMI. Based upon the year-end assessment of the value of LMI and the fact that it will no longer be a member of the Company's consolidated tax group, it was determined that deferred tax assets associated with LMI would not be recoverable by the Company. Excluding the write-off of LMI and its associated deferred tax assets, the Company's effective tax rates for 1999, 1998 and 1997 reflect the amount of investment income from tax advantaged fixed income securities, the magnitude of the underwriting loss in relation to net taxable investment income and the impact of alternative minimum tax. The Company recorded a tax benefit of $3.9 million in 1998 and a tax expense of $1.7 million in 1997.
As a result of changes in estimates of insured events in prior years, primarily asbestos and environmental claims, construction defect claims and catastrophe claims, and the effects of the termination of the Stop Loss Agreement in 1998, the provision for loss and loss adjustment expense incurred (net of reinsurance recoveries of $20.6 million, $69.3 million and $112.5 million for 1999, 1998 and 1997, respectively) decreased by $8.1 million in 1999 and increased $71.9 million in 1998 and $16.4 million in 1997. The principal reason for the loss reserve development in 1998 was the termination of the Stop Loss Agreement. In addition, the emergence of environmental, asbestos and construction defect 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 the three year period.
The Company's loss and loss adjustment expense reserves are reviewed at each year end by the Company's actuaries and external independent actuaries in connection with the process of establishing the Company's reserve position.
Highlands Group's principal sources of funds are dividends and tax sharing payments from its subsidiaries, 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 approximately $30.9 million in 2000 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.
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. 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. 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. The Company's principal insurance subsidiaries have been assigned an A.M. Best secure rating of "B++" (Very Good).
Based on the Company's evaluation of the financial condition of its reinsurers, the Company has established reserves for potentially uncollectible reinsurance of $2.2 million and $1.7 million as of December 31, 1999 and 1998, respectively. Additionally, the Company has retained $22.9 million and $22.3 million of ceded reserves related to potentially uncollectible reinsurance at December 31, 1999 and 1998. 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, 1999, such collateral totaled approximately $15.7 million. The Company's three largest reinsurance recoverable exposures at December 31, 1999 were approximately $137.9 million with underwriting syndicates at Equitas/Lloyds (Highlands (U.K.) $87.2 million and U.S. insurance subsidiaries $50.7 million), $90.9 million with American Re-Insurance Company and $64.0 million with General Reinsurance Company. American Re-Insurance Company and with General Reinsurance Company are rated by A. M. Best "A+" and "A++", respectively.
Over the past two years, the Company formalized and implemented a comprehensive plan to address the Year 2000 problem which encompassed its products, vendors, customers, technical infrastructure, facilities, telecommunications and business systems. In this process, the Company expended approximately $3.4 million. These amounts exclude the cost of system upgrades that were required to be made to meet other operational requirements.
The Consolidated Financial Statements are set forth herein beginning on page of this Report.