The following table summarizes certain selected historical consolidated financial data with respect to the Company and is based upon the historical consolidated financial statements of the Company. The information set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the Consolidated Financial Statements and related notes thereto included elsewhere herein.
- -------- (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.
(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 Statement of Financial Accounting Standards No. 128. Earnings Per Share. For further discussion of earnings per share and the impact of Statement No. 128, see the notes to the consolidated financial statements. 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. (4) Includes twelve months pro forma net premium written for American Reliance.
Gross Premiums Written. Gross premiums written for 1998, 1997 and 1996 were $378.1 million, $346.0 million and $158.5 million, respectively. The increase in 1998 is attributable to the inclusion of American Reliance for the full year 1998 ($278.2 million) compared to eight months in 1997 ($214.8 million) because it was acquired on April 30, 1997. Using full year 1997 gross premiums written for American Reliance produces a decline in 1998 of approximately 19.7% due primarily to three factors. First, the Company continues to focus on stricter underwriting standards and adequate pricing. The current pricing environment is highly competitive
In 1998, the Company entered into agreements with insurance companies which provide certain of the Company's customers access to A+ paper. These agreements were entered into to limit the future loss of business due to A.M. Best's downgrade of Highlands Insurance Company.
Gross premiums written for 1997 increased $187.5 million compared to 1996 due to the inclusion of American Reliance for eight months in 1997 which amounted to $214.8 million. Excluding the American Reliance business, gross premiums written for 1997 declined $27.3 million or approximately 17.2% in 1997. The decline was due to stricter underwriting standards and increased price competition.
Net Premiums Earned. Net premiums earned for 1998, 1997 and 1996 were $388.8 million, $312.0 million and $152.1 million, respectively. The acquisition of American Reliance increased net premiums earned by $67.4 million and $188.9 million for 1998 and 1997, respectively. Additionally, the termination of the Stop Loss Agreement had the effect of increasing reported premiums in 1998 by $34.6 million. The offsetting decreases for 1998 and 1997 of $25.2 million and $29.0 million, respectively, relate to the same items affecting gross and net premiums written.
Debt Interest and Amortization Expense. Debt interest and amortization expense for 1998 compared to the same period for 1997 increased $1.8 million as a result of the $65 million loan under a Credit Agreement entered into in April 1997 being outstanding for the full year in 1998 versus eight months in 1997. The loan was used to finance the purchase of American Reliance. The increase in debt interest and amortization expense between 1996 and 1997 of $3.6 million was also the result of the loan incurred under the Credit Agreement.
Other Expenses. Other expenses consist of parent company expenses and miscellaneous expenses from the insurance subsidiaries offset by miscellaneous income.
Income Taxes. 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). The total tax benefit for 1998 was $3.9 million. The Company's effective tax rate reflects the significant amount of net investment income from tax advantaged fixed income securities and the magnitude of the underwriting loss in relation to net taxable investment income. The total tax expense for 1997 was $1.7 million and the 1997 effective rate also reflects the relationship between net investment income from tax advantaged fixed income securities and underwriting losses. For 1996, the Company recognized the benefit of its net operating loss.
Underwriting results of the property and casualty industry are significantly influenced by estimates of loss and loss adjustment expense reserves. (See Note 11 to the Consolidated Financial Statements.) 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, changes in the Company's operations (such as underwriting and claims handling), loss payments, and the effects of court decisions, economic conditions and public attitudes. The process of establishing reserves is imprecise involving significant judgment and assumptions. As information develops that varies from experience, provides additional data or, in some cases, augments data that previously were 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, 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 $69.3 million, $112.5 million and $47.8 million for 1998, 1997 and 1996, respectively) increased by $71.9 million in 1998, $16.4 million in 1997 and $22.9 million in 1996. 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.
Highlands Group is a holding company, the principal assets of which at December 31, 1998 are all of the capital stock of Highlands Insurance Company and American Reliance, Inc. The Company's property and casualty insurance business is conducted by its direct and indirect wholly-owned insurance subsidiaries. The liquidity and capital resource considerations for the Highlands Group are different than those of the Company's insurance operations.
on the Company are not expected to be material. The annual cash interest requirements relating to the Company's outstanding 10% convertible subordinated debentures (the "Debentures") and the loan under 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. During 1998, Highlands Group repurchased 293,500 shares of its Common Stock at an aggregate cost of $4 million. Such repurchased shares are held in treasury.
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 $39.9 million in 1999 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.
Management believes that Highlands Group's liquid assets and access to the capital markets enable it to meet its liquidity needs for the next year.
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). LMI, which has ceased current operations, has been rated vulnerable--"D" (Poor).
- -------- (1) Includes twelve months pro forma net premium written for American Reliance.
Based on the Company's evaluation of the financial condition of its reinsurers, the Company has established reserves for potentially uncollectible reinsurance of $1.7 million and $2.2 million as of December 31, 1998 and 1997, respectively. Additionally, the Company has retained $22.3 million and $18.2 million of ceded reserves related to potentially uncollectible reinsurance at December 31, 1998 and 1997. 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, 1998, such collateral totaled approximately $18.9 million. The Company's three largest reinsurance recoverable exposures at December 31, 1998 were approximately $123.5 million with underwriting syndicates at Equitas/Lloyds (Highlands (U.K.) $81.8 million and U.S. Insurance Subsidiaries $41.7 million), $113.7 million with American Re-Insurance Company and $70.1 million with General Reinsurance Company. American Re-Insurance Company and General Reinsurance Company are rated by A. M. Best "A+" and "A++", respectively.
The Company has begun identifying and assessing non-IT systems such as telephones and other facility related systems. The assessment of these systems will be completed in April 1999. The Company believes that it will be able to modify, or, where appropriate, replace, these systems by September 1999. The telephone system in Lawrenceville, New Jersey was replaced in February 1999 and the Raleigh, North Carolina system is scheduled to be replaced in July 1999.