10-Q 1 d10q.txt FORM 10-Q ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 -------------------- FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 or TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to ________ HIGHLANDS INSURANCE GROUP, INC. (Exact Name of Registrant as Specified in its Charter) 1-14028 (Commission File Number) Delaware 75-2370945 (State or Other Jurisdiction (I.R.S. Employer Of Incorporation Or Organization) Identification Number) 1000 Lenox Drive, Lawrenceville, New Jersey 08648 (Address of Principal Executive Offices) (Zip Code) (609) 896-1921 (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] The number of shares of the Registrant's Common Stock, par value $.01 per share, outstanding at June 30, 2002 was 12,978,533. ================================================================================ 1 HIGHLANDS INSURANCE GROUP, INC. TABLE OF CONTENTS PART I - Financial Information Item Page 1. Financial Statements: Consolidated Balance Sheets June 30, 2002 (Unaudited) and December 31, 2001 3 Consolidated Statements of Operations (Unaudited) - Three Months and Six Months Ended June 30, 2002 and 2001 5 Consolidated Statements of Stockholders' Equity Six Months Ended June 30, 2002 (Unaudited) and Year Ended December 31, 2001 6 Consolidated Statements of Comprehensive Income (Loss) (Unaudited) - Three Months and Six Months Ended June 30, 2002 and 2001 7 Consolidated Statements of Cash Flows (Unaudited) - Six Months Ended June 30, 2002 and 2001 8 Condensed Notes to Unaudited Consolidated Financial Statements 9 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 3. Quantitative and Qualitative Disclosures About Market Risk 15 PART II - Other Information 1. Legal Proceedings 16 4. Submission of Matters to a Vote of Security Holders 18 6. Exhibits and Reports on Form 8-K 18 Signatures 19 2 HIGHLANDS INSURANCE GROUP, INC. CONSOLIDATED BALANCE SHEETS (dollars in thousands)

See Condensed Notes to Unaudited Consolidated Financial Statements. 3 HIGHLANDS INSURANCE GROUP, INC. CONSOLIDATED BALANCE SHEETS, (Continued) (dollars in thousands)

See Condensed Notes to Unaudited Consolidated Financial Statements. 4 HIGHLANDS INSURANCE GROUP, INC CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (dollars in thousands, except per share data)

See Condensed Notes to Unaudited Consolidated Financial Statements. 5 HIGHLANDS INSURANCE GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (dollars in thousands)

See Condensed Notes to Unaudited Consolidated Financial Statements. 6 HIGHLANDS INSURANCE GROUP, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited) (dollars in thousands)

See Condensed Notes to Unaudited Consolidated Financial Statements. 7 HIGHLANDS INSURANCE GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (dollars in thousands)

See Condensed Notes to Unaudited Consolidated Financial Statements. 8 HIGHLANDS INSURANCE GROUP, INC. CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS June 30, 2002 1. Basis of Presentation The accompanying consolidated financial statements as of June 30, 2002 and for the three and six months ended June 30, 2002 and 2001 are unaudited and include the accounts of Highlands Insurance Group, Inc., ("Highlands Group") and its subsidiaries (the "Company"). In the opinion of management, all adjustments, consisting of normal recurring adjustments necessary for a fair presentation, have been reflected. The results for the period are not necessarily indicative of the results to be expected for the entire year. The accompanying consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company's Form 10-K for the year ended December 31, 2001. The independent auditors report on the Company's 2001 consolidated financial statements reflects a disclaimer of opinion due to the significant uncertainty regarding the Company's ability to continue as a going concern. Highlands Group is an insurance holding company for Highlands Holding Company, Inc. and its subsidiaries ("Highlands"), American Reliance, Inc. and its subsidiaries ("American Reliance"), and Highlands Holdings (U.K.) Limited and its subsidiary ("Highlands UK") (a foreign reinsurance company located in the United Kingdom), and certain other immaterial companies. For reporting purposes, the Company considers all of its property and casualty insurance operations as one segment. All material intercompany accounts and transactions have been eliminated. The accompanying consolidated financial statements have been prepared as though the Company will continue as a going concern. The Company has been in default under the terms of its bank debt for noncompliance with certain financial ratios. The Company does not have sufficient funds to satisfy the $47.5 million principal which was due on April 30, 2002. The Company is currently negotiating a forebearance agreement with its senior debt lenders in anticipation of filing a plan under Chapter 11 of the Bankruptcy Code. The California Department of Insurance is conducting an examination of the financial statements of Pacific National Insurance Company and its subsidiary, Pacific Automobile Insurance Company (collectively, "Pacific") as of December 31, 2001. The California Department has received a report from an independent consultant indicating that the loss and expense reserves of those two companies may be materially understated at December 31, 2001. Pacific and its external actuaries have notified the California Department of their disagreement with the conclusions in the report. Discussions between Pacific and the California Department are continuing. On May 16, 2002, the Indiana Insurance Department issued Orders of Supervision covering two of the Company's subsidiaries domiciled in Indiana, Statesman Insurance Company and American Professionals Insurance Company. In February 2002, the Texas Department of Insurance issued Supervisory Orders to the Company's Texas insurance subsidiaries, including Highlands Insurance Company, the Company's principal insurance subsidiary. By their terms, the orders are also binding on all the companies' affiliates. A Supervisory Order for another of the insurance subsidiaries, State Capital Insurance Company, was issued by the North Carolina Department of Insurance in December 2001, and in October 2001, the Wisconsin Commissioner of Insurance issued a Stipulation and Order covering Northwestern National Casualty Company, the Company's second largest insurance subsidiary, and NN Insurance Company, another of the Company's insurance subsidiaries. In addition to these orders, the Company's insurance subsidiaries have had their licenses to transact business suspended, amended to permit servicing of existing business, or revoked in numerous states. Except where prohibited by law, the Company is not renewing any business upon policy term expiration. These matters raise substantial doubt regarding the Company's ability to continue as a going concern. Certain financial information that is normally included in annual financial statements prepared in accordance with generally accepted accounting principles but is not required for interim reporting purposes has 9 been condensed or omitted. Certain reclassifications have been made to the prior year's financial statements to conform to the current year's presentation. 2. Extraordinary Item In July 2001, the FASB issued Statement No. 141, Business Combinations and Statement No. 142, Goodwill and Other Intangible Assets. Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Statement 141 also specifies the criteria that intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 became effective January 1, 2002 and requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FAS Statement No. 121, Accounting for the Impairment of Long Lived Assets and for Long-Lived Assets to be Disposed Of. As of December 31, 2001, the Company had recorded negative goodwill in the amount of $2.3 million. Upon adoption of Statement 142 on January 1, 2002, the remaining balance of negative goodwill was recognized as an extraordinary item. 3. Earnings Per Share The following tables set forth the computation of basic and diluted earnings per share (in thousands, except per share data):

The convertible subordinated debentures ("Debentures"), which are convertible into approximately 3.7 million shares, were outstanding during the six months ended June 30, 2002 and 2001, but were not included in the computation of diluted earnings per share because the assumed conversion would be antidilutive. Common 10 stock warrants attached to the Debentures for approximately 3.8 million shares for 2002 and 5 million shares for 2001 were not included in the earnings per share calculation as they were antidilutive. Stock options for 654,492 and 1,150,266 shares for 2002 and 2001, respectively, were not included in earnings per share calculations as they were antidilutive. 4. Contingent Liabilities: The information set forth in Item 1 of Part II of this report is incorporated herein by reference. The Company is a party to various claims and legal actions arising in the ordinary course of its insurance business which, in the opinion of management, will not have a material effect on the Company's financial position or results of operations. 11 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations The results of the Company's consolidated operations for the periods indicated are set forth below:

Period to Period Comparisons Gross Premiums Written. Gross premiums written for the three months and six months ended June 30, 2002 and 2001 were $15.7 million, $159.8 million, $45.7 million and $322.3 million, respectively. The $144.1 million 12 and $276.6 or 90.2% and 85.8% decrease in 2002 compared to 2001 is due primarily to the Company's implementation of its plan to not renew any business upon policy term expiration, except where prohibited by law. 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. Gross premiums for these items for the three months and six months ended June 30, 2002 were $22.5 million and $25.5 million, respectively. Due to a policy backlog in 2001, an immaterial amount of such premium was included in the first half of that year. Experience rated contracts, such as retrospectively rated policies, reduce but do not eliminate risk to the insurer. Net Premiums Written. Net premiums written for the three months and six months ended June 30, 2002 and 2001 were $9.7 million, $141.3 million, $33.6 million and $291.6 million, respectively. The decrease of $131.6 million and $258 million or 93.1% and 88.5% in 2002 compared to 2001 is due to the same issues affecting gross premiums written. Included in these amounts for the three months and six months ended June 30, 2002 were $22.5 million and $25.5 million of retrospectively rated policies, respectively. Net Premiums Earned. Net premiums earned for the three months six months ended June 30, 2002 and 2001 were $60.3 million, $144.6 million, $144.7 million and $271.7 million, respectively. The decrease of $84.3 million and $127 million or 58.3% and 46.7% in 2002 compared to 2001 is due to the same reasons affecting net premiums written, but the effect is less due to the earnings pattern of net premiums written. Net premiums written are initially deferred and earned based upon the terms of the underlying policies which causes earning trends to lag behind written premium trends during periods of increasing or decreasing net premiums written. Included in these amounts for the three months and six months ended June 30, 2002 were $11.6 million and $9.6 million of retrospectively rated policies, respectively. Loss and Loss Adjustment Expense Incurred. Loss and loss and adjustment expenses incurred for the three months and six months ended June 30, 2002 and 2001 were $61.4 million, $124.0 million, $140.8 million and $238.1 million, respectively. The loss and loss adjustment expense ratio for the three months and six months ended June 30, 2002 and 2001 was 101.8%, 85.7%, 97.3%, and 87.6%, respectively. The difference in the loss ratio is due to prior year reserve development of $5.0 million, settlements of disputed items of $6.0 million in the current period and higher loss ratios being applied to 2002 premiums versus same periods in 2001. Underwriting Expenses. Underwriting expenses for the three months and six months ended June 30, 2002 and 2001 were $12.1 million, $51.7 million, $31.8 million and $92.9 million, respectively. The underwriting expense ratio for the three months and six months ended June 30, 2002 and 2001 was 20%, 35.8%, 22% and 34.2%, respectively. The decline in the 2002 underwriting expense ratio, compared to the 2001 expense ratio, of 12.2 points is primarily related to the non-recognition in 2002 of deferred acquisition costs of $49.6 million that would have been amortized in 2002 that were written off at December 31, 2001. Investment Results. Net investment income for the three months and six months ended June 30, 2002 and 2001 was $11.7 million, $14.3 million, $24.2 million and $30.6 million, respectively. Net investment income decreased $2.6 million and $6.4 from 2001 primarily due to reductions in the investment portfolio's average amortized cost and lower interest rates. Net realized investment gains (losses) for the Company were $(2.3) million, $.5 million, $(1.7) million and $1.1 million for the three months and six months ended June 30, 2002 and 2001, respectively. Included in both the three month and six month realized loss in 2002 are losses relating to $3.0 million of bonds with other than temporary impairment. Debt Interest and Amortization Expense. Debt interest and amortization expense for the three months and six months ended June 30, 2002 and 2001 was $2.9 million, $3.2 million, $5.2 million and $5.9 million, respectively. The reduction in 2002 compared to 2001 reflects the paydowns of the Company's senior bank debt as well as lower interest rates in 2002. Other Expenses. Other expenses consist of parent company expenses and miscellaneous expenses from the insurance subsidiaries offset by miscellaneous income. 13 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 expense for the three months and six months ended June 30, 2002 and 2001 was $2 thousand, $119 thousand, $(6) thousand and $126 thousand, respectively. Extraordinary Item. In July 2001, the FASB issued Statement No. 141, Business Combinations and Statement No. 142, Goodwill and Other Intangible Assets. Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Statement 141 also specifies the criteria that intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 became effective January 1, 2002 and requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FAS Statement No. 121, Accounting for the Impairment of Long Lived Assets and for Long-Lived Assets to be Disposed Of. As of December 31, 2001, the Company had recorded negative goodwill in the amount of $2.3 million. Upon adoption of Statement 142 on January 1, 2002, the remaining balance of negative goodwill was recognized as an extraordinary item. Liquidity and Capital Resources Highlands Group is a holding company, the principal assets of which at June 30, 2002 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, the Highlands Group is currently negotiating a forebearance agreement with its senior debt lenders in anticipation of filing a plan under Chapter 11 of the Bankruptcy Code. Holding Company 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 outstanding senior bank debt and $62.7 million principal amount of convertible subordinated debentures. The bank debt, which is collaterized by a first lien on the stock of the Company's principal insurance subsidiaries, matured on April 30, 2002 and has not been paid. The Company and the lender banks executed the Eighth Amendment and Waiver to the Credit Agreement dated as of May 1, 2002 which waived certain events of default and extended the maturity of the senior bank debt to June 30, 2002. The convertible subordinated debentures are due December 31, 2005; however, by virtue of the cross default provisions of the debentures, if the senior bank debt becomes due and is not paid, 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, the Highlands Group is currently negotiating a forebearance agreement with its senior debt lenders in anticipation of filing a plan under Chapter 11 of the Bankruptcy Code. 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. See Part II, Item 1 - Legal Proceedings for a 14 discussion of Regulatory Proceedings. Insurance Subsidiaries 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 has been materially reduced. 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 Company's insurance subsidiaries have not purchased any catastrophe reinsurance for the current period due to the decreasing exposures of the companies and the prohibitive cost of such reinsurance. 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. Forward Looking Information The statements included in this Form 10-Q for the quarter ended June 30, 2002, 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 the Company's Annual Report on Form 10-K for the year ended December 31, 2001 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. ITEM 3. Quantitative and Qualitative Disclosures About Market Risk There have been no material changes in the Company's investment strategies, types of financial instruments held or the risks associated with such instruments which would materially alter the market risk disclosures made in the Company's Annual statement on Form 10-K for the year ended December 31, 2001. 15 PART II Other Information ITEM 1. Legal Proceedings Halliburton. From 1958 to 1986, the Company issued fixed premium, guaranteed cost (not retrospectively rated) insurance policies to Brown & Root Company ("Brown & Root"), a subsidiary of Halliburton Company. Beginning in 1987, the Company's insurance policies with Halliburton (including Brown & Root) were written on a retrospectively rated or high-deductible basis. Since the mid-1990's, a large number of third party asbestos claims have been made against Halliburton. Through December 31, 2001, the Company paid $1.2 million on behalf of Halliburton under the fixed premium policies on asbestos claims, and billed Halliburton $8.5 million under the retrospectively rated and high-deductible policies on asbestos claims. Halliburton has not paid this billed amount and has questioned the proper allocation of the asbestos claims between the fixed premium and the retrospectively rated and high-deductible policies. On April 5, 2000, the Company filed an action in the Delaware Court of Chancery ("Delaware Action") asserting that indemnification obligations exist pursuant to the Distribution Agreement dated October 10, 1995 between the Company and Halliburton, which was executed as part of the distribution by Halliburton of the shares of the Company's common stock to Halliburton's stockholders and the public. The action is seeking (i) a declaratory judgment that Halliburton is responsible for indemnifying the Company for losses and expenses incurred on the Halliburton/Brown & Root policies; (ii) an injunction ordering Halliburton to assume responsibility for such losses and expenses; (iii) a judgment against Halliburton for non-payment of the amounts billed under the retrospectively rated and high-deductible policies; and (iv) a declaration estopping Brown & Root from invoking insurance under the fixed premium policies. On July 13, 2000, the Company amended its complaint in the Delaware Action, adding a count seeking a declaratory judgment that the Company is not liable under the fixed premium policies because those policies were terminated pursuant to the Investment Agreement dated October 10, 1995 among the Company, Halliburton, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda) L.P. The Company also filed a motion for a preliminary injunction enjoining Halliburton from instituting, continuing or prosecuting any action in any other jurisdiction arising out of or related to the subject matter of the Delaware Action. On July 26, 2000, Halliburton filed motions to dismiss the Delaware Action on the grounds of forum non conveniens and failure to state a claim upon which relief can be granted. On September 8, 2000, the Company filed a motion for judgment on the pleadings in the Delaware Action. On March 21, 2001, the Chancery Court in the Delaware Action issued its decision in favor of the Company, finding that the fixed premium policies had been terminated pursuant to the Investment Agreement. An order was issued to that effect on April 3, 2001. Halliburton filed an appeal of the order to the Delaware Supreme Court on April 18, 2001 and on March 13, 2002, the Delaware Supreme Court issued an order affirming the decision of the Chancery Court. On March 28, 2002, Halliburton filed a motion with the Delaware Supreme Court requesting reargument. On July 11, 2002, the Delaware Supreme Court denied Halliburton's motion. On July 19, 2002, the Company filed a motion for summary judgment with Delaware Chancery Court requesting reimbursement of approximately $10 million paid by the Company on behalf of Halliburton, principally for asbestos claims, and litigation expenses. On April 24, 2000, Halliburton filed an action in the District Court of Harris County, Texas ("Texas Action") seeking (i) a declaratory judgment that the Company is liable for costs and expenses under the fixed premium policies; (ii) a declaratory judgment that Halliburton has the right to select the policy under which such coverage is to be paid; and (iii) damages. The Company filed its answer in the Texas Action on July 26, 2000 denying the allegations in Halliburton's complaint. On July 27, 2000, Halliburton filed an amended petition in the Texas Action adding Brown & Root as plaintiff. On November 6, 2000, Halliburton filed a second amended petition in the Texas Action adding Highlands Group as a defendant. Proceedings in the Texas Action have largely been held in abeyance by the parties pending the resolution of the Delaware Action, although there is no assurance that Halliburton will not attempt to activate the Texas Action in the future. 16 If the Company is not ultimately successful in the litigation described above, it could have a material adverse impact on the Company. The Company believes, however, that the positions it has taken in the Delaware Action and Texas Action are meritorious, and that, ultimately, the Company will not be responsible for a material amount, if any, of Halliburton's asbestos liability. Liquidator of LMI Insurance Company. On February 26, 2002, the Liquidator of LMI Insurance Company ("LMI"), a former subsidiary of the Company now in liquidation, filed an action against Pacific National Insurance Company, a subsidiary of the Company, in the Court of Common Pleas, Franklin County, Ohio. The complaint alleges that a voidable transfer or fraudulent payment in the amount of $7 million was made by LMI to Pacific National. On March 29, 2002, the Liquidator of LMI filed an action in the Court of Common Pleas, Franklin County, Ohio against the Registrant and its present and former officers and directors, certain of the Registrant's subsidiaries, and current and former officers and directors of the named subsidiaries. The complaint alleges the following: (i) breach of representations and warranties contained in the Form A filed in 1996 and the amended and restated Form A filed in 1997 with the Ohio Department of Insurance when the Registrant acquired control of LMI; (ii) waste of the assets of LMI by failing to maintain adequate records of LMI; (iii) breach of a group services agreement among LMI and other subsidiaries of the Registrant; (iv) failure of the officers and directors of the Registrant and the named subsidiaries to implement controls to ensure performance of the subsidiaries under the group services agreement; and (v) breach of fiduciary duty by the officers and directors of the Registrant by failing to maintain and preserve the assets of LMI and negligently permitting the Registrant's subsidiaries to waste LMI's assets. The Liquidator is seeking damages in excess of $25,000 to be determined at trial on each of claims in the complaint plus interest, costs and attorney's fees. The Registrant and the other defendants filed answers to both complaints on June 2, 2002. The Company believes that these complaints are completely without merit and the defendants are vigorously defending them. Regulatory Proceedings. The California Department of Insurance is conducting an examination of the financial statements of Pacific National Insurance Company and its subsidiary, Pacific Automobile Insurance Company (collectively, "Pacific") as of December 31, 2001. The California Department has received a report from an independent consultant indicating that the loss and expense reserves of those two companies may be materially understated at December 31, 2001. Pacific and its external actuaries have notified the California Department of their disagreement with the conclusions in the report. Discussions between Pacific and the California Department are continuing. On May 16, 2002, the Indiana Insurance Department issued Orders of Supervision covering two of the Company's subsidiaries domiciled in Indiana, Statesman Insurance Company and American Professionals Insurance Company. In February 2002, the Texas Department of Insurance issued Supervisory Orders to the Company's Texas insurance subsidiaries, including Highlands Insurance Company, the Company's principal insurance subsidiary. By their terms, the orders are also binding on all the companies' affiliates. A Supervisory Order for another of the insurance subsidiaries, State Capital Insurance Company, was issued by the North Carolina Department of Insurance in December 2001, and in October 2001, the Wisconsin Commissioner of Insurance issued a Stipulation and Order covering Northwestern National Casualty Company, the Company's second largest insurance subsidiary, and NN Insurance Company, another of the Company's insurance subsidiaries. In addition to these orders, the Company's insurance subsidiaries have had their licenses to transact business suspended, amended to permit servicing of existing business or revoked in numerous states. 17 ITEM 4. Submission of Matters to a Vote of Security Holders None. ITEM 6. Exhibits and Reports on Form 8-K (a) Exhibits 10.22 - Eighth Amendment and waiver to Credit Agreement dated as of May 1, 2002 among Registrant, Various Lending Institutions and the JP Morgan Chase Bank, as Administrative Agent. 10.23 - Employment Agreement between Company and Stephen L. Kibblehouse pursuant to Section 1350 of Title 18 of the United States Code 99.1 - Statement of Chief Executive Officer pursuant to Section 1350 of Title 18 of the United States Code 99.2 - Statement of Chief Financial Officer pursuant to Section 1350 of Title 18 of the United States Code (b) Reports on Form 8-K None 18 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HIGHLANDS INSURANCE GROUP, INC. (Registrant) Date: August 14, 2002 By /s/ Stephen L. Kibblehouse ------------------------------------------ Stephen L. Kibblehouse Chief Executive Officer (Authorized Signatory) Date: August 14, 2002 By /s/ Albert J. Marino ------------------------------------------ Albert J. Marino Chief Financial Officer and Treasurer (Authorized Signatory) 19

HIGHLANDS INSURANCE GROUP INC 10-Q