-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, LiNLRFdG5XeQVHxZCafnVtCpHvZq50QN4Ldus+QFvMy/iQIRFH643TnVE4mypcOY sE3CVhJ6ttybLMn6DtWxbw== 0000950150-98-000497.txt : 19980401 0000950150-98-000497.hdr.sgml : 19980401 ACCESSION NUMBER: 0000950150-98-000497 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: SUPERIOR NATIONAL INSURANCE GROUP INC CENTRAL INDEX KEY: 0000810463 STANDARD INDUSTRIAL CLASSIFICATION: INSURANCE AGENTS BROKERS & SERVICES [6411] IRS NUMBER: 954610936 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-25984 FILM NUMBER: 98582555 BUSINESS ADDRESS: STREET 1: 26601 AGOURA RD STREET 2: ` CITY: CALABASAS STATE: CA ZIP: 91302 BUSINESS PHONE: 8188801600 MAIL ADDRESS: STREET 1: 26601 AGOURA ROAD CITY: CALABASAS STATE: CA ZIP: 91302 10-K 1 FORM 10-K FOR THE PERIOD ENDED 12/31/1997 1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934..........................FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-25984 SUPERIOR NATIONAL INSURANCE GROUP, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 95-4610936 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.)
26601 AGOURA ROAD, CALABASAS, CA 91302 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) TELEPHONE: (818)880-1600 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED ------------------- ----------------------------------------- Common Stock, $0.01 Par Value Registered -- The Nasdaq National Market
------------------------ 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 ___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulations S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the Common Stock of the registrant held by non-affiliates of the registrant on March 25, 1998, based on the closing price of $17.875 per share of the Common Stock on The Nasdaq National Market on such date was $60,514,829. The number of shares of the registrant's Common Stock outstanding as of March 1, 1998 was 5,962,766. DOCUMENTS INCORPORATED BY REFERENCE None. ================================================================================ 2 SUPERIOR NATIONAL INSURANCE GROUP, INC. INDEX TO FORM 10-K
PART I PAGE ITEM 1. Business.................................................... 1 ITEM 2. Business Properties......................................... 26 ITEM 3. Legal Proceedings........................................... 26 ITEM 4. Submission of Matters to a Vote of Security Holders......... 26 PART II ITEM 5. Market Price of and Dividends on the Company's Common Equity and Related Stockholder Matters........................... 27 ITEM 6. Selected Financial Data..................................... 29 ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................. 32 ITEM 8. Financial Statements and Supplementary Data................. F-1 ITEM 9. Changes in and Disagreements with Accountants on Equity and Related Accounting and Financial Disclosure............... 38 PART III ITEM 10. Directors and Executive Officers of the Company............. 39 ITEM 11. Executive Compensation...................................... 44 ITEM 12. Security Ownership of Certain Beneficial Owners and Management................................................ 48 ITEM 13. Certain Relationships and Related Transactions.............. 54 PART IV ITEM 14. Exhibits, Financial Statements Schedules, and Reports on Form 8-K.................................................. 57 Signatures.................................................. 63 Glossary of Terms........................................... 64 Index to Consolidated Financial Statements.................. F-1 Financial Statements and Supplementary Data................. F-1 Independant Auditors' Report................................ F-2
i 3 PART 1 Certain statements in this Annual Report on Form 10-K are forward-looking and are identified by the use of phrases such as "intended," "will be positioned," "expects," is or are "expected," "anticipates," and "anticipated." These forward-looking statements are based on the Company's current expectations. To the extent any of the information contained herein constitutes a "forward-looking statement" as defined in Section 27 A(i)(1) of the Securities Act, the factors set forth under " -- Risk Factors" are cautionary statements identifying important factors that could cause results to differ materially from those in the forward-looking statement. Further, see Glossary of Terms. ITEM 1. BUSINESS OVERVIEW Superior National Insurance Group, Inc. ("SNIG") is a holding company that, through its wholly-owned subsidiaries, Superior National Insurance Company ("SNIC") and Superior Pacific Casualty Company ("SPCC"), underwrites and markets workers' compensation insurance principally in the State of California and, until September 30, 1993, was engaged in the underwriting and marketing of commercial property and casualty ("P&C") insurance. The Company was incorporated in California in March 1985 under the name Coastal Holdings, Ltd. SNIC and SPCC conduct business under the "Superior Pacific" trade name. Unless the context indicates otherwise, "Superior Pacific," as used herein, refers to SNIC and SPCC and their combined operations from April 1997 to the present, and refers only to SNIC and its operations for all prior periods. The "Company" refers to SNIG and its subsidiaries. In April 1997, SNIG acquired Pac Rim Holding Corporation ("Pac Rim"), the parent company of The Pacific Rim Assurance Company (subsequently renamed Superior Pacific Casualty Company). SPCC's Southern California operations complement SNIC's historical focus on Central and Northern California. As a result of the acquisition of SPCC (the "Acquisition"), the Company believes that, excluding the California State Compensation Insurance Fund (the "State Fund"), it is the eighth largest California workers' compensation insurer overall, based upon 1996 direct premiums written. Pro forma for the Acquisition, the Company would have had direct premiums written of $182.2 million and $179.7 million for the years ended December 31, 1996 and 1997, respectively. In connection with the Acquisition, the Company agreed with the California Department of Insurance ("DOI") that SPCC would operate in a "run-off" situation and that all new or renewal business would be written only by SNIC. As a result, the Company has been integrating SPCC's pre-Acquisition operations into SNIC's operations and has substantially completed the process. The Acquisition has enabled the Company to increase its book of California workers' compensation business and generate significant expense savings through the consolidation of the back office operations of the two companies. In addition to California, Superior Pacific is also licensed to write business in Arizona, Arkansas, Colorado, District of Columbia, Georgia, Indiana, Iowa, Kentucky, Maryland, Mississippi, Missouri, Montana, Nevada, New Mexico, Oregon, South Dakota, Texas, Utah, and Wyoming, but virtually all of Superior Pacific's current premium is generated in California (94%) and Arizona (6%). Following the Acquisition, SPCC's operations in states other than California and Arizona were discontinued and are currently in run-off. OPERATING STRATEGY The Company specializes in writing workers' compensation insurance, principally in the State of California, which allows management to respond in a timely manner to the changing competitive and regulatory environment in the state. The key elements of its operating strategy are as follows: Focus on Specialized Market Segments. The Company's business focuses on selected policy sizes and employment classifications that management believes provide the greatest opportunity for profitability. POLICY SIZE. The Company concentrates its marketing efforts on policies with annual premium under $50,000, principally to avoid the extreme price competition usually associated with larger accounts. As of 1 4 December 31, 1997, the Company's average annual premium per policy was approximately $8,300. In 1998, the Company initiated a program to market coverage to selected large accounts that meet the Company's underwriting criteria. EMPLOYMENT CLASSIFICATIONS. While the Company underwrites many employment classifications, it targets specific classifications that management believes to be profitable. The Company believes that by focusing on certain employment classifications, it can provide claim management and standardized loss control services at a level appropriate to each policyholder. As of December 31, 1997, five employment classifications, made up primarily of office and clerical, hospitality, agricultural, garment, and health care workers, represented 35% of the Company's premium in force. The Company excludes most employment classifications that represent historically higher risk exposure, including the manufacturing, handling, and shipping of explosives; oil rig and derrick work; subway construction; and navigation of marine vessels. Underwriting Discipline. Following the advent of open rating in California in 1995, some California insurers have reduced premium rates in order to increase or maintain market share. The Company has not followed this practice and has maintained consistently stringent underwriting policies in order to maintain gross profit margins. As a result, from 1993 to 1997 the Company's combined ratio from continuing operations has improved from 100.2% to 90.9%. Relationship with Producers. The Company markets its insurance products primarily through approximately 250 small to medium-sized independent insurance agencies, referred to as "producers," most of which have an ongoing relationship with the Company. The Company is one of the primary underwriters of workers' compensation insurance for most of its producers. For the policy year ended December 31, 1997, no single producer controlled more than 5.0% of premium in force. Data Processing Systems. The Company believes that its data processing systems give it a significant competitive advantage by (i) enhancing the effectiveness of its employees' underwriting, policy administration, and claims activities, (ii) providing detailed, real-time and near real-time information to management for control and administration purposes, and (iii) providing marketing benefits through improved customer service. COMPANY STRUCTURE SNIG has two direct, wholly-owned active subsidiaries: Superior Pacific Insurance Group, Inc. ("SPIG") and Superior National Capital Trust I (the "Trust"), a statutory business trust created under the laws of the State of Delaware. SPIG has four, direct, wholly-owned active subsidiaries: SNIC, SPCC, InfoNet Management Systems, Inc. ("InfoNet"), and Superior (Bermuda) Ltd. ("SBL"). InfoNet provides data processing purchasing services to SNIG and its subsidiaries. SBL was formed in September 1995 to facilitate the management of the run-off of SNIC's P&C business. The Trust was formed by the Company in December 1997 and exists solely for the purpose of issuing 10 3/4% Trust Preferred Securities (the "Trust Preferred Securities"), having an aggregate liquidation amount of $105 million, and investing the proceeds thereof in an equivalent amount of 10 3/4% Senior Subordinated Notes due 2017 of the Company (the "Senior Subordinated Notes"). The Company owns directly all of the common securities issued by the Trust, which it purchased for an aggregate consideration of approximately $3.25 million. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." SNIC's only subsidiary is wholly owned Western Select Service Corp., which currently provides vocational rehabilitation, legal, paralegal, and other services to SNIC and SPCC. SPCC has no active subsidiaries. CALIFORNIA WORKERS' COMPENSATION MARKET Workers' Compensation. Workers' compensation is a no-fault statutory system under which an employer is required to provide its employees with medical care and other specified benefits for work-related injuries and diseases. There are four types of benefits payable under workers' compensation policies: disability, 2 5 vocational rehabilitation, medical and death benefits. The amount of benefits payable for various types of claims are established by statute and vary with the nature, severity of the injury or disease, wages, occupation and age of the employee. While no dollar limitations are set for medical benefits and dollar limitations apply only under certain circumstances to vocational rehabilitation benefits, reinsurance typically covers liability in excess of a specified dollar amount. California Marketplace. California is the country's largest workers' compensation insurance market, with total direct premiums written of $5.0 billion in 1996. The California market is composed of (i) the State Fund, (ii) companies that write workers' compensation insurance in California but have significant writings in other lines of business and/or in other states ("Multi-Line, Multi-State Writers"), and (iii) the Company, which is the one private sector company that writes exclusively workers' compensation insurance specifically focused in California. The State Fund, which is obligated to write workers' compensation insurance for any applicant, including those turned down by the private sector carriers, is the largest underwriter of workers' compensation insurance in California, accounting for approximately 19% of the direct premiums written in California in 1996. Because the State Fund must accept all risks, its combined ratios have historically been much higher than those of the private sector carriers. Although the State Fund regularly competes with the Company for profitable underwriting business, the Company views the State Fund's role as the insurer of last resort to be a significant benefit because it eliminates the need to create an assigned risk plan in which the Company and other insurers conducting business in California would be required to participate. Pricing. Prior to January 1, 1995, the DOI set minimum premium rates for workers' compensation insurance in order to provide a stable environment for the pricing of such insurance. On January 1, 1995, the State of California formally converted to a system of "open rating" for workers' compensation insurance written within the state. Insurance companies now file and use their own actuarially defensible rates. Following the introduction of open rating, total direct written premiums in the California market decreased from $9.0 billion in 1993 to $5.0 billion in 1996 as many carriers engaged in price competition. Under open rating, the DOI sets "pure premium" (effectively, the estimated claim and allocated claim adjustment expense) rates for each employment classification. Carriers then apply their own multipliers to the pure premium rate to adjust for that carrier's anticipated unallocated claim adjustment and underwriting expenses. These rates are then subject to further adjustment on a policyholder by policyholder basis to account for historical loss experience, the presence of stricter safety programs, differing dividend and commission plans, and other factors. Recent Developments. While competitive pressures in the California's workers' compensation market increased with the implementation of open rating in January 1995, certain fundamentals of the workers' compensation market have recently improved. In 1996, the total direct workers' compensation premiums written in California leveled out at approximately $5.0 billion as compared to $9.0 billion in 1993, as the market began to experience rate stabilization. This trend has continued into 1997, as demonstrated by a slight improvement in premium pricing of 0.5% for the year ended December 31, 1997 over 1996. Additionally, anti-fraud legislation passed by the State of California in 1993 continues to have a positive effect on the market's losses by controlling fraudulent claims and medical and legal expense levels. These improvements have resulted in a reduction in the frequency of claims in the California workers' compensation market. However, during 1997, the Company has recognized an increase in claims severity for injuries sustained in 1995 and thereafter. Management has taken steps to address this issue by undertaking the Claims Severity Management Program. See "-- Claims Severity Management Program" and "-- Claim and Claim Adjustment Expense Reserves" and "Risk Factors -- Uncertainty Associated with Estimating Reserves for Unpaid Claim and Claim Adjustment Expenses." Superior Pacific Within the California Workers' Compensation Market. The Company believes that it is better positioned than its competitors to compete successfully in the post-open rating California workers' compensation insurance market. Because the Company specializes in underwriting workers' compensation insurance in California, the Company believes that it can be more responsive to the changing competitive and regulatory environment in California than the Multi-Line, Multi-State Writers for which California workers' compensation insurance is one of many lines of business written, representing a smaller portion of their total 3 6 premium. In addition, Multi-Line, Multi-State Writers typically price and sell workers' compensation insurance as part of a package policy which may also include various forms of other liability and health insurance. The Company sells strictly workers' compensation insurance and, therefore, prices and underwrites its policies specifically on that basis. MARKETING Superior Pacific primarily markets its insurance products through approximately 250 small to medium-sized producers located throughout California and Arizona, most of which have an ongoing relationship with the Company's executives. Because these producers also represent one or more competing insurance companies, Superior Pacific views the producers as its marketing target and delivers service the Company believes surpasses normal industry levels. Superior Pacific's percentage of business with each of its producers, in terms of premium volume, has a significant effect on a producer's efforts, because management believes companies that represent a significant volume of a producer's business typically receive the highest quality business. The Company is one of the primary underwriters of workers' compensation insurance for most of its producers. During the year ended December 31, 1997, no single producer controlled more than 5.0% of premium in force. While the Company's principal marketing strategy is to meet the business needs of Superior Pacific's producers by providing the insurance coverage and services needed by their customers, the Company concentrates its marketing efforts on policies with annual premium under $50,000, principally to avoid the extreme price competition usually associated with larger insureds. As of December 31, 1997, the Company's average annual premium per policy was approximately $8,300. In 1998, the Company initiated a program to market coverage to selected large accounts that meet the Company's underwriting criteria. Approximately 65.7% of the Company's premium in force is concentrated in 400 non-group policies and 55 group programs that each provide annual premium in excess of $50,000. The average annual premium volume generated by each of Superior Pacific's group programs is approximately $820,000 and in the aggregate these programs represent 31.1% of the Company's premium in force. Because policies issued through group programs reflect some of the attributes of smaller non-group policies, marketing workers' compensation insurance through such programs to reach smaller policyholders is a means by which the Company can implement its strategy to underwrite smaller policies. For example, individual policies within a group typically possess rate adequacy associated with small non-group accounts. Moreover, renewal rates within a group are generally superior to non-group business. However, group programs, because of their overall premium, also reflect some of the attributes of large non-group policies, mainly their greater vulnerability to price competition than the individual accounts within the group. The average size of Superior Pacific's non-group policies that exceed $50,000 in annual premium is approximately $129,000 and in the aggregate represent 34.6% of premium in force. Most of these policies were obtained by the Company upon its acquisition of Pac Rim. The Company's strategy is to maintain adequate pricing on accounts regardless of their size, and in pursuing this strategy the Company has not been able to retain a portion of these large non-group policies. However, the Company expects to replace many of them with new, smaller accounts through its newly acquired relationships with policyholders and producers previously associated with Pac Rim, and with larger accounts (where adequate pricing can be obtained) through the Company's new large account marketing program. Superior Pacific closely monitors its producers through its on-line management information systems, with special attention given to the volume and profitability of business written through Superior Pacific. Relationships with producers who consistently write unprofitable business, or do not meet the minimum guideline of annual premium per year, may be terminated. Superior Pacific believes that by continually monitoring and improving the quality of the business acquired through its producers, long-term profitability will be enhanced. See "-- Information Services." The marketing staff, along with the branch office managers and the underwriting, loss control, and regional claim staffs, work closely with producers and frequently make joint presentations with producers to 4 7 potential workers' compensation policyholders. Superior Pacific conducts its marketing by territory to enable its marketing representatives to better address the specific types of accounts located in each region. Producer commissions are generally determined by negotiation and are dependent on the size and profit potential of the producer's accounts. Superior Pacific's average direct commission rate was 11.1% for the years ended December 31, 1997, 1996, and 12.0% in 1995. The Company believes the stabilization in the average direct commission rate for the year ended December 31, 1997, was due primarily to a combination of firming prices and a greater use by larger policyholders of fee-based arrangements (as opposed to traditional commission arrangements) with their insurance brokers. Superior Pacific's producers are not permitted to bind Superior Pacific with respect to any account. All new and renewal policyholder applications must be submitted to Superior Pacific for approval. Superior Pacific is not committed to accept a fixed portion of any producer's business. UNDERWRITING Because the types of accounts that Superior Pacific insures vary among different geographic regions, Superior Pacific conducts its underwriting activities through branch offices that are focused on the local economies. While Superior Pacific underwrites over 400 of the approximately 500 employment classifications established by the Workers' Compensation Insurance Bureau (the "WCIRB"), it targets specific classifications that management believes to be profitable. The Company believes that by focusing on certain employment classifications, it can provide claim management and standardized loss control services at a level appropriate to each policyholder. For the year ended December 31, 1997, four employment classifications, made up primarily of office and clerical, hospitality, agricultural, garment, and health care workers, represented 35% of Superior Pacific's premium in force. The Company excludes most employment classifications that represent historically higher risk exposure, including the manufacturing, handling, and shipping of explosives; oil rig and derrick work; subway construction; and navigation of marine vessels. Classifications that require the approval of Superior Pacific's principal underwriting officer include those that represent potential exclusions from Superior Pacific's reinsurance treaties, unusual hazards or catastrophic exposures such as taxicab fleets, carnivals, ski resorts, and detective agencies. Certain risks, such as the transportation of groups of employees, are generally ceded to reinsurers under separate reinsurance agreements. Prior to insuring an account, Superior Pacific's underwriting department reviews, inter alia, the employer's prior loss experience and safety record, premium payment and credit history, operations, geographic location, and employment classifications. Superior Pacific verifies employment classifications principally through information provided by the WCIRB and, in many instances, through its own on-site surveys of the employer's place of business. The Company's underwriting system is a fully-integrated rating, quoting, and policy issuance system for use both internally and remotely from producers' offices. The system contains edit and blocking features that prohibit underwriters from issuing policies associated with business that is deemed inappropriate or undesirable by management, or that may be inappropriately priced. See " -- Information Services." SPCC historically underwrote larger accounts than SNIC, and in a more limited range of risk classification codes. Since SPCC's acquisition, Superior Pacific has been re-underwriting SPCC's book of business at policy renewal dates in conformity with SNIC's historic underwriting standards and pricing guidelines. SPCC's average policy size has declined significantly, standing at approximately $17,000 for the policy year ended December 31, 1997, versus approximately $20,300 for the policy year ended December 31, 1996. Management believes that the re-underwriting of SPCC's business will produce a new book of business mirroring SNIC's historical book of business, both as to size and range of risk classifications, by the end of 1998. Virtually all of SPCC's business is located in urban and suburban Southern California. Until 1993, claim experience in Southern California was more volatile and less favorable than the remainder of the state. Further, since open rating began in 1995, the relatively large accounts that SPCC has underwritten have been subject to extreme price competition consequently, the nature of SPCC's historical book of business may 5 8 cause historical claim reserves to be subject to more uncertainty versus claim reserves established on prospective business. LOSS CONTROL In addition to its responsibility for risk evaluation as part of the underwriting process, Superior Pacific's loss control department may assist policyholders in developing and maintaining safety programs and procedures to minimize on-the-job injuries and health hazards. After analyzing the policyholder's loss profile, Superior Pacific's loss control consultants will help develop a loss control program and establish accident reporting and claim follow-up activities for the policyholder. Superior Pacific's loss control personnel may also consult with policyholder management about safety and health issues, as well as about the effectiveness of the policyholder's loss prevention procedures. CLAIMS SEVERITY MANAGEMENT PROGRAM Effective December 31, 1997, the Company entered into agreements with Risk Entire Management Limited ("REM") and Zurich Reinsurance (North America), Inc. ("ZRNA"), affiliates of Zurich, to provide claims management services ("Claims Severity Management Program" or "CSMP"). Under the CSMP, REM acting as a third party administrator ("TPA"), will provide claim processing and management services to Superior Pacific, and ZRNA will provide Superior with protection predicated on REM's ability to reduce Superior Pacific's severity. The Company may terminate the contract with six months notice after the initial three year term of the contract, with a penalty that will not exceed $250,000 plus REM's reasonable expenses to unwind the agreement. REM in its capacity of a TPA will provide certain claims management services, while the Company will provide claims facilities and data processing systems. The terms of the agreement bind REM to certain operational restrictions and performance standards designed to assure quality claims administration. The Company believes that combining REM's claims management techniques with the Company's claims processing systems should produce material improvements in the Company's claims severity, more than off-setting the cost of such services. The Company believes the Claims Severity Management Program will reduce the Company's ultimate severity with favorable cost-benefit trade-offs. Under the agreement with ZRNA, ZRNA will credit the Company's direct claim costs, up to an aggregate of $30 million to the extent that REM is unsuccessful in minimizing the claims severity. The Company's open indemnity claims severity on average through 1997 exceeds $39,912. The Company and REM will continue to work closely with policyholders to return injured workers to the job quickly as is medically appropriate. The Company and REM intend to continue to maintain the Company's four full service claim service offices (CSO) in California located in Woodland Hills, Fresno, Pleasanton and Sacramento. Additionally, the Company maintains CSO in Phoenix, Arizona. Each CSO is managed by a claims manager. The claims technical staffs are organized into units with, generally, one supervisor supervising four claims examiners and two claims assistance per unit. The Company's Claims Department relies extensively on the Company's data processing systems. The Company's data processing systems were developed internally through a joint effort of the Claim and Management Information Systems departments' personnel with three goals in mind: capture timely and meaningful data; reduce the possibility of human error through a series of system prompts and edit checks; and the automation of manual functions. An additional benefit of the claims system is the increased productivity, as a result of claims examiners handling larger case loads. Superior Pacific's claims handling also includes a specialized subrogation function. Claims examiners are responsible for the identification of potential recoupments from third parties responsible for a work-related accident, after which the examiner notifies a subrogation specialist of this potential. The subrogation specialist determines whether a subrogation situation exists, and, if so, assumes responsibility for all aspects of subrogation to finalization. 6 9 CLAIM AND CLAIM ADJUSTMENT EXPENSE RESERVES Several years or more may elapse between the occurrence of a workers' compensation loss, the reporting of the loss, and final payment of the loss. Claim and claim adjustment expense reserves are estimates of what an insurer expects to pay claimants. Superior Pacific is required to maintain reserves for payment of estimated claim and claim adjustment expense for both reported claims and claims which have been incurred but not reported ("IBNR"). Superior Pacific's ultimate liability may be materially more or less than current reserve estimates. Reserves for reported claims are established on a case-by-case basis. Case-by-case reserve amounts are determined by claim examiners, based on the examiner's judgment and experience, and on Superior Pacific's reserving practices, which take into account the type of risk, the circumstances surrounding the claim or policy provisions relating to type of loss, and historical paid claims and claim adjustment expense data for similar claims. Case-by-case reserves are not established for claim adjustment expense, and the entire reserve for claim adjustment expense is established primarily based upon the Company's historical paid data. Superior Pacific's claims department regularly monitors reserve adequacy for claims which have occurred and been reported to it and adjusts such reserves as necessary. Claim and claim adjustment expense reserves for IBNR are estimated based on many variables including historical and statistical information, inflation, legal developments, the regulatory environment, benefit levels, economic conditions, judicial administration of claims, general frequency and severity trends, medical costs, and other factors affecting the adequacy of loss reserves. See "Risk Factors -- Uncertainty Associated with Estimating Reserves for Unpaid Claim and Claim Adjustment Expense." The senior officers of the Company review and adjust IBNR reserves monthly. Adjustments in aggregate reserves are reflected in the operating results of the period during which such adjustments are made. Although claims for which reserves are established may not be paid for several years or more, the reserves are not discounted, except to calculate taxable income as required by the Internal Revenue Code of 1986, as amended (the "Code"). The following table provides a reconciliation of the beginning and ending claim and claim adjustment expense reserves for each of the years in the three-year period ended December 31, 1997, computed in accordance with GAAP. RECONCILIATION OF LIABILITY FOR CLAIM AND CLAIM ADJUSTMENT EXPENSE
YEARS ENDED DECEMBER 31, -------------------------------- 1997 1996 1995 -------- -------- -------- (AMOUNTS IN THOUSANDS) Beginning reserve, gross of reinsurance.................. $115,529 $141,495 $171,258 Less: Reinsurance recoverable on unpaid losses........... 24,986 27,076 31,897 -------- -------- -------- Beginning reserve, net of reinsurance.................... 90,543 114,419 139,361 Pac Rim reserves at acquisition.......................... 104,588 -- -- Provision for net claim and claim adjustment expenses For claims occurring in current year................... 95,826 57,614 58,842 For claims occurring in prior years.................... (5,379) (1,976) (4,872) -------- -------- -------- Total claim and claim adjustment expenses.............. 90,447 55,638 53,970 -------- -------- -------- Payments for net claim and claim adjustment expense: Attributable to insured events incurred in current year................................................ (37,945) (19,816) (19,732) Attributable to insured event incurred in prior years............................................... (95,533) (59,698) (59,180) -------- -------- -------- Total claim and claim adjustment expense payments...... (133,478) (79,514) (78,912) -------- -------- -------- Ending reserves, net of reinsurance...................... 152,100 90,543 114,419 Reinsurance recoverable on unpaid losses................. 49,155 24,986 27,076 -------- -------- -------- Ending reserves, gross of reinsurance.................... $201,255 $115,529 $141,495 ======== ======== ========
7 10 During 1997, the Company continued to experience decreased frequency of claims and at the same time experienced an increase in claims severity for accident years 1995 and thereafter. The Company's net claim and claim adjustment expense ratio for accident year 1997 at the end of calendar year 1997 was 68.0%, versus 65.0% and 65.6% for accident years 1996 and 1995, at their respective calendar year ends. In 1997, the Company experienced approximately $5.4 million in favorable development on net claim and claim adjustment expense reserves estimated at December 31, 1996. This $5.4 million favorable development is the result of a $10.8 million favorable development on ceded reserves for accident years 1996 and prior. The $10.8 million favorable development on ceded reserves is attributable to SPCC and due to the post-acquisition review of all open claim files and the subsequent adjustment to reserves, which caused many claims to have incurred claim and claim adjustment expenses in excess of the retention on SPCC's reinsurance treaties. The $10.8 million favorable development is offset by a $5.4 million adverse development on direct reserves attributable to the accident years 1995 and 1996. Similar adverse development due to an increase in claims severity has been experienced throughout the California workers' compensation industry. In 1996, the Company experienced approximately $2.0 million in favorable development on net claims and claim adjustment expense reserves estimated at December 31, 1995. This $2.0 million favorable development is the result of $8.4 million in favorable development on direct reserves for accident years 1994 and prior. The favorable development was offset in part by $4.1 million adverse development on direct reserves for accident year 1995 accident year net claims and claim adjustment expense ratio for accident year 1995 at the end of calendar year 1995 was 65.6%, verses 74.6% at the end of the 1996 calendar year. Similar adverse development has been experienced throughout the California workers' compensation industry. During 1995, the Company experienced approximately $8.6 million of favorable development on direct claim and claim adjustment expense reserves estimated at December 31, 1994. Management believes the favorable development resulted from the Company's improved claims management controls and decreased claim severity, particularly in the medical component of the workers' compensation line. Similar favorable development on pre-1995 losses has been experienced elsewhere in the California workers' compensation industry. Offsetting the favorable direct development in large part was the re-estimation during 1995 of reinsurance receivables recorded at December 31, 1994, from approximately $66.2 million to approximately $59.9 million at December 31, 1995. 8 11 On April 11, 1997, the Company acquired SPCC. The claim and claim adjustment expenses related to SPCC for this analysis are reflected in the Company's 1997 claim and claim adjustment expense balances regardless of the year the claim was previously reported to SPCC. To the extent that claims develop in the future or close favorably, the result will be reflected in the calendar year development to which it relates. The following table discloses the development of direct workers' compensation claim and claim adjustment expense reserves of Superior Pacific from December 31, 1987 through December 31, 1997. ANALYSIS OF DIRECT CLAIM AND CLAIM ADJUSTMENT EXPENSE DEVELOPMENT
CALENDAR YEARS ENDED DECEMBER 31, ---------------------------------------------------------------------- 1987 1988 1989 1990 1991 1992 1993 ------- ------- ------- ------- -------- -------- -------- (IN THOUSANDS) Reserve for Unpaid Losses and Loss Adjustment Expenses, Gross of Reinsurance Recoverables Reserve......... $21,969 $42,268 $60,615 $88,270 $116,811 $136,102 $171,038 Reserve Re-estimated as of: One Year Later............... 24,241 43,581 68,718 112,160 144,676 162,634 171,960 Two Years Later.............. 26,120 46,788 79,059 111,151 143,912 148,906 161,262 Three Years Later............ 29,140 50,955 74,619 117,506 138,607 152,420 148,654 Four Years Later............. 29,423 47,696 78,112 113,029 137,939 144,898 148,983 Five Years Later............. 29,541 49,297 75,475 112,840 135,074 146,867 Six Years Later.............. 29,082 47,554 75,913 109,655 138,048 Seven Years Later............ 27,759 49,470 74,149 111,871 Eight Years Later............ 27,846 48,653 75,898 Nine Years Later............. 27,573 49,451 Ten Years Later.............. 27,803 Cumulative (Deficiency) Redundancy................... (5,834) (7,183) (15,283) (23,601) (21,237) (10,765) 22,055 Cumulative Amount of Reserve Paid Through One Year Later............... $ 9,447 $17,698 $24,478 $42,627 $ 53,914 $ 57,348 $ 60,726 Two Years Later.............. 14,482 19,879 35,195 51,160 56,299 61,648 66,077 Three Years Later............ 15,777 25,830 38,067 52,761 63,354 63,523 64,464 Four Years Later............. 18,666 26,165 38,261 57,332 64,703 66,547 66,754 Five Years Later............. 19,384 26,026 40,794 59,093 68,152 66,750 Six Years Later.............. 19,660 27,181 42,032 59,917 69,052 Seven Years Later............ 20,707 27,202 43,146 60,749 Eight Years Later............ 20,803 27,947 42,898 Nine Years Later............. 21,123 27,857 Ten Years Later.............. 20,899 Gross Reserve -- December 31............................................................... 171,038 Reinsurance Recoverables................................................................... 28,971 -------- 142,067 Reclassification of Amounts Recoverable from Centre Re..................................... 42,032 -------- Net Reserve -- December 31................................................................. 100,035 ======== Gross Re-estimated Reserve................................................................. 148,983 Re-estimated Reinsurance Recoverables...................................................... 25,775 -------- 123,208 Reclassification of Amounts Recoverable from Centre Re..................................... 42,032 -------- Net Re-estimated Reserve................................................................... 81,176 ======== Net Cumulative Redundancy.................................................................. 18,859 ======== CALENDAR YEARS ENDED DECEMBER 31, ----------------------------------------- 1994 1995 1996 1997 -------- -------- -------- -------- Reserve for Unpaid Losses and Loss Adjustment Expenses, Gross of Reinsurance Recoverables Reserve......... $171,258 $141,495 $115,529 $201,255 Reserve Re-estimated as of: One Year Later............... 162,635 137,242 120,999 Two Years Later.............. 145,626 145,209 Three Years Later............ 144,173 Four Years Later............. Five Years Later............. Six Years Later.............. Seven Years Later............ Eight Years Later............ Nine Years Later............. Ten Years Later.............. Cumulative (Deficiency) Redundancy................... 27,085 (3,714) (5,470) Cumulative Amount of Reserve Paid Through One Year Later............... $ 67,757 $ 63,587 $ 69,658 Two Years Later.............. 61,952 72,946 Three Years Later............ 67,388 Four Years Later............. Five Years Later............. Six Years Later.............. Seven Years Later............ Eight Years Later............ Nine Years Later............. Ten Years Later.............. Gross Reserve -- December 31.. 171,258 141,495 115,529 201,255 Reinsurance Recoverables...... 31,897 27,076 24,986 49,155 -------- -------- -------- -------- 139,361 114,419 90,543 152,100 Reclassification of Amounts Re 34,269 11,696 -- -- -------- -------- -------- -------- Net Reserve -- December 31.... 105,092 102,723 90,543 152,100 ======== ======== ======== ======== Gross Re-estimated Reserve.... 144,173 145,209 120,999 Re-estimated Reinsurance Recov 34,083 35,648 35,835 -------- -------- -------- 110,090 109,561 85,164 Reclassification of Amounts Re 34,269 11,696 -- -------- -------- -------- Net Re-estimated Reserve...... 75,821 97,865 85,164 ======== ======== ======== Net Cumulative Redundancy..... 29,271 4,858 5,379 ======== ======== ========
The first line of the preceding table depicts the estimated liability for unpaid claim and claim adjustment expense recorded on the balance sheets of Superior Pacific at the indicated balance sheet dates. This liability 9 12 represents the estimated amount of claim and claim adjustment expense for claims arising during all years prior to the indicated balance sheet date that are unpaid as of that balance sheet date, gross of reinsurance recoverables, including losses that have been incurred but not yet reported. The table also shows the re-estimated liability as of the end of each succeeding year through the latest balance sheet date, and the cumulative payments made for such claims, at annual intervals after the initial indicated balance sheet date. The claim and claim adjustment expense liability estimates change as more information becomes known about the frequency and severity of claims for each year. A direct reserve redundancy or deficiency is displayed for each balance sheet date in the center of the table when the initial liability estimate is greater (or less) than the re-estimated liability at the latest balance sheet date. A net-of-reinsurance redundancy is displayed for each of the years ended December 31, 1993, 1994, 1995, and 1996 at the bottom of the table. The direct reserve deficiencies associated with the years ended December 31, 1987 and 1988 were due to the lack of claim and claim adjustment expense history, which prevented management from accurately estimating ultimate claim costs. The direct deficiencies associated with reserves as of December 31, 1989, 1990, 1991, and 1992 were due to unexpected increases in claims costs resulting from increased litigation in the California workers' compensation system, an economic recession in California, and workers' compensation laws that at the time effectively encouraged workers to file unwarranted psychiatric stress and fraudulent claims. The direct redundancies associated with the years ended December 31, 1993 and 1994 occurred as a result of significant reforms in the California workers' compensation laws that became effective January 1, 1993 and an improvement in the California economy that were not anticipated when reserves were established. The direct reserve deficiencies associated with the years ended December 31, 1995 and 1996 occurred as a result of unexpected increases in severity affecting claims occurring in 1995 and 1996. Superior Pacific's experience with direct reserve deficiencies occurring for the years ended December 31, 1989 through 1992, 1995, and 1996 and direct redundancies occurring for the years ended December 31, 1993 and 1994 is consistent with the results experienced by the California workers' compensation industry during the same time periods. The underlying improvement in claims frequency and severity during the years ended December 31, 1993 and 1994 that caused Superior Pacific to develop direct redundant reserves is also consistent with industry experience. The direct reserve deficiencies occurring for the years ended December 31, 1995 and 1996 resulted from unexpected increases in claims severity, consistent with some California workers' compensation insurers' experience. The net-of-reinsurance redundancies displayed at the bottom of the table reflect Superior Pacific's per risk excess of loss, quota share, and aggregate excess of loss reinsurance, the effects of which were to reduce Superior Pacific's direct redundancies/deficiencies due to the cession of a portion of Superior Pacific's favorable development. Currently, management prepares on a monthly basis a comprehensive analysis of workers' compensation experience, and the process of estimating claim and claim adjustment expense liabilities is continually modified to consider additional information regarding trends in pricing, frequency, and severity. Further, conditions and trends that have historically affected Superior Pacific's claims may not necessarily be indicative of conditions and trends that will affect future claims, and it is not appropriate to extrapolate future reserve redundancies or deficiencies based on the data set forth above. By frequently reviewing reserves, management is generally able to detect trends in claim and claim adjustment expenses and take appropriate actions in a timely manner to avoid having to increase substantially reserves at a later date. For example, the Company was one of the first to recognize and quantify the increase in claims severity appearing in claims with 1995 and subsequent dates of injury. Recognition of this shift has enabled management to take pro-active steps, an example of which is its undertaking of the Claims Severity Management Program. See "-- Claims Severity Management Program." DISCONTINUED OPERATIONS Superior Pacific's discontinued operations consist of P&C business that was discontinued effective September 30, 1993. The discontinued operations liabilities principally pertain to contractors' general liability policies underwritten during the years 1986 through 1990. There is often a significant lag between the date of loss of construction-related claims and the date such claims are reported to Superior Pacific. Superior Pacific 10 13 believes the existing provision is sufficient to cover future claims, but there is significant uncertainty associated with the reporting and severity of construction claims. Management estimates that discontinued operations will essentially have "run-off" by the year 2000. In 1993, the Company recorded a pre-tax charge to income of $4.5 million for estimated operating losses during the phase-out period. During the second quarter of 1995, the Company increased by approximately $15.0 million its reserves for discontinued operations for accident years 1993 and prior and has not increased them since. The following table provides a reconciliation of the beginning and ending claim and claim adjustment expense reserves for discontinued operations for each of the years in the three-year period ended December 31, 1997, computed in accordance with GAAP. RECONCILIATION OF LIABILITY FOR DISCONTINUED OPERATIONS CLAIM AND CLAIM ADJUSTMENT EXPENSE
YEARS ENDED DECEMBER 31, ------------------------------- 1997 1996 1995 ------- -------- -------- (AMOUNTS IN THOUSANDS) Beginning reserve, gross of reinsurance................... $25,466 $ 40,526 $ 36,410 Less: Reinsurance recoverable on unpaid losses............ 6,976 9,159 8,777 ------- -------- -------- Beginning reserve, net of reinsurance..................... 18,490 31,367 27,633 Provision for net claim and claim adjustment expenses For claims occurring in current year.................... -- -- -- For claims occurring in prior years..................... -- -- 15,006 ------- -------- -------- Total claim and claim adjustment expenses............... -- -- 15,006 ------- -------- -------- Payments for net claim and claim adjustment expense For claims occurring in current year.................... -- -- -- For claims occurring in prior years..................... (5,020) (12,877) (11,272) ------- -------- -------- Total claim and claim adjustment expense................ (5,020) (12,877) (11,272) ------- -------- -------- Ending reserves, net of reinsurance....................... 13,470 18,490 31,367 Reinsurance recoverable on unpaid losses.................. 5,216 6,976 9,159 ------- -------- -------- Ending reserves, gross of reinsurance..................... $18,686 $ 25,466 $ 40,526 ======= ======== ========
11 14 The following table discloses the development of direct discontinued operations claims and claim adjustment expense reserves from December 31, 1987 through December 31, 1997. ANALYSIS OF DISCONTINUED OPERATIONS DIRECT CLAIM AND CLAIM ADJUSTMENT EXPENSE DEVELOPMENT
CALENDAR YEARS ENDED DECEMBER 31, -------------------------------------------------------------------------- 1987 1988 1989 1990 1991 1992 1993 -------- -------- -------- -------- -------- -------- -------- (IN THOUSANDS) Reserve for Direct Unpaid Claim and Claim Adjustment Expenses, Gross of Reinsurance Recoverables Reserve........ $ 12,678 $ 25,935 $ 41,088 $ 56,735 $ 65,629 $ 66,532 $ 54,898 Re-estimated as of: One Year Later.............. 19,879 32,395 56,093 73,295 83,770 73,298 56,041 Two Years Later............. 25,865 43,160 60,679 89,336 91,453 73,067 75,703 Three Years Later........... 30,455 43,585 72,860 98,206 90,717 96,531 76,079 Four Years Later............ 30,134 52,261 82,218 102,538 117,215 92,569 82,026 Five Years Later............ 34,215 61,539 84,304 126,431 113,084 99,009 Six Years Later............. 38,051 63,072 103,326 123,722 119,112 Seven Years Later........... 38,844 77,080 104,428 130,055 Eight Years Later........... 44,129 78,938 108,897 Nine Years Later............ 44,866 80,906 Ten Years Later............. 45,315 Cumulative (Deficiency)...... (32,637) (54,971) (67,809) (73,320) (53,483) (32,477) (27,128) Cumulative Amount of Reserve Paid Through One Year Later....................... 7,529 13,754 19,839 27,397 29,274 26,473 23,043 Two Years Later............. 13,146 15,301 26,399 35,278 29,165 23,483 16,203 Three Years Later........... 15,900 19,844 32,188 39,203 28,136 18,380 19,649 Four Years Later............ 18,915 23,007 37,758 42,135 23,255 17,777 19,263 Five Years Later............ 22,329 28,609 38,798 41,835 22,047 18,276 Six Years Later............. 26,129 31,715 37,585 42,943 23,104 Seven Years Later........... 27,645 31,247 42,260 42,363 Eight Years Later........... 27,791 37,394 40,796 Nine Years Later............ 27,780 41,325 Ten Years Later............. 29,163 Gross Reserve -- December 31.................................................................. 54,898 Reinsurance Recoverables...................................................................... 8,379 -------- Net Reserve -- December 31.................................................................... 46,519 ======== Gross Re-estimated Reserve.................................................................... 82,026 Re-estimated Reinsurance Recoverables......................................................... 21,249 -------- Net Re-estimated Reserve...................................................................... 60,777 ======== Net Cumulative (Deficiency)................................................................... ($14,258) ======== CALENDAR YEARS ENDED DECEMBER 31, -------------------------------------- 1994 1995 1996 1997 -------- ------- ------- ------- Reserve for Direct Unpaid Claim and Claim Adjustment Expenses, Gross of Reinsurance Recoverables Reserve........ $ 36,410 $40,526 $25,466 $18,686 Re-estimated as of: One Year Later.............. 54,855 41,293 30,693 Two Years Later............. 55,622 46,520 Three Years Later........... 60,849 Four Years Later............ Five Years Later............ Six Years Later............. Seven Years Later........... Eight Years Later........... Nine Years Later............ Ten Years Later............. Cumulative (Deficiency)...... (24,439) (5,994) (5,227) Cumulative Amount of Reserve Paid Through One Year Later....................... 14,329 15,827 10,717 Two Years Later............. 16,765 10,717 Three Years Later........... 11,857 Four Years Later............ Five Years Later............ Six Years Later............. Seven Years Later........... Eight Years Later........... Nine Years Later............ Ten Years Later............. Gross Reserve -- December 31. 36,410 40,526 25,466 18,686 Reinsurance Recoverables..... 8,777 9,159 6,976 5,216 -------- ------- ------- ------- Net Reserve -- December 31... 27,633 31,367 18,490 13,470 ======== ======= ======= ======= Gross Re-estimated Reserve... 60,849 46,520 30,693 Re-estimated Reinsurance Reco 18,210 15,153 12,203 -------- ------- ------- Net Re-estimated Reserve..... 42,639 31,367 18,490 ======== ======= ======= Net Cumulative (Deficiency).. (15,006) $ -- $ -- ======== ======= =======
The first line of the preceding table depicts the estimated liability for unpaid claims and claim adjustment expense for discontinued operations recorded for each of the indicated periods. The table follows the form of the table depicting workers' compensation reserve development in "Analysis of Direct Claims and Claim Adjustment Expense Development," above. From 1987 to 1990, the increase in ultimate claims and claim adjustment expense for discontinued operations was due to the lack of Company history, as well as changes in economic and legal environments which prevented management from reasonably estimating ultimate loss costs. Thereafter, a full actuarial 12 15 analysis has been performed semi-annually taking into account the Company's history of reserve development, industry claim experience, and the effects of litigation on future loss costs. The predominant number of the Company's pre-1991 discontinued operations claims are attributable to construction defect claims associated with commercial package policies sold to general contractors, developers, and artisan contractors underwritten from 1986 to 1993. Other carriers writing these same lines of business have also been negatively affected by the unfavorable increase in claims frequency and severity that occurred as a result of changes in the economic and legal environment during this time. At December 31, 1997 approximately $16.8 million of the total $18.7 million (approximately 90%) of direct reserves for discontinued operations were attributable to construction defect claims. The Company began to monitor separately the effects of construction defect claims beginning in 1993. Prior to 1993 the effects of construction defect claims were combined with all other general liability business for reserve valuation purposes. The frequency, severity, and time lag between the occurrence and reporting dates of such claims vary significantly from the statistics associated with all other lines and sublines of the Company's claims and claim adjustment expense reserves for discontinued operations. Effective June 30, 1995, the Company recorded a pre-tax charge of approximately $15.0 million ($9.8 million net of tax) for discontinued property and casualty operations due principally to an increase in management's estimates of IBNR construction defect claims. The frequency of newly reported construction defect claims increased significantly in July 1995. Management believes the increase in new construction defect claims was attributable to the California Supreme Court decision in Montrose Chemical Corporation v. Admiral Insurance Company ("Montrose") handed down in July 1995. The Montrose decision effectively broadened the definition of "loss occurrence" to include the entire period beginning with the construction date and ending with the date of judgment associated with defective construction. Since July 1995 the Company has received notices of claims on allegedly defective construction projects where the manifestation of the loss, the immediate cause of the loss, and the first report of the loss, all fall outside of the Company's policy terms. Regardless, under the California Supreme Court's ruling, the Company is compelled to defend the "insured" and contribute to loss settlements. Management cannot predict the volume of future Montrose-related claims, the cost of handling the claims, or the ultimate severity of loss associated with such claims, but believes its current reserves are adequate to cover this increase in claims activity, depending on the length of time the recent reporting trends continue. There can be no assurance, however, that further upward development of ultimate loss costs associated with construction defect claims will not occur. The Company has also experienced significant development with respect to loss costs for components of discontinued operations other than construction defect claims. While these other claims are generally more predictable than construction defect claims, there can be no assurance that further upward development of loss costs associated with such claims will not occur. REINSURANCE Reinsurance is generally used to reduce the liability on individual risks and to protect against individual risk or aggregate catastrophic losses. Superior Pacific follows the industry practice of reinsuring a portion of its risks. The availability and cost of reinsurance are subject to prevailing market conditions and may affect Superior Pacific's profitability. Superior Pacific's reinsurance program is based on the security of the reinsurers, coverage, and price. Superior Pacific monitors its reinsurers' financial condition carefully and recoverable losses are pursued aggressively. Occasionally, Superior Pacific is involved in disputes with reinsurers, which, if not settled, may be resolved in arbitration. At December 31, 1997, there were no disputes related to the workers' compensation operations. Superior Pacific maintains excess of loss reinsurance contracts with various reinsurers and a quota-share contract with ZRNA, an affiliate of Zurich. Under its current excess of loss contracts (with multiple reinsurers), various reinsurers collectively assume liability on that portion of each loss that exceeds $500,000 on a per occurrence basis, up to a maximum of $150.0 million per occurrence. 13 16 Effective January 1, 1994, SNIC entered into a quota-share reinsurance contract (the "Quota-Share Contract") with ZRNA. Under the Quota-Share Contract, ZRNA may provide Superior Pacific with an Assumption of Liability Endorsement ("ALE") facility, or, effective January 1, 1997, Superior Pacific may write directly on policy forms of ZC Insurance Company ("ZCIC"), an affiliate of Zurich (the "ZCIC Front"). The ceding rate under the contract was 20% for 1994, and ZRNA and Superior Pacific mutually agreed to reduce the quota-share participation to 5% for 1995 and 1996. Further, Superior Pacific received ceding commissions ranging between 22.5% and 24.5% for premiums ceded to ZRNA under the 1994 -1997 contracts. The purpose of the ceding commission is to cover Superior Pacific's cost of acquiring new business and may be changed as a result of changes in market conditions on a quarterly basis. Effective January 1, 1997, the terms of the Quota Share Contract were amended whereby ZRNA increased its participation from 5% of premiums written in 1996 to 6.5% in 1997. In exchange for the increased participation, ZRNA no longer received a separate fee for policies written on ALEs, but received an additional 2% of premiums written on ZCIC Front policies only. Effective January 1, 1998, the terms of the quota share contract were amended whereby the ceding commission was increased to 27.5% for non-ZCIC and an ALE premium. The ceding commission on ZCIC policies remained at 20%. Further, the additional 2% of premium paid on ZCIC front policies was eliminated. Effective February 1, 1998, Superior Pacific entered into an unrelated quota share reinsurance contract under which it cedes 100% of premiums and claim and claim adjustment expenses associated with policies having $100,000 or more of estimated annual premium. Superior Pacific receives a 35% ceding commission on premiums ceded under this contract. Superior Pacific entered into a contract with Centre Re effective June 30, 1997, under which Centre Re assumed $10 million of reserves associated with claims open for future medical payments from Superior Pacific in consideration of $1 million in cash and the assignment of the rights of Superior Pacific's contribution and subrogation recoveries during the term of the contract. The contract is accounted for as a deposit, and no gain will be recognized until net cash payments from Centre Re are either greater than Superior Pacific's $1 million premium. See "Management Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." Reinsurance makes the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded, but it generally does not legally discharge an insurer of its primary liability for the full amount of the policy liability (except for ALEs). If a reinsurer fails to meet its obligations under the reinsurance agreement, the ceding company is required to pay the loss. With respect to policies with an ALE, however, in the event that Superior Pacific is unable to meet its claim payment obligations, ZRNA assumes all responsibility for the payment of losses related to the policy. All of the excess of loss reinsurance is with non-affiliated reinsurers. Superior Pacific generally enters into its contracts on an annual basis. Superior Pacific has maintained reinsurance contracts with many reinsurers for a number of years. In general, Superior Pacific's reinsurance contracts cover specified underwritten risks. Superior Pacific also from time to time purchases reinsurance covering specific liabilities or policies underwritten. As of December 31, 1997, ZRNA and General Reinsurance Corporation accounted for 24.5% and 21.6%, respectively, of total amounts recoverable by Superior Pacific from all reinsurers on paid and unpaid claims and claim adjustment expenses, and were the only reinsurers that accounted for more than 10% of such amounts. INVESTMENTS The amount and types of investments that may be made by the Company are regulated under the California Insurance Code and rules and regulations promulgated by the DOI. The investments of the Company are primarily managed externally, based upon guidelines and strategies approved by management. The Company's consolidated portfolio consisted almost entirely of fixed income securities as of December 31, 1997. The bond portfolio is heavily weighted toward short to intermediate term, investment grade securities rated "A" or better, with approximately 91% rated "AA" or better. 14 17 Funds withheld assets having carrying and market values of $114.9 million and $117.1 million, respectively, at December 31, 1995, were withheld from Centre Re as collateral under an excess of loss reinsurance contract. These assets were carried as held to maturity until they were returned to Centre Re in 1996 upon the commutation of the reinsurance contract. All investment income and market value risk associated with such assets was Centre Re's. Interest expense in the amount $6.1 million and $8.8 million was paid to Centre Re during 1996 and 1995, respectively. In November 1996, the Company entered into a financing transaction involving Centre Re and The Chase Manhattan Bank ("Chase") pursuant to which Chase extended a $93.1 million term loan, net of transaction costs. The Company used proceeds from the transaction to purchase from SNIC reinsurance receivables due from Centre Re. On June 30, 1997, the Company reached an agreement under which the Company agreed to transfer reinsurance receivables to Chase in exchange for the cancellation of the Company's debt to Chase. As a result of these actions, the Company's investable assets increased by $93.1 million. The table below contains information concerning the composition of the Company's investment portfolio at December 31, 1997:
CARRYING AMOUNT MARKET TYPE OF INVESTMENT (1) VALUE ------------------ -------- -------- (IN THOUSANDS) Bonds (2) U.S. government and agencies................................ $165,273 $165,273 AA/Aa rated................................................. 21,127 21,127 A rated..................................................... 12,584 12,584 BBB/Baa rated............................................... 2,150 2,150 BB/Ba rated................................................. 4,080 4,080 -------- -------- Total Bonds............................................... 205,214 205,214 Invested cash and short-term investments.................... 35,376 35,376 Common stocks............................................... 1,526 1,526 -------- -------- Total..................................................... $242,116 $242,116 ======== ========
(1) Carrying amount is amortized cost for bonds held to maturity and short-term investments. Market value is used for bonds held for sale and common stocks. (2) Standard & Poor's Corporation defines "AAA" rated securities as "highest rating, extremely strong security," "AA" rated securities as "very strong security," "A" as "strong security," "BBB" as "adequate security," and "BB" as "low quality." Moody's Investor Services, Inc. defines "Aaa" rated securities as "best quality," "Aa" as "high quality," "A" as "strong security," "Baa" as "adequate security," and "Ba" as "low quality." The table below reflects investments and interest earned thereon and average annual yield on investments for each year in the five-year period ended December 31, 1997.
YEAR ENDED DECEMBER 31, ---------------------------------------------------- 1997 1996 1995 1994 1993 -------- -------- -------- -------- -------- (DOLLAR AMOUNTS IN THOUSANDS) Total investments at end of period.......... $242,116 $149,440 $163,951 $174,345 $144,778 Net investment income before taxes.......... $ 12,674 $ 7,769 $ 9,784 $ 9,049 $ 9,550 Average annual yield on ending investment portfolio (before taxes).................. 5.2% 5.2% 5.9% 5.2% 6.6%
In monitoring its asset and liability match, the Company attempts to keep the investment duration at the mid-point of its anticipated payout pattern of claims. As of December 31, 1997, the investments under the Company's management had a duration of 2.90 years. 15 18 The table below sets forth the maturity profile of the Company's bond portfolio at market value as of December 31, 1997:
BONDS RATED (1) ---------------------------------------------------------- AAA/AAA AA/AA A BBB/BAA BB/BA TOTAL -------- ------- ------- ------- ------ -------- (DOLLAR AMOUNTS IN THOUSANDS) 1 year or less........................... $ 25,086 $ 25,086 More than 1 year, through 3 years........ 9,038 5,544 14,582 More than 3 years, through 5 years....... 11,988 15,120 3,020 30,128 More than 5 years, through 10 years...... 26,519 6,007 4,020 2,150 4,080 42,776 More than 10 years, through 15 years..... 2,866 2,866 More than 15 years....................... 89,776 89,776 -------- ------- ------- ------ ------ -------- Total.................................... $165,273 $21,127 $12,584 $2,150 $4,080 $205,214 ======== ======= ======= ====== ====== ========
(1) Standard & Poor's Corporation defines "AAA" rated securities as "highest rating, extremely strong security," "AA" rated securities as "very strong security," "A" as "strong security," "BBB" as "adequate security," and "BB" as "low quality." Moody's Investor Services, Inc. defines "Aaa" rated securities as "best quality," "Aa" as "high quality," "A" as "strong security," "Baa" as "adequate security," and "Ba" as "low quality." INFORMATION SERVICES Superior Pacific emphasizes the development of personal computer based information and processing systems for use in all areas of its business and to that end strives to maintain a creative, flexible, and dynamic data processing capability that (i) enhances the effectiveness of its employees' underwriting, policy administration, and claims activities, (ii) provides detailed, real-time and near real-time information to management for control and administration purposes, and (iii) provides marketing benefits through improved customer service. The Company believes that these systems give it a significant competitive advantage over competitors that lack such systems. Superior Pacific expensed or capitalized 3.7%, 4.2%, and 3.3% of direct premiums written in 1997, 1996, 1995, respectively. Data Warehouse Decision Support System. In 1993 the Company developed SWAMI(R), its proprietary "data warehouse decision support" system. Beginning with the installation of SWAMI(R), Superior Pacific adjusted the Company's monitor and feedback cycle to no less frequently than weekly, and, in many respects, to a daily basis. Management believes this to be necessary due to the information intensive nature of the insurance business; lack of information represents a major aspect of underwriting risk. Accordingly, SWAMI(R) was developed to provide quality, detailed, real-time and near real-time information to management as needed to reduce the risk represented by lack of information. The SWAMI(R) system has been constantly enhanced since its implementation. Management believes that SWAMI(R) is the first comprehensive "data warehouse decision support" system developed in the insurance industry. Underwriting. The Company's underwriting system is a fully-integrated rating, quoting, and policy issuance system for use both internally and remotely from producers' offices. The system contains edit and blocking features that prohibit underwriters from issuing policies associated with business that is deemed inappropriate or undesirable by management, or that may be inappropriately priced. Detailed information for each producer can be instantaneously reviewed on an accident year, policy year, or calendar year basis. The system provides analytical information as to producers, underwriters, or branch operations, which management uses to take corrective action with respect to unprofitable producers or ineffective staff. The system permits management to evaluate commissions, in force business, collections activity, and product pricing, in detail, utilizing information that is no more than 24 hours old. Policy Administration. Policy administration, including premium collection and audit activities, is fully automated. In addition to traditional "agency" billing services, the Company's collections capabilities also include direct bill, automatic withdrawals from policyholders' bank accounts, and credit card billings, which, management believes, dramatically improve credit experience and policy persistency. 16 19 Claims Administration. The core of the claims system is a proprietary document imaging system that, combined with sophisticated workflow protocols, improves the productivity of the Company's claims staff. The Company has comprehensive physical and virtual safeguards for its information and processing systems. Disaster recovery programs and back-up procedures include nightly back-up storage of all transactions and changes to the system's database. At the end of each business day, the Company transfers this information to tapes that are stored off site. The Company maintains back-up systems in the branch offices to use if the main system fails. Computer access is restricted by use of codes and passwords. The Company does not believe that it will incur any material expenditures or liabilities as a result of the "year 2000" problem in computer software. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Year 2000 Strategy." COMPETITION California is the country's largest workers' compensation insurance market. Competitive pressures in the California workers' compensation market increased with the implementation of open rating in January, 1995. As a result, total direct premiums written for the California market decreased from $9.0 billion in 1993 to $5.0 billion in 1996. More recently, certain fundamentals of the workers' compensation market in California have improved, as demonstrated by an actual improvement in premium pricing of 0.5% for the year ended December 31, 1997, as compared to the same period in 1996. The workers' compensation insurance industry in California is extremely competitive. Many of Superior Pacific's competitors have been in business longer, have a larger volume of business, offer more diversified types of insurance coverage, have greater financial resources, and have greater distribution capabilities than Superior Pacific. Of the approximately 300 companies that report to the WCIRB that they write workers' compensation insurance, the Company believes that Liberty Mutual Insurance Companies, California Compensation Insurance Company, and American International Group are the largest private sector underwriters of workers' compensation insurance in California. Superior Pacific believes the dominant competitor in the California workers' compensation industry is the State Fund. As a result of the Acquisition, the Company believes that, excluding the State Fund, it is the eighth largest California workers' compensation insurer overall, based upon 1996 direct premiums written. The workers' compensation market is commodity-oriented, highly fragmented, and reflective of intense price competition. Nevertheless, because each risk is unique in terms of insurance exposure, different insurers can develop widely divergent estimates of prospective losses. Most insurers attempt to segment classes within markets so that they target the more profitable sub-classes with lower, although adequate, rates given the estimated profitability of the segment. In some cases, no statistics are available for the sub-classes involved, and the insurer implements discounted rate structures based solely on theoretical judgment. Finally, different insurers have widely-divergent internal expense positions, due to distribution methods, economies of scale, and efficiency of operations. Therefore, although workers' compensation insurance is a commodity, the price of insurance does not necessarily reflect commodity pricing. Superior Pacific's existing and prospective customer bases are vulnerable to competition, especially from larger insurers that at any time are capable of penetrating Superior Pacific's markets with products priced at levels substantially below Superior Pacific's. RATINGS Superior Pacific is currently rated "BBB" by S&P, a claims paying rating it has held since 1995. Insurance companies rated "BBB" are considered by S&P to offer adequate financial security, but capacity to meet policyholder obligations is susceptible to adverse economic and underwriting conditions. A.M. Best has currently assigned a "B+" (Very Good) rating to Superior Pacific, a rating it has held since 1995. A.M. Best's ratings are based upon an evaluation of a company's: (i) financial strength (leverage/capitalization, capital structure/holding company, quality, appropriateness of reinsurance program, adequacy of loss/policy reserves, quality, diversification of assets, and liquidity); (ii) operating performance (profitability, revenue composition, and management experience and objectives); and (iii) market profile (market risk, competitive market position, spread of risk, and event risk). A "B+" rating is assigned to companies that have on balance, in 17 20 A.M. Best's opinion, very good financial strength, operating performance, and market profile when compared to the standards established by A.M. Best, and have a good ability to meet their ongoing obligations to policyholders. "B+" is A.M. Best's sixth highest rating classification out of 15 ratings. A.M. Best's and S&P's ratings represent an independent opinion of a company's financial strength and ability to meet its obligations to policyholders and are not based upon factors concerning investors. Such ratings are subject to change and are not recommendations to buy, sell, or hold securities. One factor in an insurer's ability to compete effectively is its A.M. Best rating. The Company's A.M. Best rating is lower than that of many of its competitors. There can be no assurance that such ratings or future changes therein will not affect the Company's competitive position. In addition, the Company currently maintains a facility that allows it to offer certain policyholders insurance policies written by a Zurich affiliate having an A.M. Best "A" rating. REGULATION SNIG and its insurance subsidiaries are subject to extensive governmental regulation and supervision. Regulations relate to such matters as the filing of premium rates and policy forms, adequacy of reserves, types and quality of investments, minimum capital and surplus requirements, deposits of securities for the protection of policyholders, statutory financial reporting, and restrictions on shareholder dividends. SNIG and its insurance subsidiaries are also subject to periodic examination by the DOI. In addition, assessments are made against Superior Pacific to cover liabilities to policyholders of insolvent insurance companies. The regulation and supervision of insurance companies by state agencies is designed principally for the benefit of policyholders, not shareholders. SNIG believes that it and its subsidiaries are in material compliance with state regulatory requirements that are relevant to their respective businesses. The DOI Triennial Examination of SNIC, which covered the three years ended December 31, 1994, was completed in 1996 and indicated no material issues or actions needed to be taken by SNIC in either its operations or financial statements. SPCC's Triennial Examination, which was completed in 1996, resulted in an additional $18.5 million of claim and claim adjustment expense reserves being recorded as of December 31, 1996. An additional $12.0 million in claim and claim adjustment expense was recorded by SPCC in the first quarter of 1997. These events preceded SPCC's acquisition on April 11, 1997. The California Insurance Code requires the DOI to approve any proposed change of control of the Company. For such purposes, "control" is presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote, or holds proxies representing more than 10% of the voting securities of the Company. The California Insurance Code also limits the amount of dividends or distributions an insurance subsidiary may pay without DOI approval in any 12-month period to the greater of (a) net income for the preceding year or (b) 10% of statutory policyholders' surplus as of the preceding December 31. Payments of greater amounts require the approval of the DOI. The maximum dividends permitted under the California Insurance Code are not necessarily indicative of an insurer's actual ability to pay dividends or other distributions to a parent company, which also may be constrained by business and regulatory considerations, such as the impact of dividends on surplus, which could affect an insurer's competitive position, the amount of premiums that can be written, and the ability to pay future dividends. Further, the California Insurance Code requires that the statutory surplus of an insurance company following any dividend or distribution by such company be reasonable in relation to its outstanding liabilities and adequate for its financial needs. In 1989, 1991, 1993 and 1995, various workers' compensation reform laws that were passed into law by the California Legislature materially impacted the Company's rates, claims experience, financial condition and results of operations. Under the last important measure, adopted in 1993 and declared effective as of January 1995, California's minimum rate law was replaced by an open rating system. Under this new rating system, individual insurance companies file rates and rules not less than 30 days prior to their effective date, and such rates and rules can only be disapproved by the DOI after a hearing and only on the basis of solvency, market share, or improper filing. Superior Pacific cannot predict the ultimate effect of open rating on its workers' compensation business, 18 21 but during the first three years of open rating, the intense price competition that ensued led to lower average premiums per policy. Rates stabilized in 1996, and appeared to increase slightly during 1997. Superior Pacific believes the rates it has filed with the DOI are adequate, but it is unable to predict the degree to which such rates are competitive in the marketplace. The California legislature passed, and the DOI has issued its guidelines with respect to the implementation of, Assembly Bill 1913 ("AB 1913"). AB 1913 causes, among other things, the experience modification factor of a current workers' compensation policy and the immediately preceding two policies (regardless of carrier) to be subject to revision if a claim used in a modification closes on or after January 1, 1995, for a value of 60% or less of its highest earlier reported value, if the highest reported incurred value was $10,000 or more. This was amended effective January 1, 1998. Under the new rules of AB 1913, if the aggregate amount of incurred claims changes by more than 60% or less, than the WCIRB will calculate a new experience modification factor. Such a change in the experience modification factor will require the current workers' compensation carrier to return a portion of a policyholders' premium for the current and preceding two policies' periods regardless if the current carrier was the insured's previous carrier. WCIRB estimates of the ultimate cost to California workers' compensation underwriters range from 1% to 2.5% of 1996 premium; however, these estimates are based upon broad industry estimates and could vary significantly from company to company based upon the type of claims incurred, size of employer, and employer industry group. Because of the uncertainty and variability regarding the effects of AB 1913, no reasonable estimate of the cost can be made. The Company paid approximately $2.0 million in AB 1913 refunds in the year ending December 31, 1997. Proposed federal legislation has been introduced from time to time in recent years that would provide the federal government with substantial power to regulate property and casualty insurers, including state workers' compensation systems, primarily through the establishment of uniform solvency standards. Proposals also have been discussed to modify or repeal the antitrust exemption for insurance companies provided by the McCarran-Ferguson Act. The adoption of such proposals could have a material adverse impact upon the operations of the Company. In order to enhance the regulation of insurer solvency, the National Association of Insurance Commissioners (the "NAIC") has adopted a formula and model law to implement risk-based capital ("RBC") requirements for property and casualty insurance companies designed to assess minimum capital requirements and to raise the level of protection that statutory surplus provides for policyholder obligations. The NAIC model law has been incorporated into the California Insurance Code. The RBC formula for property and casualty insurance companies measures four major areas of risk: (i) underwriting, which encompasses the risk of adverse loss developments and inadequate pricing, (ii) declines in asset values arising from credit risk, (iii) declines in asset values arising from investment risks, and (iv) off-balance sheet risk arising from adverse experience from non-controlled assets, guarantees for affiliates, contingent liabilities and reserve and premium growth. Pursuant to the model law, insurers having less statutory surplus than that required by the RBC calculation will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy. The RBC model law provides for four levels of regulatory action. The extent of regulatory intervention and action increases as the level of surplus as a percentage of the RBC amount falls. The first level, the Company Action Level (as defined by the NAIC), requires an insurer to submit a plan of corrective actions to the regulator if surplus falls below 200% of the RBC amount. The Regulatory Action Level (as defined by the NAIC) requires an insurer to submit a plan containing corrective actions and requires the relevant insurance commissioner to perform an examination or other analysis and issue a corrective order if surplus falls below 150% of the RBC amount. The Authorized Control Level (as defined by the NAIC) gives the relevant insurance commissioner the option either to take the aforementioned actions or to rehabilitate or liquidate the insurer if surplus falls below 100% of the RBC amount. The fourth action level is the Mandatory Control Level (as defined by the NAIC) which requires the relevant insurance commissioner to rehabilitate or liquidate the insurer if surplus falls below 70% of the RBC amount. Based on the foregoing formulae, as of December 31, 1997, the RBC ratios of SNIC and SPCC were in excess of the Company Action Level, the first trigger level that would require regulatory action. 19 22 The NAIC's Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies eleven industry ratios and specifies "usual values" for each ratio. Departure from the usual values on four or more of the ratios may lead to increased regulatory oversight. Based on its 1997 statutory financial statement, SNIC was within the usual range of all twelve IRIS tests, and SPCC fell outside the usual range of three of the twelve IRIS tests. SPCC was outside of the usual range of the tests measuring change in net writings, two-year overall operating ratio, and two-year reserve development to surplus. The unusual values were the result of 1996 claim and claim adjustment expense reserve increases, and the runoff of SPCC's premium in force during 1997. Early in 1998, the NAIC completed a project to codify SAP, as prior SAP does not address all accounting issues and differed from state to state. The codification replaced prescribed or permitted practices as the new comprehensive statutory basis of accounting for insurance companies. Final implementation of codification is required as of December 31, 1999. Due to the recent implementation of the project, the Company has not yet quantified the impact such changes may have on the statutory capital and surplus or statutory results of operations of SNIC and SPCC. The impact of adopting this new comprehensive statutory basis of accounting may, however, materially impact statutory capital and surplus. It is not possible to predict the future impact of changing state and federal regulation on the Company's operations and there can be no assurance that laws and regulations enacted in the future will not be more restrictive than existing laws. EMPLOYEES As of December 31, 1997, the Company had approximately 410 employees, none of whom was covered by a collective bargaining agreement. RISK FACTORS The following risk factors should be carefully reviewed in addition to the other information included in this Annual Report on Form 10-K. Uncertainty Associated with Estimating Reserves for Unpaid Claim and Claim Adjustment Expenses The reserves for unpaid claim and claim adjustment expenses established by the Company are estimates of amounts needed to pay reported and unreported claim and related claim adjustment expenses based on facts and circumstances then known. These reserves are based on estimates of trends in claims severity, judicial theories of liability, market conditions and other factors. The establishment of adequate reserves is an inherently uncertain process, and there can be no assurance that the ultimate liability will not materially exceed the Company's reserves for claim and claim adjustment expenses and have a material adverse effect on the Company's results of operations and financial conditions. Although the Company has recently experienced reduced claims frequency, there has been an increase in claims severity for injuries sustained in 1995 and thereafter. In response, the Company has undertaken the Claims Severity Management Program. There can be no assurance that such program will have the effect the Company anticipates. See "Business -- Claims Severity Management Program." Due to the inherent uncertainty of estimating reserve amounts, it has been necessary, and may over time continue to be necessary, to revise estimates of the Company's reserves for claim and claim adjustment expenses in response to trends in claim severity, judicial theories of liability, market conditions and other factors. The historic development of reserves for claim and claim adjustment expenses may not necessarily reflect future trends in the development of these amounts. Accordingly, it may not be appropriate to extrapolate redundancies or deficiencies based on historical information. See "Business -- Claim and Claim Adjustment Expense Reserves." 20 23 Uncertain Pricing and Profitability One of the distinguishing features of the insurance industry, including the workers' compensation insurance industry, is that its products generally are priced before its costs are known because premium rates usually are determined before losses are reported. Premium rate levels are related in part to the availability of insurance coverage, which varies according to the level of surplus in the industry. Increases in surplus have generally been followed by increased price competition among workers' compensation insurers. For these reasons, together with the commencement of open rating in January, 1995, the California workers' compensation insurance business in recent years has experienced very competitive pricing conditions and there can be no assurance as to the Company's ability to achieve adequate pricing for its policies. Changes in case law, the passage of new statutes or the adoption of new regulations relating to the interpretation of insurance contracts can retroactively and dramatically affect the liabilities associated with known risks after an insurance contract is in place. Product enhancements also present special issues in establishing appropriate premium levels in the absence of sufficient experience with such products' performance. See "Business -- California Workers' Compensation Market" and "-- Underwriting." The number of competitors and the similarity of products offered, as well as regulatory constraints, limit the ability of workers' compensation insurers to increase prices in response to declines in profitability or market demand. In addition, the reported profits and losses of a workers' compensation insurance company are also determined, in part, by the establishment of, and adjustments to, reserves reflecting estimates made by management as to the amount of claim and claim adjustment expenses that will ultimately be incurred in the settlement. of claims. The ultimate liability of the insurer for all claim and claim adjustment expenses reserved at any given time will likely be greater or less than these estimates, and differences in the estimates may have a material adverse effect on the insurer's financial position, results of operations or cash flows in the future periods. See "Business -- Claim and Claim Adjustment Expense Reserves." Risks of Acquisitions The Company may pursue acquisitions of insurance companies or other companies related to the California workers' compensation insurance market that can be acquired on acceptable terms and which the Company believes can be operated profitably. Some of these acquisitions could be material in size and scope. The Company believes that its future growth may depend, in part, upon the successful implementation of this strategy. While the Company will continually be searching for acquisition opportunities, there can be no assurance that the Company will be successful in identifying suitable acquisitions. If any potential acquisition opportunities are identified, there can be no assurance that the Company will consummate such acquisitions. The Company may in the future face increased competition for acquisition opportunities, which may inhibit its ability to consummate suitable acquisitions or increase the expense of completing acquisitions. In addition, to the extent that the Company's strategy results in the acquisition of businesses, such acquisitions could pose a number of special risks, including the diversion of management's attention, the assimilation of the operations and personnel of the acquired companies, the integration of acquired assets with existing assets, adverse short-term effects on reported operating results, the amortization of acquired intangible assets, and the loss of key employees. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Overview" and "-- Year Ended December 31, 1997 as compared to year ended December 31, 1996." Leverage As of December 31, 1997, the Company had $113 million of long term debt outstanding, comprised of $105 million in Senior Subordinated Notes and $7.6 million in the form of a capital lease. The Company's ratio of earnings to fixed charges and distributions on Preferred Securities was 1.98 to 1. The Indenture pursuant to which the Senior Subordinated Notes were issued permits the Company to incur additional indebtedness, subject to certain limitations. Management believes that cash flow from operations and existing funds available for payments of principal and interest will be adequate to permit the Company to make its required payments of principal and interest on its indebtedness, although there can be no 21 24 assurance that this will be the case. To the extent that cash flow from operations is insufficient to satisfy the Company's cash requirements, the Company may seek to raise funds from additional borrowings or equity financings, by restructuring, or by acquiring other businesses that would provide cash flow (in all such cases to the extent permitted by the Indenture). See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." There can be no assurance that such actions could be effected on satisfactory terms, in a timely manner, or at all, that would enable the Company to make any payments due on the Senior Subordinated Notes or that any such actions would be permitted under the related Indenture. The degree to which the Company is leveraged could have adverse consequences, including the following: (i) a substantial portion of the Company's cash flow from operations must be dedicated to the payment of principal and interest on its indebtedness, thereby reducing the funds available to the Company for other purposes, (ii) the Company's ability to obtain additional financing in the future for working capital, acquisitions or other purposes may be impaired, (iii) certain of the Company's borrowings may be at variable rates of interest, which would expose the Company to the risk of higher interest rates, (iv) the Company's flexibility in planning for or reacting to changes in market conditions may be limited, (v) the Company may be substantially more leveraged than certain of its competitors, which may place the Company at a competitive disadvantage, and (vi) the Company may be more vulnerable in the event of a downturn in its business. The Company's ability to satisfy its obligations will be dependent upon its future performance, which will be subject to prevailing economic conditions and to financial, business and other factors, including factors beyond the control of the Company. Variability of Workers' Compensation Insurance Business The workers' compensation insurance business is affected by many factors that can cause fluctuations in the results of operations of companies participating in this business. Many of these factors are not subject to the control of the Company. For example, an economic downturn in California could result in an increase in the number of claims and less demand for workers' compensation insurance. These factors, together with competitive pricing and other considerations, could result in fluctuations in the Company's underwriting results and net income. See "Business -- Regulation" and "-- Ratings." Highly Competitive Businesses The Company writes exclusively workers' compensation insurance, which is a highly competitive business. Many of the Company's competitors have substantially greater financial and other resources than the Company, and there can be no assurance the Company will be able to compete effectively against such competitors in the future. The Company's competitors include other companies which, like the Company, serve the independent agency market, as well as companies which sell insurance directly to insureds. Direct writers may have certain competitive advantages over agency writers, including increased name recognition, loyalty of the customer base to the insurer rather than an independent agency and, potentially, reduced acquisition costs. In addition, certain competitors of the Company have decreased their prices from time to time in an attempt to gain market share. The Company believes that to compete successfully in the workers' compensation business it will have to market and service a level of premiums sufficiently large to enable the Company to continue to realize operating efficiencies in conducting its business. No assurance can be given the Company will be able to compete successfully if its current level of premiums decreases significantly. See "Business -- Competition." Importance of an A.M. Best Rating One factor in an insurer's ability to compete effectively is its A.M. Best rating. The Company's A.M. Best, "B+" (Very Good), rating is lower than that of many of its competitors. A "B+" rating is assigned to companies which have on balance, in A.M. Best's opinion, very good financial strength, operating performance and market profile when compared to the standards established by A.M. Best, and have a good ability to meet their ongoing obligations to policyholders. "B+" is A.M. Best's sixth highest rating classification out of 15 ratings. A.M. Best bases its ratings on factors that concern policyholders and not upon factors concerning 22 25 investors. Such ratings are subject to change and are not recommendations to buy, sell or hold securities. There can be no assurance that such ratings or future changes therein will not affect the Company's competitive position. See "Business -- Ratings." Geographic Concentration The Company writes workers' compensation insurance almost exclusively in the State of California; consequently, the Company will be significantly affected by changes in the regulatory and business climate in California. See "Business -- Regulation." Availability of Net Operating Loss Carryforwards As of December 31, 1997, SNIG had available approximately $130.2 million in net operating loss carryforwards ("NOLs") to offset taxable income recognized by it for periods after December 31, 1997. For federal income tax purposes, these NOLs will expire in material amounts beginning in the year 2006. SNIG's ability to pay interest on the Senior Subordinated Notes may be dependent on the continued availability of the NOLs until their normal expiration. On April 11, 1997, SNIG reincorporated in Delaware and in doing so adopted certain restrictions on the transfer of its Common Stock in its Certificate of Incorporation, intended to prevent a change in ownership under Section 382 of the Internal Revenue Code, which change could materially limit the availability of the NOLs. In addition, all holders of outstanding warrants to purchase SNIG common stock entered into a Standstill Agreement in which they agreed not to exercise such warrants until such time as their exercise would not result in a change of ownership for purposes of Section 382. The transfer restrictions adopted in SNIG's Certificate of Incorporation and the Standstill Agreement serve to reduce, but not necessarily eliminate, the risk that Section 382 would be applied to limit the availability of the Company's NOLs. In the event that transfers occur in violation of the transfer restrictions, there can be no assurance the Internal Revenue Service ("IRS") will not assert such transfers have federal income tax significance notwithstanding the transfer restrictions, or that a court might hold the transfer restrictions to be unenforceable. In addition, the Board of Directors of SNIG has the power to waive the transfer restrictions and enter into a transaction that may result in an ownership change for purposes of Section 382 that would limit the use of the NOLs. The Board of Directors would only permit such transaction after making a determination that the issuance or transfer of equity securities is in the best interests of the Company, after consideration of the risk that an ownership change might occur and any additional factors that the Board of Directors deems relevant (including possible future events). See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Taxes" and "Certain Relationships and Related Transactions -- Transactions with IP and Limitations on Related Party control." Future Growth and Continued Operations Dependent on Access to Capital The underwriting of workers' compensation insurance is a capital intensive business. The Company must maintain minimum levels of surplus in SNIC and SPCC in order to continue to write business and meet the other related standards established by insurance regulatory authorities and insurance rating bureaus. The Company achieved premium growth in 1997 as a result of its acquisition of SPCC. It intends to continue to pursue acquisition and internal growth opportunities. Among the factors that may restrict the Company's future growth is the availability of capital. Such capital will likely have to be obtained through debt or equity financing or retained earnings. There can be no assurance that the Company will have access to sufficient capital to support future growth and also satisfy the capital requirements of rating agencies and regulators. In addition, the Company may require additional capital to finance future acquisitions. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." Importance of Reinsurance In order to reduce its underwriting risk, the Company purchases reinsurance. SNIC and SPCC follow the industry practice of reinsuring a portion of their respective risks. Reinsurance does not relieve the Company of 23 26 liability to its insureds for the risks ceded to reinsurers. As such, the Company is subject to credit risk with respect to amounts not recoverable from reinsurers. Although the Company places its workers' compensation reinsurance with reinsurers that are "A" rated or higher by A.M. Best and which the Company generally believes to be financially stable, a significant reinsurer's insolvency or inability to make payments under the terms of a reinsurance treaty could have a material adverse effect on the Company's financial condition or results of operations. The amount and cost of reinsurance available to companies specializing in workers' compensation insurance are subject, in large part, to prevailing market conditions beyond the control of such companies. The Company's ability to provide insurance at competitive premium rates and coverage limits on a continuing basis depends upon its ability to obtain adequate reinsurance in amounts and at rates that will not adversely affect its competitive position. Due to continuing market uncertainties regarding reinsurance capacity, no assurances can be given as to the Company's ability to maintain its current reinsurance facilities, which generally are subject to annual renewal. If the Company is unable to renew such facilities upon their expiration, the Company may need to reduce the levels of its underwriting commitments. See "Business -- Reinsurance." Risks Associated with Investments The Company's results of operations depend in part on the performance of its invested assets. As of December 31, 1997, virtually all of the Company's investment portfolio was invested in fixed-income securities. Certain risks are inherent in connection with fixed-income securities, including loss upon default, price volatility in reaction to changes in interest rates and general market factors, and in the case of certain asset backed securities, prepayment and reinvestment risk. See "Business -- Investments." Comprehensive State Regulation The Company is subject to comprehensive regulation by government agencies in California and Arizona. The nature and extent of that regulation typically involve prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company, regulation of certain transactions entered into by an insurance company with any of its affiliates, limitations on dividends, filing of premium rates and policy forms, solvency standards, minimum amounts of capital and surplus which must be maintained, limitations on types and amounts of investments, restrictions on the size of risks which may be insured by a single company, limitation of the right to cancel or nonrenew policies in some lines, regulation of the right to withdraw from markets, requirements to participate in residual markets, licensing of insurers and agents, deposits of securities for the benefit of policyholders, reporting and satisfying certain regulatory standards with respect to financial condition, and other matters. In addition, state insurance department examiners perform periodic financial and market conduct examinations of insurance companies and dictate the accounting practices to be used by insurance companies when reporting to regulatory authorities. Such regulation is generally intended for the protection of policyholders rather than security holders. No assurance can be given that future legislative or regulatory changes will not adversely affect the Company. See "Business -- Regulation." Holding Company, Structure; Dividend and Other Restrictions SNIG is a holding company whose principal asset is the capital stock of its subsidiaries. SNIG relies primarily on dividends and other payments from SNIC and SPCC to meet its obligations to creditors and to pay corporate expenses, including the principal and interest on the Senior Subsidiaries Notes. SNIC and SPCC are domiciled in the State of California, which limits the payment of dividends and other distributions by insurance companies. Under California law the maximum aggregate amount of dividends permitted to be paid in 1998 without regulatory approval by SNIC is $7.2 million and by SPCC is $3.1 million. In addition, state insurance laws and regulations require that the statutory surplus of an insurance company following any dividends or distribution by such company be reasonable in relation to its outstanding liabilities and adequate 24 27 for its financial needs. See "Business -- Overview" and "-- Regulation" and "Managements Discussion and Analysis of Financial Condition and Results of Operations." Dependence Upon Producers Superior Pacific depends on outside producers to provide it with insurance business. The renewal rights of all of such business written are owned by the producers, and not by Superior Pacific. While Superior Pacific believes that its relationships with its producers are generally excellent, there can be no assurance that producers will not move business currently written by Superior Pacific to another carrier. If renewal rates were to drop significantly at Superior Pacific as a result of producers moving business to other carriers, or if producers were to deliver less business of the type Superior Pacific prefers to underwrite, then the earnings of Superior Pacific could be adversely affected. Approximately $39.3 million (26.8%), $47.0 million (25.0%), and $44.0 million (26.0%) of Superior Pacific's premiums for the years ended December 31, 1997, 1996 and 1995, respectively, were derived from 10 producers. The loss of any of these producers could have a material adverse effect on Superior Pacific. See "Business -- Marketing." Premium Volume Concentration Approximately 65.7% of the Company's premium in force is concentrated in 400 non-group policies and 55 group programs that provide annual premium in excess of $50,000. While marketing through group programs to reach smaller policyholders is a means by which the Company can pursue its strategy to underwrite smaller policies, group programs, like large non-group policies, are vulnerable to price competition. If the Company is not able to retain a sufficient number of group programs, the loss of overall premium by the Company could materially and adversely affect the Company's ability to achieve profitability. While the Company expects to write many new, small accounts through its newly acquired relationships with policyholders and producers previously associated with Pac Rim, if the Company fails to underwrite a sufficient number of smaller accounts to offset in part the expected loss of premium from the loss of some of SPCC's larger policies, the loss of overall premium by the Company could materially and adversely affect the Company's ability to achieve profitability. See "Business -- Marketing." Significant Ownership by Affiliates of Zurich and Related Parties Certain affiliates of Zurich collectively own approximately 21% of the Company's Common Stock, on a diluted basis, and less than one percent of the Company's issued and outstanding Common Stock on a non-diluted basis. In addition, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda), L.P. (collectively, "IP"), own approximately 24% of the Company's Common Stock, on a diluted basis, and approximately 36% of the Company's issued and outstanding Common Stock on a non fully-diluted basis. Certain affiliates of Zurich are limited partners of IP, holding approximately 23% of IP's limited partnership interests. Further, International Insurance Investors, L.P., ("III") owns all of the outstanding Voting Notes (as defined herein) issued by SNIG. Certain affiliates of Zurich are limited partners of III and hold approximately 32% of III's limited partnership interests. See "Security Ownership of Certain Beneficial Owners and Management" and "Certain Relationships and Related Transactions -- Transactions with IP-Limitation on Related Party Control." Five of the Company's eleven directors have relationships with such parties. Consequently, such parties have significant influence over the management of the Company and have a significant portion of the votes needed to approve any action requiring stockholder approval, including adopting amendments to SNIG's Certificate of Incorporation and approving certain actions, such as mergers or sales of all or substantially all of the Company's assets, which could cause a Change of Control or otherwise materially affect the Company's financial condition. Dependence on Key Personnel in Connection with Future Success The future success of the Company depends significantly upon the efforts of certain key management personnel, including William L. Gentz, a director and the President and Chief Executive Officer, J. Chris 25 28 Seaman, a director, an Executive Vice President and the Chief Financial Officer, and Arnold J. Senter, an Executive Vice President and the Chief Operating Officer. A loss of any of these officers or other key employees could materially and adversely affect the Company's business. See "Management -- Executive Officers." ITEM 2. BUSINESS PROPERTIES The Company's principal executive offices are located in Calabasas, California and are subject to a lease that expires in 2000. The Company also leases space for branch offices in Woodland Hills, Pleasanton, Sacramento, and Fresno (all in California). Such leases expire in 2002, 2003, 2001, and 2000, respectively. ITEM 3. LEGAL PROCEEDINGS SNIG and its subsidiaries are parties to various legal proceedings, all of which are considered routine and incidental to the business of the Company and are not material to the financial condition and operation of the business. Neither SNIG nor any of its subsidiaries is a party to any litigation expected to have a material adverse effect upon the Company's business or financial position. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders of SNIG's, through the solicitation of proxies or otherwise, during the fourth quarter of 1997. 26 29 PART II ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS SNIG's common stock (the "Common Stock") is listed and traded on The Nasdaq National Market under the trading symbol "SNTL". "The Nasdaq National Market" or "Nasdaq" is a highly-regulated electronic securities market comprised of competing Market Makers whose trading is supported by a communications network linking them to a quotation dissemination, trade reporting, and order execution system. This market also provides specialized automation services for screen-based negotiations of transactions, on-line comparison of transactions, and a range of informational services tailored to the needs of the securities industry, investors and issuers. Nasdaq consists of two distinct market tiers: The Nasdaq National Market and The Nasdaq SmallCap Market. Nasdaq is operated by The Nasdaq Stock Market, Inc., a wholly-owned subsidiary of the National Association of Securities Dealers, Inc. Set forth below are the quarterly high and low closing sale prices for the Common Stock as reported to SNIG by those broker-dealers believed by SNIG to be most active in making a market in the Common Stock. As SNIG's Common Stock was not approved for listing on The Nasdaq National Market until March 5, 1996, quotations prior to SNIG's being listed on Nasdaq are inter-dealer prices (giving effect to the May 25, 1995, four-into-one reverse stock split), without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions.
HIGH LOW ------ ------ 1997 Fourth quarter........................................... $15.25 $14.00 Third quarter............................................ $15.50 $13.25 Second quarter........................................... $13.63 $11.63 First quarter............................................ $15.25 $11.25 1996 Fourth quarter........................................... $13.75 $ 9.88 Third quarter............................................ $10.75 $ 7.13 Second quarter........................................... $ 8.00 $ 4.87 First quarter............................................ $ 5.63 $ 4.87 1995 Fourth quarter........................................... $ 6.00 $ 4.75 Third quarter............................................ $ 5.50 $ 4.75 Second quarter........................................... $ 5.00 $ 4.00 First quarter............................................ $ 5.40 $ 4.60
As of March 1, 1998, the number of shareholders of record of SNIG's Common Stock was 261 and 5,962,766 shares of Common Stock were outstanding on that date. The Company believes the increase in price in the third and fourth quarter of 1996 and the first quarter of 1997 was primarily due to the announcement of the Pac Rim acquisition. The Pac Rim acquisition was completed on April 11, 1997. The Company's current policy is to retain its earnings for use in its business; it has paid no cash dividends to its stockholders in its two most recent fiscal years and has no present intention of paying cash dividends in the foreseeable future. The payment of dividends in the future is subject to the discretion of the Board of Directors and will depend on the Company's operating results, financial condition and capital requirements, general business conditions, and other relevant factors, including legal restrictions applicable to the payment of dividends by SNIC and SPCC. The California Insurance Code restricts the dividends or distributions an insurance subsidiary may pay in any 12-month period to the greater of (a) net income for the preceding year, or (b) 10% of statutory policyholders' surplus as of the preceding December 31. Payments of greater amounts require the approval of the DOI. Because the Company conducts no substantial business other than through 27 30 SNIC and SPCC, SNIG would be dependent upon dividends from SNIC and SPCC in order to pay dividends to SNIG's stockholders. During the fiscal year ended December 31, 1997, the Company, through a series of grants to certain employees pursuant to its 1995 Stock Incentive Plan, awarded (a) an aggregate of 36,450 shares of restricted Common Stock, which shares are subject to the Company's right of repurchase, and (b) options to purchase an aggregate of 132,257 shares of Common Stock, vesting in equal annual increments of 20% from the date of grant of such option and having exercise prices ranging from $11.38 to $14.875 per share. In issuing such securities, the Company relied on a Registration Statement on Form S-8, promulgated pursuant to the Securities Act. UNREGISTERED SALES OF SNIG'S EQUITY SECURITIES DURING LAST FISCAL YEAR On December 3, 1997, the Trust, a direct subsidiary of SNIG, issued and sold $105.0 million in aggregate liquidation amount of its 10 3/4% Trust Preferred Securities in reliance upon the exemption provided by Section 4(2) of the Securities Act of 1933, as amended (the "Securities Act"), and Regulations D and S thereunder, as transactions exempt from the registration requirements of the Securities Act to persons reasonably believed by Donaldson, Lufkin & Jenrette Securities Corporation and Chase Securities Inc., as the initial purchasers (the "Initial Purchasers") of the Trust Preferred Securities, to be "qualified institutional buyers" (as defined by Rule 144A under the Securities Act), other institutional "accredited investors" (as defined in Rule 501(a)(1), (2), (3) or (7) under the Securities Act) or in transactions complying with the provisions of Regulation S under the Securities Act. In view of the fact that the proceeds of the sale of the Trust Preferred Securities were invested in the Senior Subordinated Notes, the Company paid the Initial Purchasers, as compensation, $29.50 per Trust Preferred Security (or approximately $3.01 million in the aggregate). The Trust Preferred Securities are traded in the Private Offering, Resales and Trading through Automated Linkages ("PORTAL") Market. See Note (9) to the Notes to Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." Pursuant to its agreement with the Initial Purchasers, the Company and the Trust filed with the SEC a registration statement (the "Registration Statement") covering an offer to exchange the Trust Preferred Securities, Senior Subordinated Notes and related Company Guarantee (as defined herein) for substantially similar securities. The Registration Statement was declared effective on January 16, 1998 and in February 1998, the exchange offer was completed, with the participation of substantially all of such securities. 28 31 ITEM 6. SELECTED FINANCIAL DATA SELECTED FINANCIAL DATA -- YEARS ENDED 1993 THROUGH 1997 (AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS.)
OPERATIONS FOR THE YEAR ENDED DECEMBER 31: -------------------------------------------------------------- 1997(1) 1996 1995 1994 1993 ---------- ---------- ---------- ---------- ---------- REVENUES: Gross premiums written............. $ 159,352 $ 99,282 $ 97,084 $ 134,769 $ 157,986 Net premiums written............... 136,929 87,715 89,139 105,946 154,431 Net premiums earned................ 140,920 88,648 89,735 110,418 153,585 Net investment income (excluding capital gains and losses)....... 12,630 7,738 10,309 9,014 8,481 Net capital gain (loss)............ 44 31 (525) 35 1,069 Other income (expense), net........ (817) 186 (536) (340) (743) ---------- ---------- ---------- ---------- ---------- Total revenues.................. 152,777 96,603 98,983 119,127 162,392 EXPENSES: Claim and claim adjustment expenses, net of reinsurance.... 90,447 55,638 53,970 78,761 113,817 Underwriting and general and administrative expenses......... 37,695 34,138 29,447 21,660 28,779 Policyholder dividends............. -- (5,927) (5,742) 4,983 11,371 Goodwill amortization.............. 1,039 -- -- -- -- Interest expense................... 6,335 7,527 9,619 8,726 6,221 Income from continuing operations before preferred securities and extraordinary items -- pre-tax................ 17,261 5,227 11,689 4,997 2,204 Income tax benefit (expense)....... 1,788 (739) 5,849 (4) 2,304 Accretion on preferred securities -- pre-tax........... (4,650) (2,525) (2,255) (1,035) -- (Loss) from operations of discontinued P&C operations -- pre-tax(2)........ -- -- (14,912) -- (4,532) Extraordinary (loss) -- pre-tax.... (19,540) -- -- (3,064) (686) Cumulative effect of change in accounting for income taxes..... -- -- -- -- 2,297 ---------- ---------- ---------- ---------- ---------- Net income (loss)(4)............ $ (5,141) $ 1,963 $ 371 $ 894 $ 1,587 BASIC EPS(3) Income before items below -- after all taxes....................... $ 3.63 $ 1.31 $ 5.12 $ 1.45 $ 1.31 Preferred Securities -- pre-tax.... (0.89) (0.74) (0.66) (0.30) -- Discontinued Operations -- pre-tax......................... -- -- (4.35) -- (1.32) Extraordinary Items -- pre-tax..... (3.72) -- -- (0.89) (0.20) Cumulative Effect of Change in Accounting -- pre-tax........... -- -- -- -- 0.67 ---------- ---------- ---------- ---------- ---------- Net income (loss).................. $ (0.98) $ 0.57 $ 0.11 $ 0.26 $ 0.46 ========== ========== ========== ========== ==========
29 32
OPERATIONS FOR THE YEAR ENDED DECEMBER 31: -------------------------------------------------------------- 1997(1) 1996 1995 1994 1993 ---------- ---------- ---------- ---------- ---------- DILUTED EPS(3) Income before items below -- after all taxes....................... $ 2.71 $ 0.93 $ 4.44 $ 0.97 $ 0.94 Preferred Securities -- pre-tax.... (0.66) (0.52) (0.57) (0.20) -- Discontinued Operations -- pre-tax......................... -- -- (3.78) -- (0.95) Extraordinary Items -- pre-tax..... (2.79) -- -- (0.60) (0.14) Cumulative Effect of Change in Accounting pre-tax.............. -- -- -- -- 0.48 ---------- ---------- ---------- ---------- ---------- Net income (loss).................. $ (0.74) $ 0.41 $ 0.09 $ 0.17 $ 0.33 ========== ========== ========== ========== ========== OTHER DATA: EBITDA(5).......................... 24,749 14,727 22,652 15,276 9,300 GAAP RATIOS:(6) Claim and claim adjustment expense ratio........................... 64.2% 62.8% 60.1% 71.3% 74.1% Expense ratio...................... 26.7% 31.8% 26.4% 24.1% 26.1% ---------- ---------- ---------- ---------- ---------- Continuing operations combined ratios, net of reinsurance...... 90.9% 94.6% 86.5% 95.4% 100.2% ========== ========== ========== ========== ========== Ratio of earnings to combined fixed charges and accretion on preferred securities(7)......... 1.98x 1.27x 1.87x 1.36x 1.33x FINANCIAL POSITION: Total cash and investments(8) Carrying value.................. $ 242,116 $ 149,440 $ 163,951 $ 176,878 $ 150,179 Market value.................... 242,116 149,440 166,103 172,706 156,744 Total assets....................... 416,569 306,569 240,781 286,776 264,098 Long-term debt..................... 30 98,961 8,530 9,730 6,743 Claim and claim adjustment expense liability....................... 201,225 115,529 141,495 171,258 171,038 Total liabilities.................. 255,474 237,807 176,256 227,622 224,044 Preferred securities issued by affiliate....................... 101,277 23,571 21,045 18,790 -- Net stockholders' equity........... 59,818 45,191 43,480 40,364 40,055 Book value per share(3)............ $ 10.19 $ 13.11 $ 12.68 $ 11.77 $ 11.68 Outstanding shares(3).............. 5,871,279 3,446,492 3,430,373 3,429,873 3,429,873
- --------------- (1) The information for the year ended December 31, 1997 includes the financial data of SPCC for the period beginning April 1, 1997. (2) The Company's losses from discontinued operations resulted principally from contractors' and developers' liability business underwritten from 1986 to 1991. (3) Adjusted to reflect a four-into-one reverse stock split effective as of May 24, 1995. (4) Since the Company's inception it has not declared or paid any dividends to its stockholders. Income before items below -- after all taxes has been calculated to include the tax benefits related to the items following. (5) EBITDA consists of earnings before interest, taxes, minority interest, depreciation, and amortization. EBITDA is presented here not as a measure of operating results, but rather as a measure of the Company's cash flow and debt service ability, and should not be considered as an alternative to net earnings and cash flows determined in accordance with GAAP. Because the Company's ability to obtain dividends from its insurance subsidiaries may be subject to certain restrictions, EBITDA is not necessarily indicative of the Company's ability to service its indebtedness. 30 33 (6) These ratios are for continuing operations. The claim and claim adjustment expense ratio is calculated by dividing the claim and claim adjustment expenses by net premiums earned. The expense ratio is calculated by dividing the sum of commissions (net of reinsurance ceding commissions), policyholder dividends, and general and administrative expenses by net premiums earned. The combined ratio is the sum of the claim and claim adjustment expense ratio and the expense ratio. (7) For purposes of calculating the ratio of earnings to combined fixed charges and preferred stock dividends, earning represent income before the provision (benefit) for income taxes, plus fixed charges. Fixed charges consist of interest expense, amortization of financing costs and the portion of rental expense on operating leases which the Company estimates to be representative of the interest factor attributable to the leases. Preferred stock dividends consist of dividends on approximately $26.6 million in preferred securities having an effective interest rate of 11.7% issued in June 1994 by an affiliate. (8) Investments as of December 31, 1997 and 1996 are reflected at market value. As of December 31, 1995 and 1994 a portion of the portfolio was classified as held to maturity and was therefore reflected at amortized cost and the remaining portfolio was shown at market value. Investments as of December 31, 1993 are reflected at amortized cost. The changes in portfolio valuation reflect the adoption of Statement of Financial Accounting Standard No. 115, effective for fiscal years following December 15, 1993. 31 34 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis provides information that management believes to be relevant for an understanding of the Company's consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and the notes thereto. OVERVIEW During 1997, the Company entered into three significant extraordinary transactions: the acquisition of Pac Rim Holding Corporation, the parent of SPCC, completed April 11, 1997, the prepayment of approximately $88.6 million of long term debt completed June 30, 1997, and the issuance of $105 million in Trust Preferred Securities by the Trust completed December 3, 1997. The Company's income before preferred securities' dividends and accretion, discontinued operations and extraordinary items was $10.8 million in 1997, as compared to $3.6 million in 1996. The increase of $7.2 million in income before income taxes, preferred securities' dividends and accretion, discontinued operations and extraordinary items was primarily the result of a $4.9 million increase in investment income. The increase of $4.9 million in net investment income is primarily due to increases of $92.7 million and $93.1 million in assets available for investment that resulted, respectively, from the acquisition of SPCC and the November 1996 financing transaction. See "-- Liquidity and Capital Resources." For the year ended December 31, 1997, the Company recorded a net loss of $5.1 million after preferred securities' dividends and accretion, discontinued operations, and extraordinary items, as compared to income of $2.0 million for the year ended December 31, 1996. Net loss per share for the year ended December 31, 1997 was $0.74 (diluted) versus net income per share of $0.41 diluted in 1996. The Company recorded during 1997, $12.9 million in extraordinary losses, net of income tax benefits, as a result of the prepayment of debt or the retirement of debt instruments, as compared to 1996, when no extraordinary losses were recorded. Further, during 1997, the Company recorded $3.0 million in dividend expense and accretion on preferred securities, as compared to $1.7 million in 1996. For the year ended December 31, 1996, the Company's net income was $2.0 million, diluted as compared to $0.4 million in 1995. Net income per share for the year ended December 31, 1996 was $0.41 versus $0.09 for the year ended December 31, 1995. Income before preferred securities' dividends and accretion, discontinued operation, and extraordinary loss was $3.6 million for the year ended December 31, 1996, versus $11.7 million in 1995. The decrease in 1996 was due principally to a $5.3 million fee for reinsurance, as well as an increase of $1.7 million from 1995 claims and claims adjustment expense. Income before preferred securities' dividends and accretion, discontinued operations, and extraordinary loss, excluding the above discussed adjustments, was $10.6 million for the year ended December 31, 1996, as compared to $11.7 million for the comparable period of 1995. YEAR ENDED DECEMBER 31, 1997 AS COMPARED TO YEAR ENDED DECEMBER 31, 1996 Gross premiums written for the years ended December 31, 1997 and 1996 were $159.4 million and $99.3 million, respectively. This increase in gross premiums written represents an increase of $60.1 million or 60.5% for the 1997 policy year as compared to the 1996 policy year. Substantially all of this increase can be attributed to business written related to SPCC. Net premiums written increased $49.2 million or 56.1% to $136.9 million for the year ended December 31, 1997, as compared to the year ended December 31, 1996. This increase reflects the increase in gross premiums written. Net premiums earned increased $52.3 million or 59.0% to $140.9 million for the year ended December 31, 1997, as compared to the year ended December 31, 1996. For the year ended December 31, 1997, net claim and claim adjustment expenses increased $34.8 million or 62.6% to $90.4 million as compared to $55.6 million for the year ended December 31, 1996. The entire increase of claim and claim adjustment expense relates to the acquisition of SPCC. The net claim and claim adjustment expense ratio increased to 64.2% for the year ended December 31, 1997, as compared to 62.8% for the year ended December 31, 1996. The increase in the claim and claim adjustment expense ratio is due 32 35 primarily to the 1997 accident year. Although the Company has continued to experience a reduction in the frequency of claims, at the same time there has been an increase in claims severity for injuries sustained in 1995 and thereafter. To address the increasing severity trend, management has put into place the Claims Severity Management Program that is intended to reduce the Company's average ultimate per claim and claim adjustment expense for 1995 and subsequent dates of injury. See "Business -- Claims Severity Management Program." Underwriting and general and administrative expenses, excluding policyholder dividends, increased $3.6 million or 10.4% to $37.7 million for the year ended December 31, 1997, as compared to the same period in 1996. This increase primarily resulted from the SPCC acquisition. Excluding the onetime expense of $5.3 million for the cancellation in 1996 of a reinsurance contract, underwriting expenses for 1997 increased $8.9 million or 30.9%. The Company's expense ratio decreased to 26.7% from 38.5% for the year ended December 31, 1997, as compared to 1996. The decrease in the expense ratio from 1997 to 1996 is due to the 1996 one-time charge of $5.3 million previously mentioned, and an increase in premium without a corresponding increase in expense resulting from the SPCC acquisition. No policyholder dividends were paid during the year ended December 31, 1997, as compared to $1.3 million of such dividends during fiscal 1996. Prior to open rating, policyholder dividends served both as an economic incentive to employers for safe operations and as a means of price differentiation. As a result of consumers' preference for the lowest price at a policy's inception under open rating, dividends are currently no longer a significant factor in the marketing of workers' compensation insurance in California. In 1995, as a result of the diminishing value of policyholder dividends as a marketing tool, the Company's management declared a moratorium in the payment of policyholder dividends for California policies. In December 1996, the Company discontinued dividend payments. Estimated amounts to be returned to policyholders were accrued when the related premium was earned by the Company. Dividends were paid to the extent that a surplus was accumulated from premium on workers' compensation policies. Net investment income increased $4.9 million or 63.1% to $12.7 million for the year ended December 31, 1997, as compared to the year ended December 31, 1996. The increase in investment income is due to a $92.7 million increase in assets available for investment that resulted from the acquisition of SPCC. Interest expense decreased 15.8% to $6.3 million for the year ended December 31, 1997, as compared to the year ended December 31, 1996. The decline in interest expense is due primarily to the elimination of funds withheld balance, which was partially off-set by the issuance of $105 million of Senior Subordinated Notes in November 1997. Discontinued operations claim counts and losses as of December 31, 1997 were 215 and $13.5 million, respectively. These amounts and estimates are consistent with management's expectations. The Company has significant exposure to construction defect liabilities on P&C insurance policies underwritten from 1986 to 1993. Management continues to monitor closely its potential exposure to construction defect claims and has not changed its estimates of ultimate claim and claim adjustment expense on discontinued operations since 1995. Management believes its current reserves are adequate to cover its claim liabilities. There can be no assurance, however, that further upward development of ultimate loss costs associated with construction defect claims will not occur. See "Business - -- Discontinued Operations." YEAR ENDED DECEMBER 31, 1996 AS COMPARED TO YEAR ENDED DECEMBER 31, 1995 Gross premiums written increased $2.2 million or 2.3% to $99.3 million in 1996 from 1995. The increase in gross premiums written in 1996 was due primarily to the Company's continued strategy of underwriting smaller risks where the competition has been less fierce, as compared to larger policies. Net premiums written decreased $1.4 million or 1.6% to $87.7 million reflecting an increased amount of premiums ceded to reinsurers. Net premiums earned decreased $1.1 million or 1.2% to $88.6 million in 1996 from 1995, reflecting in part, an increase in ceded premiums. Claim and claim adjustment expenses increased $1.7 million or 3.1% to $55.6 million in 1996 from 1995, due principally to adverse development in claim and claim adjustment expense reserves related to the 1995 33 36 accident year. The claim and claim adjustment expense ratio as a percentage of net earned premium increased slightly to 62.8% in 1996 from 60.1% in the 1995 accident year. Underwriting and general and administrative expenses, excluding policyholder dividends, increased $4.7 million or 16% to $34.1 million in 1996 from 1995. The increase in underwriting and general and administrative expenses, excluding policyholder dividends, was due primarily to a $5.3 million adjustment recorded in the second quarter of 1996 for accrued costs related to the cancellation of a reinsurance contract. Underwriting and general and administrative expenses for 1996, excluding the $5.3 million in accrued costs, were $28.8 million as compared to $29.4 million in 1995. The Company's expense ratio, excluding the $5.3 million in accrued costs and policyholder dividends, was 32.5% for 1996, which is comparable to 32.8% in 1995. Policyholder dividend expenses for 1996 were comparable to 1995, constituting a decrease in underwriting expense of $5.9 million in 1996 as compared to $5.7 million in 1995. Underwriting profit from continuing operations decreased $7.3 million or 60% to $4.8 million in 1996 from 1995, principally due to a $4.7 million increase in underwriting expense. The increase in underwriting and general and administrative expenses was due primarily to the cost of canceling the reinsurance contract discussed above, and $2.0 million in claim and claim adjustment expense due as a result of adverse development on reserves related to prior accident years. Net investment income decreased $2.0 million or 20% to $7.8 million in 1996 as compared to 1995. The decline in investment income was due to a decrease in the average investable assets of $11.3 million and a decline in the average portfolio investment yield as a result of generally lower market interest rates in 1996 as compared to 1995. While a financing transaction involving Chase Manhattan Bank and an affiliate of Zurich entered into in November 1996 substantially increased the size of the investment portfolio on which the Company retained investment income, it occurred too late in 1996 to have a material effect on 1996 net investment income results. See "-- Liquidity and Capital Resources." LIQUIDITY AND CAPITAL RESOURCES The Company's cash inflows are generated from cash collected from policies sold, investment income generated from its existing portfolio, and sales and maturities of investments. The Company's cash outflows consist primarily of payments for policyholders' claims, operating expenses and debt service. For their insurance operations, SNIC and SPCC must have available cash and liquid assets to meet their obligation to policyholders and claimants in accordance with contractual obligations in addition to meeting their ordinary operating costs. Absent adverse material changes in the workers' compensation insurance market, management believes the Company's present cash resources are sufficient to meet its needs for the foreseeable future. During the year ended December 31, 1997, the Company used $52.4 million of cash in its operations versus $14.9 million in the year ended December 31, 1996. The Company's continued negative cash flow is the result of the Company's premium in force being significantly higher historically versus its current level. The Company anticipates that it will continue to experience the negative cash flow from operations until the claims related to the historically higher premium base have been paid out. The $37.5 million increase in cash used in operations during the year ended December 31, 1997 is primarily due to the addition of the SPCC operations. The Company believes that it has adequate short-term investments and readily marketable investment grade securities to cover both claim payments and expenses. At December 31, 1997, the Company had total cash and cash equivalents, and investments of $242.1 million and had 99.4% of its investment portfolio invested in cash, cash equivalents, and fixed maturities. In addition, 90.8% of the Company's fixed-income portfolio had ratings of "AA" or equivalent or better and 98.0% had ratings of "BBB" or equivalent or better. The Company generated $77.3 million from financing activities during the year ended December 31, 1997, as compared to $90.5 million in 1996. The 1996 financing activities consisted primarily of the transaction with The Chase Manhattan Bank discussed below. During 1997, the Company's financing activities were used to fund the acquisition of SPCC, to repay outstanding bank debt, to redeem outstanding preferred stock issued by an affiliate and to refinance existing debt. The Company generated the necessary 34 37 cash to acquire SPCC from the proceeds of a $44.0 million term loan and the sale of approximately $18.0 million in common stock. Of the approximately $62.0 million raised in such financing transactions, approximately $42.0 million was used to fund the acquisition of SPCC, approximately $6.6 million was used to repay an existing bank loan, $10.0 million was contributed to as capital to SPCC, with the remainder of the funds being used for general corporate purposes, including the payment of related transaction costs. On December 3, 1997, the Trust, a wholly owned subsidiary of SNIG, issued its Trust Preferred Securities, having an aggregate liquidation amount of $105 million, in a private placement and also issued to SNIG, for an aggregate consideration of approximately $3.25 million, all of the Trust's common securities. The proceeds from the sale of these securities were used to purchase SNIG's Senior Subordinated Notes, all of which were issued in connection with such transaction. In addition, the Company entered into several contractual undertakings which, the Company believes, when taken together, guarantee (the "Company Guarantee") to the holders of such securities a full and unconditional right to enforce the payment of the distributions with respect to such securities. On January 16, 1998, SNIG and the Trust completed the registration with the Securities and Exchange Commission of an exchange offer for the outstanding Trust Preferred Securities, Senior Subordinated Notes and Company Guarantee, pursuant to which substantially all of such securities were exchanged for substantially similar securities. SNIG used the proceeds it received from the issuance of the Senior Subordinated Notes to repay the $40.3 million outstanding balance on the term loan used to acquire SPCC, to redeem approximately $27.7 million in preferred stock issued by a SNIG affiliate to an affiliate of Zurich, to pay approximately $4.0 million in related transaction costs, and for general corporate purposes, including a $15.0 million contribution to the surplus of SNIC. Distributions on the Trust Preferred Securities (and interest on the related Senior Subordinated Notes) are payable semi-annually, in arrears, on June 1 and December 1 of each year, commencing June 1, 1998. Subject to certain conditions, on or after December 1, 2005, SNIG has the right to redeem the Senior Subordinated Notes, in whole or in part at any time, at call prices ranging from 105.375% at December 1, 2005 to 101.792% at December 1, 2007, and 100% thereafter. The proceeds from any such redemption will be immediately applied by the Trust to redeem Trust Preferred Securities and the Trust's common securities at such redemption prices. In addition, SNIG has the right, at any time, subject to certain conditions, to defer payments of interest on the Senior Subordinated Notes for Extension Periods (as defined in the Indenture), each not exceeding 10 consecutive semi-annual periods; provided that no Extension Period may extend beyond the maturity date of the Senior Subordinated Notes. As a consequence of any such extension by SNIG of the interest payment period, distributions on the Trust Preferred Securities would be deferred (though such distributions would continue to accrue interest at a rate of 10.75% per annum compounded semi-annually). Upon the termination of any Extension Period and the payment of all amounts then due, SNIG may commence a new Extension Period, subject to certain requirements. In addition, during 1997 the Company repaid approximately $0.6 million of an existing bank loan and $3.7 million of the principal of the term loan used to acquire SPCC. In November 1996, the Company entered into a financing transaction involving Centre Re and The Chase Manhattan Bank ("Chase") pursuant to which Chase extended a $93.1 million term loan, net of transaction costs. The Company used the proceeds from the transaction to purchase from SNIC reinsurance receivables due from Centre Re. On June 30, 1997, the Company and Chase reached an agreement under which the Company agreed to transfer such reinsurance receivables to Chase in exchange for the cancellation of the Company's debt to Chase. As a result of these actions, the Company's investable assets increased $93.1 million. The additional investments contributed to the increase in investment income in 1997. The Company has a reverse purchase facility with a national securities brokerage firm that allows it to engage in up to $20.0 million in reverse purchase transactions secured by either U.S. Treasury instruments, U.S. Agency debt, or corporate debt. This arrangement provides the Company with additional short-term liquidity. Reverse purchase transactions may be rolled from one period to the next, at which time the transaction is repriced. This type of financing allows Superior Pacific a great deal of flexibility to manage short-term investments, avoiding unnecessary realization of losses to satisfy short-term cash needs. Further, 35 38 this method of financing is less expensive than bank debt. As of December 31, 1997, the Company had no obligation outstanding under this facility. SNIG, as a holding company, depends on dividends and intercompany tax allocation payments from Superior Pacific for its net cash flow requirements, which consist primarily of periodic payments on its outstanding debt obligations. Absent other sources of cash flow, SNIG cannot expend funds materially in excess of the amount of dividends or tax allocation payments that could be paid to it by Superior Pacific. Further, insurance companies are subject to restrictions affecting the amount of shareholder dividends and advances that may be paid within any year without the prior approval of the DOI. The California Insurance Code provides that amounts may be paid as dividends on an annual noncumulative basis (generally up to the greater of (i) net income for the preceding year and (ii) 10% of statutory surplus as regards policyholders as of the preceding December 31) without prior notice to, or approval by, the DOI. No dividends were paid during 1997; however SNIC paid $2.9 million to SNIG for its current income taxes. The Company is party to several leases principally associated with the Company's home and branch office space, as well as its fixed assets. Such leases contain provisions for scheduled lease charges and escalations in base rent over the lease term. The Company's minimum lease commitment with respect to these leases in 1998 is approximately $7.0 million. These leases expire from 2000 to 2003. While the Company does not presently foresee any expenditures during the next twelve months other than those arising in the normal course of business, the Company may seek to expand market share without deviating from its pricing strategy, by seeking strategic alliances, investment opportunities or acquisitions. However there can be no assurances any such opportunities will be realized. The effect of inflation on the revenues and net income of the Company during the years ended December 31, 1997, 1996, and 1995 was not significant. TAXES As of December 31, 1997, the Company has available $130.2 million in NOLs to offset taxable income recognized by the Company in periods after December 31, 1997. For federal income tax purposes, these NOLs will expire in material amounts beginning in the year 2006. Any 5% shift in the current ownership of the Company may result in a "change of ownership" under Section 382 of the Code, and severely limit the Company's ability to utilize NOLs. In an effort to protect these NOLs, the Company's charter documents prohibit 5% owners of the Company's common stock (including holders of options and warrants) from acquiring additional stock and prohibit any additional person or entity from becoming a 5% holder of common stock. The prohibition against changes in ownership by the 5% holders of common stock expires in April 2000. See "Business -- Risk Factors -- Availability of Net Operating Loss Carryforwards." PRIMARY DIFFERENCES BETWEEN GAAP AND SAP The financial statements contained herein have been prepared in conformity with Generally Accepted Accounting Principles ("GAAP"), as opposed to Statutory Accounting Practices ("SAP") prescribed or permitted for insurance companies by regulatory authorities. SAP differs from GAAP principally in the following respects: (a) premium income is taken into operations over the periods covered by the policies, whereas the related acquisition and commission costs are expensed when incurred; (b) deferred income taxes are not recognized under SAP; (c) certain assets such as agent's balances over ninety days due and prepaid expenses are nonadmitted assets for statutory reporting purposes; (d) policyholder dividends are accrued when declared; (e) the cash flow statement is not consistent with classifications and the presentation under GAAP; (f) bonds are recorded at amortized cost, regardless of trading activities; (g) loss and loss adjustment expense reserves and unearned premium reserves are stated net of reinsurance; and (h) minimum statutory reserves for losses in excess of the Company's estimates are required. In March 1998, the NAIC approved the codification of statutory accounting practices. Included in the codification of statutory accounting practices is the change in the definition of prescribed versus permitted 36 39 statutory accounting policies that insurance companies use to prepare their statutory financial statements. The company has not yet determined the impact of the adoption of the codification project. YEAR 2000 STRATEGY A significant percentage of the software that runs most of the computers in the United States and the rest of the world relies on two-digit date codes to perform computations and decision making functions. Commencing January 1, 2000, these computer programs may fail from an inability to interpret date codes properly, misinterpreting "00" as the year 1900 rather than 2000. The Company is in the process of identifying all necessary software changes to ensure that it does not experience any loss of critical business functionality due to the year 2000 issue. The Company has appointed an internal Year 2000 project manager and adopted a three phase approach of assessment, correction and testing. The scope of the project includes all internal software, hardware, and operating systems, and assessment of risk to the business from producers, vendors and other partners in Year 2000 issues. The Company believes that this formal assessment of risk (including the prioritization of business risk), correction (including conversions to new software), and testing of necessary changes will minimize the business risk of Year 2000 from internal systems. The Company plans to complete its Year 2000 conversion not later than December 31, 1998. Although the Company has not completed its Year 2000 project, the Company does not believe the Year 2000 issue will cause any system problems that could have a material adverse effect on the operations of the Company. The Company does not expect the cost associated with its year 2000 project to be material. SUPPLEMENTARY DATA Summarized quarterly financial data for 1997 and 1996 is as follows (in thousands, except per share data):
QUARTER-TO-DATE ENDED ------------------------------------------------------------------ MARCH 31, JUNE 30, SEPT. 30, DEC. 31, ------------- --------------- ------------- ------------- 1997 Earned premiums.................................. $ 18,978 $ 45,410 $ 34,760 $ 41,772 Income before income taxes, preferred securities dividends and accretion and extraordinary items.......................................... $ 1,881 $ 382 $ 5,460 $ 9,538 Net income (loss)................................ $ 756 $ (10,530) $ 2,132 $ 2,501 Basic earnings per share......................... $ 0.22 $ (1.80) $ 0.36 $ 0.42 Diluted earnings per share....................... $ 0.14 $ (1.39) $ 0.28 $ 0.32 1996 Earned premiums.................................. $ 18,897 $ 24,136 $ 23,007 $ 22,608 Income before income taxes, preferred securities dividends and accretion and extraordinary items.......................................... $ 1,656 $ 1,406 $ 1,440 $ 725 Net income (loss)................................ $ 678 $ 526 $ 712 $ 47 Basic earnings per share......................... $ 0.20 $ 0.15 $ 0.21 $ 0.02 Diluted earnings per share....................... $ 0.17 $ 0.12 $ 0.15 $ 0.01
NEW ACCOUNTING STANDARDS In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 128, "Earnings per Share" ("SFAS 128"), which was adopted for the year ended December 31, 1997. The Company has changed its method used to compute per share results and restated all prior periods. The impact of SFAS 128 did not have a material effect on the Company's earnings per share. In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 is effective for periods ending after December 15, 1997, including interim periods. SFAS 130 requires companies to report comprehensive income and its components in a financial statement and display the accumulated balance of 37 40 other comprehensive income separately from retained earnings and additional paid-in-capital. Comprehensive income includes all changes in equity during a period except those resulting from investments by stockholders and distributions to stockholders. The Company has not determined the impact of SFAS 130. Also, in June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard, 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). This statement specifies revised guidelines for determination of an entity's operating segments and the type and level of financial information to be disclosed. SFAS 131 is effective for periods ending after December 15, 1997, including interim periods. The Company's adoption of SFAS 131 will not have any impact on its current financial reporting practices. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 38 41 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY DIRECTORS Information is set forth below concerning the directors of the Company and the year in which each was first elected as a director of the Company.
DIRECTOR NAME AGE POSITION WITH THE COMPANY SINCE ---- --- ------------------------- -------- C. Len Pecchenino(1)............. 70 Director, Chairman of the Board 1988 Steven D. Germain(2)............. 44 Director 1995 Thomas J. Jamieson(1)(3)......... 54 Director 1985 Gordon E. Noble(2)............... 69 Director 1990 Craig F. Schwarberg(1)(3)........ 42 Director 1992 Robert A. Spass.................. 42 Director 1992 Bradley E. Cooper(2)(3).......... 31 Director 1992 William Gentz.................... 57 President, Chief Executive 1994 Officer and Director J. Chris Seaman(3)............... 43 Executive Vice President, Chief 1993 Roger W. Gilbert................. 66 Director 1997
- --------------- (1) Member of Audit Committee (2) Member of Compensation Committee (3) Member of Investment Committee No arrangement or understanding exists between any director and any other person pursuant to which any director holds such position. None of the directors has any family relationship to any other director or executive officer of the Company. C. Len Pecchenino became a director of the Company in May 1988 and was elected as Chairman in June 1994. He served as the Company's Chief Executive Officer from September 1991 to February 1992 and as the President and Chief Executive Officer from February 1994 to May 1994. He also served as the Chairman from September 1991 to August 1992. Mr. Pecchenino held various executive officer positions, including President and Chief Operating Officer, with IC Industries, Inc. and Pneumo Corporation until his retirement in 1986. Steven D. Germain was elected to the Company's Board of Directors in April 1995. From 1988 to 1994 he served as General Counsel to the Centre Reinsurance Group of Companies. Since 1994 he has served as Managing Director of Zurich Centre Group L.L.C., a company that provides management services to the Centre Reinsurance Group of Companies. Mr. Germain continues to serve as a director and as Managing Director, General Counsel and Secretary to Centre Re and as a director, Senior Vice President and Secretary of CentreLine. Mr. Germain is also a director, President, and Chief Executive Officer of Home Holdings, Inc. and a director of certain of its subsidiaries. Thomas J. Jamieson has been a director of the Company since December 1985. Since 1971, he has served as President of Jaco Oil Company, and has been a director of Berry Oil Co. since 1993. Gordon E. Noble became a director of the Company in October 1990. Since July 1990, he has been Chairman and Chief Executive Officer of Commodore Insurance Services and previously served as Executive Vice President and as a director and member of the Executive Committee of Sedgwick James, an international insurance brokerage and risk management firm. Craig F. Schwarberg was appointed to the Board of Directors in March 1992. From 1991 to 1997, Mr. Schwarberg worked for International Insurance Advisors, Inc. ("IIA"), serving as a Managing Director 39 42 through February 1994. From 1994 to March 1996, Mr. Schwarberg was a director and Chairman of the Board of NACOLAH Holding Corporation. Prior to 1991, he held various positions at Lehman Brothers Inc., most recently as Senior Vice President. Robert A. Spass was appointed to the Board of Directors in March 1992. Since 1990, Mr. Spass has served as President and Chief Executive Officer, and a director, of IIA. From 1994 to the present, Mr. Spass has been a Managing Partner of Insurance Partners Advisors, L.P. Prior to 1990, Mr. Spass held various positions at Salomon Brothers Inc, most recently as a Director. Since January 1996, he has served as a director of Highlands Insurance Group, Inc. Since January 1998, he has served as a director of MMI Companies, Inc. From 1990 to 1996, he served as a director of National Reinsurance Holdings Corp. From 1994 to 1997, he served as a director of Unionamerica Holdings plc and from 1994 to 1996 he served as a director of NACOLAH Holding Corporation. Bradley E. Cooper became a director of the Company in May 1992. Currently, Mr. Cooper is a Partner of Insurance Partners Advisors, L.P., joining at its formation in 1994. From May 1990 to February 1994, Mr. Cooper served as Vice President of IIA. Prior to 1990, Mr. Cooper was an analyst with Salomon Brothers Inc. Since January 1996, he has served as a director of Highlands Insurance Group, Inc. William Gentz became a director of the Company in June 1994. Mr. Gentz has held the position of President and Chief Executive Officer since mid-1994. Mr. Gentz joined the Company after seventeen years at Zenith Insurance Company where he was responsible for marketing, underwriting, loss control, and field operations for Zenith's workers' compensation operations. Mr. Gentz began his insurance career in 1958, and from 1958 to 1968 worked in the marketing and underwriting departments of a variety of insurance companies in the mid-west and California. J. Chris Seaman became a director of the Company in March 1993. Mr. Seaman has held the positions of Executive Vice President since February 1995 and Chief Financial Officer since July 1991. Prior to joining the Company, Mr. Seaman was the CFO of a private company engaged in insurance company acquisitions following ten years with Ernst & Whinney. Mr. Seaman previously held staff and management positions at Industrial Indemnity Insurance Company and Allianz of America Corporation, respectively. Steven B. Gruber became a director of the Company in April 1997. He was a founder of, and since February 1994, has served as a Managing Partner of, Insurance Partners Advisors, L.P. From May 1990 to present, Mr. Gruber has served as the Managing Director of Oak Hill Partners, Inc. and from October 1992 to present, has served as a Vice President of Keystone, Inc. From 1981 to April 1990 he was associated with Lehman Brothers Inc., most recently as Managing Director and Co-Head of high-yield securities. From 1994 to 1997 he served as a director of Unionamerica Holdings plc. He is also a director of Reliant Building Products, Inc. and MVE Inc. Roger W. Gilbert became a director of the Company in April 1997. From May 1988 until his retirement in June 1993, Mr. Gilbert served simultaneously as the Chief Executive Officer and Chairman of the Board of TIC Indemnity Co., the Chief Executive Officer of TMIC Insurance Co. Inc., and a California Special Deputy Insurance Commissioner, a position to which he was appointed by the California Insurance Commissioner. Prior to 1988, Mr. Gilbert served as Senior Vice President and director of Great American Insurance Companies, and as President of Great America West Inc. EXECUTIVE OFFICERS Set forth in the table below are the names, ages and current offices held by all executive officers of the Company and Superior Pacific. Unless specifically noted, the positions named are held at both the Company and at Superior Pacific. 40 43
EXECUTIVE OFFICER NAME AGE POSITION WITH THE COMPANY SINCE ---- --- ------------------------- --------- William L. Gentz............... 57 President and Chief Executive Officer 1994 Executive Vice President and Chief Financial J. Chris Seaman................ 43 Officer 1991 Executive Vice President and Chief Operating Arnold J. Senter............... 56 Officer 1997 Thomas I. Boggs, Jr............ 51 Senior Vice President -- Underwriting 1995 Karl O. Johnson................ 66 Senior Vice President, Superior Pacific 1989 Douglas R. Roche............... 58 Senior Vice President 1990 Senior Vice President, General Counsel and Robert E. Nagle................ 49 Secretary 1996 James L. Cinney................ 57 Senior Vice President, Superior Pacific 1994 Edward C. Shoop................ 53 Senior Vice President and Chief Actuary 1997 Matthew Natalizio.............. 43 Vice President, Finance and Treasurer 1994 Sue A. Binder.................. 50 Vice President, Superior Pacific 1992 Harold J. Fedora............... 47 Vice President, Superior Pacific 1993 Curtis H. Carson............... 37 Vice President, Superior Pacific 1997 Jack W. Solomon (1)............ 64 Resident Vice President, Superior Pacific 1991 Robert J. Niebur............... 62 Resident Vice President, Superior Pacific 1995
- --------------- (1) Mr. Solomon retired from the Company on February 6, 1998. Executive officers of the Company are elected by and serve at the discretion of the Board. No arrangement exists between any executive officer and any other person or persons pursuant to which any executive officer was or is to be selected as an executive officer. None of the executive officers has any family relationship to any director or to any other executive officer of the Company. Set forth below is a brief description of the business experience for the previous five years of all of the executive officers. William L. Gentz has held the positions of President and Chief Executive Officer since mid-1994, and has served as a director of the Company since June 1994. Mr. Gentz joined the Company after seventeen years at Zenith Insurance Company where he was responsible for marketing, underwriting, loss control, and field operations for Zenith's workers' compensation operations. Mr. Gentz began his insurance career in 1958, and from 1958 to 1968 worked in the marketing and underwriting departments of a variety of insurance companies in the mid-west and California. J. Chris Seaman has held the positions of Executive Vice President since February 1995 and Chief Financial Officer since July 1991, and has served as a director of the Company since March 1993. Prior to joining the Company, Mr. Seaman was the CFO of a private company engaged in insurance company acquisitions, following ten years with Ernst & Whinney. Mr. Seaman previously held staff and management positions at Industrial Indemnity Insurance Company and Allianz of America Corporation, respectively. Arnold J. Senter has held the positions of Executive Vice President and Chief Operating Officer since February 1997. Prior to joining the Company, Mr. Senter most recently served as Senior Vice President, Southwest and Southeast Operations, at Zenith National Insurance Company, and had previously held various operational positions in nearly every functional area for Zenith since 1981. Mr. Senter has 30 years experience with both regional and national carriers. Thomas I. Boggs, Jr. was appointed Senior Vice President of Workers' Compensation Underwriting effective March 1995. From October 1993 to March 1995, he served as Assistant Vice President of Fremont Compensation Insurance Company and from October 1991 to October 1993, served as Business Development Executive for the Southern California CIC Commercial Insurance Center for Fireman's Fund Insurance Company. Prior to October 1991, Mr. Boggs held various underwriting and marketing positions at Cypress Insurance Company, Industrial Indemnity Insurance Company, and Safeco. 41 44 Karl O. Johnson has been responsible for SNIC's Central California Operations since 1989. He was promoted to Senior Vice President in 1994. Mr. Johnson has served with various insurance organizations in loss control and marketing capacities since 1955; he joined the Company in 1987. Douglas R. Roche was appointed Senior Vice President -- Management Information Systems in 1994 and served in such position until January 1997 at which point he was appointed Senior Vice President -- Claims. He served in such position until September 1997 when he was reappointed Senior Vice President -- Management Information Systems. Before 1994, he served as Vice President of Internal Operations from the time he joined the Company in 1990. From 1987 to 1990, Mr. Roche sold software and provided systems consulting services to the insurance industry. From 1969 to 1987 he held a variety of management positions in various insurance companies' systems analysis operations. Robert E. Nagle has held the positions of Senior Vice President, General Counsel, and Secretary since January 1996. From 1986 until he joined the Company, Mr. Nagle was corporate counsel and senior corporate counsel for Farmers Group, Inc. James L. Cinney has held the position of Senior Vice President -- Loss Control of SNIC since 1994. Before joining the Company, Mr. Cinney was self-employed in the hospitality industry for one year. Prior to that, he was Vice President, responsible for loss control, at Industrial Indemnity Insurance Company. Mr. Cinney has 30 years of workers' compensation loss control experience in a variety of staff and management positions with Industrial Indemnity Insurance Company, Zenith Insurance Company, Employee Benefits Insurance Company, and Hanover Cal/Comp Insurance Company. Edward C. Shoop was appointed Senior Vice President and Chief Actuary in October 1997. From April 1995 to August 1997 he served as Senior Vice President and Actuary with Zenith Insurance Company, and from March 1994 to April 1995 served as Vice President and Actuary with Great States Insurance Company. Prior to that, Mr. Shoop was Vice President and Actuary with the Workers' Compensation Insurance Rating Bureau of Massachusetts from November 1991 to March 1994. Mr. Shoop's 31 years of actuarial experience also includes working for Fireman's Fund Insurance Company and Royal Insurance Company of Canada, as a Vice President, and Aetna Life and Casualty Company. Matthew Natalizio has held the position of Vice President -- Finance and Treasurer since 1994. From 1988 until he joined the Company, Mr. Natalizio was employed by KPMG Peat Marwick LLP. Sue A. Binder has held the position of Home Office Claims Manager of SNIC since 1991 and was appointed a Vice President in 1992. Prior to 1991, Ms. Binder held a variety of claims department staff and management positions at Fremont Indemnity Company where she had been employed since 1977. Harold J. Fedora, Jr. has held the position of Vice President -- Claims Services of SNIC since 1993, prior to which he was Calabasas Branch Claims Manager. From 1975 to 1987 Mr. Fedora was employed at several insurance companies in various claims department staff and management positions. Curtis H. Carson has held the position of Vice President -- Human Resources since January 1997. From 1984 until he joined the Company, Mr. Carson was employed by Farmers Insurance, most recently as Manager -- Human Resources. Jack W. Solomon held the position of Vice President of SNIC and Phoenix Manager since 1995 until he retired from the Company on February 6, 1998. From 1990 until 1995, Mr. Solomon was the Sacramento Branch Manager. Prior to joining the Company, Mr. Solomon had 30 years experience in workers' compensation underwriting, marketing, and executive level management in a variety of insurance companies, principally in the mid-west. Robert J. Niebur became Resident Vice President of SNIC, in charge of the South San Francisco branch, in July 1995. Prior to joining the Company, he was Workers' Compensation Manager for Flinn, Gray & Herterich, an insurance brokerage firm, from 1994 to 1995, and operated his own insurance consulting business from 1993 to 1994. Prior to forming his own company, Mr. Niebur was an operating executive with Great States Insurance Company and held various staff and executive positions with Zenith Insurance Company. 42 45 SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Exchange Act ("Section 16(a)") requires the Company's directors and certain of its officers, and persons who own more than ten percent of a registered class of the Company's equity securities (collectively, "Insiders"), to file reports of ownership and changes in ownership with the SEC. Insiders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely on its review of the copies of such forms received by it, or written representations from certain reporting persons that no Forms 5 were required for those persons, the Company believes that its Insiders complied with all applicable Section 16(a) filing requirements for fiscal 1997, with the exception of (i) Curtis H. Carson, an executive officer of the Company, who filed a Form 5 to report one transaction that was not reported on a Form 4 on a timely basis and (ii) International Insurance Advisors, Inc. and International Insurance Investors (Bermuda) Limited, each of which filed a late Form 4 to report the same two transactions. 43 46 ITEM 11. EXECUTIVE COMPENSATION The following table sets forth certain information concerning the compensation for services in all capacities to the Company for the fiscal years ended December 31, 1997, 1996, and 1995, of those persons who were, at December 31, 1997, (i) the chief executive officer and (ii) the other four most highly compensated executive officers of the Company. SUMMARY COMPENSATION TABLE
ANNUAL COMPENSATION ------------------------------------------------- OTHER ANNUAL COMPEN- NAME AND PRINCIPAL POSITION YEAR SALARY(1) BONUS(2) SATION($) --------------------------- ---- --------------- --------------- ------------- William L. Gentz..................... 1997 $ 298,300 $ -- -- President and Chief 1996 298,300 278,500 -- Executive Officer 1995 294,508 203,500 -- J. Chris Seaman...................... 1997 231,616 -- -- Executive Vice President 1996 235,298 128,500 -- and Chief Financial Officer 1995 215,600 128,500 -- Arnold J. Senter(7).................. 1997 229,335 -- -- Executive Vice President 1996 -- -- -- and Chief Operating Officer 1995 -- -- -- Matthew Natalizio.................... 1997 183,292 -- -- Vice President 1996 131,004 35,000 -- 1995 138,504 30,000 -- Thomas I. Boggs, Jr.................. 1997 164,261 -- -- Senior Vice President(9) 1996 155,800 32,000 -- 1995 115,917 7,000 -- LONG TERM COMPENSATION ----------------------------------------- AWARDS PAYOUT ----------- --------- RESTRICTED SECURITIES ALL OTHER STOCK UNDERLYING COMPEN- AWARDS OPTIONS/ LTIP SATION NAME AND PRINCIPAL POSITION ($)(3) SARS(#) PAYOUT(#) ($)(4) --------------------------- --------------- ----------- --------- ---------- William L. Gentz..................... $ 121,250(5) 18,800 -- 2,250 President and Chief 46,874 17,875 -- 2,250 Executive Officer 53,690 19,175 -- 2,250 J. Chris Seaman...................... 109,125(6) 17,500 -- 2,250 Executive Vice President 36,223 13,813 -- 2,250 and Chief Financial Officer 40,170 39,325 -- 2,250 Arnold J. Senter(7).................. -- 25,000 -- 2,250 Executive Vice President -- -- -- -- and Chief Operating Officer -- -- -- -- Matthew Natalizio.................... 18,188(8) 2,786 -- 2,250 Vice President 20,058 6,500 -- 1,875 7,280 2,600 -- 2,078 Thomas I. Boggs, Jr.................. 30,313(10) 4,643 -- 2,250 Senior Vice President(9) 21,306 8,125 -- 2,163 13,000 12,150 -- 1,098
- --------------- (1) The amounts set forth for fiscal year 1997 include salary and other cash compensation paid in that year, other than amounts listed in the column entitled "Bonus." (2) Bonus amounts represent cash payments and are presented in the year to which they apply, although payment typically is made in March of the subsequent year. Bonus amounts for fiscal year 1997 have not yet been declared. (3) Represents the fair market value of the underlying shares on the date of grant. (4) Other than as specifically noted, represents the employer's contribution under the Company's 401(k) Plan. (5) Represents a grant of 10,000 shares of restricted stock that vests in nine equal annual increments following the date of grant. As of December 31, 1997, Mr. Gentz held an aggregate of 29,950 shares of restricted stock valued at $434,275, based upon the $14.50 per share fair market value of the Common Stock on such date. (6) Represents a grant of 9,000 shares of restricted stock that vests in nine equal annual increments following the date of grant. As of December 31, 1997, Mr. Seaman held an aggregate of 24,163 shares of restricted stock valued at $350,364, based upon the $14.50 per share fair market value of the Common Stock on such date. (7) Mr. Senter began his employment with the Company in February 1997. (8) Represents a grant of 1,500 shares of restricted stock that vests in nine equal increments following the date of grant. As of December 31, 1997, Mr. Natalizio held an aggregate of 6,399 shares of restricted stock valued at $92,786, based upon the $14.50 per share fair market value of the Common Stock on such date. 44 47 (9) Mr. Boggs began his employment with the Company in March 1995. (10) Represents a grant of 2,500 shares of restricted stock that vests in nine equal annual increments following the date of grant. As of December 31, 1997, Mr. Boggs held an aggregate of 9,375 shares of restricted stock valued at $135,938, based upon the $14.50 per share fair market value of the Common Stock on such date. EMPLOYMENT AGREEMENTS The Company has in effect employment agreements with the following officers: William L. Gentz, President and Chief Executive Officer. Mr. Gentz's agreement expires on June 1, 1999, but is subject to automatic renewal in one-year increments unless notification of non-renewal is given sixty days prior to the expiration of the then-current term. His salary was set as of June 1, 1994 at $275,000 annually, plus benefits and incidentals generally provided to officers of the Company, and is thereafter as determined by the Board. Mr. Gentz's annual salary was increased to $287,500 effective August 1, 1995. If Mr. Gentz's employment is terminated by the Company other than for cause, he is entitled to payments of his salary and benefits for the then-remaining term of his agreement. In the event of a change in control of the Company, Mr. Gentz would be deemed terminated without cause and his employment agreement would be deemed to have a three-year remaining term. Arnold J. Senter, Executive Vice President and Chief Operating Officer. Mr. Senter's agreement expires on February 17, 1999, but is subject to automatic renewal in one-year increments unless notification of non-renewal is given sixty days prior to the expiration of the then-current term. His salary was set as of February 17, 1997 at $200,000 annually, plus benefits and incidentals generally provided to officers of the Company, and is thereafter as determined by the Board. If Mr. Senter's employment is terminated by the Company other than for cause, he is entitled to payments of his salary and benefits for the then-remaining term of his agreement. In the event of a change in control of the Company, Mr. Senter would be deemed terminated without cause and his employment agreement would be deemed to have a three-year remaining term. J. Chris Seaman, Executive Vice President and Chief Financial Officer. Mr. Seaman's agreement expires on June 1, 1998, but is subject to automatic renewal in one-year increments unless notification of non-renewal is given sixty days prior to the expiration of the then-current term. His annual salary under the agreement is $200,000, plus benefits and incidentals generally provided to officers of the Company, and is thereafter as determined by the Board. If Mr. Seaman's employment is terminated by the Company other than for cause, he is entitled to payments of his salary and benefits for the then-remaining term of his agreement. In the event of a change in control of the Company, Mr. Seaman would be deemed terminated without cause and his employment agreement would be deemed to have a three-year remaining term. Edward C. Shoop, Senior Vice President-Chief Actuary. Mr. Shoop's agreement expires on October 6, 1999 and provides that, if his employment with the Company is terminated as a result of a change in control, he will be entitled to his salary and benefits for two years from the date of his termination. Matthew Natalizio, Vice President, Finance and Treasurer. Mr. Natalizio's agreement is open-ended. His compensation and benefits are determined by the Board. If Mr. Natalizio's employment is terminated by the Company other than for cause, he is entitled to payments of his salary and benefits for one year from the date of the termination. Mr. Natalizio's agreement does not provide any special rights in the event of a change in control. DIRECTOR COMPENSATION Each director who is not an officer of the Company is paid a fee of $4,000 for each regular Board of Directors meeting attended and $500 for each committee meeting attended. In addition, in May 1997, the Board of Directors of the Company approved the payment to C. Len Pecchenino, the Chairman of the Board, of an annual salary of $50,000 so long as he remains Chairman of the 45 48 Board and serves on the Audit Committee of the Board of Directors. This salary is to be paid in addition to the compensation he normally receives for attendance at regularly scheduled Board of Directors meetings. Mr. Pecchenino was paid $50,000 in September 1997 and from thereafter will receive this salary in four equal quarterly installments. CHANGE-IN-CONTROL ARRANGEMENTS In addition to the rights described above with respect to Messrs. Gentz, Senter, Seaman, and Shoop, the only change-in-control arrangement in place is in connection with the Company's stock incentives. Under the terms of the 1986 Non-Statutory Stock Option and 1986 Non-Statutory Stock Purchase Plan (the "1986 Plan"), upon a change of control of the Company, unless replacement options to purchase stock in the new or recapitalized entity are offered, all option holders will have thirty days to exercise their outstanding options, excluding those that have then not yet vested. Under the terms of the 1995 Stock Incentive Plan (the "1995 Plan"), under similar circumstances, the Option Committee of the Board of Directors (the "Option Committee") may, in its discretion, allow each person holding an option or restricted stock who did not receive a replacement equity incentive grant to exercise that option without regard to its vesting provisions, or to retain that restricted stock without regard to the Company's repurchase right, as applicable. EQUITY INCENTIVE GRANTS Officers, key employees, including directors who are key employees, and consultants chosen by the Compensation Committee (which acts as the Option Committee under the terms of the 1986 Plan and 1995 Plan) are eligible to participate in the 1995 Plan. Under the 1995 Plan, officers, key employees, and consultants of the Company or its subsidiaries may be granted options to purchase shares of Common Stock or they may be given the opportunity to purchase restricted stock of the Company. The 1995 Plan permits the granting both of options that qualify for treatment as incentive stock options ("Incentive Stock Options") under Section 422 of the Code, and options that do not qualify as Incentive Stock Options ("Nonqualified Stock Options"). In 1986, the Company adopted the 1986 Plan, which allowed the Company to issue to employees of the Company and its subsidiaries Nonqualified Stock Options and rights to purchase Common Stock. The purchase right aspect of the 1986 Plan was terminated by the Board of Directors in 1989. Following the adoption of the 1995 Plan, the Board of Directors determined to make no further grants pursuant to the 1986 Plan. OPTION GRANTS IN LAST FISCAL YEAR The following table sets forth information concerning options granted during fiscal 1997 to each of the executive officers named in the Summary Compensation Table set forth above under "Executive Compensation."
INDIVIDUAL GRANTS ----------------------------------------------------------- NUMBER OF SECURITIES % OF TOTAL EXERCISE POTENTIAL REALIZABLE UNDERLYING OPTIONS/SARS OR BASE VALUE AT ASSUMED OPTIONS/SARS GRANTED TO EMPLOYEES PRICE EXPIRATION ANNUAL RATES OF STOCK PRICE NAME GRANTED (#) IN FISCAL YEAR ($/SH)(1) DATE APPLICATION FOR OPTION TERM ---- ------------ -------------------- --------- ---------- ----------------------------- 0% 5%($)(3) 10%($)(3) ---- --------- ---------- William L. Gentz..... 18,800(4) 14.9 12.125 3/31/07 0 143,414 363,294 J. Chris Seaman...... 17,500(4) 13.8 12.125 3/31/07 0 133,497 338,172 Arnold J. Senter..... 25,000(4) 19.8 11.380 2/17/07 0 178,920 434,795 Matthew Natalizio.... 2,786(4) 2.2 12.125 3/31/07 0 21,244 53,837 Thomas I. Boggs, Jr................. 4,643(4) 3.7 12.125 3/31/07 0 35,419 89,722
- --------------- (1) Represents the fair market value of the underlying shares of Common Stock at the time of the grant. 46 49 (2) Unless the stock price increases, which will benefit all stockholders commensurately, an option holder will realize no gain. (3) Represents the value of the shares of Common Stock issuable upon the exercise of the option, assuming the stated rates of price appreciation for ten years, compounded annually, with the aggregate exercise price deducted from the final appreciated value. The 5% and 10% rates are established by the SEC as examples only and are not intended to forecast future appreciation in the Company's stock price. (4) Represents a ten-year, incentive stock option grant, vesting at a rate of 20% per year for five years from the date of grant, granted pursuant to the 1995 Plan. OPTION EXERCISES AND YEAR-END VALUE The following table sets forth information concerning the aggregate number of options exercised during fiscal 1997 by each of the executive officers named in the Summary Compensation Table set forth above under "Executive Compensation," and outstanding options held by each such officer as of December 31, 1997.
NUMBER OF SECURITIES VALUE OF UNDERLYING UNEXERCISED UNEXERCISED IN-THE-MONEY OPTIONS/SARS AT OPTIONS/SARS AT FISCAL YEAR-END(#) FISCAL YEAR-END(1) ------------------- -------------------- SHARE ACQUIRED VALUE EXERCISABLE EXERCISABLE NAME ON EXERCISE(#) REALIZED($) UNEXERCISABLE UNEXERCISABLE ---- --------------- ----------- ------------------- -------------------- William Gentz..................... -- -- 29,995/57,105 $280,133/405,606 J. Chris Seaman................... -- -- 40,591/45,047 392,016/304,878 Arnold J. Senter.................. -- -- 0/25,000 0/78,000 Matthew Natalizio................. -- -- 8,340/13,546 78,068/104,719 Thomas I. Boggs, Jr............... -- -- 6,485/18,433 60,847/141,419
- --------------- (1) Uses a fair market value at December 31, 1997 of $14.50 per share, with the aggregate exercise price deducted from the total value of the stock underlying the options. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Compensation Committee during the fiscal year ended December 31, 1997 consisted of Messrs. Noble, Cooper and Germain, each of whom was a non-employee director. Mr. Cooper is an employee and beneficial owner of less than one percent of the equity securities of IIA, which was paid $250,000 by the Company in fiscal 1997 for investment banking and financial consulting services. Mr. Germain is an officer and a director of Centre Re, which was involved in several transactions with the Company during 1997 involving payments in excess of $60,000. See "Certain Relationships and Related Transactions." During fiscal 1997, no officers participated in deliberations of the Company's Compensation Committee concerning executive officer compensation, except William Gentz, the Company's President and Chief Executive Officer. COMPANY PERFORMANCE The graph below compares the cumulative total shareholder return of the Company with the cumulative total return on the The Nasdaq National Market (U.S. Companies) Index and the Nasdaq Insurance Stocks Index for the period from June 30, 1995 (the date on which the Company's registration statement under Section 12 of the Exchange Act became effective) through December 31, 1997. 47 50 COMPARISON OF CUMULATIVE TOTAL RETURN
NASDAQ MEASUREMENT PERIOD NASDAQ STOCK INSURANCE STOCK (FISCAL YEAR COVERED) MARKET INDEX INDEX SNTL 6/30/95 100.00 100.00 100.00 12/31/95 112.72 122.72 113.89 12/31/96 138.97 139.12 283.33 12/31/97 170.08 170.69 322.22 Superior National Insurance Group, Inc. Common Stock........ $322.22 Nasdaq Insurance Stocks Index............................... $170.69 The Nasdaq National Market (U.S. Companies) Index........... $170.08
Assumes that $100 was invested on June 30, 1995 (the date on which the Company's registration statement under Section 12 of the Exchange Act became effective) in each of the Company's Common Stock, The Nasdaq National Market (U.S. Companies) Index, and the Nasdaq Insurance Stocks Index, and that all dividends were reinvested. The Company believes that the Company's total stockholder return improved during 1997 primarily as a result of the consumation of the acquisition of SPCC and the anticipated savings that will result from the transaction. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS The table below sets forth certain information regarding the beneficial ownership of the Company's voting securities as of March 1, 1998 by each person who is known by the Company to be the beneficial owner of more than 5% of the indicated classes of the Company's voting securities. On March 31, 1992, the Company issued its 14.5% Senior Subordinated Voting Notes due April 1, 2002 (the "Voting Notes") in connection with a transaction wherein the Company issued its 14.5% Senior Subordinated promissory notes in an aggregate principal amount of $11.0 million, together with warrants to purchase approximately 1,616,886 shares of the Company's Common Stock. The Company redeemed all of those promissory notes with a prepayment, effective June 30, 1994, except for the Voting Notes, with respect to which prepayment is prohibited. See "Certain Relationships and Related Transactions -- Transactions with Zurich, Including Centre Re." The outstanding principal amount of the Voting Notes is $30,000. The number of votes attaching to the Voting Notes is equal to the number of shares of Common Stock that may be purchased upon exercise of the warrants that were issued in that March 31, 1992 transaction and remain outstanding and are unexercised as of the applicable record date for a stockholder vote. As of March 1, 1998, the number of votes held by the holder of the Voting Notes was equivalent to 1,566,465 shares of Common Stock. The Voting Notes are permitted to vote only in director elections, director removals, votes on amending that right to vote, 48 51 and changes to the number of authorized directors. As a result of the cancellation of a portion of the relevant warrants, the number of common stock equivalent votes held by the Voting Notes has decreased somewhat since March 31, 1992. The specific voting rights of the Voting Notes are set forth in the Company's Certificate of Incorporation and Bylaws. CERTAIN BENEFICIAL OWNERS
COMMON STOCK(1) VOTING NOTES ----------------------- --------------------- SHARES- NAME AND ADDRESS SHARES PERCENT(2) EQUIVALENT PERCENT ---------------- --------- ---------- ---------- ------- "III"............................................ 217,942(3) 3.53% 1,566,465(3) 100% International Insurance Investors, L.P., a Bermuda limited partnership c/o International Insurance Investors (Bermuda) Limited, General Partner Cumberland House One Victoria Street Hamilton HM HX, Bermuda "IP Delaware".................................... 1,375,547(4) 23.07% -- -- Insurance Partners, L.P. 201 Main Street Suite 2600 Ft. Worth, Texas 76102 "IIA"............................................ 1,243,332(5) 17.25% -- -- International Insurance Advisors, Inc. One Chase Manhattan Plaza 44th Floor New York, New York 10005 "IP Bermuda"..................................... 765,304(6) 12.83% -- -- Insurance Partners Offshore (Bermuda), L.P. Cedar House 41 Cedar Avenue P.O. Box HM 1179 Hamilton HM HX, Bermuda "TJS"............................................ 529,652(7) 8.88% -- -- TJS Partners, L.P. 115 East Putnam Greenwich,Connecticut 06830 "CentreLine"..................................... 579,356(8) 8.86% -- -- CentreLine Reinsurance Limited, a Bermuda corporation Cumberland House One Victoria Street Hamilton HM HX, Bermuda "Centre Re"...................................... 395,128(9) 6.21% -- -- Centre Reinsurance Limited, One Victoria Street Seventh Floor Hamilton HM HX, Bermuda "Bishop Estate".................................. 326,552(10) 5.19% -- -- Trustees of the Estate of Bernice P. Bishop 567 South King Street Suite 200 Honolulu, Hawaii 96813
- --------------- (1) Includes warrants expiring on April 1, 2002 to purchase 1,566,465 shares of Common Stock (the "Warrants") and a warrant expiring on April 1, 2002 to purchase 579,356 shares of Common Stock 49 52 described more fully in footnote 8, below. All such warrants are subject to an agreement among all warrant holders, which prohibits the exercise or transfer of any such warrants until April 2000 unless prior approval from the Company's Board of Directors is obtained. The Warrants were issued on March 31, 1992 in a transaction in which the Company issued (a) Warrants to purchase approximately 1,616,886 shares of Common Stock and (b) promissory notes in the aggregate principal amount of $11.0 million to III and certain members of the Company's management. The Warrants are exercisable at $4.00 per share. The Warrants purchased by III, initially exercisable into 1,474,306 shares of Common Stock, were originally issued to IIA, as agent for each of the limited partners and the general partner of III. The Warrants have since been distributed to the partners of III; however, IIA's revocable agency relationship with such partners was reestablished after the distribution. Since the distribution, several such partners sold their Warrants to certain third parties that do not have such an agency relationship with IIA. See footnote 5 below. The Company has retired certain Warrants issued to members of management no longer employed by the Company. (2) Percent ownership is based on the number of shares outstanding as of March 1, 1998, which number is 5,962,766 shares, plus any shares issuable pursuant to warrants held by the entity in question which may be exercised within 60 days after March 1, 1998. See footnote 1 above regarding certain contractual provisions that restrict the ability of warrant holders to exercise such warrants. (3) Robert A. Spass, Craig F. Schwarberg, and Bradley E. Cooper, each of whom is a director of the Company, beneficially owns limited partnership interests in III of 0.583%, 0.225%, and 0.075%, respectively. In addition, Mr. Spass has voting power over all of the voting capital stock of International Insurance Investors (Bermuda) Limited ("III (Bermuda)"), the general partner of III; however, pursuant to an agreement between the Board of Directors of III (Bermuda) and Mr. Spass, the Board of Directors (with Mr. Spass abstaining) is entitled to make all voting and investment decisions with respect to the Warrants held by III (Bermuda) and the Common Stock issuable upon the exercise thereof. III (Bermuda) beneficially owns Warrants to purchase 13,183 shares of Common Stock that are held by IIA, as its agent. In addition, as contemplated by the terms of III's limited partnership agreement, the limited partners and III (Bermuda) transferred Warrants to purchase an aggregate of 204,759 shares of Common Stock to III to be held by III (subject to IIA's revocable agency relationship) in reserve for the payment to III (Bermuda) of its incentive fee under such limited partnership agreement. Upon the occurrence of certain events, Messrs. Spass, Schwarberg and Cooper, Centre Re and others will be entitled to a distribution of the Warrants presently held by III (subject to IIA's revocable agency relationship) in amounts to be determined at the time of distribution. Each such party presently disclaims beneficial ownership (as defined in Rule 13d-3 under the Exchange Act) of all such Warrants. See footnote 5 below. See also "Certain Relationships and Related Transactions -- Transactions with IP and Limitations on Related Party Control" regarding restrictions on III's ability to acquire additional equity securities of the Company or exercise such Warrants. (4) Represents shares of Common Stock held by IP Delaware. Robert A. Spass and Steven B. Gruber, directors of the Company, are the President and a Vice President, respectively, of Insurance GenPar MGP, Inc. ("GenPar Inc."), the general partner of Insurance GenPar MGP, L.P. ("GenPar MGP"), the general partner of Insurance GenPar, L.P. ("GenPar" and, together with GenPar MGP and IP Delaware, the "Delaware Partnerships"), which is the general partner of IP Delaware. Robert A. Spass owns 40% and Messrs. Gruber and Daniel L. Doctoroff each own 30% of the voting capital stock of GenPar Inc. In addition, Messrs. Spass, Gruber, Doctoroff and Bradley E. Cooper, a director of the Company, own direct or indirect limited partnership interests in certain of the Delaware Partnerships. Each of Messrs. Spass, Gruber and Cooper, as well as Mr. Doctoroff, disclaims beneficial ownership (as defined in Rule 13d-3 under the Exchange Act) of all shares of Common Stock held by IP Delaware. See "Certain Relationships and Related Transactions -- Transactions with IP and Limitations on Related Party Control" regarding restrictions on IP Delaware's ability to acquire additional equity securities of the Company. (5) Represents Warrants to purchase shares of Common Stock that are held by IIA, as agent for each of the limited partners and for the general partner of III, as discussed in footnotes 1 and 3 above. As agent for such partners, IIA has the revocable authority to exercise rights set forth in the Warrants and to vote 50 53 any shares of Common Stock issuable upon exercise of the Warrants. Robert A. Spass, a director of the Company, is an officer of IIA and as such, has the authority to exercise these rights. The partners who, upon revocation of IIA's authority, would be entitled to exercise Warrants covering more than 5% of the Common Stock are Centre Re and Bishop Estate, in the share amounts and percentages stated. See "Certain Relationships and Related Transactions -- Transactions with IP and Limitations on Related Party Control" regarding restrictions on IIA's ability to acquire additional equity securities of the Company or exercise warrants to purchase Common Stock. The reported number of shares issuable upon exercise of Warrants varies slightly from previously reported numbers as a result of differences in rounding due to the four-into-one reverse split that SNIG's Common Stock underwent in May 1995 and subsequent distributions of such Warrants to the partners of III. (6) Represents shares of Common Stock held by IP Bermuda. Robert A. Spass and Steven B. Gruber, directors of the Company, are the President and a Vice President, respectively, of Insurance GenPar (Bermuda) MGP, Ltd. ("GenPar (Bermuda) Ltd."), the general partner of Insurance GenPar (Bermuda) MGP, L.P. ("GenPar (Bermuda) MGP"), the general partner of Insurance GenPar (Bermuda), L.P. ("GenPar (Bermuda)" and, together with GenPar (Bermuda) MGP and IP Bermuda, the "Bermuda Partnerships"), which is the general partner of IP Bermuda. Robert A. Spass owns 40% and Messrs. Gruber and Doctoroff each own 30% of the voting capital stock of GenPar (Bermuda) Ltd. In addition, each of Messrs. Spass, Gruber, Doctoroff and Bradley E. Cooper, a director of the Company, owns direct or indirect limited partnership interests in certain of the Bermuda Partnerships. Each of Messrs. Spass, Gruber, and Cooper, as well as Mr. Doctoroff, disclaims beneficial ownership (as defined in Rule 13d-3 under the Exchange Act) of all shares of Common Stock held by IP Bermuda. See "Certain Relationships and Related Transactions -- Transactions with IP and Limitations on Related Party Control" regarding restrictions on IP Bermuda's ability to acquire additional equity securities of the Company. (7) TJS Corporation and its controlling stockholder, sole director, and executive officer, Thomas J. Salvatore, are the general partners of TJS Management, L.P., the general partner of TJS, and exercise voting control and dispositive power over all shares presently owned and are the beneficial owners of all such shares. The information contained in this footnote is based, in part, on an Amendment No. 2 to Schedule 13D/A, filed with the SEC in May 1997. Does not include 173,223 shares issuable upon the exercise of Warrants acquired since May 1997 that are subject to an agreement among all holders of Company warrants, which prohibits the exercise or transfer of such warrants until April 2000 unless prior approval from the Company's Board of Directors is obtained. See footnote 1 above. Because of such restrictions, TJS, TJS Management, L.P., TJS Corporation, and Thomas J. Salvatore disclaim beneficial ownership (as defined in Rule 13d-3 under the Exchange Act) of such Warrants. (8) Represents a warrant to purchase 579,356 shares of Common Stock issued as of June 30, 1994 (the "CentreLine Warrant"). CentreLine is an affiliate of Centre Re. See footnote 9 below for information regarding Centre Re's beneficial ownership of securities of the Company. The CentreLine Warrant was issued in connection with a $20.0 million investment in the Company (and its affiliate, Superior National Capital, L.P.) by CentreLine and a second Centre Re affiliate, Centre Reinsurance Services (Bermuda) III Limited. The CentreLine Warrant is exercisable at $5.20 per share. Steven D. Germain, a director of the Company, is an officer and a director of both Centre Re and CentreLine. In addition to Mr. Germain, each of Steven M. Gluckstern, Michael D. Palm, and David A. Brown, is an officer and/or director of both Centre Re and CentreLine. Messrs. Germain, Gluckstern, Palm and Brown disclaim any beneficial interest in the CentreLine Warrant and the Common Stock issuable upon its exercise, and in the Warrants held by IIA, as agent for Centre Re (as described in footnote 9 below), and the shares of Common Stock issuable upon the exercise of such Warrants. However, as officers and/or directors of both Centre Re and CentreLine, such persons share voting and/or investment power over such securities (subject to the agency appointment described in footnotes 1 and 5 above). See "Certain Relationships and Related Transactions -- Transactions with IP and Limitations on Related Party Control" regarding restrictions on CentreLine's ability to acquire additional equity securities of the Company or exercise the CentreLine Warrant. 51 54 (9) Represents Warrants to purchase shares of Common Stock received upon the distribution by III to its partners of the Warrants, as described in footnote 1 above. See footnote 5 above for information concerning Centre Re's agency relationship with IIA with respect to such Warrants and see footnote 8 above for information concerning Centre Re's relationships with Steven D. Germain and CentreLine. See also "Certain Relationships and Related Transactions -- Transactions with IP and Limitations on Related Party Control" regarding restrictions on Centre Re's ability to acquire additional equity securities of the Company or exercise the Warrants. The reported number of shares issuable upon exercise of Warrants does not include Warrants to purchase 75,262 shares of Common Stock held by III (subject to IIA's revocable agency relationship) in reserve for the payment to III (Bermuda) of its incentive fee under III's limited partnership agreement. See footnote 3 above. (10) Represents Warrants to purchase shares of Common Stock received upon the distribution by III to its partners of the Warrants as described in footnote 1 above. Richard S.H. Wong, Oswald K. Stender, Lokelani Lindsey, Gerard A. Jervis, and Henry H. Peters, the trustees of the Bishop Estate, share voting and/or investment power over securities held by the Bishop Estate. Mr. Peters is a director of IIA. The reported number of shares issuable upon exercise of Warrants does not include Warrants to purchase 62,200 shares of Common Stock held by III (subject to IIA's revocable agency relationship) in reserve for the payment to III (Bermuda) of its incentive fee under III's limited partnership agreement. See footnote 3 above. SECURITY OWNERSHIP OF MANAGEMENT The following table sets forth certain information regarding the beneficial ownership of the Common Stock as of March 1, 1998 by (i) each director and certain executive officers of the Company, individually, and (ii) all directors and executive officers as a group: OWNERSHIP OF MANAGEMENT
PERCENT OF COMMON NAME SHARES OWNED(1) STOCK(2) ---- --------------- ----------------- William L. Gentz............................................ 109,099(3) 1.81% J. Chris Seaman............................................. 175,309(4) 2.88% Arnold J. Senter............................................ 7,000(5) * Matthew Natalizio........................................... 25,539(6) * Thomas I. Boggs, Jr......................................... 24,166(7) * Thomas J. Jamieson.......................................... 245,300(8) 4.11% Gordon E. Noble............................................. 10,000 * C. Len Pecchenino........................................... 14,250 * Robert A. Spass............................................. 15,216(9) * Craig F. Schwarberg......................................... 2,790(10) * Bradley E. Cooper........................................... 4,930(11) * Steven D. Germain........................................... 980,964(12) 14.14% Steven B. Gruber............................................ --(13) -- Roger W. Gilbert............................................ -- -- Directors and Executive Officers as a Group (23 persons).... 1,762,752(14) 24.24%
- --------------- * Less than 1% (1) Shares owned by the executive officers do not reflect shares of restricted stock that the Company anticipates it will grant in the Spring of 1998 to such officers. (2) Percent ownership is based on the number of shares outstanding as of March 1, 1998 which number is 5,962,766 shares, plus any shares issuable pursuant to options or warrants held by the person in question that may be exercised within 60 days after March 1, 1998. 52 55 (3) Includes 41,165 shares issuable upon exercise of stock options that are exercisable within 60 days of March 1, 1998, in addition to 29,950 restricted stock grants awarded under the 1995 Plan, of which the restrictions have lapsed as to 6,698 shares. (4) Includes 58,795 shares issuable upon exercise of Warrants and 49,719 shares issuable upon exercise of stock options, each of which is exercisable within 60 days of March 1, 1998, in addition to 24,163 restricted stock grants awarded under the 1995 Plan, of which the restrictions have lapsed as to 5,240 shares. (5) Includes 5000 shares issuable upon exercise of stock options that are exercisable within 60 days of March 1, 1998. (6) Includes 11,914 shares issuable upon exercise of stock options that are exercisable within 60 days of March 1, 1998, in addition to 6,399 restricted stock grants awarded under the 1995 Plan, of which the restrictions have lapsed as to 1,425 shares. (5) Includes 11,471 shares issuable upon exercise of stock options that are exercisable within 60 days of March 1, 1998, in addition to 9,375 restricted stock grants awarded under the 1995 Plan, of which the restrictions have lapsed as to 2,102 shares. (8) Includes 98,050 shares owned of record by Jaco Oil Company, an entity controlled by Mr. Jamieson. (9) Includes 8,000 shares of Common Stock owned directly by Mr. Spass. Also includes Warrants to purchase 7,216 shares of Common Stock held by IIA, as agent, as described in footnote 3 of the preceding "Certain Beneficial Owners." Mr. Spass disclaims beneficial ownership (as defined in Rule 13d-3 under the Exchange Act) of Warrants to purchase 13,183 shares of Common Stock held by III (Bermuda) (subject to IIA's revocable agency relationship) and Warrants to purchase 1,375 held by III (subject to IIA's revocable agency relationship) in reserve for the payment to III (Bermuda) of its incentive fee under III's limited partnership agreement. See footnotes 3 and 5 of the preceding "Certain Beneficial Owners" table. Mr. Spass is an officer of IIA and is the beneficial owner of less than one percent of the equity securities of IIA. IIA holds, as agent for the partners of III, Warrants to purchase 1,243,332 shares of Common Stock. In addition, see footnote 3 to the preceding "Certain Beneficial Owners" table concerning Mr. Spass' voting power with respect to the Voting Notes. Separately, 1,375,547 shares of Common Stock are beneficially owned by IP Delaware and 765,304 shares of Common Stock are beneficially owned by IP Bermuda. Mr. Spass is the President of GenPar Inc. and GenPar (Bermuda) Ltd., the ultimate general partners of IP Delaware and IP Bermuda, respectively. Mr. Spass disclaims beneficial ownership (as defined in Rule 13d-3 under the Exchange Act) of all shares of Common Stock that are held by IP Delaware and IP Bermuda. See footnotes 4 and 6 to the preceding "Certain Beneficial Owners" table for information concerning such partnerships. Pursuant to the terms of the stock purchase agreement under which IP Delaware and IP Bermuda purchased their shares of Common Stock, so long as certain conditions apply, each of IP Delaware and IP Bermuda has agreed that Mr. Spass will abstain from votes of the investment committees of each of IP Delaware and IP Bermuda with respect to each such entity's holdings of shares of Common Stock. See "Certain Relationships and Related Transactions -- Transactions with IP and Limitations on Related Party Control." (10) Represents Warrants to purchase 2,790 shares of Common Stock held by IIA, as agent, as described in footnote 5 of the preceding "Certain Beneficial Owners" table. In addition, Mr. Schwarberg is the beneficial owner of less than one percent of IIA's equity securities. (11) Includes 4,000 shares of Common Stock owned directly by Mr. Cooper. Also includes Warrants to purchase 930 shares of Common Stock held by IIA, as agent, as described in footnote 5 of the preceding "Certain Beneficial Owners" table. In addition, Mr. Cooper is the beneficial owner of less than one percent of IIA's equity securities. (12) Includes (i) 5,600 shares of Common Stock owned directly, (ii) 880 shares of Common Stock owned indirectly as custodian for the benefit of his children under the New York Uniform Gift to Minors Act, and (iii) warrants to purchase Common Stock, consisting of the CentreLine Warrant to purchase 579,356 shares and the Warrants to purchase 395,128 shares held by IIA as agent for Centre Re. See the preceding "Certain Beneficial Owners" table and footnotes 8 and 9 thereto. Mr. Germain is an 53 56 officer and director of both Centre Re and CentreLine. As such, he shares voting and/or dispositive control over such securities (subject to the termination of the agency relationship with IIA by Centre Re). Mr. Germain disclaims any beneficial interest in the CentreLine Warrant, the Warrants held by IIA as agent for Centre Re, and the Common Stock issuable upon their exercise. (13) Mr. Gruber, a director of the Company, is a Vice President of each of GenPar Inc. and GenPar (Bermuda) Ltd., the ultimate general partners of IP Delaware and IP Bermuda, respectively. IP Delaware beneficially owns 1,375,547 shares of Common Stock and IP Bermuda beneficially owns 765,304 shares of Common Stock. Mr. Gruber disclaims beneficial ownership (as defined in Rule 13d-3 under the Exchange Act) of all shares of Common Stock held by IP Delaware and IP Bermuda. See footnotes 4 and 6 to the preceding "Certain Beneficial Owners" table for information concerning such partnerships. (14) Includes (i) 1,048,477 shares issuable upon exercise of warrants and (ii) 183,928 shares issuable upon exercise of stock options, each of which are exercisable within 60 days of March 1, 1998. Also includes 99,873 shares subject to the Company's right of repurchase, of which the restrictions have lapsed as to 22,013 shares. Refer to footnotes 7 through 10 for information regarding beneficial interests in the Warrants and the CentreLine Warrant held by certain directors. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS TRANSACTIONS WITH IIA Messrs. Spass and Cooper, directors of the Company, are employees of IIA and, together with Mr. Schwarberg, also a director of the Company, are each the beneficial owner of less than one percent of IIA's equity securities. Mr. Spass is also an officer and director of IIA. IIA was paid $250,000 by the Company during fiscal 1997 for investment banking and financial consulting services pursuant to a consulting agreement entered into in 1992 that continues through 1998. TRANSACTIONS WITH AFFILIATES OF ZURICH, INCLUDING CENTRE RE As of June 30, 1994, the Company completed a $20.0 million financing transaction (the "1994 Transaction") with CentreLine and another affiliate of Centre Re involving the sale to an affiliate of Centre Re of preferred shares (the "SNCLP Preferred Shares") of Superior National Capital, L.P., a Bermuda limited partnership ("SNCLP"), an entity controlled by the Company, together with the issuance of the CentreLine Warrant. See "Security Ownership of Certain Beneficial Owners and Management -- Security Ownership of Certain Beneficial Owners." The proceeds of the 1994 Transaction were loaned by SNCLP to Superior National and partially contributed to the capital of SNIC. The SNCLP Preferred Securities paid a 9.7% annual rate of return, in semi-annual installments and were required to be redeemed on or before June 30, 2001. SNCLP issued an additional 49,167 shares of SNCLP Preferred Stock in 1997 as a dividend on the outstanding SNCLP Preferred Stock to an affiliate of Centre Re in connection with the 1994 Transaction. In December 1997, the Company used a portion of the proceeds it received from the sale of the Senior Subordinated Notes to redeem all of the approximately $26.6 million face amount of the then outstanding SNCLP Preferred Securities. Effective January 1, 1994, SNIC entered into a quota-share reinsurance contract (the "Quota-Share Contract") with ZRNA, an affiliate of Zurich, which also applies to business written by SPCC since April 1, 1997. Under the Quota-Share Contract, ZRNA may provide Superior Pacific with an Assumption of Liability Endorsement ("ALE") facility, or, effective January 1, 1997, Superior Pacific may write directly on policy forms of ZC Insurance Company ("ZCIC"), an affiliate of ZRNA (the "ZCIC Front"). The ceding rate under the contract was 20% for 1994, and ZRNA and Superior Pacific mutually agreed to reduce the quota-share participation to 5% for 1995 and 1996. Further, Superior Pacific receives ceding commissions ranging between 22.5% and 24.5% for premiums ceded to ZRNA. The purpose of the ceding commission is to cover Superior Pacific's cost of acquiring new business and may be changed as a result of changes in market conditions on a quarterly basis. Effective January 1, 1997, the terms of the Quota Share Contract were amended. Under the amended terms of the Quota Share Contract, ZRNA increased its participation from 5% 54 57 of premiums written in 1996 to 6.5% in 1997. In exchange for the increased participation, ZRNA will no longer receive a separate fee for policies written on ALEs, but will receive 2% of premiums written on ZCIC Front policies only. Superior Pacific entered into a reinsurance transaction with Centre Re effective June 30, 1997 under which Centre Re assumed $10 million of reserves associated with claims open for future medical payments only from Superior Pacific in consideration of $1 million in cash and the assignment of the rights of Superior Pacific's contribution and subrogation recoveries during the term of the contract. The contract is accounted for as a deposit, and no gain will be recognized until net cash payments from (or to) Centre Re are either greater (or less) than Superior Pacific's $1 million premium. Effective December 31, 1997, the Company entered into agreements with Risk Entire Management Limited ("REM") and Zurich Reinsurance (North America), Inc. ("ZRNA"), affiliates of Zurich, to provide claims management services ("Claims Severity Management Program" or "CSMP"). Under the CSMP, REM acting as a third party administrator ("TPA"), will provide claim processing and management services to Superior Pacific, and ZRNA will provide Superior with protection predicated on REM's ability to reduce Superior Pacific's severity. The Company may terminate the contract with six months notice after the initial three year term of the contract, with a penalty that will not exceed $250,000 plus REM's reasonable expenses to unwind the agreement. In December 1997, an affiliate of Zurich purchased $10 million of the Trust Preferred Securities. TRANSACTIONS WITH IP AND LIMITATIONS ON RELATED PARTY CONTROL Messrs. Spass and Gruber, directors of the Company, are executive officers of the ultimate general partner of each of IP Delaware and IP Bermuda (collectively, "IP"). In April 1997, IP purchased an aggregate of 2,124,834 shares of Common Stock at $7.53 per share, for an aggregate purchase price of $16.0 million, pursuant to the Stock Purchase Agreement dated as of September 17, 1996, as amended and restated effective as of February 17, 1997 (the "Stock Purchase Agreement"), among the Company, IP, TJS, and certain members of the Company's management. The Company used the proceeds to fund, in part, its acquisition of Pac Rim. The price of the Common Stock was determined based on its per share price as quoted on The Nasdaq National Market during a certain period preceding the September 17, 1996 announcement of the Pac Rim acquisition, and represented in April 1997, a significant discount to the then current market price of the Common Stock. Mr. Gruber's election as a director of the Company was effective upon the consummation of the acquisition of Pac Rim. The Company's Board of Directors (without Messrs. Gentz, Seaman, Spass, Germain, and Cooper, who disclosed their conflict of interest, withdrew from the discussion and abstained from the vote) unanimously approved the Stock Purchase Agreement. The negotiations were conducted by Mr. Pecchenino on behalf of the Company. The Stock Purchase Agreement contains, in addition to customary terms and provisions, certain covenants by IP that shall remain effective so long as IP and its Associates beneficially own an aggregate of 15% or more of SNIG's Common Stock on a fully diluted basis. For purposes of the Stock Purchase Agreement, "Associates" means each of CentreLine, Centre Re, III, IIA, and any person or entity that controls, is under common control with, or is controlled by IP or such persons or entities, and all individuals who are officers, directors, or control persons of any such entities, including IP. One such covenant, with certain limited exceptions, prohibits IP or any of its Associates from acquiring any additional shares of Common Stock, entering into a merger or business combination involving the Company, participating in any solicitation of proxies, or participating in any group with respect to the foregoing, without a two-third majority vote of either the non-Associate and non-employee directors or the Company's stockholders (excluding those shares held by IP and its Associates and by executive officers having to report transactions in Common Stock under securities laws). Other covenants provide that IP and its Associates will not elect more than five directors (or the highest number that is less than a majority of the Board of Directors) and that IP and its Associates will not transfer any of its shares except in certain types of specified transactions. 55 58 In connection with the Stock Purchase Agreement. All holders of SNIG's outstanding warrants entered into an agreement pursuant to which such holders are prohibited from exercising their warrants until April 2000 unless prior approval of the Company's Board of Directors is obtained. This restriction was implemented in order to reduce the risk that the Company would undergo an ownership change for purposes of Section 382 of the Code and thus be limited in its ability to use its NOLs. See "Business -- Risk Factors -- Availability of Net Operating Loss Carryforwards." In addition, each of Messrs. Spass and Gruber are executive officers of Insurance Partners Advisors, L.P. ("IPA"). On April 11, 1997, IPA received a transaction fee from the Company of $625,000, representing a percentage of all of the funds raised in connection with the acquisition of Pac Rim. MANAGEMENT PURCHASE OF EQUITY In April 1997, certain members of the Company's management (30 persons) and TJS, a 10% or greater stockholder of the Company, purchased an aggregate of 265,604 shares of the Company Common Stock at $7.53 per share for an aggregate purchase price of $2.0 million under the Stock Purchase Agreement. As is its policy, IP requested that management participate with IP in its purchase of Common Stock under the same Stock Purchase Agreement. Of the 2,390,438 shares of Common Stock issued in the financing transaction, 2,124,834 shares were acquired by IP, as discussed above, 132,802 shares were acquired by TJS, 25,234 were acquired by William Gentz (a director and the President and Chief Executive Officer of the Company), 25,232 were acquired by J. Chris Seaman (a director, an Executive Vice President and Chief Financial Officer of the Company), 9,296 were acquired by Joseph P. Wolonsky (who was then a Senior Vice President of the Company, but who subsequently resigned from the Company as of June 30, 1997), 9,296 were acquired by Karl O. Johnson (a Senior Vice President of Superior Pacific), 9,296 were acquired by Douglas R. Roche (a senior Vice President of the Company) and 54,448 were acquired by other members of management. 56 59 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K (A)(1) FINANCIAL STATEMENTS: Consolidated Balance Sheets as of December 31, 1997 and 1996 Consolidated Statements of Income for the Years Ended December 31, 1997, 1996 and 1995 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1997, 1996 and 1995 Consolidated Statements of Cash Flows for the Years Ended December 31, 1997, 1996 and 1995 Notes to Consolidated Financial Statements (A)(2) FINANCIAL STATEMENT SCHEDULES: Summary of Investments -- Other than Investments in Related Parties Condensed Financial Information of Registrant, Superior National Insurance Group, Inc. Supplemental Insurance Information Reinsurance Valuation and Qualifying Accounts and Reserves Supplemental Property and Casualty Insurance Information (A)(3) EXHIBITS
EXHIBIT NUMBER DESCRIPTION -------------- ----------- 2 Amended and Restated Agreement and Plan of Merger dated as of February 17, 1997 among the Company, SNTL Acquisition Corp., and Pac Rim Holding Corporation***** 3.1 Certificate of Incorporation of the Company, as currently in effect++ 3.2 By-laws of the Company, as currently in effect++ 4.1 Amended and Restated Declaration of Trust of the Trust dated as of December 3, 1997, including the Trust's Certificate of Trust and the forms of Trust Common Securities, Trust Preferred Securities and Exchange Trust Preferred Securities(4) 4.3 Senior Subordinated Indenture, including forms of the Senior Subordinated Notes and Exchange Senior Subordinated Notes, dated as of December 3, 1997 between the Company and Wilmington Trust Company, as trustee, providing for the sale by the Company to the Trust of the Senior Subordinated Notes(4) 4.4 Guarantee Agreement dated as of December 3, 1997 between the Company and Wilmington Trust Company, as trustee, with respect to the Trust Preferred Securities(4) 4.5 Guarantee Agreement with Respect to Common Securities dated as of December 3, 1997 by the Company(4) 4.6 Form of Exchange Guarantee Agreement between the Company and Wilmington Trust Company, as trustee, with respect to the Exchange Trust Preferred Securities(4) EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 10.1 Employment Agreement, dated June 1, 1997, by and between Mr. William L. Gentz, President and Chief Executive Officer of the Company, and the Company+++++ 10.2 Employment Agreement, dated February 17, 1997, by and between Mr. Arnold J. Senter, Executive Vice President and Chief Operating Officer of the Company, and the Company+ 10.3 Employment Agreement, dated June 1, 1997, by and between J. Chris Seaman, Executive Vice President and Chief Financial Officer of the Company, and the Company+++++ 10.4 1986 Non-Statutory Stock Option and 1986 Non-Statutory Stock Purchase Plan***
57 60
EXHIBIT NUMBER DESCRIPTION -------------- ----------- 10.5 1995 Stock Incentive Plan*** OTHER MATERIAL CONTRACTS 10.6 Aggregate Excess of Loss Cover entered into on the 30th day of August 1991, between Centre Reinsurance Limited (Centre Re) and the Company, as amended* 10.7 Multi-year Prospective Accident Year Stop Loss Reinsurance Contract effective the 1st of January 1993, between Centre Reinsurance International Company and the Company (the "1993 Centre Re Contract")* 10.8 Letter dated March 28, 1996 from the Company canceling the 1993 Centre Re Contract effective January 1, 1996*** 10.9 Workers' Compensation and Employers' Liability Quota Share Insurance Contract No. 30006A effective January 1, 1994, between the Company and Zurich Reinsurance Centre, as amended (the "ZRC Contract")* 10.10 Addendum No. 4 to the ZRC Contract effective as of January 1, 1996*** 10.11 Addendum No. 1 to the Retrocession Agreement (an ancillary agreement to the ZRC Contract) effective as of January 1, 1996*** 10.12 Lease, dated 27th day of October 1988, by and between Corporate Center at Malibu Canyon, a California Limited Partnership and the Company, relating to the lease of the Company's home office and Calabasas Branch Facilities* 10.13 Lease, dated 27th of July 1993, by and between TOMOE Investment and Development, Inc. and the Company, relating to the lease of its South San Francisco Facility* 10.14 Lease, dated 14th of November 1991, by and between Dean Witter Reynolds and the Company relating to the lease of its Fresno Facilities* 10.15 Lease, dated 23rd of February 1993, by and between Shaw Avenue Associates, a California Limited Partnership and the Company relating to the lease of its Fresno Facilities* 10.16 Lease, dated 14th of February 1994, by and between Contra Costa County Employees Retirement Association and the Company relating to its Sacramento Facility* 10.17 Agreement in Principle dated 29th of March 1994 by and between the Company and Centre Reinsurance Limited or one of its affiliates* 10.18 Limited Partnership Agreement of Superior National Capital, L.P. with certificate of Limited Partnership and Certificate of Exempted Partnership, all as filed on the 28th of June 1994, with the Registrar of Companies of Bermuda* 10.19 Termination and Release Agreement dated as of December 3, 1997 among the Company, Superior Pacific Insurance Group, Inc., the subsidiaries of the Company signatories thereto, The Chase Manhattan Bank and certain financial institutions with respect to the Credit Agreement dated as of April 11, 1997(4) 10.20 Purchase warrant, dated as of the 30th of June 1994, entitling Centreline Reinsurance Limited to purchase 579,356 shares of the Company's common stock* 10.21 Form of Common Stock Purchase Warrant, held by those members of the Company's management and other parties set forth on the schedule attached thereto, to purchase an aggregate of 1,566,465 shares of the Company common stock(4) 10.22 Stock Purchase Agreement dated as of September 17, 1996, as amended and restated effective as of February 17, 1997, among the Company, Insurance Partners, L.P., Insurance Partners Offshore (Bermuda), L.P., TJS Partners, L.P., and certain members of the Company's management*****
58 61
EXHIBIT NUMBER DESCRIPTION -------------- ----------- 10.23 Registration Rights Agreement dated as of April 11, 1997 among the Company, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda), L.P.+++ 10.24 Registration Rights Agreement dated as of December 3, 1997 among the Company, the Trust and the Initial Purchasers named therein(4) 10.25 Letter Agreement dated November 25, 1996 among the Company and the shareholders and holders of warrants party thereto, relating to such warrants and certain registration rights+++ 10.26 Agreement with Prime Advisors regarding investment Management Services provided to the Company dated April 12, 1997+++ 10.27 Addendum No. 2 to the Retrocession Agreement between Superior National Insurance Company and Zurich Reinsurance Centre, Inc. effective January 1, 1997(4) 10.28 State of California Department of Insurance Amended Certificate of Authority+++++ 10.29 The Pacific Rim Assurance Company 401(k) Plan (incorporated by reference from Exhibit 10.11 of Pac Rim Holding Corporation's Registration Statement on Form S-1)(1) 10.33 Office Space Lease dated February 11, 1991 between Rancon Realty Fund V and The Pacific Rim Assurance Company(1) 10.34 Office building lease dated January 21, 1992 between The Pacific Rim Assurance Company and Trizec Warner, Inc. for office space in Woodland Hills, California, and related Guaranty of Pac Rim Holding Corporation(1) 10.35 Addendum No. 2 dated as of September 2, 1992 of Office Building Lease between The Pacific Rim Assurance Company and Trizec Warner, Inc.(1) 10.36 Office Building Lease dated October 2, 1992, between The Pacific Rim Assurance Company and Richard V. Gunner & George Andros, for office space in Fresno, California(1) 10.37 Sublease dated February 3, 1994 between The Pacific Rim Assurance Company and the Federal Emergency Management Agency, for office space in Woodland Hills, California(1) 10.38 Sublease dated February 25, 1994 between The Pacific Rim Assurance Company and The Money Store, for office space in Woodland Hills, California(1) 10.39 Lease Amendment #1, dated April 1, 1993, to the Office Property Lease between Rancon Realty Fund V, and The Pacific Rim Assurance Company(1) 10.40 Sublease dated May 1, 1994 between The Pacific Rim Assurance Company and Group Data Services, Incorporated(1) 10.41 Office lease between L.A.X. Business Center, and Pac Rim Holding Corporation dated June 1, 1995(1) 10.42 Certificate of Authority from Department of Insurance, State of Arizona to transact the business of Casualty With Workers' Compensation Insurance(1) 10.43 Certificate of Authority from Department of Insurance, State of Texas to transact the business of casualty with workers' compensation insurance(1) 10.44 Sublease dated August 15, 1995 between The Pacific Rim Assurance Company and the General Services Administration(1) 10.45 Sales, License and Service Agreement dated November 14, 1995 between Macess Corporation and The Pacific Rim Assurance Company for equipment purchases, software license and professional prepaid support and software maintenance(1) 10.47 Certificate of Authority from the State of Georgia Office of Commissioner of Insurance, to transact the business of Property and Casualty (including Workers' Compensation)(1)
59 62
EXHIBIT NUMBER DESCRIPTION -------------- ----------- 10.48 Producer agreement between Regional Benefits Insurance Services, a subsidiary of Superior Pacific Casualty Company, and Hull & Co., Inc., dated May 15, 1996(2) 10.49 Producer agreement between Regional Benefits Insurance Services, and Gulf Atlantic Management Group, Inc., dated May 15, 1996(2) 10.50 Office lease between Gulf Atlantic Investment Group, Inc. and Regional Benefits Insurance Services, Inc., dated May 20, 1996(2) 10.51 Employment Agreement between Pac Rim Holding Corporation and Stanley Braun, dated April 15, 1994, as amended March 27, 1995, and March 30, 1996(3) 10.52 Third Amendment to Employment Agreement between Pac Rim Holding Corporation and Stanley Braun, dated as of April 10, 1997++++ 10.53 Agreement for Services between REM and SNIC, relating to the Claims Severity Management Program 10.54 Average Existing Claim Severity Agreement Effective: December 31, 1997 between ZRNA and Superior Pacific 10.55 Lease dated October 29, 1997 between Property California OB One Corporation and SNIC, relating to the lease of its Pleasanton, California, facility 21 Subsidiaries of the Company(4) 27.1 Financial Data Schedule 99.1 Form of Letter of Transmittal(4) 99.2 Form of Notice of Guaranteed Delivery(4) 99.3 Form of Exchange Agent Agreement(4)
- --------------- * Previously filed as an exhibit to the Company's Registration Statement on Form 10, as filed with the Securities and Exchange Commission ("SEC") on May 1, 1995 (File No. 0-25984). ** Previously filed as an exhibit to Amendment No. 2 to the Company's Registration Statement on Form 10/A, as filed with the SEC on November 1, 1995 (File No. 0-25984). *** Previously filed as an exhibit to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1995, as filed with the SEC on March 29, 1996. ***** Previously filed as an exhibit to the Company's statement on Schedule 13D, as filed with the SEC on February 27, 1997. + Previously filed as an exhibit to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996, as filed with the SEC on March 10, 1997. ++ Previously filed as an exhibit to the Company's Current Report on Form 8-K, as filed with the SEC on April 24, 1997. +++ Previously filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997, as filed with the SEC on May 15, 1997. ++++ Previously filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997, as filed with the SEC on August 14, 1997. 60 63 +++++ Previously filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997, as filed with the SEC on November 13, 1997. (1) Incorporated by reference from the Exhibits to the Annual Report on Form 10-K of Pac Rim Holding Corporation for the year ended December 31, 1995. (2) Previously filed with the Quarterly Report on Form 10-Q of Pac Rim Holding Corporation, for the quarter ended June 30, 1996. (3) Previously filed as Exhibit K to Annex C of the Company's Proxy Statement on Schedule 14A dated March 10, 1997. (4) Previously filed as an exhibit to the Company's and the Trust's Registration Statement on Form S-4 (Registration No. 333-43505) on December 30, 1997. 61 64 (b) Reports on Form 8-K: On November 19, 1997, the Company filed a Current Report on Form 8-K in order to file with the Securities and Exchange Commission a press release issued by the Company announcing the Trust's intent to offer to sell the Trust Preferred Securities in a private placement. On December 5, 1997, the Company filed a Current Report on Form 8-K in order to file with the Securities and Exchange Commission a press release issued by the Company announcing the completion of the Trust's issuance and sale of the Trust Preferred Securities in a private placement. (c) The page numbers of the Exhibits filed in response to this portion of Item 14 are listed on an Index of Exhibits that follows the signature page. (d) The response to this portion of Item 14 is presented in response to Item 8 of this report. 62 65 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 27, 1998 SUPERIOR NATIONAL INSURANCE GROUP, INC. /s/ J. CHRIS SEAMAN By: -------------------------------------- J. Chris Seaman Executive Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- /s/ WILLIAM GENTZ Director, President and Chief March 27, 1998 - --------------------------------------------- Executive Officer (Principal Executive William Gentz Officer) /s/ J. CHRIS SEAMAN Director, Executive Vice President and March 27, 1998 - --------------------------------------------- Chief Financial Officer (Principal J. Chris Seaman Financial Accounting Officer) /s/ STEVEN D. GERMAIN Director March 27, 1998 - --------------------------------------------- Steven D. Germain /s/ THOMAS J. JAMIESON Director March 27, 1998 - --------------------------------------------- Thomas J. Jamieson /s/ GORDON E. NOBLE Director March 27, 1998 - --------------------------------------------- Gordon E. Noble /s/ C. LEN PECCHENINO Director March 27, 1998 - --------------------------------------------- C. Len Pecchenino /s/ CRAIG F. SCHWARBERG Director March 27, 1998 - --------------------------------------------- Craig F. Schwarberg /s/ ROBERT A. SPASS Director March 27, 1998 - --------------------------------------------- Robert A. Spass /s/ BRADLEY E. COOPER Director March 27, 1998 - --------------------------------------------- Bradley E. Cooper /s/ STEVEN B. GRUBER Director March 27, 1998 - --------------------------------------------- Steven B. Gruber /s/ ROGER W. GILBERT Director March 27, 1998 - --------------------------------------------- Roger W. Gilbert
63 66 GLOSSARY OF TERMS DEFINED TERMS AND SELECTED INSURANCE TERMS Admitted Assets............ Assets recognized and accepted by state insurance regulatory authorities for their purposes in determining the financial condition of an insurance company. Centre Re.................. Centre Reinsurance Limited. Claim and Claim Adjustment Expenses................. The estimated ultimate cost of claims, whether reported or unreported, charged against earnings when claims occur, including the estimated expenses of settling claims (claim adjustment expenses). Claim and Claim Adjustment Expense Ratio............ The ratio of claim and claim adjustment expenses to net premiums earned. Code....................... Internal Revenue Code of 1986, as amended. Combined Ratio............. The sum of the claim and claim adjustment expense ratio and the expense ratio for continuing operations. A combined ratio under 100% generally indicates an underwriting profit, and a combined ratio over 100% generally indicates an underwriting loss. Common Stock............... Common Stock of SNIG. Company.................... Superior National Insurance Group, Inc., a Delaware corporation, including, if the context requires, its subsidiaries, on a consolidated basis. Direct Premiums Written.... Direct premiums written include all premiums arising from policies issued by the Company acting as primary insurance carrier, adjusted for any return or additional premiums arising from endorsements, cancellations, audits and retrospective rating plans. DOI........................ California Department of Insurance. EBITDA..................... Earnings before interest, taxes, minority interest, depreciation, and amortization. Exchange Act............... Securities Exchange Act of 1934, as amended. Expense Ratio.............. The ratio of commissions (net of reinsurance ceding commissions), policyholder dividends, and general and administrative expenses to net premiums earned. GAAP....................... Generally accepted accounting principles of the United States of America, including those set forth in: (i) the opinions and pronouncements of the Accounting Principles Board of the American Institute of Certified Public Accounts, (ii) statements and pronouncements of the Financial Accounting Standards Board, (iii) in such other statements by such other entity as approved by a significant segment of the accounting profession, and (iv) the rules and regulations of the SEC governing the inclusion of financial statements in periodic reports required to be filed pursuant to Section 13 of the Exchange Act, including opinions and pronouncements in staff accounting bulletins and similar written statements from the accounting staff of the SEC. Gross Premiums Written..... Gross premiums written include all premiums arising from policies issued by the Company acting as primary insurance carrier and policies 64 67 issued through fronting facilities, adjusted for any additional or return premiums arising from endorsements, cancellations, audits and retrospective rating plans. IIA........................ International Insurance Advisors, Inc., a New York corporation, investment advisors to III. III........................ International Insurance Investors, L.P., a Bermuda limited partnership, owner of the Voting Notes. IP......................... IP Bermuda and IP Delaware, collectively. IP Bermuda................. Insurance Partners Offshore (Bermuda), L.P., a Bermuda limited partnership. IP Delaware................ Insurance Partners, L.P., a Delaware limited partnership. IRS........................ Internal Revenue Service. NAIC....................... National Association of Insurance Commissioners. Net Premiums Earned........ The portion of net premiums written applicable to the insurance coverage provided in any particular accounting period. Net Premiums Written....... Premiums retained by an insurance company after deducting premiums on business reinsured with others. P&C........................ Property and casualty. Pac Rim.................... Pac Rim Holding Corporation, and where the context requires, its subsidiaries including The Pacific Rim Assurance Company. Policy Acquisition Costs... Agents' or brokers' commissions, premium taxes, marketing, underwriting, and other expenses associated with the production of premium. Premium in Force........... Premium in force is the sum of the estimated annual gross written premiums for policies on which the Company is currently providing workers' compensation coverage. Reinsurance................ An agreement whereby an insurer transfers ("cedes") a portion of the insurance risk to a reinsurer in exchange for the payment of a premium. Reinsurance can be effected by "treaties," which automatically cover all risks of a defined category, amount, and type, or by "facultative reinsurance," which is negotiated between an original insurer and the reinsurer on an individual, contract-by-contract basis. REM........................ Risk Enterprise Management Limited, a Delaware corporation, an affiliate of Zurich. SEC........................ Securities and Exchange Commission. Securities Act............. Securities Act of 1933, as amended. SNIC....................... Superior National Insurance Company, a wholly-owned insurance subsidiary of SNIG. SNIG....................... Superior National Insurance Group, Inc., a Delaware corporation, the holding company of SNIC and SPCC. SPCC....................... Superior Pacific Casualty Company, a wholly-owned insurance subsidiary of SNIG. 65 68 Statutory Accounting Practices ("SAP").................. An accounting method prescribed or permitted by state insurance regulators. The more significant differences from GAAP are: (a) premium income is taken into operations over the periods covered by the policies, whereas the related acquisition and commission costs are expensed when incurred; (b) deferred income taxes are not recognized; (c) certain assets such as agents' balances over ninety days due and prepaid expenses are nonadmitted assets for statutory reporting purposes; (d) policyholder dividends are accrued when declared; (e) the cash flow statement is not consistent with classifications and the presentation under GAAP; (f) bonds are recorded at amortized cost, regardless of trading activities; (g) loss and loss adjustment expense reserves and unearned premium reserves are stated net of reinsurance; and (h) minimum statutory reserves for losses in excess of the Company's estimates are required. Superior Pacific........... SNIC and SPCC, the principal operating subsidiaries of the Company. In addition, "Superior Pacific" is the trade name under which SNIC and SPCC conduct business. Triennial Examination...... A regularly scheduled triennial review of the operations and financial condition of a regulated California insurance company by the DOI as required under various provisions of the California Insurance Code. Underwriting............... The process whereby an insurer reviews applications submitted for insurance coverage, determines whether it will accept all or part of the coverage requested, and determines the premiums to be charged. Underwriting Expenses...... The aggregate of commissions and other policy acquisition costs, as well as the portion of administrative, general, and other expenses attributable to the underwriting operations. Underwriting Profit (Loss)..................... The excess (deficiency) resulting from the difference between net premiums earned and the sum of claim and claim adjustment expenses, underwriting expenses, and policyholder dividends. Unpaid Claim and Claim Adjustment Expenses...... An estimate of claims that have occurred, both reported and unreported (including claim adjustment expenses), and have been charged against earnings but remain unpaid. WCIRB...................... Workers' Compensation Insurance Rating Bureau. ZRNA....................... Zurich Reinsurance (North America), Inc., a Connecticut corporation, an affiliate of Zurich. ZCIC....................... Zurich Centre Insurance Company, an affiliate of Zurich. Zurich..................... Zurich Reinsurance Centre Holdings, Inc., a Delaware corporation. 66 69 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS SUPERIOR NATIONAL INSURANCE GROUP, INC.
PAGE ----- INDEX TO CONSOLIDATED FINANCIAL STATEMENTS.................. F-1 INDEPENDENT AUDITORS' REPORT................................ F-2 AUDITED CONSOLIDATED FINANCIAL STATEMENTS: Consolidated Balance Sheets as of December 31, 1997 and 1996................................................... F-3 Consolidated Statements of Operations for the years ended December 31, 1997, 1996 and 1995....................... F-4 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1997, 1996 and 1995... F-5 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995....................... F-6 Notes to Consolidated Financial Statements................ F-7 FINANCIAL STATEMENTS SCHEDULES: Schedule I: Condensed Financial Information of Registrant, Superior National Insurance Group, Inc. ...... F-28 Schedule II: Valuation and Qualifying Accounts and Reserves..................................... F-32 Schedule V: Supplemental Insurance Information, Reinsurance and Supplemental Property and Casualty Insurance Information................ F-33
F-1 70 INDEPENDENT AUDITORS' REPORT The Board of Directors Superior National Insurance Group, Inc.: We have audited the consolidated financial statements of Superior National Insurance Group, Inc. and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Superior National Insurance Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK LLP Los Angeles, California March 27, 1998 F-2 71 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1997 AND 1996
1997 1996 --------- --------- (IN THOUSANDS, EXCEPT SHARE DATA) ASSETS Investments: Bonds and Notes Available-for-sale, at market (cost: 1997, $203,373; 1996, $46,549)......................................... $205,214 $ 46,330 Equity securities, at market Common stock (cost: 1997, $1,356; 1996, $1,199)......... 1,526 1,173 Cash and Invested cash (Restricted cash: 1997, $651; 1996, $297)................................................... 35,376 100,487 Restricted investment..................................... -- 1,450 -------- -------- TOTAL INVESTMENTS.................................. 242,116 149,440 Reinsurance recoverable: Paid and unpaid claims and claim adjustment expenses...... 53,082 25,274 Premiums receivable (less allowance for doubtful accounts of $800 in 1997 and $300 in 1996)....................... 24,364 9,390 Earned but unbilled premiums receivable................... 12,524 5,251 Accrued investment income................................. 2,661 1,035 Deferred policy acquisition costs......................... 5,879 3,042 Deferred income taxes..................................... 12,200 9,520 Funds held by reinsurer................................... 5,152 1,948 Receivable from reinsurer................................. -- 93,266 Prepaid reinsurance premiums.............................. 1,598 1,039 Goodwill.................................................. 35,887 -- Prepaid and other......................................... 21,106 7,364 -------- -------- TOTAL ASSETS....................................... $416,569 $306,569 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Claims and claim adjustment expenses...................... $201,255 $115,529 Unearned premiums......................................... 12,913 9,702 Reinsurance payable....................................... 3,412 874 Long-term debt............................................ 30 98,961 Policyholder dividends.................................... 1,370 -- Capital lease obligation.................................. 7,626 -- Accounts payable and other liabilities.................... 28,868 12,741 -------- -------- TOTAL LIABILITIES.................................. 255,474 237,807 1994 PREFERRED SECURITIES ISSUED BY AFFILIATE; authorized 1,100,000 shares; issued and outstanding 1,013,753 shares in 1996................................................... -- 23,571 COMPANY-OBLIGATED TRUST PREFERRED SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY SENIOR SUBORDINATED NOTES OF SNIG; $1,000 face per share; issued and outstanding 105,000 shares in 1997............................................ 101,277 -- STOCKHOLDERS' EQUITY Common stock, $0.01 par value; authorized 25,000,000 shares; issued and outstanding 5,871,279 shares in 1997 and 3,446,492 shares in 1996.................................. 59 34 Paid-in capital excess of par............................... 34,242 15,988 Unrealized (loss) gain on investments, net of taxes......... 1,327 (162) Paid-in capital -- warrants................................. 2,206 2,206 Retained earnings........................................... 21,984 27,125 -------- -------- NET STOCKHOLDERS' EQUITY........................... 59,818 45,191 -------- -------- TOTAL LIABILITIES, PREFERRED SECURITIES AND NET STOCKHOLDERS' EQUITY.............................. $416,569 $306,569 ======== ========
See accompanying notes to consolidated financial statements. F-3 72 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
1997 1996 1995 -------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) REVENUES: Premiums written, net of reinsurance ceded................ $136,929 $87,715 $89,139 Net change in unearned premiums........................... 3,991 933 596 -------- ------- ------- Net premiums earned....................................... 140,920 88,648 89,735 Net investment income..................................... 12,674 7,769 9,784 -------- ------- ------- TOTAL REVENUES...................................... 153,594 96,417 99,519 -------- ------- ------- EXPENSES: Claims and claim adjustment, net of reinsurance recoveries of $32,383, $6,064 and $2,418 in 1997, 1996 and 1995 respectively............................................ 90,447 55,638 53,970 Commissions, net of reinsurance ceding commissions of $4,868, $2,030 and $1,350 in 1997, 1996 and 1995 respectively............................................ 13,838 10,426 11,881 Policyholder dividends.................................... -- (5,927) (5,742) Interest.................................................. 6,335 7,527 9,619 General and administrative Underwriting............................................ 23,857 23,712 17,566 Other................................................... 817 (186) 536 Goodwill................................................ 1,039 -- -- -------- ------- ------- TOTAL EXPENSES...................................... 136,333 91,190 87,830 -------- ------- ------- Income before income taxes, preferred securities dividends and accretion, discontinued operations, and extraordinary items..................................................... 17,261 5,227 11,689 Income tax expense (benefit)................................ 6,437 1,597 (12) -------- ------- ------- Income before preferred securities dividends and accretion, discontinued operations and extraordinary items........... 10,824 3,630 11,701 Preferred Securities dividends and accretion, net of income tax benefit of $1,260, $858 and $767 in 1997, 1996 and 1995 respectively......................................... (2,445) (1,667) (1,488) Trust Preferred Securities dividends and accretion, net of income tax benefit of $321 in 1997........................ (624) -- -- Loss from operations of discontinued property and casualty operations, net of income tax benefit of $5,070 in 1995... -- -- (9,842) Extraordinary loss on retirement of long-term debt, net of income tax benefit of $5,315.............................. (10,317) -- -- Extraordinary loss on retirement of long-term debt, net of income tax benefit of $785................................ (1,524) -- -- Extraordinary loss on redemption of Pac Rim's outstanding debentures, net of income tax benefit of $327............. (635) -- -- Extraordinary loss on retirement of preferred securities, net of income tax benefit of $134......................... (259) -- -- Extraordinary loss on early retirement of Imperial Bank loan net of income tax benefit of $83.......................... (161) -- -- -------- ------- ------- NET (LOSS) INCOME................................... $ (5,141) $ 1,963 $ 371 ======== ======= ======= BASIC EARNINGS PER SHARE: Income before preferred securities dividends and accretion, and extraordinary items...................... $ 2.06 $ 1.06 $ 3.41 Preferred securities dividends and accretion.............. (0.58) (0.49) (0.43) Discontinued operations................................... -- -- (2.87) Extraordinary items....................................... (2.46) -- -- -------- ------- ------- NET (LOSS) INCOME................................... $ (0.98) $ 0.57 $ 0.11 ======== ======= ======= DILUTED EARNINGS PER SHARE: Income before preferred securities dividends and accretion, and extraordinary items...................... $ 1.54 $ 0.75 $ 2.97 Preferred securities dividends and accretion.............. (0.44) (0.34) (0.38) Discontinued operations................................... -- -- (2.50) Extraordinary items....................................... (1.84) -- -- -------- ------- ------- NET INCOME.......................................... $ (0.74) $ 0.41 $ 0.09 ======== ======= =======
See accompanying notes to consolidated financial statements. F-4 73 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
NET UNREALIZED UNREALIZED COMMON STOCK GAIN GAIN (LOSS) -------------------- (LOSS) ON AVAILABLE- PAID IN TOTAL SHARES $.01 PAR ON EQUITY FOR-SALE CAPITAL -- RETAINED STOCKHOLDERS' ISSUED VALUE SECURITIES INVESTMENTS WARRANTS EARNINGS EQUITY --------- -------- ---------- ------------- ---------- -------- ------------- (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) Balance at December 31, 1994..................... 3,429,873 $15,941 -- $(2,574) $2,206 $24,791 $40,364 Net Income................. -- -- -- -- -- 371 371 Unrealized gain on equity securities............... -- -- 2 -- -- -- 2 Change in unrealized loss on available-for-sale investments, net of taxes.................... -- -- -- 2,741 -- -- 2,741 Stock issued under stock option plan.............. 500 2 -- -- -- -- 2 --------- ------- ---- ------- ------ ------- ------- Balance at December 31, 1995..................... 3,430,373 15,943 2 167 2,206 25,162 43,480 --------- ------- ---- ------- ------ ------- ------- Net Income................. -- -- -- -- -- 1,963 1,963 Unrealized gain on equity securities............... -- -- (19) -- -- -- (19) Change in unrealized loss on available-for-sale investments, net of taxes.................... -- -- -- (312) -- -- (312) Stock issued under a stock option plan.............. 3,100 12 -- -- -- -- 12 Common stock issued under a stock incentive plan..... 13,019 67 -- -- -- -- 67 --------- ------- ---- ------- ------ ------- ------- Balance at December 31, 1996..................... 3,446,492 16,022 (17) (145) 2,206 27,125 45,191 --------- ------- ---- ------- ------ ------- ------- Net Loss................... -- -- -- -- -- (5,141) (5,141) Unrealized gain on equity securities............... -- -- 129 -- -- -- 129 Change in unrealized gain on available-for-sale investments, net of taxes.................... -- -- -- 1,360 -- -- 1,360 Common stock issued........ 2,390,438 18,000 -- -- -- -- 18,000 Stock issued under a stock option plan.............. 22,127 105 -- -- -- -- 105 Common stock issued under a stock incentive plan..... 12,222 174 -- -- -- -- 174 --------- ------- ---- ------- ------ ------- ------- Balance at December 31, 1997..................... 5,871,279 $34,301 $112 $ 1,215 $2,206 $21,984 $59,818 ========= ======= ==== ======= ====== ======= =======
See accompanying notes to consolidated financial statements. F-5 74 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
1997 1996 1995 -------- -------- --------- (AMOUNTS IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income......................................... $ (5,141) $ 1,963 $ 371 -------- -------- --------- Adjustments to reconcile net income to net cash provided by (used in) operating activities: Amortization of bonds and preferred stock............... (1,073) (1,581) (3,575) Amortization of long-term debt.......................... 68 -- -- Loss/(gain) on sale of investments...................... 98 (31) 525 Gain on sale of Centre Re investments................... -- (2,036) (4,891) Amortization of goodwill................................ 1,039 -- -- Extraordinary loss...................................... 12,896 -- -- Interest expense on long-term debt...................... 3,581 -- -- Preferred securities dividends and accretion............ 3,069 2,526 2,255 (Increase) decrease in reinsurance balances receivable............................................. (23,789) 14,339 28,516 (Increase) decrease in premiums receivable.............. (1,848) 2,184 6,901 (Increase) decrease in earned but unbilled premiums receivable............................................. (3,131) (2,101) 3,336 (Increase) decrease in accrued investment income........ (986) 792 (491) (Increase) decrease in deferred policy acquisition costs.................................................. (2,837) (262) 125 Decrease in income taxes receivable..................... -- -- 1,721 Decrease (increase) in deferred taxes................... 6,433 735 (5,853) Increase in funds held by reinsurer..................... (3,204) (976) (972) Increase in prepaid reinsurance premiums................ (2,406) (287) (88) Decrease (increase) in other assets..................... 1,637 (1,287) (1,413) Decrease in claims and claim adjustment expense reserves............................................... (24,523) (25,966) (29,763) Decrease in unearned premium reserves................... (3,648) (645) (508) Increase (decrease) in reinsurance payable.............. 2,538 504 (2,835) Decrease in policyholder dividends payable.............. -- (8,094) (10,970) Decrease in discontinued operations..................... -- -- (4,223) (Decrease) increase in accounts payable and other liabilities............................................ (11,143) 5,321 (1,994) -------- -------- --------- Total adjustments....................................... (47,229) (16,865) (24,197) -------- -------- --------- Net cash used in operating activities............... (52,370) (14,902) (23,826) -------- -------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Paid-in-capital -- stock options taken.................. 279 79 2 Proceeds from issuance of common stock.................. 18,000 -- -- Proceeds from Trust Preferred Securities net of $3.7 million issuance....................................... 101,272 -- -- Long-term debt -- Chase Manhattan Bank.................. 41,257 -- -- Retirement of long-term debt -- Chase Manhattan Bank.... (44,000) -- -- Retirement of 1994 Preferred Securities................. (27,668) -- -- Retirement of long-term debt............................ (7,250) (2,660) (1,200) Prepayment penalty on long-term debt.................... (244) -- -- Funding of discontinued operations...................... (4,357) -- -- Proceeds from Chase Financing........................... -- 93,091 -- -------- -------- --------- Net cash provided by (used in) financing activities.......................................... 77,289 90,510 (1,198) -------- -------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of bonds and notes: Investments available-for-sale.......................... (226,749) (43,257) (4,611) Investment funds withheld from reinsurers............... -- (88,568) (204,577) Purchases of common stock................................. (1,496) (513) (680) (Increase) in receivable from reinsurer................... -- (93,266) -- Purchase of Pacific Rim Holding Company................... (44,016) -- -- Investments and cash allocated to discontinued operations.............................................. -- -- (1,581) Sales of bonds and notes: Investments available-for-sale...................................... 109,082 25,343 17,643 Maturities of bonds and notes: Investments held-to-maturity............................ -- -- 2,250 Investments available-for-sale.......................... 15,042 12,771 3,035 Sales and maturities of funds withheld from reinsurers.... -- 206,548 191,238 Sales of equity securities................................ 1,197 -- -- Net decrease in invested cash............................. 55,460 983 26,062 -------- -------- --------- Net cash (used in) provided by investing activities....... (91,480) 20,041 28,779 -------- -------- --------- Net (decrease) increase in cash........................... (66,561) 95,649 3,755 Cash and invested cash at beginning of period............. 101,937 6,288 2,533 -------- -------- --------- Cash and invested cash at end of period................... $ 35,376 $101,937 $ 6,288 ======== ======== ========= Supplemental disclosure of cash flow information: Cash paid during the year for income taxes.............. $ 4 $ 4 $ 4 ======== ======== ========= Cash paid during the year for interest.................. $ 2,803 $ 641 $ 808 ======== ======== =========
See accompanying notes to consolidated financial statements. F-6 75 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1997 AND 1996 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Superior National Insurance Group, Inc. ("SNIG") and all subsidiaries (together with SNIG, the "Company"). The Company's principal insurance subsidiaries (collectively referred to as "Superior Pacific"), Superior National Insurance Company ("SNIC") and Superior Pacific Casualty Company ("SPCC"), are licensed to write workers' compensation insurance and commercial property and casualty insurance in 20 states and the District of Columbia. During the third quarter of 1993, the Company adopted a plan to discontinue underwriting commercial property and casualty risks. Earned premiums reported in 1997, 1996, and 1995 reflect workers' compensation premiums from policies that were primarily located in California. The Company's consolidated financial statements have been prepared on the basis of generally accepted accounting principles that vary in certain respects from accounting practices prescribed or permitted by state insurance regulatory authorities. The results of all significant intercompany transactions have been eliminated. Certain reclassifications have been made to prior year financial statements to conform to the 1997 presentation. Acquisition On April 11, 1997, the Company acquired all of the outstanding stock of Pac Rim Holding Corporation ("Pac Rim") for aggregate consideration of $42.0 million in cash. This consideration resulted in payments of $20.0 million to Pac Rim stockholders, $20.0 million to Pac Rim's convertible debenture holders, and $2.0 million to Pac Rim's warrant and option holders. In addition, the Company incurred $2.0 million in transaction fees and related expenses. The Company financed the acquisition of Pac Rim through a $44.0 million term loan and the sale of $18 million of newly issued shares of common stock. The term loan was subsequently retired from funds raised from the sale of $105 million of 10.75% Trust Preferred Securities. As a result of the term loan's being retired the Company recorded an extraordinary loss, net of federal income taxes, of $1.5 million. The transaction resulted in $36.9 million in goodwill that is being amortized on a straight line basis over 27.5 years. The transaction was accounted for using the purchase method and the results of operations since the date of the acquisition have been included in operations. The transaction's designated accounting effective date is April 1, 1997. The balance sheet of Pac Rim at the acquisition date included the following assets: investments of $105,913, cash of $2,627, receivables of $17,268, and other assets of $22,272. Liabilities assumed in the acquisition included unearned premiums of $6,859, claims and claim adjustment expense reserves of $107,743, and other liabilities of $32,289. F-7 76 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The unaudited proforma condensed consolidated results of operations presented below assume the transaction occurred had the acquisition taken place at the beginning of each period presented.
PRO FORMA RESULTS FOR THE YEAR ENDED DECEMBER 31, ------------------------------- 1997 1996 ------------ ------------ (IN THOUSANDS, EXCEPT PER SHARE DATA) Revenues.................................................... $174,550 $187,732 Loss before income taxes, preferred securities dividends and accretion, and extraordinary items........................ $ (253) $(18,620) Net (loss).................................................. $(23,280) $(23,226) Basic earnings per share.................................... $ (4.43) $ (3.01) Diluted earnings per share.................................. $ (3.32) $ (2.55)
These unaudited proforma results are not necessarily indicative of the results of operations that would have occurred had the acquisition taken place at the beginning of each period or of future operations of the combined companies. Reverse Stock Split Effective May 25, 1995, shareholders of SNIG approved a four-into-one reverse split of SNIG's common stock. The purpose of the reverse split was to increase the per-share price of the SNIG common stock in order to enhance public trading of the common stock upon the effectiveness of the Company's registration with the Securities and Exchange Commission. Consequently, the shares of common stock and stock options information included in the accompanying consolidated financial statements were prepared assuming the reverse stock split had been outstanding at the beginning of all periods presented. Cash and Invested Cash Cash includes currency on hand and demand deposits with financial institutions. Invested cash represents short-term, highly liquid investments, readily convertible to known amounts of cash and near maturity such that there is insignificant risk of changes in value because of changes in interest rates. Invested cash is carried at cost, which approximates market. Investments Investments in debt instruments consist primarily of bonds and collateralized mortgage obligations. Debt instruments and equities are classified as (i) "held-to-maturity" (carried at amortized cost); (ii) "trading" (carried at market with differences between cost and market being reflected in the results of operations); or (iii) if not otherwise classified, as "available-for-sale" (carried at market with differences between cost and market being reflected as a separate component of stockholders' equity, net of applicable income tax effect). The premiums and discounts on fixed maturities and collateralized mortgage obligations are amortized using the scientific method. Amortization and accretion of premiums and discounts on collateralized mortgage obligations are adjusted for principal paydowns and changes in expected maturities. Current market values of investments are obtained from published sources. Declines in market value that are considered other than temporary are charged to operations. The Company does not own any investments that qualify as derivatives as defined by Statement of Financial Accounting Standard No. 119, "Disclosure About Derivative Financial Investments and Fair Value of Financial Investments." Securities not designated as held-to-maturity have been designated as available- for-sale. The Company did not have any investments categorized as trading securities. For determining realized gains or losses on securities sold, cost is based on average cost. F-8 77 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Investments in equity securities are carried at fair value. Unrealized gains or losses on equity securities are reflected, net of applicable tax, in stockholders' equity. Premiums Receivable Superior Pacific records premiums receivable for both billed and unbilled amounts. Unbilled premiums receivable, which are substantially all earned, primarily represent Superior Pacific's estimate of the difference between amounts billed on installment policies and the amount to be ultimately billed on the policy. Unbilled premiums receivable also include estimated billings on payroll reporting policies which were earned but not billed prior to year end. Superior Pacific uses its historical experience to estimate earned but unbilled amounts which are recorded as premiums receivable. These unbilled amounts are estimates, and while the Company believes such amounts are reasonable, there can be no assurance that the ultimate amounts received will equal the recorded unbilled amounts. The ultimate collectability of the unbilled receivables can be affected to a greater degree by general changes in the economy and the regulatory environment than billed receivables due to the increased time required to determine the billable amount. The Company attempts to consider these factors when estimating the receivable for unbilled premiums. Deferred Policy Acquisition Costs Acquisition costs, consisting principally of commissions, premium taxes, and certain marketing, policy issuance, and underwriting costs related to the production of SNIC's workers' compensation business, are deferred and amortized ratably over the terms of the policies. If recoverability of such costs is not anticipated, the amounts not considered recoverable are charged to income. In determining estimated recoverability, the computation gives effect to the premium to be earned, related investment income, claims and claim adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Policy acquisition costs incurred and amortized into income are as follows:
1997 1996 1995 -------- -------- -------- Balance at beginning of year....................... $ 3,042 $ 2,780 $ 2,905 Cost deferred during the year...................... 22,814 17,132 18,163 Amortization charged to expense.................... (19,977) (16,870) (18,288) -------- -------- -------- Balance at end of year............................. $ 5,879 $ 3,042 $ 2,780 ======== ======== ========
Claims and Claim Adjustment Expenses Claims and claim adjustment expenses are based on case-basis estimates of reported claims and on estimates, based on experience and industry data, for unreported claims and claim adjustment expenses. The provision for unpaid claims and claim adjustment expenses, net of estimated salvage and subrogation, has been established to cover the estimated net cost of incurred claims. The amounts are necessarily based on estimates, and accordingly, there can be no assurance the ultimate liability will not differ from such estimates. There is a high level of uncertainty inherent in the evaluation of the required claims and claim adjustment expense reserves. Management has selected ultimate claim and claim adjustment expenses that it believes will reasonably reflect anticipated ultimate experience. The ultimate costs of such claims are dependent upon future events, the outcomes of which are affected by many factors. Claims reserving procedures and settlement philosophy, current and perceived social and economic factors, inflation, current and future court rulings and jury attitudes, and many other economic, scientific, legal, political, and social factors all can have significant effects on the ultimate costs of claims. Changes in Company operations and management philosophy also may cause actual developments to vary from the past. F-9 78 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Policyholder Dividends Prior to the inception of open rating in January 1995, policyholder dividends served both as an economic incentive to employers for safe operations and as a means of price differentiation; however, since open rating, the consumer's preference has been for the lowest net price at a policy's inception. This is evidenced by the decline in participating policies written by Superior Pacific as a percent of total policies from 24% of workers' compensation premiums in force at December 31, 1995 to 1% at December 31, 1996. A small increase in the percentage of participating policies to 3% at December 31, 1997 is attributable to policies written in Arizona. In 1995, as a result of the diminishing value of policyholder dividends, Superior Pacific's management declared a moratorium in the payment of policyholder dividends. In December 1996, the Company discontinued policyholder dividend payments. Estimated amounts to be returned to policyholders were accrued when the related premium was earned by Superior Pacific. Dividends were paid to the extent that a surplus was accumulated from premiums on workers' compensation policies. Premium Income Recognition Insurance premiums are earned ratably over the terms of the policies. Unearned premiums are computed on a daily pro-rata basis. Income Taxes The Company files a consolidated Federal income tax return which includes all qualifying subsidiaries. Deferred income taxes are provided for temporary differences between financial statement and tax return bases using the asset and liability method, in accordance with Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under the asset and liability method, deferred taxes are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be settled. Tax rate changes are accounted for in the year in which the tax law is enacted. Earnings per Share ("EPS") In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 128, "Earnings per Share", which requires presentation of basic and diluted earnings per share for all publicly traded companies effective for fiscal years ending after December 15, 1997. Note 16 contains the required disclosures which make up the calculation of basic and diluted earnings per share. The required restatement of prior years earnings per share reflect an immaterial difference. Property, Equipment, Leasehold Improvements and Assets Under Capital Lease Property, equipment, and leasehold improvements are stated at cost, net of accumulated depreciation and amortization. The accumulated depreciation and amortization as of December 31, 1997 and 1996 was $2,207 and $4,289 respectively. Depreciation and amortization are provided principally on the straight-line method over the estimated useful lives of the assets, or, if less, the term of the lease. Property, equipment, and leasehold improvements are included as a component of "Prepaid and other assets" on the consolidated balance sheets. Use of Management Estimations The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts of assets, liabilities, and disclosures of contingent assets and liabilities at the date of the financial statements. The Company has provided such estimates for its workers' compensation claims and claim adjustment expenses; discontinued operations; policyholder dividends; earned but unbilled premiums; and deferred taxes balances in its financial F-10 79 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) statements. While these estimates are based upon analyses performed by management, outside consultants, and actuaries, the amounts the Company will ultimately pay may differ materially from the amounts presently estimated. Stock-Based Compensation The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and Related Interpretations in accounting for its employee stock options. Business Relationships with Zurich Certain affiliates of Zurich Reinsurance Centre Holdings, Inc., a Delaware corporation ("Zurich"), collectively own approximately 45% of SNIG's common stock on a diluted basis, and approximately 36% of SNIG's issued and outstanding common stock on a non-diluted basis. In March 1992, the Company issued warrants (the "Warrants") to purchase 1,616,886 shares of Common Stock in connection with the sale of its 14.5% Senior Subordinated promissory notes in an aggregate principal amount of $11.0 million, which notes have since been redeemed. The Warrants are exercisable at $4.00 per share and expire April 1, 2002. International Insurance Investors, L.P. ("III"), an affiliate of Zurich, originally purchased 1,474,306 of such Warrants (which are held by International Insurance Advisers, Inc. pursuant to a revocable agency relationship) with the remaining 142,580 Warrants being issued to management. As of December 31, 1997 Warrants to purchase 1,566,465 shares of Common Stock were outstanding, as Warrants to purchase 50,421 shares of Common Stock held by management have since been retired upon the termination of their employment with the Company. In June 1994 in connection with a $20.0 million investment in the Company (and its affiliate, Superior National Capital, L.P.) by CenterLine Reinsurance Limited ("CenterLine"), an affilate of Zurich, the Company issued to CenterLine a warrant to purchase 579,356 shares of Common Stock at an exercise price of $5.20 per share, which expires April 1, 2002. (2) INVESTMENTS The amortized cost and market values of bonds and notes classified as available-for-sale at December 31, 1997 are as follows:
GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- -------- Available-for-sale: United States government agencies and authorities........................ $ 89,884 $ 420 $(207) $ 90,097 Collateralized mortgage obligations... 72,478 1,100 (97) 73,481 Corporate instruments................. 41,011 657 (32) 41,636 State and political subdivisions...... -- -- -- -- -------- ------ ----- -------- Total available-for-sale.............. $203,373 $2,177 $(336) $205,214 ======== ====== ===== ========
F-11 80 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The market values of equity securities as of December 31, 1997 are as follows:
GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ------ Equity Securities: Corporate Instruments................... $1,356 $171 $(1) $1,526 ------ ---- --- ------ Total Equity Securities................. $1,356 $171 $(1) $1,526 ====== ==== === ======
The amortized cost and estimated market values of investments classified as available for sale at December 31, 1997 by contractual maturity are shown below. Expected maturities are likely to differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalty. Mortgage-backed securities are included based upon the expected payout pattern and duration of the fixed income security. Changes in interest rates, investor expectations, and political agendas could cause the ultimate payout pattern to differ.
AVAILABLE FOR SALE --------------------- AMORTIZED FAIR COST VALUE --------- -------- Due in one year or less..................................... $ 25,044 $ 25,086 Due after one year through five years....................... 44,254 44,710 Due after five years through ten years...................... 42,101 42,776 Due after ten years......................................... 91,974 92,642 -------- -------- Total....................................................... $203,373 $205,214 ======== ========
The amortized cost and market values of bonds and notes classified as available for sale at December 31, 1996 are as follows:
GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ------- Available-for-sale: United States government agencies and authorities......................... $22,596 $ 62 $(174) $22,484 Collateralized mortgage obligations.... 12,989 -- (134) 12,855 Corporate instruments.................. 9,864 23 (20) 9,867 State and political subdivisions....... 1,100 24 -- 1,124 ------- ---- ----- ------- Total available-for-sale............... $46,549 $109 $(328) $46,330 ======= ==== ===== =======
The market value of equity securities as of December 31, 1996 are as follows:
GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ------ Equity Securities: Corporate Instruments................... $1,199 $73 $(99) $1,173 ------ --- ---- ------ Total Equity Securities................. $1,199 $73 $(99) $1,173 ====== === ==== ======
F-12 81 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A summary of net investment income for the years ended December 31, are as follows:
1997 1996 1995 ------- ------ ------- Interest on bonds and notes............................ $ 9,124 $6,628 $ 9,310 Interest on invested cash.............................. 4,068 1,609 1,297 Realized gains (losses)................................ 44 31 (525) Other.................................................. 190 -- -- ------- ------ ------- Total investment income................................ 13,426 8,268 10,082 Investment expense..................................... (752) (499) (298) ------- ------ ------- Net investment income.................................. $12,674 $7,769 $ 9,784 ======= ====== =======
Realized gains (losses) on investments for the years ended December 31, are as follows:
1997 1996 1995 ---- ---- ----- Bonds and notes............................................. $44 $31 $(525) Equity securities........................................... -- -- -- --- --- ----- Total....................................................... $44 $31 $(525) === === =====
The changes in unrealized gains (losses) on debt instruments held as available-for-sale and equity security investments at December 31, are as follows:
1997 1996 1995 ------ ----- ------ Bonds and notes........................................... $2,060 $(472) $4,154 Equity securities......................................... 196 (29) 2 ------ ----- ------ Total..................................................... $2,256 $(501) $4,156 ====== ===== ======
Proceeds from sales of bonds and notes held as available-for-sale for the years ended December 31, 1997, 1996, and 1995 were $109,082, $25,343, and $17,643, respectively. Gross gains of $176 and gross losses of $132 were realized on those sales in 1997. Gross gains of $44 and gross losses of $13 were realized on those sales in 1996. Gross gains of $4 and gross losses of $529 were realized on those sales in 1995. Bonds and other securities with a market value of $180,447 at December 31, 1997, $127,112 at December 31, 1996 and $143,462 at December 31, 1995, were on deposit with various insurance regulatory authorities. Additionally, see Note (7) regarding investments held related to reinsurance contracts. (3) FAIR VALUE OF FINANCIAL INSTRUMENTS The following table represents the carrying amounts and estimated fair values of the Company's financial liabilities at December 31, 1997 and 1996. Statement of Financial Accounting Standard No. 107, "Disclosure about Fair Value of Financial Instruments," ("SFAS 107") defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. Fair values with respect to investments are presented in Note (2) and the fair value of all other investments approximates their fair value. F-13 82 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The carrying amounts shown in the table below are included in the Consolidated Balance Sheet under the indicated options:
1997 1996 -------------------- ------------------- CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE -------- -------- -------- ------- Financial liabilities: Chase financing agreement................. $ -- $ -- $91,681 $91,374 Imperial Bank debt........................ $ -- $ -- $ 7,250 $ 7,541 1994 Preferred Securities issued by affiliate............................... $ -- $ -- $23,571 $19,998 Trust Preferred Securities issued by affiliate............................... $101,277 $104,990 $ -- $ --
Fair value is estimated based on the quoted market prices for similar issues or by discounting expected cash flows at the rates currently offered to the Company for debt of the same remaining maturities. However, there can be no assurances that in the event the assets and liabilities would be required to be liquidated that the amounts received or due would be the amounts reflected herein. (4) CLAIM AND CLAIM ADJUSTMENT EXPENSE RESERVES The activity in the claim and claim adjustment expense reserve account is summarized as follows:
YEARS ENDED DECEMBER 31, -------------------------------- 1997 1996 1995 -------- -------- -------- (AMOUNTS IN THOUSANDS) Beginning reserve, gross of reinsurance............ $115,529 $141,495 $171,258 Less: Reinsurance recoverable on unpaid losses..... 24,986 27,076 31,897 -------- -------- -------- Beginning reserve, net of reinsurance.............. 90,543 114,419 139,361 Pac Rim reserves at acquisition.................... 104,588 -- -- Provision for net claims and claim adjustment expenses For claims occurring in current year............. 95,826 57,614 58,842 For claims occurring in prior years.............. (5,379) (1,976) (4,872) -------- -------- -------- Total claims and claim adjustment expenses....... 90,447 55,638 53,970 -------- -------- -------- Payments for net claims and claim adjustment expense: Attributable to insured events incurred in current year.................................. (37,945) (19,816) (19,732) Attributable to insured events incurred in prior years......................................... (95,533) (59,698) (59,180) -------- -------- -------- Total claims and claim adjustment expense payments...................................... (133,478) (79,514) (78,912) -------- -------- -------- Ending reserves, net of reinsurance................ 152,100 90,543 114,419 Reinsurance recoverable on unpaid losses........... 49,155 24,986 27,076 -------- -------- -------- Ending reserves, gross of reinsurance.............. $201,255 $115,529 $141,495 ======== ======== ========
During 1997, the Company continued to experience decreased frequency of claims and at the same time experienced an increase in claims severity for accident years 1995 and thereafter. The Company's net claim and claim adjustment expense ratio for accident year 1997 at the end of calendar year 1997 was 68.0%, versus 65.0% and 65.6% for accident years 1996 and 1995, at their respective calendar year ends. In 1997, the Company experienced approximately $5.4 million in favorable development on net claim and claim adjustment expense reserves estimated at December 31, 1996. This $5.4 million favorable development is the result of a $10.8 million favorable development on ceded reserves for accident years 1996 and prior. The $10.8 million favorable development on ceded reserves is attributable to SPCC and due to the post-acquisition F-14 83 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) review of all open claim files and the subsequent adjustment to reserves, which caused many claims to have incurred claim and claim adjustment expenses in excess of the retention on SPCC's reinsurance treaties. The $10.8 million favorable development is offset by a $5.4 million adverse development on direct reserves attributable to the accident years 1995 and 1996. In 1996, the Company experienced approximately $2.0 million in favorable development on net claims and claim adjustment expense reserves estimated at December 31, 1995. This $2.0 million favorable development is the result of $8.4 million in favorable development on direct reserves for accident years 1994 and prior. The favorable development was offset in part by $4.1 million adverse development on direct reserves for accident year 1995, and $2.3 million adverse development on ceded reserves for accident years 1995 and prior. The Company's 1995 accident year net claims and claim adjustment expense ratio for accident year 1995 at the end of calendar year 1995 was 65.6%, verses 74.6% at the end of the 1996 calendar year. Offsetting the favorable development in large part was the re-estimation during 1995 of reinsurance receivables recorded at December 31, 1994, from approximately $66.2 million to approximately $59.9 million at December 31, 1995. During 1995, the Company experienced approximately $8.6 million of favorable development on direct claim and claim adjustment expense reserves estimated at December 31, 1994. Management believes the favorable development resulted from the Company's improved claims management controls and decreased claim severity, particularly in the medical component of the workers' compensation line. (5) DISCONTINUED OPERATIONS During the third quarter of 1993, the Company adopted a plan to discontinue underwriting commercial property and casualty risks. As a result, the Company recorded a pre-tax charge to income of $2,991 for estimated operating losses during the phase-out period. During the second quarter of 1995, the Company increased its reserves by approximately $15 million for discontinued operations for accident years 1994 and prior. This increase in claims and claim adjustment expense reserves from the original estimate at the measurement date resulted from increased frequency and severity of claims incurred from those years relative to previous expectations, which in turn caused an increase in the estimated ultimate claims and claim adjustment expense reserves related to 1994 and prior years. At December 31, 1997 and 1996, liabilities of discontinued operations relating to unpaid claim and claim adjustment expenses, off-set by certain assets, have been reclassified in the balance sheet. Management estimates the discontinued operations will be "run off" by the year 2000. The assets and liabilities of discontinued operations are summarized below.
DECEMBER 31, ------------------ 1997 1996 ------- ------- Assets: Reinsurance recoverables.................................. $ 5,937 $ 8,604 Deferred tax asset........................................ 12,904 -- Investments and other assets.............................. -- 17,261 ------- ------- Total Assets...................................... $18,841 $25,865 ======= ======= Liabilities: Claims and claim adjustment expense reserves.............. $18,686 $25,466 Other liabilities......................................... 155 399 ------- ------- Total Liabilities................................. $18,841 $25,865 ======= =======
F-15 84 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (6) INCOME TAXES Total income tax expense (benefit) for the years ended December 31, 1997, 1996, and 1995 was allocated as follows:
1997 1996 1995 ------- ------ ------- Continuing operations.................................. $ 6,437 $1,597 $ (12) Dividend accrued on preferred securities............... (1,581) (858) (767) Discontinued operations................................ -- -- (5,070) Extraordinary items.................................... (6,643) -- -- ------- ------ ------- Total........................................ $(1,787) $ 739 $(5,849) ======= ====== =======
Income tax expense (benefit) from continuing operations for the years ended December 31, 1997, 1996, and 1995 is composed of the following amounts:
1997 1996 1995 ------ ------ ---- Current.................................................... $ 4 $ 4 $ 4 Deferred................................................... 6,433 1,593 (16) ------ ------ ---- Total............................................ $6,437 $1,597 $(12) ====== ====== ====
Taxes computed at the statutory rate of 34% varied from the amounts reported in the consolidated statements of income at December 31, as follows:
1997 1996 1995 ------ ------ ------- Income taxes at statutory rates......................... $5,869 $1,777 $ 3,974 Effect of tax-exempt interest........................... (10) (22) (15) Effect of meals and entertainment....................... 42 38 38 Effect of goodwill amortization......................... 353 -- -- Research and development credit......................... 179 (200) -- Change in valuation allowance for tax assets............ -- -- (4,013) Other................................................... 4 4 4 ------ ------ ------- Total......................................... $6,437 $1,597 $ (12) ====== ====== =======
F-16 85 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, are presented below:
1997 1996 -------- -------- Deferred tax assets: Original issue discount................................... $ -- $ 5,764 Net operating loss carryforward........................... 43,918 29,062 Alternate minimum tax credit carryforward................. 1,035 701 Loss reserve discounting.................................. 7,787 -- Unearned premium liability................................ 878 660 Policyholder dividends.................................... 466 -- Deferred gain on capital lease............................ 546 -- Unrealized loss on available-for-sale securities.......... -- 84 Research and development credit........................... 21 200 Other..................................................... 403 281 -------- -------- Total gross deferred tax assets........................... 55,054 36,752 Less: Valuation allowance................................. (8,129) -- -------- -------- Total............................................. 46,925 36,752 -------- -------- Deferred tax liabilities: Loss reserves............................................. -- (9,139) Discontinued operations................................... (3,039) (1,245) Reinsurance experience refunds............................ (15,300) (15,300) Deferred acquisition costs................................ (1,999) (1,034) Direct collection allowance............................... (799) (510) Unrealized gain on available-for-sale investments......... (684) -- Reinsurance payable....................................... -- (4) -------- -------- Total gross deferred tax liabilities...................... (21,821) (27,232) -------- -------- Net deferred tax asset................................. 25,104 9,520 Net deferred tax asset allocated to discontinued operations............................................. (12,904) -- -------- -------- Net deferred tax asset -- continuing operations........ $ 12,200 $ 9,520 ======== ========
Management believes it is more likely than not that the existing net deductible temporary differences will reverse during the periods in which the Company generates net taxable income. However, there can be no assurance the Company will generate any earnings or any specific level of continuing earnings in future years. Certain tax planning strategies could be implemented to supplement income from operations to fully realize recorded tax benefits. At December 31, 1997, the Company had a tax net operating loss carryforward of $130.2 million that begins to expire in the year 2006. (7) REINSURANCE Superior Pacific cedes claims and claim adjustment expenses to reinsurers under various contracts that cover individual risks, classes of business, or claims that occur during specified periods of time. Reinsurance is ceded on pro-rata, per-risk, excess-of-loss, and aggregate bases. These reinsurance arrangements provide greater diversification of risk and limit SNIC's claims arising from large risks or from hazards of an unusual nature. Superior Pacific is contingently liable to the extent that any reinsurer becomes unable to meet its F-17 86 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) contractual obligations. Therefore, the Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risks arising from reinsurance activities and economic characteristics to minimize its exposure to significant losses from reinsurer insolvencies. As of December 31, 1997, SNIC was involved in a dispute with certain of its reinsurers, which, if not settled, may be resolved in arbitration. SNIC's dispute exists with its property and casualty reinsurers as to the existence of coverage related to a claim in the amount of $456. Management expects to recover the entire disputed amount from the reinsurers. At December 31, 1997, there were no disputes related to the workers' compensation operations. Effective June 30, 1991, SNIC entered into an aggregate excess of loss reinsurance contract ("1991 Contract") with Centre Reinsurance Limited ("Centre Re"). Under the 1991 Contract, SNIC purchased for $50 million reinsurance for claims and claim adjustment expenses incurred on or prior to June 30, 1991 to the extent that these amounts were unpaid at June 30, 1991. The coverage obtained amounted to $87.5 million in excess of SNIC's retention. Additionally, SNIC ceded approximately $69.1 million of earned premiums to Centre Re through December 31, 1992. Claims and claim adjustment expenses occurring prior to December 31, 1992 were ceded to Centre Re in the amount of $165.6 million under the 1991 Contract. Prospective cessions of premium and claims were terminated by mutual consent of SNIC and Centre Re effective December 31, 1992; however, all other terms of the 1991 Contract remained in effect until the treaty was commuted in June 1997. In 1996, as a result of the transaction entered into between the Company, Centre Re, and Chase Manhattan Bank (see Note 8), the reinsurance receivables related to the 1991 Contract no longer qualify as reinsurance receivables under the conditions established in SFAS 113. Therefore, in 1996 the receivables were reclassified as receivables from reinsurer on the balance sheet. Effective January 1, 1993, SNIC entered into an aggregate excess of loss reinsurance contract ("1993 Contract") with Centre Re. From SNIC's perspective, the 1993 Contract substantively operated as a one-year contract with at least four one-year options to renew that were exercisable solely at the Company's election during the first five years of the contract. Subsequent to January 1, 1998, the 1993 Contract could have been terminated by either SNIC or Centre Re upon 30 days notice. The 1993 Contract required the Company to cede not less than $15 million and not more than $20 million of premium to Centre Re with respect to any covered accident year. Claims and allocated claim adjustment expenses occurring during the accident year are ceded to Centre Re in excess of a variable percentage of earned premium (60%, 56.5%, and 57.5% for the 1995, 1994, and 1993 accident years, respectively) and are subject to a limit of 130% of ceded earned premium, such limit not to exceed $26 million for any accident year. Effective January 1, 1996, the 1993 Contract was canceled at the Company's election. In 1997, the Company paid $5.3 million related to the cancellation of the 1993 Contract. Effective January 1, 1994, SNIC entered into a quota-share reinsurance contract ("Quota-Share Contract") with Zurich Reinsurance (North America), Inc., ("ZRNA") an affiliate of Zurich. Under the Quota-Share Contract, ZRNA may provide Superior Pacific with an Assumption of Liability Endorsement facility ("ALE"), or, effective January 1, 1997, Superior Pacific may write directly on policy forms of ZC Insurance Company ("ZCIC"), an affiliate of Zurich (the "ZCIC Front"). The ceding rate under the Quota-Share Contract was 20% for 1994, and ZRNA and Superior Pacific mutually agreed to reduce the quota-share participation to 5% for 1995 and 1996. Further, Superior Pacific receives ceding commissions ranging between 22.5% and 24.5% for premiums ceded to ZRNA. The purpose of the ceding commission is to cover Superior Pacific's cost of acquiring new business and may be changed as a result of changes in market conditions on a quarterly basis. Effective January 1, 1997, the terms of the Quota-Share Contract were amended. Under the amended terms of the Quota-Share Contract, ZRNA increased its participation from 5% of premiums written in 1996 F-18 87 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) to 6.5% in 1997. In exchange for the increased participation, ZRNA will no longer receive a separate fee for policies written on ALEs, but will receive 2% of premiums written on ZCIC Front policies only. Superior Pacific entered into a reinsurance contract with Centre Re effective June 30, 1997, under which Centre Re assumed $10 million of reserves associated with claims open for future medical payments from Superior Pacific in consideration of $1 million in cash and the assignment of the rights of Superior Pacific's contribution and subrogation recoveries during the term of the contract. The contract is accounted for as a deposit, and no gain will be recognized until net cash payments from Centre Re are greater than Superior Pacific's $1 million premium. Superior Pacific's contracts are generally entered into on an annual basis. Superior Pacific has maintained reinsurance treaties with many reinsurers for a number of years. In general, Superior Pacific's reinsurance contracts are of the treaty variety, and cover underwritten risks specified in the treaties. Superior Pacific also from time to time purchases facultative reinsurance covering specific liabilities or policies underwritten. As of December 31, 1997, ZRC, General Reinsurance Corporation, and Allstate Insurance account for 24.5%, 21.6%, and 10.4%, respectively, of total amounts recoverable from all reinsurers on paid and unpaid claims and claim adjustment expenses. Amounts included in the income and expense accounts in continuing operations in connection with all ceded reinsurance at December 31, are as follows:
1997 1996 1995 -------- -------- ------- Net Premiums written: Premiums written.................................. $159,352 $ 99,282 $97,084 Premiums ceded.................................... (22,423) (11,567) (7,945) -------- -------- ------- Net premiums written........................... $136,929 $ 87,715 $89,139 ======== ======== ======= Net change in unearned premiums: Direct............................................ $ (3,649) $ (645) $ (381) Ceded............................................. (342) (288) (215) -------- -------- ------- Net change in unearned premiums................ $ (3,991) $ (933) $ (596) ======== ======== ======= Net claims and claim adjustment expenses: Claims and claim adjustment expenses.............. $122,830 $ 61,702 $56,388 Reinsurance recoveries............................ (32,383) (6,064) (2,418) -------- -------- ------- Net claims and claim adjustment expenses....... $ 90,447 $ 55,638 $53,970 ======== ======== =======
(8) LONG-TERM DEBT The following is a summary of the Company's long-term debt balances at December 31:
1997 1996 ---- ------- Chase Financing Agreement -- 6.87% due through 2004......... $-- $91,681 Imperial Bank debt -- 8.25% due through 2001................ -- 7,250 Voting Notes due 2002....................................... 30 30 --- ------- Balance at end of period.................................... $30 $98,961 === =======
Effective June 30, 1994, the Company entered into a $10 million term loan agreement ("1994 Loan") with Imperial Bank, which was used to retire subordinated notes issued during 1992. This term loan was to be fully amortized over seven years with quarterly payments of $300 plus interest per quarter for years one and two, $350 plus interest per quarter for years three and four, and $400 plus interest per quarter for years five, six F-19 88 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and seven. Effective July 1, 1995, the borrowing rate was changed from Imperial Bank's prime rate plus one-half percent to a fixed rate of 8% per annum. Additionally, under the amended terms of the 1994 Loan, the Company could not prepay it until July 1, 1996. The Company adhered to certain requirements and provisions in compliance with the terms of the 1994 Loan. The provisions required SNIC to maintain certain financial ratios and SNIG to maintain Imperial Bank certificates of deposit in an amount equal to 20% of the Company's outstanding balance under the 1994 Loan. At December 31, 1996, the Imperial Bank certificates of deposit were $1.5 million, all of which was restricted. On April 11, 1997, the Company retired its outstanding 1994 Loan with Imperial Bank. As a result of the early extinguishment, the Company recognized an extraordinary loss of $0.2 million, net of a tax benefit of $0.1 million. During 1996, the Company entered into a financing transaction involving Centre Re and Chase. Chase extended a $93.1 million term loan (net of transaction costs). The Company used the proceeds from the financing to purchase from SNIC reinsurance receivables due from Centre Re. The principal balance of the loan was collateralized by receivables due from the reinsurer and amortized based upon the payout pattern of the underlying claims of the reinsurance receivables. In June 1997, the $93.1 million term loan was retired, offsetting the entire amount due against the reinsurance receivable balance. The retirement of this collateralized financing resulted in the Company's recognizing a $10.3 million extraordinary loss, net of income taxes. Voting notes ("Voting Notes") in the amount of $30 related to SNIG's 14.5% Senior Subordinated Series A and Series B Notes ("14.5% Senior Subordinated Notes") were still outstanding as of December 31, 1997. The 14.5% Senior Subordinated Notes were retired in 1994. The Voting Notes of $30 will mature in the year 2002. Warrants related to the 14.5% Senior Subordinated Notes remain outstanding and provide their holders the right to purchase 1,566,465 shares of SNIG common stock at a strike price of $4 per share. These warrants, which are currently exercisable and expire on April 1, 2002, are held by senior management and a nominee for III. The Company has an agreement with a national brokerage house to allow it to enter into $20 million of reverse repurchase transactions that must be secured by either U.S. treasuries, government agency bonds, or corporate debt. There were no outstanding transactions at December 31, 1997. (9) PREFERRED SECURITIES ISSUED BY AFFILIATES On June 30, 1994, SNIG completed the sale of $20 million of preferred securities and warrants to affiliates of Centre Re in a transaction approved by the shareholders and the California Department of Insurance ("DOI"). The preferred securities were subordinate to the 1994 Loan. A special purpose investment partnership, Superior National Capital, L.P. (the "Limited Partnership"), was formed in Bermuda to issue $20 million face amount of 9.7% redeemable preferred securities ("1994 Preferred Securities") to Centre Reinsurance Services (Bermuda) III, Limited in exchange for $18 million. CentreLine Reinsurance Limited paid the Company $2 million for warrants to purchase 579,357 shares of SNIG's common shares at $5.20 per share, representing a fully-diluted 10 percent interest in SNIG. The warrants may be exercised at any time and expire in 2002. In December 1997, SNIG formed a trust, whose sole purpose was to issue 10 3/4% Trust Preferred Securities (the "Trust Preferred Securities"), having an aggregate liquidation amount of $105 million, and to invest the proceeds thereof in an equivalent amount of 10 3/4% Senior Subordinated Notes due 2017 of the Company (the "Senior Subordinated Notes"). The Company owns directly all of the common securities issued by the Trust, which it purchased for an aggregate consideration of $3.25 million. The proceeds from the sale of the Trust Preferred Securities were used solely to purchase SNIG's Senior Subordinated Notes. In addition, the Company entered into several contractual undertakings, that when taken together, guarantee to the holders of the Trust Preferred securities an unconditional right to enforce the payment of the distributions F-20 89 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) with respect to such securities. Holders of the Trust Preferred Securities are entitled to receive cumulative cash distributions at an annual rate of 10 3/4% of the stated liquidation amount of $1,000 per Trust Preferred Security, accruing from the date of original issuance of the Trust Preferred Securities and payable semi-annually, in arrears, commencing on June 1, 1998. The Company has the right to defer payments at any time or from time to time for a period not exceeding 10 consecutive semi-annual periods, provided that no extension period may extend beyond the stated maturity date. In the event there is a change in control, holders of the Trust Preferred Securities may redeem their securities at 101% of the principal. The Company used the net proceeds from the sale of the 10 3/4% Senior Subordinated Notes in the amount of approximately $101.2 million, (i) to repay outstanding debt, consisting of $40.8 million of bank debt and interest incurred in connection with the acquisition of Pac Rim that would have matured in April 2003, bearing an average effective interest rate of 10.2%, (ii) to redeem from an affiliate of Zurich $27.7 million Preferred of principal and interest, with an effective rate of 11.7%, of the 1994 Securities, and (iii) to make a $15 million capital contribution to SNIC. The remaining proceeds are invested in short-term, income-generating, investment-grade securities. The difference between the face value and the carrying value of the Trust Preferred Securities is amortized over their nineteen-year maturity using the scientific method. The amortization, net of tax benefits and accrued dividends, is charged to current year income after continuing operations, net of taxes. The following is a summary of the preferred securities balance as of December 31:
1997 1996 -------- ------- Beginning balance........................................... $ 23,571 $21,045 Dividends and accretion..................................... 3,709 2,526 Retirement of 1994 Preferred Securities..................... (27,275) -- Issuance of Trust Preferred Securities...................... 101,272 -- -------- ------- Balance at end of period.................................... $101,277 $23,571 ======== =======
(10) STATUTORY SURPLUS AND DIVIDEND RESTRICTIONS SNIC and SPCC are domiciled in the State of California and prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the DOI. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners ("NAIC"), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. SNIC's statutory policyholders' surplus as reported to regulatory authorities was $71,663 and $51,998 at December 31, 1997, and 1996, respectively. SNIC's statutory net income, as reported to regulatory authorities, was $2,888, $791 and $1,050 for the years ended December 31, 1997, 1996, and 1995 respectively. SPCC's statutory policyholders' surplus as reported to regulatory authorities was $30,542 and $20,930 at December 31, 1997 and 1996, respectively. SPCC's statutory net income, as reported to regulatory authorities, was $(6,074), $(13,069), and $4,879 for the years ended December 31, 1997, 1996, and 1995 respectively. Insurance companies are subject to insurance laws and regulations established by the states in which they transact business. The laws of various states establish supervisory agencies with broad administrative and supervisory powers. Most states have also enacted legislation regulating insurance holding company systems, including acquisitions, extraordinary dividends, the terms of affiliate transactions, and other related matters. The Company and Superior Pacific have registered as holding company systems pursuant to such legislation in California. The NAIC has formed committees and appointed advisory groups to study and formulate regulatory proposals on such diverse issues as the use of surplus debentures and accounting for reinsurance F-21 90 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) transactions. It is not possible to predict the future impact of changing state and federal regulation on the operations of the Company and Superior Pacific. The Risk Based Capital Model ("RBC") for property and casualty insurance companies was adopted by the NAIC in December 1993, and starting in 1995, companies were required to report their RBC ratios to the NAIC. SNIC and SPCC have calculated and met their RBC requirements. Insurance companies are also subject to restrictions affecting the amount of stockholder dividends and advances that may be paid within any one year without the prior approval of the DOI. The California Insurance Code provides that the maximum amount that may be paid as dividends on an annual noncumulative basis without prior notice to, or approval by, the DOI is the greater of (1) net income for the preceding year or (2) 10% of statutory surplus as regards policyholders as of the preceding December 31. At December 31, 1997, SNIC and SPCC could pay approximately $7.2 million and $3.1 million, respectively, in dividends and advances to the Company without the DOI's prior approval based on 10% of reported statutory surplus. In 1995, after receiving prior approval from the DOI, SNIC made an extraordinary dividend distribution to SNIG of 100% of its shares in Superior (Bermuda) Limited, which represented $15 million of SNIC's statutory capital and surplus. (11) EMPLOYEE BENEFIT PLANS SNIG has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related Interpretations in accounting for its employee stock options. As discussed below in management's opinion, the alternative fair value accounting provided for under SFAS 123, requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized. SNIG has two equity option plans, the 1986 Stock Option Plan ("1986 Plan") and the 1995 Stock Incentive Plan ("1995 Plan"). The terms of the 1986 Plan permit SNIG, at the Board of Directors' discretion, to grant options to its management to purchase up to 225,000 shares of common stock. Options granted under the 1986 Plan are not intended to qualify as incentive stock options within the meaning of Section 422 of the Internal Revenue Code ("Code"). The 1995 Plan permits the granting of both options that qualify for treatment as incentive stock options under Section 422 of the Code and options that do not qualify as incentive stock options. Under the 1995 Plan, officers and key employees of the Company may be granted options to purchase shares of SNIG common stock or may be given the opportunity to receive restricted stock of SNIG. Under the 1995 Plan, the aggregate number of shares of common stock that may be granted, either through the exercise of options or the issuance of restricted stock, is 625,000 shares. Under both plans, the exercise price of each option equals the market price of SNIG's stock on the date of grant and options have a maximum term of ten years. The Board of Directors may grant options at any point during a year and the options generally vest over five years. Pro forma information regarding net income and earnings per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions. The risk free interest rate used in the calculation is the 10 year Treasury Note rate on the date the options were granted. The risk free interest rate range used for options granted during 1997, 1996, and 1995 was 5.8% to 6.9%, 6% to 6.79%, and 6% to 7.11%, respectively. The volatility factors for the expected market price of the common stock of 65%, 70%, and 77% were used for options granted in 1997, 1996, and 1995 respectively. A weighted average expected life of ten years was used as the Company has little history of options' being exercised prior to their expiration. F-22 91 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that do not have vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the value of an estimate, in management's opinion the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized into expense over the options' vesting period. The Company's pro forma information follows (in thousands except for earnings per share information):
1997 1996 ------- ------ Pro forma net income........................................ $(5,366) $1,857 Pro forma earnings per share Basic..................................................... (1.02) 0.54 Diluted................................................... $ (0.77) 0.38
A summary of the Company's stock option activity, and related information for the years ended December 31, follows:
1997 1996 1995 -------------------------- -------------------------- -------------------------- WEIGHTED- WEIGHTED- WEIGHTED- NUMBER AVERAGE NUMBER AVERAGE NUMBER AVERAGE OF SHARES EXERCISE PRICE OF SHARES EXERCISE PRICE OF SHARES EXERCISE PRICE --------- -------------- --------- -------------- --------- -------------- Stock options outstanding beginning of year......... 389,516 $ 5.13 252,500 $4.90 138,750 $4.47 Stock options granted....... 132,257 12.43 146,516 5.46 135,000 5.20 Stock options exercised..... (22,127) 4.74 (3,100) 4.00 (500) 4.00 Stock options canceled...... (38,567) 5.94 (6,400) 4.61 (20,750) 4.00 -------- -------- -------- Stock options outstanding, end of year............... 461,079 $ 7.17 389,516 $5.13 252,500 4.90 ======== ====== ======== ===== ======== ===== Exercisable at end of year...................... 152,525 -- 102,200 -- 56,690 -- Weighted-average fair value of options granted during the year.................. $ 9.76 $ 4.41 $ 4.40
F-23 92 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Exercise prices for options outstanding as of December 31, 1997 ranged from $4 to $14.875. The weighted-average remaining contractual life of those options is 8.3 years. Since the range of exercise prices is wide, the following is a summary of information for each exercise price range:
WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE NUMBER OF EXERCISE PRICE OF OPTIONS REMAINING OPTIONS (SHARES) OF CURRENTLY EXERCISE PRICE (SHARES) WEIGHTED-AVERAGE CONTRACTUAL LIFE CURRENTLY EXERCISABLE RANGE OUTSTANDING EXERCISE PRICE (YEARS) EXERCISABLE OPTIONS - --------------- ----------- ---------------- ---------------- ---------------- ---------------- $ 4.00-$ 4.99 111,566 $ 4.54 7.56 48,261 $ 4.25 $ 5.00-$ 5.99 176,450 5.18 7.68 95,130 5.18 $ 6.00-$ 6.99 40,112 6.25 9.00 7,864 6.25 $ 7.00-$11.99 28,850 10.89 9.85 770 7.70 $12.00-$12.99 81,851 12.16 10.00 500 12.75 $13.00-$14.99 22,250 14.64 10.00 -- -- ------- ------- 461,079 $ 7.17 8.30 152,525 $ 4.98 ======= ====== ===== ======= ======
The following is a summary of the transactions under the 1986 Plan for the years ended December 31:
1997 1996 1995 ----------------------- ----------------------- ----------------------- NUMBER OPTION NUMBER OPTION NUMBER OPTION OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE --------- ----------- --------- ----------- --------- ----------- Stock options outstanding beginning of year.............. 120,000 $4.00-$5.20 127,500 $4.00-$5.20 138,750 $4.00-$5.20 Stock options granted.............. -- -- -- -- 10,000 5.20 Stock options exercised............ (9,125) 4.00 (3,100) 4.00 (500) 4.00 Stock options canceled............. (2,125) 4.00 (4,400) 4.00-5.20 (20,750) 4.00 ------- ------- --------- Stock options outstanding, end of year................. 108,750 $4.00-$5.20 120,000 $4.00-$5.20 127,500 $4.00-$5.20 ======= =========== ======= =========== ========= ===========
At December 31, 1997, 72,475 vested options were exercisable under the 1986 Plan. No additional options or purchase rights will be granted under the 1986 Plan. The following is a summary of the transactions under the 1995 Plan for the years ended December 31:
1997 1996 1995 ------------------------- ----------------------- ------------------ NUMBER OPTION NUMBER OPTION NUMBER OPTION OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE --------- ------------- --------- ----------- --------- ------ Stock Options: Stock options outstanding beginning of year............ 269,516 $5.20-$7.70 125,000 $5.20 -- -- Stock options granted......... 132,257 11.375-14.875 146,516 5.20-7.70 125,000 $5.20 Stock options exercised....... (13,002) 4.87-7.70 -- -- -- -- Stock options canceled........ (36,442) 4.87-12.125 (2,000) 5.20 -- -- ------- ------- ------- Stock options outstanding end of year......... 352,329 $4.87-$14.875 269,516 $5.20-$7.70 125,000 $5.20 ======= ============= ======= =========== ======= =====
F-24 93 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1997 1996 1995 ------------------------- ----------------------- ------------------ NUMBER OPTION NUMBER OPTION NUMBER OPTION OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE --------- ------------- --------- ----------- --------- ------ Restricted Options: Shares outstanding beginning of year............ 69,265 $4.87-$6.25 36,350 $5.20 -- -- Shares granted..... 36,450 12.125 45,934 4.87-6.25 36,350 $5.20 Shares issued...... (12,222) 4.87-12.125 (13,019) 4.87-5.20 -- -- Shares canceled.... (9,813) 4.87-12.125 -- -- -- -- ------- ------- ------- Shares outstanding end of year..... 83,680 $4.87-$12.125 69,265 $4.87-$6.25 36,350 5.20 ======= ============= ======= =========== ======= =====
At December 31, 1997, 80,050 vested options were exercisable under the 1995 Plan. Shares available for future grants under the 1995 Plan at December 31, 1997 were 188,991. Effective January 1, 1990, the Company implemented a 401(k) Plan ("Company Plan") which is available for substantially all employees and under which the Company matches a percentage of the participant's compensation. The employer contributions are discretionary and vest over a five year period. The employer contributions for plan years 1997, 1996, and 1995 were $186, $170, and $150, respectively. The Company has no formal post-employment retirement benefit plans; however, the Company has entered into severance contracts with certain former employees for which approximately $366, $48, and $322 of accrued expenses were recorded at December 31, 1997, 1996, and 1995, respectively. The Pac Rim Assurance Company 401(k) Plan ("Pac Rim Plan") permits employees of Pac Rim who attain the age of 21 and complete 30 days of employment to elect to make tax-deferred contributions of a specified percentage of their compensations during each year through payroll deductions. As of December 31, 1997, there were 38 participants in the Pac Rim Plan employed by the Company. Under the Pac Rim Plan, the Company, as successor to Pac Rim, has discretion to make additional contributions. The Company made a $200 discretionary employer contribution to the Pac Rim Plan in April 1997. The Company plans to merge the Pac Rim Plan into the Company Plan by the end of December 31, 1998. (12) COMMITMENTS The Company occupies offices under various operating leases and leases substantially all of its fixed assets through a capital lease. The future minimum lease payments at December 31, 1997, are as follows:
OPERATING CAPITAL INTEREST ON CAPITAL TOTAL LEASE COMMITMENTS COMMITMENTS COMMITMENTS COMMITMENTS ----------- ----------- ------------------- ----------- 1998........................ $ 4,655 $1,659 $ 685 $ 6,999 1999........................ 4,681 2,005 552 7,238 2000........................ 3,414 2,232 325 5,971 2001........................ 3,083 1,797 16 4,896 2002........................ 1,279 -- -- 1,279 ------- ------ ------ ------- $17,112 $7,693 $1,578 $26,383 ======= ====== ====== =======
Rental expenses totaled approximately $4,020, $1,918, and $1,772 for the years ended December 31, 1997, 1996, and 1995 respectively. Effective December 1, 1997, the Company entered into an $8,000 capital lease with BancBoston for substantially all of the property and equipment of both SNIC and SPCC acquired on or before March 31, 1997. The transaction resulted in a deferred gain of $1,651 that will be amortized over 36 months. F-25 94 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In a transaction associated with the sale of the 14.5% Senior Subordinated Notes to III, the Company and SNIC agreed to pay International Insurance Advisors, Inc., agent for each of the III limited partners and for the general partner of III, a consulting fee in the amount of $250 beginning on April 1, 1993, and on each April 1 thereafter, to and including April 1, 1998. The retirement of the 14.5% Senior Subordinated Notes in 1994 did not affect the obligation of the Company and SNIC to pay the consulting fee. (13) LITIGATION The Company is subject to various litigation which arises in the ordinary course of business. Management is of the opinion that such litigation will not have a material adverse effect on the consolidated financial position of the Company or its consolidated results of operations. (14) PREPAID AND OTHER ASSETS A summary of prepaid and other assets at December 31, are as follows:
1997 1996 ------- ------ Furniture and fixtures, net................................. $ 7,970 $1,260 Data processing equipment, net.............................. 71 3,560 Prepaid and advances........................................ 2,178 1,091 Funds due from lender....................................... 8,000 -- Other....................................................... 2,887 1,453 ------- ------ $21,106 $7,364 ======= ======
(15) ACCOUNTS PAYABLE AND OTHER LIABILITIES A summary of accounts payable and other liabilities at December 31, are as follows:
1997 1996 ------- ------- Escheatment payable......................................... $ 1,401 $ 333 Rent and lease liability.................................... 371 527 Accounts payable............................................ 15,526 8,683 Liabilities associated with Pac Rim acquisition............. 7,608 -- Other liabilities........................................... 3,962 3,198 ------- ------- $28,868 $12,741 ======= =======
F-26 95 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (16) EARNINGS PER SHARE RECONCILIATION The following is an illustration of the reconciliation of the numerators and denominators of the basic and diluted earnings per share (EPS) computations:
FOR THE YEAR ENDED 1997 FOR THE YEAR ENDED 1996 ------------------------------------------ ------------------------------------------ INCOME SHARES PER SHARE INCOME SHARES PER SHARE (NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT ----------- ------------- --------- -------------- ------------- --------- (IN THOUSANDS) (IN THOUSANDS BASIC EPS Income before items below................. $ 10,824 5,249,736 $ 2.06 $ 3,630 3,432,679 $ 1.06 Preferred Securities.... (3,069) (0.58) (1,667) (0.49) Discontinued Operations............ -- -- -- -- Extraordinary Items..... (12,896) (2.46) -- -- -------- ------ ------- ------ Net Income.............. $ (5,141) $(0.98) $ 1,963 $ 0.57 ======== ====== ======= ====== EFFECT OF DILUTIVE SECURITIES Options................. 295,065 266,183 Warrants................ 1,471,364 1,167,178 DILUTED EPS Income before items below................. $ 10,824 7,016,165 $ 1.54 $ 3,630 4,826,040 $ 0.75 Preferred Securities.... (3,069) (0.44) (1,667) (0.34) Discontinued Operations............ -- -- -- -- Extraordinary Items..... (12,896) (1.84) -- -- -------- ------ ------- ------ Net Income............... $ (5,141) $(0.74) $ 1,963 $ 0.41 ======== ====== ======= ====== FOR THE YEAR ENDED 1995 ------------------------------------------ INCOME SHARES PER SHARE (NUMERATOR) (DENOMINATOR) AMOUNT -------------- ------------- --------- (IN THOUSANDS) BASIC EPS Income before items below................. $11,701 3,429,915 $ 3.41 Preferred Securities.... (1,488) (0.43) Discontinued Operations............ (9,842) (2.87) Extraordinary Items..... -- -- ------- ------ Net Income.............. $ 371 $ 0.11 ======= ====== EFFECT OF DILUTIVE SECURITIES Options................. 47,052 Warrants................ 464,627 DILUTED EPS Income before items below................. $11,701 3,941,594 $ 2.97 Preferred Securities.... (1,488) (0.38) Discontinued Operations............ (9,842) (2.50) Extraordinary Items..... -- -- ------- ------ Net Income............... $ 371 $ 0.09 ======= ======
Options to purchase 1,250 shares at $14.81, 12,500 shares at $14.875, 7,250 shares at $14.25, and 1,250 shares at $14.31 were outstanding during the last quarter of 1997 but were not included in the computation of diluted EPS because the options' exercise price was greater than the average market price of the common shares. The options, which expire in 2002, were still outstanding at the end of year 1997. F-27 96 SCHEDULE I.1 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT SUPERIOR NATIONAL INSURANCE GROUP, INC. BALANCE SHEET
DECEMBER 31, ---------------------- 1997 1996 --------- --------- (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) ASSETS INVESTMENTS Bonds and Notes: Available-for-sale, at market (cost: 1997, $7,539)........ $ 7,533 $ -- Cash and short-term instruments (certificates of deposit and other short-term instruments)...................... 5,404 1,787 -------- -------- TOTAL INVESTMENTS................................. 12,937 1,787 Accrued investment income................................. 38 1 Receivable from reinsurer................................. -- 110,527 Investment in subsidiaries................................ 168,856 72,788 Intercompany receivable................................... 91 91 Deferred income taxes..................................... 1,884 4,957 Other..................................................... 174 1,087 -------- -------- TOTAL ASSETS...................................... $183,980 $191,238 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES Long-term debt.............................................. $ 30 $ 98,961 Intercompany liability...................................... 21,462 23,465 Accounts payable and other liabilities...................... 1,393 50 -------- -------- TOTAL LIABILITIES................................. 22,885 122,476 -------- -------- 1997 PREFERRED SECURITIES ISSUED BY AFFILIATE; authorized 105,000 shares in 1997......................... 101,277 -- 1994 PREFERRED SECURITIES ISSUED BY AFFILIATE; authorized 1,100,000 shares: issued and outstanding 1,013,753 shares in 1996.................................. -- 23,571 STOCKHOLDERS' EQUITY Common stock, $0.01 par value; authorized 25,000,000 shares: issued and outstanding 5,871,279 shares in 1997 and 3,446,492 shares in 1996.................................. 59 34 Paid-in capital excess of par............................... 34,242 15,988 Paid in capital -- warrants................................. 2,206 2,206 Unrealized gain on equity securities, net of taxes.......... 112 (17) Unrealized gain (loss) on available-for-sale investments, net of income taxes....................................... 1,215 (145) Retained earnings........................................... 21,984 27,125 -------- -------- TOTAL STOCKHOLDERS' EQUITY........................ 59,818 45,191 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY........ $183,980 $191,238 ======== ========
See notes to condensed financial information F-28 97 SCHEDULE I.2 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT SUPERIOR NATIONAL INSURANCE GROUP, INC. STATEMENTS OF INCOME
TWELVE MONTHS ENDED DECEMBER 31, ------------------------------ 1997 1996 1995 -------- ------- ------- (AMOUNTS IN THOUSANDS) REVENUES: Net investment income..................................... $ (112) $ 89 $ 330 -------- ------- ------- TOTAL REVENUES.................................... (112) 89 330 EXPENSES: Interest expense.......................................... 5,965 1,465 804 Other operating expenses.................................. 518 (446) 304 -------- ------- ------- TOTAL EXPENSES.................................... 6,483 1,019 1,108 -------- ------- ------- LOSS BEFORE INCOME TAXES, PREFERRED SECURITIES DIVIDENDS AND ACCRETION, AND EXTRAORDINARY ITEMS........................ (6,595) (930) (778) Income tax expense.......................................... 8,246 858 767 -------- ------- ------- INCOME BEFORE PREFERRED SECURITIES DIVIDENDS AND ACCRETION, AND EXTRAORDINARY ITEMS................................... (14,841) (1,788) (1,545) Equity in net income of subsidiaries........................ 25,709 5,418 3,404 1994 Preferred securities dividends and accretion, net of income tax benefit of $1,260 and $858 in 1997 and 1996, respectively.............................................. (2,445) (1,667) (1,488) 1997 Preferred securities dividends and accretion, net of income tax benefit of $321 in 1997........................ (624) -- -- Extraordinary loss on retirement of long-term debt, net of income tax benefit of $5,338 in 1997...................... (10,361) -- -- Extraordinary loss on retirement of long-term debt, net of income tax benefit of $785 in 1997........................ (1,524) -- -- Extraordinary loss on redemption of Pac Rim's outstanding debentures, net of income tax benefit of $327 in 1997..... (635) -- -- Extraordinary loss on retirement of preferred securities, net of income tax benefit of $134 in 1997................. (259) -- -- Extraordinary loss on early retirement of Imperial Bank Loan net of income tax benefit of $83 in 1997.................. (161) -- -- -------- ------- ------- NET INCOME (LOSS)................................. $ (5,141) $ 1,963 $ 371 ======== ======= =======
See notes to condensed financial information F-29 98 SCHEDULE I.3 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT SUPERIOR NATIONAL INSURANCE GROUP, INC. STATEMENTS OF CASH FLOWS
TWELVE MONTHS ENDED DECEMBER 31, ------------------------------ 1997 1996 1995 -------- --------- ------- (AMOUNTS IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income......................................... $ (5,141) $ 1,963 $ 371 -------- --------- ------- Adjustments to reconcile net (loss) income to net cash used in operating activities: Amortization of bonds and preferred stock............... -- -- (1) Loss on sale of investment.............................. 7 5 -- Income from subsidiaries................................ (25,709) (5,418) (3,404) Extraordinary loss...................................... 12,940 -- -- Interest expense on long-term debt...................... 3,581 -- -- Preferred securities dividends and accretion............ 3,069 2,525 2,255 Increase in current income taxes........................ -- -- 1,721 (Increase) decrease in accrued investment income........ (37) 8 1 Decrease in deferred income taxes....................... 8,247 -- -- (Increase) decrease in other assets..................... 2,209 (994) (11) Increase in accounts payable and other liabilities...... 446 19,334 78 -------- --------- ------- Total adjustments..................................... 4,753 15,460 639 -------- --------- ------- Net cash (used in) provided by operating activities... (388) 17,423 1,010 -------- --------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Paid-in-capital -- restricted stock....................... 279 78 2 Proceeds from issuance of common stock.................... 18,000 -- -- Proceeds from 1997 Trust Preferred Securities............. 101,272 -- -- Long-term debt -- Chase Manhattan Bank.................... 41,257 -- -- Retirement of long-term debt -- Chase Manhattan Bank...... (44,000) -- -- Retirement of 1994 Preferred Securities................... (27,668) -- -- Retirement of long-term debt -- Imperial Bank............. (7,250) (1,250) (1,200) Prepayment penalty on long-term debt...................... (244) -- -- Proceeds from Chase financing............................. -- 93,091 -- Retirement of long-term debt -- Chase Financing........... -- (1,410) -- -------- --------- ------- Net cash provided by (used in) financing activities... 81,646 90,509 (1,198) -------- --------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of bonds and notes: Investments available-for-sale.......................... (7,539) -- (1,496) Increase in receivable from reinsurer................... -- (110,527) -- Purchase of Pacific Rim Holding Company................... (44,016) -- -- Investment in subsidiary.................................. (1,175) -- -- Sales of bonds and notes: Investments available for sale.................................................... -- 1,493 -- Capital contribution to subsidiaries...................... (25,000) -- (1,500) Net decrease in invested cash............................. 89 -- -- -------- --------- ------- Net cash used in investing activities................. (77,641) (109,034) (2,996) -------- --------- ------- Net increase (decrease) in cash....................... 3,617 (1,102) (3,184) Cash and invested cash at beginning of period............. 1,787 2,889 6,073 -------- --------- ------- Cash and invested cash at end of period................... $ 5,404 $ 1,787 $ 2,889 ======== ========= ======= Supplemental disclosure of cash flow information: Cash paid during the year for income taxes.............. $ 1 $ 1 $ 1 ======== ========= ======= Cash paid during the year for interest.................. $ 2,433 $ 641 $ 808 ======== ========= =======
See notes to condensed financial information F-30 99 SCHEDULE I.4 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT SUPERIOR NATIONAL INSURANCE GROUP, INC. NOTES TO CONDENSED FINANCIAL INFORMATION 1. BASIS OF PRESENTATION In accordance with the requirements of Regulation S-X of the Securities and Exchange Commission, the financial statements of the registrant are condensed and omit many disclosures presented in the consolidated financial statements and the notes thereto. 2. LONG TERM DEBT The following is a summary of the long-term debt balances at December 31:
1997 1996 ---- ------- Chase Financing Agreement -- 6.87% due through 2004......... $-- $91,681 Imperial Bank Debt -- 8.25% due through 2001................ -- 7,250 Voting Notes due 2002....................................... 30 30 --- ------- Balance at end of period.................................... $30 $98,961 === =======
The voting notes of $30 will mature in the year 2002. 3. DIVIDENDS FROM SUBSIDIARIES During 1997, 1996, and 1995, there were no dividends paid to SNIG by its consolidated subsidiaries; however SNIC paid SNIG $2.9 million for its current income taxes. 4. CONTINGENCIES The Company is subject to various litigation which arises in the ordinary course of business. Based upon discussions with counsel, management is of the opinion that such litigation will not have a material adverse effect on the consolidated financial position of the Company or its consolidated results of operations. 5. RECONCILIATION -- RECEIVABLE FROM REINSURER The following is a reconciliation between the Condensed Financial Information of Registrant Balance Sheet and the Consolidated Balance Sheet for Receivable from reinsurer.
RECEIVABLE FROM REINSURER ---------------- 1997 1996 ---- -------- Balance per Consolidated Balance Sheet...................... $-- $ 93,266 Add: Elimination for Discontinued Operations................ -- 17,261 --- -------- Balance per Condensed Balance Sheet......................... $-- $110,527 === ========
F-31 100 SCHEDULE II SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E -------- ---------- ------------------------- ---------- --------- ADDITIONS ------------------------- BALANCE AT CHARGED TO CHARGED TO BALANCE BEGINNING COSTS OTHER AT END OF PERIOD AND EXPENSES ACCOUNTS DEDUCTIONS OF PERIOD ---------- ------------ ---------- ---------- --------- (AMOUNTS IN THOUSANDS) Year ended December 31, 1997 Allowance for possible losses on premiums receivable............... $300 $2,311 -- $(1,811) $800 ==== ====== ===== ======= ==== Allowance for possible losses on reinsurance recoverable........... -- -- -- -- -- ==== ====== ===== ======= ==== Year ended December 31, 1996 Allowance for possible losses on premiums receivable............... $500 $1,369 -- $(1,569) $300 ==== ====== ===== ======= ==== Allowance for possible losses on reinsurance recoverable........... -- -- -- -- -- ==== ====== ===== ======= ==== Year ended December 31, 1995 Allowance for possible losses on premiums receivable............... $900 $1,531 -- $(1,931) $500 ==== ====== ===== ======= ==== Allowance for possible losses on reinsurance recoverable........... -- -- -- -- -- ==== ====== ===== ======= ====
F-32 101 SCHEDULE V.1 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES SUPPLEMENTAL INSURANCE INFORMATION
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F COLUMN G COLUMN H -------- ----------- -------------- -------- ------------ -------- ---------- ---------- FUTURE POLICY BENEFITS, DEFERRED BENEFITS, OTHER POLICY CLAIMS, POLICY LOSSES, CLAIMS CLAIMS AND NET LOSSES AND ACQUISITION AND LOSS UNEARNED BENEFITS PREMIUM INVESTMENT SETTLEMENT COSTS EXPENSES PREMIUM PAYABLE REVENUE INCOME EXPENSES ----------- -------------- -------- ------------ -------- ---------- ---------- (AMOUNTS IN THOUSANDS) 1997 Workers' Compensation.......... $5,879 $201,255 $12,913 $ -- $140,920 $12,674 $90,447 ====== ======== ======= ====== ======== ======= ======= 1996 Workers Compensation........... $3,042 $115,529 $ 9,702 $ -- $ 88,648 $ 7,769 $55,638 ====== ======== ======= ====== ======== ======= ======= 1995 Workers' Compensation.......... $2,780 $141,495 $10,347 $ -- $ 89,735 $ 9,784 $53,970 ====== ======== ======= ====== ======== ======= ======= COLUMN A COLUMN I COLUMN J COLUMN K -------- ------------ --------- -------- AMORTIZATION OF DEFERRED POLICY OTHER ACQUISITION OPERATING PREMIUMS COSTS EXPENSES WRITTEN ------------ --------- -------- (AMOUNTS IN THOUSANDS) 1997 Workers' Compensation.......... $19,977 $25,909 $136,929 ======= ======= ======== 1996 Workers Compensation........... $16,870 $24,609 $ 87,715 ======= ======= ======== 1995 Workers' Compensation.......... $18,288 $21,314 $ 89,139 ======= ======= ========
F-33 102 SCHEDULE V.2 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES REINSURANCE
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F -------- -------- --------- ------------ -------- ------------- PERCENTAGE OF CEDED TO ASSUMED FROM AMOUNT GROSS OTHER OTHER NET ASSUMED AMOUNT COMPANIES COMPANIES AMOUNT TO NET -------- --------- ------------ -------- ------------- (AMOUNTS IN THOUSANDS) Year ended December 31, 1997 Premiums: Workers' compensation insurance... $152,253 $22,081 $10,748 $140,920 8.3% -------- ------- ------- -------- --- Total premiums................. $152,253 $22,081 $10,748 $140,920 8.3% ======== ======= ======= ======== === Year ended December 31, 1996 Premiums: Workers' compensation insurance... $ 97,270 $11,280 $ 2,658 $ 88,648 3.0% -------- ------- ------- -------- --- Total Premiums................. $ 97,270 $11,280 $ 2,658 $ 88,648 3.0% ======== ======= ======= ======== === Year ended December 31, 1995 Premiums: Workers' compensation insurance... $ 96,630 $ 7,730 $ 835 $ 89,735 0.9% -------- ------- ------- -------- --- Total premiums................. $ 96,630 $ 7,730 $ 835 $ 89,735 0.9% ======== ======= ======= ======== ===
F-34 103 SCHEDULE V.3 SUPERIOR NATIONAL INSURANCE GROUP, INC. AND SUBSIDIARIES SUPPLEMENTAL PROPERTY AND CASUALTY INSURANCE INFORMATION
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F COLUMN G COLUMN H -------- ----------- ---------- ----------- -------- -------- ---------- --------------------- DISCOUNT IF ANY, DEDUCTED RESERVES IN RESERVES CLAIMS AND CLAIM FOR UNPAID FOR UNPAID ADJUSTMENT EXPENSES DEFERRED CLAIMS AND CLAIMS AND INCURRED RELATED TO: POLICY CLAIMS CLAIM NET --------------------- ACQUISITION ADJUSTMENT ADJUSTMENT UNEARNED EARNED INVESTMENT CURRENT PRIOR COSTS EXPENSES EXPENSES PREMIUM PREMIUM INCOME YEAR YEAR ----------- ---------- ----------- -------- -------- ---------- --------- --------- (AMOUNTS IN THOUSANDS) 1997 Workers' Compensation.... $5,879 $201,255 $ -- $12,913 $140,920 $12,674 $95,826 $(5,379) ====== ======== ====== ======= ======== ======= ======= ======= 1996 Workers' Compensation.... $3,042 $115,529 $ -- $ 9,702 $ 88,648 $ 7,769 $57,614 $(1,976) ====== ======== ====== ======= ======== ======= ======= ======= 1995 Workers' Compensation.... $2,780 $141,495 $ -- $10,347 $ 89,735 $ 9,784 $58,842 $(4,872) ====== ======== ====== ======= ======== ======= ======= =======
F-35 EX-10.53 2 AGREEMENT FOR SERVICES BETWEEN REM AND SNIC 1 EXHIBIT 10.53 AGREEMENT FOR SERVICES RISK ENTERPRISE MANAGEMENT LIMITED, 59 Maiden Lane, New York, New York 10038 (hereafter referred to as "TPA") hereby agrees to provide services as described herein ("Services") for SUPERIOR NATIONAL INSURANCE COMPANY, 26601 Agoura Road, Calabasas, California 91302 (hereinafter referred as "Client") in connection with the administration of [existing] claims against policies written by Client or claims that have loss dates or are reported or transferred to TPA during the term of this agreement. All claims shall be handled in accordance and in full compliance with the requirements of all applicable regulatory authorities. ARTICLE 1. INDEPENDENT CONTRACTOR 1.01 The term ("Term") of this agreement ("Agreement") shall commence March __, 1998 and continue for a minimum period of three (3) years until March 31, 2001 ("Minimum Period"), and thereafter may canceled by either party giving to the other six (6) months written notice. 1.02 TPA enters into this Agreement, and will remain throughout the term of this Agreement, as an independent contractor. TPA agrees that this Agreement does not create with Client an employer-employee, partner, or joint venture relationship. TPA agrees that it, and its employees and agents, are not entitled to the rights or benefits afforded to Client's employees including disability or unemployment insurance, workers compensation insurance, medical insurance, sick leave or any other employment benefit. 1.03 Client shall pay all taxes and tariffs, assessed or levied by any governmental entity, if any, that are now or may become applicable to the Services rendered hereunder or measured by payments made by Client to TPA hereunder, or are required to be collected by TPA or paid by TPA to tax authorities. This includes, but is not limited to, sales, use, excise, gross receipt and personal property taxes or any other form of tax based on the Services performed or equipment or services used by TPA solely to perform Services for Client, but does not include taxes based upon TPA's net income. Client shall also pay any interest or penalties on such taxes and tariffs, provided, however, Client shall not be responsible for any interest or penalties resulting from TPA's failure to forward tax funds received from Client to the applicable tax authority. TPA is responsible for paying all income taxes, incurred as a result of compensation paid by Client to TPA for Services under this Agreement. On request, TPA will provide Client with proof of timely payment. TPA agrees to indemnify Client for any claims, costs, losses, fees, penalties, interest, or damages suffered by Client, including attorneys fees and all related costs, resulting from TPA's failure to comply with this provision. ARTICLE 2. NOTICES 2.01 All notices given related to this Agreement must be delivered either by personal delivery by messenger or by mail, registered or certified, postage pre-paid with return receipt requested. Mailed notices must be addressed to the parties at the addresses appearing in paragraph 2.02 of this Agreement, but each party may change the address by giving written notice in accordance with this paragraph. Notices given personally will be deemed communicated on the day evidenced by receipted delivery; notices given by mail will be deemed communicated on the date of actual receipt, or on the fifth day after mailing, whichever is earlier. 1. 2 2.02 Notices under this Agreement are to be given to the following persons: To Client: Chief Claims Executive Superior National Insurance Company Vice President Claims 26601 Agoura Road Calabasas, Ca. 91302 To TPA: Risk Enterprise Management Limited 59 Maiden Lane New York, NY 10038 Attn.: General Counsel, 28th Floor ARTICLE 3. QUALIFICATIONS 3.01 TPA represents that it has the qualifications and skills necessary to perform the services under this Agreement in a competent, professional manner and that it, and its staff, are sufficiently familiar with the applicable statutes, regulations and case law authorities relating to the area of workers' compensation, specifically relating to the handing of workers' compensation claims, to permit the services to be so provided. Failure to perform any of the requirements mandated by this Article may be considered a material breach of the Agreement. ARTICLE 4. IN CONSIDERATION OF THE PROVISIONS, STIPULATIONS, COVENANTS AND CONDITIONS OF THIS AGREEMENT, TPA AGREES: 4.01 To adjust workers' compensation claims on a timely basis as required by the workers' compensation laws of California; to avoid unnecessary liability to Client; to close claims in a timely and cost effective manner, and to provide designated services for the described program, which includes Client's requirements for claim reporting, legal, investigation, vocational rehabilitation, medical management, bill review, subrogation, fraud and medical cost containment programs. 4.02 To investigate all reported claims and losses to the extent deemed necessary in the judgment of TPA and to adjust, settle, resist or otherwise handle all such claim or losses from inception through closure (with the exception noted in this Agreement) within the authority granted by Client. 4.03 To investigate all reported claims and losses to the extent deemed necessary in the judgment of TPA in order to be in full compliance with the Audit Regulations of the Division of Workers' Compensation and to adjust, settle, resist or otherwise handle all such claims or losses that are in excess of the authority granted with prior approval of Client, all pursuant to the TPA's Claim Handling Guidelines. 4.04 To establish and maintain case reserves in accordance with Client's reserving guidelines. 4.05 To exclusively utilize Client's computer system and enter therein all reported losses involving Client's policyholders in accordance with Client's systems procedures. Said computer system will be upgraded by Client, at Client's expense, during the term of this Agreement. TPA agrees to be trained and otherwise become familiar with the upgraded computer system at the time it is made available at 2. 3 Client's expense. TPA may not load any unauthorized software into the computer equipment provided by Client. Client's equipment is for the sole purpose of providing access to systems related to the handling of Client's claims. All computer equipment remains the sole property of Client to be returned at time of upgrade or termination of Agreement. The computer systems referenced herein include the intellectual property of Client and permission to use same, as granted herein, in no way represents a waiver of any intellectual property and or confidentiality rights held by the Client. 4.06 To return the information maintained on each claim under this Agreement regardless of whether it exists in electronic format through use of Client's equipment or in hard copy ("Claim Files") to the Client, at Client's expense, at the time of their closure; provided, however, in the event that a reopening of Claim Files is required for further processing or a dispute arises between Client and TPA, TPA shall have the right at any time after closing the Claim File or the termination of this Agreement to obtain the Claim Files returned to Client, in so far as such Claim Files relate to the additional processing or to the dispute, and, at TPA's cost in the event of a dispute, to make copies thereof or extracts therefrom; and provided, further, that nothing in this Article 4 shall supersede, preclude or otherwise limit any discovery rights otherwise available to TPA or Client. 4.07 To refer any Claim File, where the issue of potential fraud has been identified, to the Client's SIU Examiner responsible for that territory where the claimant is located. 4.08 To exclusively utilize the services of outside vendors, as directed by Client, for legal services (refer to Client's legal department for assignment of defense counsel), investigations (refer to Client's Home Office, Investigation Unit), vocational rehabilitation services (refer to Client's Rehabilitation Unit), medical services, photocopy services and bill review. TPA cannot make a promise to an Insured for assignment of a particular vendor. All vendor assignments are at the direction of the Client. Medical management services will be assigned from panel of nurses provided by Client 4.09 {To return all claims to Client for handling in accordance with the authority levels which may be specified from time to time by Client. The file, if any, will be returned to the Client's claim office in Woodland Hills.} 4.10 To provide status reports and file review summaries, at no additional cost to Client. 4.12 To allow Client to review its files on-site at any time and to respond to Client's recommendations/questions within three (3) business days. At all times the Claim Files remain the property of Client. 4.13 To return any client file within three (3) business days of request. 4.14 To pay any and all fine(s), penalty(ies), assessment(s), award(s) and/or damage(s) arising from and solely attributable in accordance with Article 10 herein to TPA's negligent or intentional errors and omissions the handling of any claim under its dominion or control (assessed in accordance with Title 8, CCR 10112). 4.15 To submit "Denials" of coverage or compensability to Client's TPA Supervisor in accordance with Client's then current procedures. 4.16 To bill the Client monthly. 3. 4 4.17 To assure that Client is given timely notice of all meetings and file reviews with policyholders and/or agents/brokers and permitted the opportunity to participate is such meetings and file reviews, at its discretion. 4.18 To report all new losses to Client through the KWIK Report process (800) 579-1300. 4.19 To display the Client post office box address along with the TPA Examiner name and phone number on all correspondence and forms generated by Client's claim system. All outgoing correspondence from TPA must display the same information. 4.20 To send all original correspondence received by TPA, within one (1) business day of receipt, to Client for document imaging processing. 4.21 To notify Client immediately (within one (1) business day) upon receipt of inquiry and/or notice of audit, relative to Clients files, by the Department of Industrial Relations Division of Workers' Compensation Audit Unit. 4.25 To receive full handling fee for all files, even if returned to Client. 4.26 To remit invoice for service fees to Client as soon as practical each month for new files received as well as pending files as of the last day of the previous month. 4.27 To apply the pricing described herein to those claims that occur during the Agreement period and are reported to TPA or Client's KWIK Report within the Term. 4.28 That it is expressly understood and agreed that all information relating to any Employer/ Employees shall be used for the purpose of administering workers' compensation claims under California's workers' compensation laws and shall not be released to any other party except in accordance with the California Confidentiality of Medical Information Act. The parties further agree that all confidential information, including the proprietary business information, names of insured and payment rates paid to providers, and all other such confidential information, released either intentionally or unintentionally by Client, shall be held in strict confidence by TPA and shall be specifically protected from disclosure to other clients, insurance brokers and any other third parties. 4.29 That if any existing Claim Files are transferred to TPA, TPA shall notify all parties of record on each file of the change in claims administrator. All open files shall be administered by TPA from the date of their receipt through to their final resolution and closure, within the Term. 4.30 That Client will be responsible for the cost of any communications lines and/or on-line charges for the computer interface with Client. 4.32 In the event there is a conflict of interest which arises on a particular file (e.g. TPA handles two carriers and there is a disagreement over contribution), TPA shall immediately advise Client and obtain a conflict waiver within ten (10) business days. If a conflict waiver cannot be obtained, TPA shall assure that the file is returned to Client immediately, assuring that the claim is handled properly and in accordance with the workers' compensation statutes, regulations and case law authorities through the time of transfer. 4. 5 4.33 TPA will maintain management and staffing at levels necessary to provide Services in accordance with Client's contractual obligations, regulatory requirements and generally accepted industry standards. ARTICLE 5. IN CONSIDERATION OF THE PROVISIONS, STIPULATIONS, COVENANTS AND CONDITIONS OF THIS AGREEMENT, CLIENT AGREES: 5.01 To cooperate with TPA with respect to the performance of Services, including, but not limited to, responding to TPA's requests for any and all information promptly; promptly forwarding, or causing to be forwarded to TPA for handling by TPA, all claims, claim forms, demands, notices, inquiries or correspondence concerning or related to Claims; meeting with TPA, as may be needed, and making decisions on Claims matters, as required by this Agreement and within such time period as to allow TPA to meet all legal requirements applicable to the handling of such Claims; 5.02 To provide TPA, during TPA's business hours, with Systems, personnel, service, maintenance, and training sufficient to permit TPA to execute fully Services. To the extent Client fails to meet this requirement, and fines or penalties are imposed on TPA, Client will pay all such fines or penalties. For purposes of this Agreement, "Systems" shall mean Client's claims system and workstations, document imaging center, database, data, software applications processing, word processing software, spreadsheet software, E-Mail, communications lines, and related systems necessary for TPA to provide Services. 5.03 To issue unit statistical reports, annual claim log reports, and financial reports to the appropriate regulatory agencies. 5.04 To pay TPA the per claim fees ("Fees") shown in the following table:
==================================================================================================== PER CLAIM FEES -------------------------------------------- TYPE OF CLAIM ASSIGNED TO TPA INITIAL CHARGE CARRYING CHARGE ==================================================================================================== Workers' Comp. Indemnity Within 60 days of 1st $216.00 $86.00 Notice to Client ---------------------------------------------------------------------------------------------------- Workers' Comp. Indemnity 60 days after 1st $86.00 $86.00 Notice to Client ---------------------------------------------------------------------------------------------------- Workers' Comp. Medical Only Not Applicable $90.00 No additional charge ====================================================================================================
The Initial Charge shall be deemed fully earned in the month a Claim is assigned to TPA by Client, notwithstanding any expiration or sooner termination of this Agreement. The Carrying Charge shall be assessed for each claim open at the end of each month, including the month the claim is opened by TPA. All amounts due TPA shall be stated and payable in US dollars. Each invoice issued by TPA shall be paid by Client to TPA within thirty (30) days from the date of such invoice. Amounts which remain unpaid in excess of thirty (30) days from the date of billing shall be subject to a late charge which shall be computed from the date due at the lesser of (i) 1% per month or (ii) the highest rate permitted by law. Such Fees and expenses shall exclude all claims and losses, unallocated loss adjustment expenses, and allocated loss adjustment expenses as defined herein - all such costs shall be paid by Client. 5. 6 5.05 To pay all claims and losses, unallocated loss adjustment expenses, and allocated loss adjustment expenses as defined herein, in addition to the claims service fees as provided for in this Agreement. For the purposes of this Agreement, allocated loss adjustment expense(s) ("Allocated Loss Adjustment Expense(s)") shall mean any expense which is chargeable or attributable to the investigation, coverage analysis, adjustment, negotiation, settlement, defense or general handling of any Claim(s) or action(s) related thereto, or to the protection and/or perfection of Client's insured's right of subrogation, contribution or indemnification, all as reasonably determined by TPA, whether incurred for services provided by TPA, its affiliates, subsidiaries, or third parties and shall include, but is not limited to, the following: legal fees, court costs, photocopy costs, subpoena fees, bill review fees, investigation costs, court reported and transcription fees, witness fees and witness travel expenses, all outside expense items required for subrogation and/or recovery activities on behalf of the Client, and such other and further expenses, including but not limited to, expert fees that are necessary to properly handle matters assigned to TPA which are not possible nor feasible to TPA to provide with its own employees. (A) With respect to TPA's determination that an expense(s) incurred pursuant to this Agreement is an Allocated Loss Adjustment Expense, TPA makes no representation or warranty and assumes no responsibility that such determination (i) is in compliance with or meets the requirements of any statistical plan filing, statutory, regulatory, or insurance industry reporting scheme or the definition of "Allocated Loss Adjustment Expense" thereunder; (ii) is or could be characterized as payment of loss or indemnity; or (iii) is or is not subject to insurance or reinsurance coverage or limits. Client agrees that it is responsible for making all such judgments and for complying with any and all such requirements. ARTICLE 6. PROPRIETARY RIGHTS 6.01 TPA agrees that all designs, plans, reports, process, and other information, whether derived from the above referenced computer system, or otherwise, produced by TPA as Services under this Agreement are the sole and exclusive property of Client and Client's assigns, successors and nominees. ARTICLE 7. CONFIDENTIALITY OF DATA 7.01 Any written, printed, graphic or electronically or magnetically recorded information furnished by a party is the sole property of that party and considered to be extremely confidential and proprietary, and includes the trade secrets of that party. This proprietary information includes but is not limited to information derived from access to Client's computer system. This proprietary information also includes a party's specific insured requirements, marketing information and information concerning a party's employees, products, services, prices, operations and subsidiaries. 7.02 Each party will maintain all confidential information in the strictest confidence, and will not disclose it by any means to any person or entity without the other party's express written approve and only to the extent necessary to perform the services under this Agreement. This prohibition applies to all Client's and TPA's employees, agents and subcontractors. On termination of this Agreement, each party will return any confidential information to the other party immediately upon request. 7.03 TPA agrees that all information communicated to it by Client with respect to the work conducted by or for the Client, whether or not that information was directly or intentionally communicated, is considered confidential, as well. All information, conclusions, recommendations, 6. 7 reports, advise or other documents generated by TPA is confidential. All such confidential information belongs solely to the Client. TPA agrees to use its best efforts to prevent inadvertent disclosure of any confidential information by taking all reasonable and prudent steps in accordance with its good faith obligations under the terms and conditions outlined in this Agreement. ARTICLE 8. OWNERSHIP OF CLAIM FILES 8.01 All records of the Claim Files, referenced above, whether in hard copy or electronic form, relating whatsoever to the handling of the claims, whether prepared by TPA or Client, shall be the exclusive property of the Client. ARTICLE 9. SURETY BOND AND INSURANCE 9.01 TPA shall furnish to Client evidence of a fidelity bond conditioned on the rendering of a true account by TPA of all moneys, goods or other property that may come into the custody, charge, control or possession of the TPA. Said fidelity bond must cover the dishonest act of the TPA's employees, including, but not limited, to coverage for conversion, theft of moneys, instruments, equipment, software and other tangible and intangible items in an amount not less than Five Million ($5,000,000) dollars per occurrence and Ten Million ($10,000,000) dollars in the aggregate. 9.02 Client's own fidelity bond coverage will be excess over the bond furnished by TPA pursuant to this Article. 9.03 TPA shall furnish to Client evidence of a General Liability policy, said policy must include coverage for personal injury, naming the TPA as the insured with limits of not less than Five Hundred Thousand ($500,000) dollars. 9.04 TPA shall furnish to Client evidence of an Automobile Insurance policy naming TPA as the insured, covering all drivers and automobiles used by TPA in the course of performing Services, with limits of not less than Five Hundred Thousand ($500,000) dollars. 9.05 TPA shall furnish to Client evidence of a Workers' Compensation policy naming TPA as the insured. 9.06 TPA shall furnish to Client evidence of an Errors and Omissions policy naming TPA as the insured with limits of not less than One Million ($1,000,000) dollars. 9.07 TPA agrees that all of the policies referenced in this Article, including the fidelity bond, shall be written and maintained by carriers with ratings, as defined by Best, initially acceptable to Client. 9.08 TPA agrees that all of the insurance requirements referenced in this Article shall be in full force and effect for the time period of the life of any claim upon which TPA has provided Services. 9.09 If, for any reason any of the insurance coverage policies mandated in this Article terminate, TPA agrees that it will immediately replace the coverage and that in any such circumstance, TPA agrees that it will hold Client free and harmless from any and all claims that may arise during a period of lapsed or terminated coverage. 7. 8 9.10 The failure of TPA to maintain the insurance coverage referenced in this Article shall represent a breach of the Agreement which shall permit Client to purchase the coverage and charge TPA for the cost of same. This provision (9.10) in no way, manner or form, constitutes a waiver of rights held by Client in the event of a breach of this article; or any provision in the Agreement. 10. INDEMNIFICATION 10.01 TPA shall indemnify, defend and hold harmless Client from and against any and all costs, expenses, liabilities losses, damages, injunctions, suits, actions, fines, penalties, levies, assessments (excluding any levy or assessment of any tax on earnings or capital gains arising out of any function of Client under this Agreement) and claims and demands of every kind or nature, including legal costs and attorneys fees, made by or on behalf of any party, person or governmental authority, arising out of or resulting from: the inaccuracy or breach of any representation or warranty of TPA contained in this Agreement, any breach or default by TPA of any material covenant, obligation or agreement of TPA contained in this Agreement; any material act or omission by TPA or any of its agents or employees; or any negligent, fraudulent or dishonest act or omission of TPA or its agents or employees. 10.02 Client shall indemnify, defend and hold harmless TPA from and against any and all costs, expenses, liabilities, losses, damages, injunctions, suits, actions, fines, penalties, levies, assessments (excluding any levy or assessment of any tax on earnings or capital gains arising out of any function of TPA under this Agreement) and claims and demands of every kind or nature, including legal costs and attorneys fees, made by or on behalf of any party, person or governmental authority arising out of or resulting from: the inaccuracy or breach of any representation or warranty of Client contained in this Agreement; any breach or default by Client of any material covenant, obligation or agreement of Client contained in the Agreement, any material act or omission by Client or any of its agents or employees, or any negligent, fraudulent or dishonest act or omission of Client or its agents or employees. 10.03 Pursuant to this Article 10, when the indemnified party receives notice of a claim or suit with respect to claims resulting from the assertion of liability by a third party for which indemnification is provided by this Section, the indemnified Party will promptly notify the indemnifying party and provide a copy of the claim notice, summons and complaint, or other relevant documents. The indemnified party shall cooperate fully with the defense of any such claim. The indemnifying party shall consult with the indemnified party concerning counsel retained. Should the parties fail to reach agreement on selection of counsel, the opinion of the indemnifying party shall govern the selection. The indemnifying party shall control the conduct of the litigation and of other proceedings. The indemnifying party shall instruct counsel to keep both parties apprised of the status of the proceedings by promptly reporting all significant developments and, in addition, by providing general status reports on a timely basis. With regard to any claim for which indemnification is sought hereunder, the parties shall mutually agree as to the acceptance of any settlement offer(s), or alternatively, the indemnifying party shall decide whatever action is to be taken regarding any settlement offer(s), provided, that, the indemnifying party in such case shall obtain the complete and written release of the indemnified Party with respect thereto. 10.04 As used in this Article 10, the terms "TPA" and "Client" shall include, respectively, the directors, officers, attorneys, employees, contractors, subcontractors, agents and other representatives of TPA or Client. 8. 9 10.05 This Article shall survive the termination of this Agreement. ARTICLE 11. ASSIGNMENT 11.01 This Agreement, including its benefits, duties and obligations, may not be assigned or otherwise transferred, whether voluntarily or involuntarily, by merger, consolidation, operation of law or otherwise, by TPA without the prior written consent of the Client. In the event of such assignment or transfer without such consent, Client may elect in its sole discretion, to terminate this Agreement upon giving written notice thereof, without waiving any remedies it may otherwise have at law, equity or under this Agreement. 11.02 This Agreement, including its benefits, duties and obligations, may not be assigned or otherwise transferred, whether voluntarily or involuntarily, by merger, consolidation, operation of law or otherwise, by Client without the prior written consent of the TPA. In the event of such assignment or transfer without such consent, TPA may elect in its sole discretion, to terminate this Agreement upon giving written notice thereof, without waiving any remedies it may otherwise have at law, equity or under this Agreement. 11.03 For purposes of these paragraphs 11.01 and 11.02 above, transfer (by one or more transfers) in the aggregate of 51% or more of the issued and outstanding shares of common stock of the assigning party, shall be deemed an assignment thereunder; provided however, that any transfer of stock by TPA to an affiliate of the Zurich Insurance Company shall not be deemed to be as assignment hereunder. ARTICLE 12. TERMINATION OF CONTRACT 12.01 This Agreement may be terminated by either party upon thirty (30) days written notice to the other party if such party fails to perform or observe in any material respect, or commits a material breach of, any material provision of this Agreement and such failure or breach has not been cured to the reasonable satisfaction of the other party within thirty (30) days after written notice thereof. 12.02 Material breach pursuant to section 12.01 may be, but is not limited to, a failure to comply with any of the provisions enumerated in Articles 3, 4, 5, 6, 7, 8, 9, 10 and 11. ARTICLE 13. ENTIRE AGREEMENT 13.01 This Agreement supersedes any and all agreements, either oral or written between the parties and contains all of the representations, covenants, and agreements between the parties with respect to the rendering of the Services specified in the Agreement. Each party acknowledges that no representations, promises, agreements, orally or otherwise, have been made by any party, or anyone acting on behalf of any party, which are not contained in this Agreement; and that no agreement, statement or promise not contained in this Agreement will be valid or binding. 13.02 Any modification of this Agreement will be effective only if it is in writing signed by the party to be charged. 9. 10 13.03 Any renewal of the Agreement may be subject to further negotiations between the parties if there is a material change in circumstances. ARTICLE 14. PARTIAL INVALIDITY AND CONTRACT INTERPRETATION 14.01 If any provision is held to be invalid by a court of competent jurisdiction, the remaining provisions will continue in full force and effect without being impaired or invalidated in any way. 14.02 This Agreement shall be interpreted and construed in accordance with the laws of the State of California. 14.03 The failure of any party to enforce any of the provisions herein shall not be construed as a waiver of the right to enforce any such provision. ARTICLE 15. DISPUTE RESOLUTION PROCEDURE 15.01 NEGOTIATION. In the event of any dispute, claim, question, or disagreement arising out of or relating to this Agreement or the breach thereof, the parties hereto shall use their best efforts to settle such disputes, claims, questions, or disagreement. To this effect, they shall consult and negotiate with each other, in good faith and, recognizing their mutual interests, attempt to reach a just and equitable solution satisfactory to both parties. 15.02 MEDIATION. If a dispute arises out of or relates to this Agreement, or the breach thereof, and if said dispute cannot be settled through direct discussions, the parties agree to first endeavor to settle the dispute in an amicable manner by mediation administered by a mediator mutually agreeable to all parties, before resorting to arbitration. 15.03 ARBITRATION. Thereafter, any unresolved controversy or claim arising out of or relating to this Agreement, or breach thereof, shall be settled by arbitration administered by and in accordance with the provisions of California Code of Civil Procedure Sections 1280 et seq., and judgment upon the Award rendered by the arbitrator(s) may be entered in any court having jurisdiction thereof. (a) The arbitration shall be held in Los Angeles, California or at such other place as may be selected by mutual agreement. (b) Within fifteen (15) days after the demand for commencement of arbitration, each party shall select one person to act as arbitrator, and the two selected shall select a third arbitrator within ten (10) days of their appointment who will act as sole arbitrator of the dispute. If the arbitrators selected by the parties are unable or fail to agree upon the third arbitrator, the third arbitrator shall be appointed by a Superior Court judge pursuant to California Code of Civil Procedure Section 1281.6 on petition of a party to the arbitration agreement. (c) The arbitrator will be selected from a panel of persons having experience with and knowledge of workers' compensation insurance and the workers' compensation insurance industry. (d) The arbitrator shall have the authority to award any remedy or relief that a court of this state could order or grant including, without limitation, specific performance of any obligation created 10. 11 under the agreement, the awarding of punitive damages, the issuance of an injunction, or the imposition of sanctions for abuse or frustration of the arbitration process. (e) The arbitrators shall award to the prevailing party, if any, as determined by the arbitrators, all of its costs and fees. "Costs and fees" means all reasonable pre-award expenses of the arbitration, including the arbitrators' fees, administrative fees, travel expense, out-of-pocket expenses such as copying and telephone, court costs, witness fees and attorneys' fees. (f) Neither party nor the arbitrators may disclose the existence, content, or results of any arbitration hereunder without the prior written consent of both parties. (g) Limited civil discovery shall be permitted for the production of documents and taking of depositions. All discovery shall be governed by the California Rules of Civil Procedure. All issues regarding conformation with discovery requests shall be decided by the arbitrators. (h) The arbitration award shall be in writing and shall specify the factual and legal bases for the award. (i) Within twenty (20) days after receipt of the Notice of Decision by the Arbitrator, either party may appeal the arbitration panel's award to an appellate arbitrator by filing a written Notice of Appeal served on the opposing party and the Arbitrator. (j) Within fifteen (15) days after Notice of Appeal, each party shall select one person to act as appellate arbitrator, and the two selected shall select a third appellate arbitrator within ten (10) days of their appointment who will act as sole arbitrator of the dispute. If the arbitrators selected by the parties are unable or fail to agree upon the third appellate arbitrator, the third arbitrator shall be appointed by a Superior Court judge pursuant to California Code of Civil Procedure section 1281.6 on petition of a party to the Arbitration agreement. (k) The Appellate Arbitrator shall be a retired judge of a court of record in the state in which the arbitration was held. (l) Within twenty (20) days after selection of an Appellate Arbitrator, a written brief, not to exceed twenty (20) pages stating the reasons why the panel's decision should be reversed or modified shall be filed with the Appellate Arbitrator and served to the opposing party. The opposing party shall file with the Appellate Arbitrator and serve on the appealing party within twenty (20) days after receiving the appeal brief, an opposition brief not to exceed twenty (20) pages. Either party may request oral argument which must be conducted within fourteen (14) days following the submission of the final brief. The appellate arbitration shall be based only on the record of the initial hearing and oral argument if any. The appellate arbitrator shall render a written decision affirming, reversing, modifying or remanding the arbitration panel's decision within thirty (30) days after receiving the final appellate submission. (m) The appellate arbitrator may reverse, modify or remand the matter for further proceeding by the arbitration panel only on one of the following grounds: 1. Any ground specified in 901 et. seq. of the California Code of Civil Procedure; 2. If the award contains material errors of applicable law; 11. 12 3. If the award is arbitrary or capricious; 4. If there is a demonstration of bias, prejudice or undisclosed conflict of interest between the arbitrator and the prevailing party. (n) The appellate arbitrator may render a final decision on appeal or remand the matter for further proceedings by the arbitration panel (o) The arbitrators shall award to the prevailing party, if any, as determined by the arbitrators, all of its costs and fees. "Costs and fees" means all reasonable pre-award expenses of the arbitration, including the arbitrators' fees, administrative fees, travel expenses, out-of--pocket expenses such as copying and telephone, court costs, witness fees and attorneys' fees. CLIENT: SUPERIOR NATIONAL INSURANCE COMPANY a California Corporation By: /s/ J. CHRIS SEAMAN --------------------------------- Name: J. Chris Seaman Title: Date: 3/18/98 --------------------------------- TPA: RISK ENTERPRISE MANAGEMENT LIMITED By: /s/ MICHAEL RINEY --------------------------------- Name: Michael Riney --------------------------------- Title: Executive Vice President --------------------------------- Date: 3/19/98 --------------------------------- EX-10.54 3 AVERAGE EXISTING CLAIM SEVERITY AGREEMENT 1 EXHIBIT 10.54 AVERAGE EXISTING CLAIM SEVERITY AGREEMENT Effective: December 31, 1997 Parties: Zurich Reinsurance (North America), Inc., a Connecticut domiciled company ("Zurich Re") and Superior National Insurance Company and Superior Pacific Casualty Company, each a California domiciled company (hereinafter individually or collectively "Superior") Coverage: Claims arising under Superior's Policies occurring prior to January 1, 1998 and closing subsequent to December 31, 1997. Term: Continuous, effective 11:59 A.M., Standard Time, December 31, 1997 until terminated by either party in accordance with the provisions herein. "Standard Time" shall be defined in accordance with the original Policies. Territory: As per the original Policies. Exclusions: 1. Claims which Superior has fully and finally settled and paid prior to January 1, 1998. 2. Claims for which Superior has determined the final settlement amount but which have not been fully and finally closed prior to January 1, 1998. Protection Amounts: To pay up to $4,166 each Average Covered Existing Claim in excess of $39,912 each Average Covered Existing Claim, but not to exceed $30,000,000 in the aggregate for all Average Covered Existing Claims during the entire term of this Agreement. Consideration: $100,000 shall be payable on the date that this Agreement is executed. Termination: This Agreement may be terminated by mutual agreement of the parties. Further, this Agreement may also be terminated in accordance with the Special Termination Article, attached hereto. Termination shall constitute a complete and final release of Zurich Re in respect of any and all of its obligations of any nature whatsoever to Superior under or related to this Agreement. 2 SPECIAL CONDITIONS: 1. In the event that Superior enters into any transaction, agreement or commitment regarding structured settlements or other similar arrangements or purchases insurance or reinsurance that materially affects the payout patterns of claims, as contemplated by Zurich Re (any of the foregoing transactions, agreements or commitments individually or collectively referred to as the "Transaction"), any such Transaction shall have no effect whatsoever in determining the liability of Zurich Re as respects the calculation of Average Covered Existing Claims. 2. Superior shall not materially change its underwriting and claims administration practices, policies and procedures in place at the inception of this Agreement without Zurich Re's prior written consent. 3. Superior hereby acknowledges that it has entered into a claims/medical management and administration services agreement with Risk Enterprise Management Limited to provide such services for Superior's claims arising under its Policies, and this Agreement is contingent upon the continuation of the agreement with Risk Enterprise Management Limited. DEFINITIONS: 1. "Covered Existing Claim" shall mean any claim for indemnity, including claims for medical expense and/or allocated loss adjustment expense, under Superior's Policies which occurs prior to January 1, 1998 and which closes subsequent to December 31, 1997. 2. "Average Covered Existing Claim" shall be determined by the fraction whose numerator is the total amount paid by Superior in respect of all Covered Existing Claims during the term of this Agreement, after the deduction of recoveries by Superior from any reinsurance applicable to such Covered Existing Claims, whether or not such amount is actually recoverable. For purposes of this calculation, the maximum amount of any one Covered Existing Claim shall not exceed $500,000, before the deduction of any inuring reinsurance and regardless of the number of claimants, insureds, policies or risks involved in an occurrence giving rise to a Covered Existing Claim; and whose denominator is the greater of: (i) 70,089; or (ii) the actual number of ultimate Covered Existing Claims paid by Superior during the term of this Agreement; less 62,888. Notwithstanding anything to the contrary herein, Covered Existing Claims under this Agreement shall be not be recoverable from Zurich Re until the amount of Superior's ultimate Average Covered Existing Claims are known and fully and finally determined. 3. "Policy" shall mean all policies, binders, contracts or certificates of insurance written and classified by Superior as workers' compensation, including employers' liability. 3 General Provisions: Access to Records (as per clause attached) Arbitration (Venue: New York, New York) Errors and Omissions Insolvency Salvage and Subrogation (as per clause attached) Offset (as per clause attached) Overdue Payments (as per clause attached) Special Termination (as per clause attached) No Third Party Rights Signed in New York, New York For and on behalf of Zurich Reinsurance (North America), Inc. Signed by: /s/ [illegible] ---------------------------------- Signed in Calabasas, CA For and on behalf of Superior National Insurance Company Superior Pacific Casualty Company Signed by: /s/ [illegible] ---------------------------------- 4 OFFSET Zurich Re and Superior may offset at any time or from time to time any balances or amounts due from one party to the other under this Agreement or any other contract heretofore or hereafter entered into between said parties whether acting as assuming or ceding insurer or otherwise. The offset rights as set forth above shall not be contingent upon the exercise of such rights or affected in any manner whatsoever by the insolvency of any party to this Agreement. 5 ACCESS TO RECORDS Zurich Re or its designated representatives shall have access, at any reasonable time during the currency of this Agreement and at any time thereafter, to all records of Superior which pertain in any way to this Agreement. 6 SALVAGE AND SUBROGATION Zurich Re shall be credited with its proportionate share of salvage or subrogation recoveries on account of claims or settlements involving the protection hereunder. Salvage or subrogation recoveries shall mean reimbursement obtained or recovery made by Superior, less the actual cost, excluding salaries of officials and employees of Superior, of obtaining such reimbursement or making such recovery. 7 OVERDUE PAYMENTS Interest rate as determined by the one year United States Treasury Bill, (as quoted in the Wall Street Journal on the first business day of the month for which the calculation is made) plus 1% per month, as calculated on a daily basis, shall be payable by Superior or Zurich Re on any consideration or claims unpaid more than fifteen (15) days after the dates provided for herein. 8 SPECIAL TERMINATION This Agreement may be terminated in the event that: a. Any legal authority orders Superior or Zurich Re to cease writing business. b. The Employment status of J. Chris Seaman, Executive Vice President & Chief Financial Officer or William Gentz, President & Chief Executive Officer of Superior have materially and adversely changed in any manner whether by reassignment, relocation, termination or otherwise and whether for cause or otherwise. c. Superior's surplus falls below 200% of the required amount of Risk Based Capital in accordance with the Company Action Level, as defined by the National Association of Insurance Commissioners. d. The agreement with Risk Enterprise Management Limited to provide claims/medical management and administration services is not continued. As respects the events set forth above, the non-breaching party shall have the right to terminate this Agreement by giving not less than thirty (30) days notice of its intention to do so. Any notice of termination pursuant to the foregoing provisions above shall be sent by certified mail return receipt requested. Such notice period shall commence upon the date that such notice of termination was dispatched. EX-10.55 4 LEASE BETWEEN PROPERTY CALIFORNIA OB ONE & SNIC 1 EXHIBIT 10.55 DIABLO CENTER OFFICE LEASE between PROPERTY CALIFORNIA OB ONE CORPORATION ("LANDLORD") and SUPERIOR NATIONAL INSURANCE COMPANY ("TENANT") 2 TABLE OF CONTENTS 1. USE....................................................................... 1 2. TERM...................................................................... 2 3. POSSESSION................................................................ 3 4. RENT...................................................................... 3 5. RULES AND REGULATIONS..................................................... 5 6. PARKING................................................................... 6 7. EXPENSES OF OPERATION, MANAGEMENT, AND MAINTENANCE........................ 6 8. REPAIR AND MAINTENANCE.................................................... 11 9. ACCEPTANCE AND SURRENDER OF PREMISES...................................... 11 10. ALTERATIONS AND ADDITIONS................................................. 12 11. UTILITIES AND SERVICES.................................................... 13 12. TAXES..................................................................... 13 13. LIABILITY INSURANCE....................................................... 15 14. TENANT'S PERSONAL PROPERTY INSURANCE AND WORKER'S COMPENSATION INSURANCE.................................................... 16 15. PROPERTY INSURANCE........................................................ 16 16. INDEMNIFICATION........................................................... 17 17. COMPLIANCE................................................................ 17 18. LIENS..................................................................... 17 19. ASSIGNMENT AND SUBLETTING................................................. 18 20. SUBORDINATION AND MORTGAGES............................................... 19 21. ENTRY BY LANDLORD ........................................................ 19
i 3 22. BANKRUPTCY AND DEFAULT.................................................... 19 23. ABANDONMENT............................................................... 22 24. DESTRUCTION .............................................................. 22 25. EMINENT DOMAIN............................................................ 23 26. SALE OR CONVEYANCE BY LANDLORD............................................ 24 27. ATTORNMENT TO LENDER OR THIRD PARTY....................................... 24 28. HOLDING OVER.............................................................. 24 29. CERTIFICATE OF ESTOPPEL................................................... 24 30. CONSTRUCTION CHANGES...................................................... 25 31. RIGHT OF LANDLORD TO PERFORM.............................................. 25 32. ATTORNEYS' FEES........................................................... 25 33. WAIVER.................................................................... 26 34. NOTICES................................................................... 26 35. EXAMINATION OF LEASE...................................................... 26 36. DEFAULT BY LANDLORD....................................................... 26 37. CORPORATE AUTHORITY....................................................... 27 38. LIMITATION OF LIABILITY................................................... 27 39. BROKERS................................................................... 28 40. SIGNS..................................................................... 28 41. ASSESSMENTS............................................................... 28 42. MORTGAGEE PROTECTION CLAUSE............................................... 29 43. HAZARDOUS MATERIALS....................................................... 29
ii 4 44. MISCELLANEOUS AND GENERAL PROVISIONS...................................... 30 45. LEASE OPTION TO EXTEND.................................................... 31 46. LEASE OPTION TO EXPAND.................................................... 33 47. LEASE OPTION TO TERMINATE................................................. 33
iii 5 TABLE OF EXHIBITS Exhibit A The Premises Exhibit B The Property Exhibit C Work Letter Exhibit D Rules and Regulations Exhibit E Reserved Spaces iv 6 LEASE AGREEMENT This Lease is made this ____ day of ________________ 1997, by and between PROPERTY CALIFORNIA OB ONE CORPORATION, an Oregon corporation ("Landlord"), and SUPERIOR NATIONAL INSURANCE COMPANY, a California corporation ("Tenant"). WITNESSETH: Landlord hereby leases to Tenant and Tenant hereby hires and takes from Landlord those certain premises (the "Premises") cross-hatched on Exhibit A more particularly described as follows: Approximately 21,000 rentable square feet on the ground floor of the building ("Building") located at 5775 West Las Positas, Pleasanton, California, consisting of a total area of approximately Thirty-Nine Thousand Three Hundred Six (39,306) rentable square feet together with the non-exclusive right to use the Common Area of the Building and the Outside Area of the Property. As used herein, the term "Property" shall mean the land shown on Exhibit B and all of the buildings, improvements, fixtures and equipment now or hereafter situated on said land, commonly known as "Diablo Center". The Property is part of a larger group of land, buildings and improvements referred to as "Hacienda Business Park" or the "Park". "Rentable square feet" as used in this Lease refers to an area calculated in accordance with the BOMA method for measuring the Building. Within 60 days of the Commencement Date, as defined herein, the Premises shall be remeasured and this Lease shall be amended by restatement to reflect. the rentable square feet determined by such remeasurement, including changes to the Basic Rent, parking spaces, Tenant's Building Percentage, and Tenant's Property Percentage. Landlord agrees to construct the Tenant Improvements set forth in the Work Letter (the "Work Letter") attached hereto as Exhibit C, and upon such terms and conditions as set forth in the Work Letter. Said leasing and hiring is upon and subject to the terms, covenants and conditions hereinafter set forth and Tenant covenants as a material part of the consideration for this Lease to perform and observe each and all of said terms, covenants and conditions. This Lease is made upon the condition of such performance and observance. 1. USE. Tenant shall use the Premises only in conformance with applicable governmental laws, regulations, rules and ordinances for the purpose of general office use and for no other purpose. Tenant shall not do or permit to be done in or about the Premises or the Property, nor bring or keep or permit to be brought or kept in or about the Premises or the Property, anything which is prohibited by or will in any way increase the existing rate, or cause a cancellation of, fire or any other insurance covering the Property or any of its contents. Tenant shall not do or permit to be done anything in, on or about the Premises or the Property which will in any way obstruct or interfere with the rights of other tenants or occupants of the Building or injure or annoy them, or 1 7 use or allow the Premises to be used for any improper, immoral, unlawful or objectionable purpose, nor shall Tenant cause, maintain or permit any nuisance in, on or about the Premises or the Property. No sale by auction shall be permitted on the Premises. Tenant shall not place any loads upon the floors, walls, or ceiling, which endanger the structure, or place any harmful fluids or other materials in the drainage system of the Building, or overload existing electrical or other mechanical systems. No waste materials or refuse shall be dumped upon or permitted to remain upon any part of the Premises or outside of the Building, except in trash containers placed inside exterior enclosures designated by Landlord for that purpose or inside of the Building where designated by Landlord. No materials, supplies, equipment, finished products or semifinished products, raw materials or articles of any nature shall be stored upon or permitted to remain outside the Premises or on any portion of the Outside Area of the Property. No loudspeaker or other device, system or apparatus which can be heard outside the Premises shall be used in or at the Premises without the prior written consent of Landlord. Tenant shall not commit or suffer to be committed any waste in or upon the Premises. Tenant shall indemnify, defend and hold Landlord harmless against any loss, expense, damage, attorneys' fees, or liability arising out of failure of Tenant to comply with any law applicable to Tenant or Tenant's business. The provisions of this paragraph are for the benefit of Landlord only and shall not be construed to be for the benefit of any tenant or occupant of the Building. Tenant acknowledges that it has received and read a copy of the Declaration of Covenants, Conditions and Restrictions for Hacienda Business Park (No. 2) recorded January 24, 1985 as Instrument No. 85-14396, Official Records of Alameda County, California (the "CC&R's"). Tenant shall comply with the CC&R's. Tenant's initials: _____________ 2. TERM. A. The term of this Lease shall be for a period of approximately five (5) years (unless sooner terminated as hereinafter provided) beginning on the Commencement Date, as defined below, and ending on the day before the fifth (5) anniversary of the Commencement Date. B. Possession of the Premises shall be deemed tendered and the term of this Lease shall commence on the date ("Commencement Date") which is the earlier of. (i) Three business days after certification by Landlord's architect or contractor that the Tenant Improvements have been substantially completed; or (ii) The first day that the Premises are occupied for business by Tenant. Upon determination of the Commencement Date Landlord and Tenant shall execute a commencement date memorandum. Tenant shall have the right to enter the Premises prior to the Commencement Date for the purpose of installing telecommunications and data cabling, and for delivery and installation of its furniture, fixtures, and equipment, provided that such installation and delivery shall not interfere with the construction of the Tenant Improvements. 2 8 3. POSSESSION. If Landlord, for any reason whatsoever, cannot deliver possession of the Premises to Tenant by the anticipated Commencement Date, this Lease shall not be void or voidable, no obligation of Tenant shall be affected thereby; nor shall Landlord or Landlord's agents be liable to Tenant for any loss or damage resulting therefrom; but in that event the commencement and termination dates of this Lease, and all other dates affected thereby shall be revised to conform to the date of Landlord's delivery of possession, as specified in Paragraph 2.B above. The above is, however, subject to the provision that the period of delay of delivery of the Premises shall not exceed ninety (90) days from the anticipated Commencement Date (except those delays caused by Tenant (as defined in the Work Letter), acts of God, strikes, war, lack of utilities, weather, unavailable materials, delays caused solely by governmental bodies, and other delays beyond Landlord's control shall be excluded in calculating such period), in which instance Tenant, at its option, may by written notice to Landlord terminate this Lease. Notwithstanding anything contained herein, if the Commencement Date does not occur by January 31, 1997 for reasons other than delays caused by Tenant, Tenant shall be entitled to one day of free rent for every one day of delay beyond the such date. 4. RENT. A. BASIC RENT. Tenant agrees to pay to Landlord at such place as Landlord may designate without deduction, offset, prior notice, or demand, and Landlord agrees to accept as Basic Rent for the leased Premises in lawful money of the United States of America, payable as follows:
Months of Term Monthly Basic Rent -------------- ------------------- 1-24 $32,130.00 ($1.53 square foot) 25-36 $34,230.00 ($1.63 square foot) 37-60 $36,330.00 ($1.73 square foot)
B. TIME FOR PAYMENT. Within five (5) business days of the execution of this Lease, Tenant shall pay to Landlord the Basic Rent due for the first month of the term in the amount of $32,130.00 Thereafter, Basic Rent shall be due on or before the first day of each calendar month of the term. If the term of this Lease commences on a date other than the first day of a calendar month, on the Commencement Date, Tenant shall pay to Landlord as rent for the period from the Commencement Date to the first day of the next succeeding calendar month that proportion of the monthly rent hereunder which the number of days between the Commencement Date and the first day of the next succeeding calendar month bears to thirty (30). If the term of this Lease ends on a date other than the last day of a calendar month, on the first day of the last calendar month of the term hereof Tenant shall pay to Landlord as rent for the period from said first day of said last calendar month to and including the last day of the term hereof that proportion of the monthly rent hereunder which the number of days between said first day of said last calendar month and the last day of the term hereof bears to thirty (30). C. LATE CHARGE. Notwithstanding any other provision of this Lease, if Tenant fails to pay any Rent when due, and such Rent is not received by Landlord within ten (10) days after the date such Rent is due, Tenant shall pay to Landlord, in addition to the delinquent Rent, a late 3 9 charge equal to ten percent (10%) of the delinquent Rent. In addition to the foregoing late charge, if any Rent remains unpaid for 30 days or more after the date due, such Rent shall accrue interest at the rate of ten percent (10%) per annum until paid. D. ADDITIONAL RENT. Tenant shall pay to Landlord in addition to the Basic Rent and as Additional Rent the following: (a) Tenant's Building Percentage of Building Operating Expenses and Tenant's Property Percentage of Outside Area Expenses; and (b) All other charges, costs and expenses which Tenant is required to pay hereunder, together with all interest and penalties, costs and expenses, including attorneys' fees and legal expenses, that may accrue thereto in the event of Tenant's failure to pay such amounts. And all damages, reasonable costs and expenses which Landlord may incur by reason of default of Tenant or failure on Tenant's part to comply with the terms of this Lease. In the event of nonpayment by Tenant of Additional Rent, Landlord shall have all the rights and remedies with respect thereto as Landlord has for nonpayment of Rent, as defined below. The Additional Rent due under Paragraph 7 shall be paid to Landlord or Landlord's agent in accordance with Paragraph 7. The Additional Rent for any item payable under a provision other than Paragraph 7 shall be paid to Landlord or Landlord's agent within twenty (20) days after receipt of an invoice to Tenant setting forth the Additional Rent due. If requested, Landlord shall provide reasonable supporting documentation for the Additional Rent. The respective obligations of Landlord and Tenant under this paragraph shall survive the expiration or other termination of the term of this Lease. As used herein, Rent shall mean Basic Rent plus Additional Rent. E. PLACE OF PAYMENT OF RENT. All Rent hereunder shall be paid to Landlord at the office of Landlord, c/o R & B Commercial Real Estate Services, Inc., 4637 Chabot Drive, Suite 100, Pleasanton, CA 94588, or to such other person or to such other place as Landlord may from time to time designate in writing. F. SECURITY DEPOSIT. Concurrently with Tenant's execution of this Lease, Tenant shall deposit with Landlord the sum of Thirty-Six Thousand Three Hundred Thirty and no/100s Dollars ($36,330). Said sum shall be held by Landlord as a Security Deposit for the faithful performance by Tenant of all of the terms, covenants and conditions of this Lease to be kept and performed by Tenant during the term hereof. Twelve months from the Commencement Date, provided Tenant is not in default, Tenant may provide Landlord with financial statements and Landlord agrees to review such statements to determine whether, in Landlord's sole discretion, the Security Deposit may be returned to Tenant. In the event that Tenant has paid all Rent when due from execution of this Lease through the 24th month from the Commencement Date and Tenant is not in default hereunder, Landlord agrees to return the Security Deposit, or any balance thereof, to Tenant. If Tenant defaults with respect to any provision of this Lease, including, but not limited to, the provision relating to the payment of rent and any of the monetary sums due 4 10 herewith, Landlord may (but shall not be required to) use, apply or retain all or any part of this Security Deposit for the payment of any rent or other sum in default, the repair of any damage to the Premises caused by Tenant, or the payment of any other amount which Landlord may spend or become obligated to spend by reason of Tenant's default or to compensate Landlord for any other loss or damage which Landlord may suffer by reason of Tenant's default to the full extent permitted by law. Tenant hereby waives any restriction on the use or application of the Security Deposit by Landlord as set forth in California Civil Code Section 1950.7. If any portion of the Security Deposit is used or applied, Tenant shall, within ten (10) days after written demand therefor, deposit cash with Landlord in the amount sufficient to restore the Security Deposit to its original amount. Tenant's failure to do so shall be a material breach of this Lease. Landlord shall not be required to keep this Security Deposit separate from its general funds, and Tenant shall not be entitled to interest on the Security Deposit. If Tenant fully and faithfully performs every provision of this Lease to be performed by it, the Security Deposit or any balance of it shall be returned to Tenant (or at Landlord's option, to the last assignee of Tenant's interest hereunder) at the expiration of the Least term and after Tenant has vacated the Premises. In the event of termination of Landlord's interest in this Lease, Landlord shall transfer the Security Deposit to Landlord's successor-in-interest whereupon Tenant agrees to release Landlord from liability for the return of the Security Deposit or the accounting therefor. 5. RULES AND REGULATIONS. Subject to the terms and conditions of this Lease and such rules and regulations as Landlord may from time to time prescribe, Tenant and Tenant's employees, invitees and customers shall, in common with other occupants of the Building, and their respective employees, invitees and customers, and others entitled to the use thereof, have the non-exclusive right to use the access roads, parking areas, and facilities provided and designated by Landlord for the general use and convenience of the occupants of the Property, which areas and facilities and all other landscaped areas, service areas, trash disposal facilities and similar areas and facilities within the Property are referred to herein as the "Outside Area". This right shall terminate upon the termination of this Lease. Landlord reserves the right from time to time to make changes in the shape, size, location, amount and extent of Outside Area. Landlord further reserves the right to promulgate such reasonable rules and regulations, and amendments thereto, relating to the use of the Outside Area, and any part or parts thereof, as Landlord may deem appropriate for the best interests of the occupants of the Property. The use of the Building and the Outside Area shall initially be subject to the Rules and Regulations attached hereto as Exhibit D. The Rules and Regulations shall be binding upon Tenant upon delivery of a copy of them to Tenant, and Tenant shall abide by them and cooperate in their observance. Such Rules and Regulations may be amended by Landlord from time to time, with or without advance notice, and all amendments shall be effective upon delivery of a copy to Tenant. Landlord shall not be responsible to Tenant for the nonperformance by any other tenant or occupant of the Property of any of said Rules and Regulations. In the event that the Rules and Regulations are changed by Landlord subsequent to the execution of this Lease and there is a conflict between this Lease and the Rules and Regulations, this Lease shall govern. 6. PARKING. Tenant shall have the right to use with other tenants or occupants of the Building parking spaces, the number of which shall be based on a ratio of 3.5 spaces per 1,000 square feet of leased premises in the common parking area of the Property, five of which shall be 5 11 designated, reserved stalls in reasonable proximity to the Premises and shown on the attached Exhibit E (the "Reserved Spaces"), and Tenant and Tenant's employees, customers, and other invitees shall have exclusive use of such spaces. Tenant's parking spaces shall be provided without charge by Landlord. Any parking charges assessed or imposed by the City of Pleasanton or other governmental entity shall be billed to Tenant as an Outside Area Expense pursuant to Paragraph 7.F. Tenant agrees that Tenant, Tenant's employees, agents, representatives and invitees shall not use parking spaces in excess of the spaces allocated to Tenant hereunder. Landlord shall have the right, at Landlord's sole discretion, to specifically designate the location of Tenant's parking spaces within the common parking areas of the Property in the event of a dispute among the tenants occupying the Building, in which event Tenant agrees that Tenant, Tenant's employees, agents, representatives and/or invitees shall not use any parking spaces other than those parking spaces specifically designated by Landlord for Tenant's use. Said parking spaces, if specifically designated by Landlord to Tenant, may be relocated by Landlord at any time and from time to time. Landlord reserves the right, at Landlord's sole discretion, to rescind any specific designation of parking spaces, thereby returning Tenant's parking spaces to the common parking area; provided that Landlord shall not rescind Tenant's right to the Reserved Spaces but may relocate the Reserved Spaces as provided herein within reasonable proximity to the existing Reserved Spaces. Landlord shall give Tenant reasonable prior written notice of any change in Tenant's parking spaces. Tenant shall not, at any time, park, or permit to be parked, any trucks or vehicles adjacent to the loading areas so as to interfere in any way with the use of such areas, nor shall Tenant at any time park, or permit the parking of Tenant's trucks or vehicles or the trucks and vehicles of Tenant's suppliers or others, in any portion of the Outside Area not designated by Landlord for such use by Tenant. Tenant shall not park nor permit to be parked, any inoperative vehicles or equipment on any portion of the Outside Area. Tenant agrees to assume responsibility for compliance by its employees with the parking provisions contained herein. If Tenant or its employees park in other than such designated parking areas, then Landlord may charge Tenant, as an additional charge, and Tenant agrees to pay, Ten and no/100ths Dollars ($10.00) per day for each day or partial day each such vehicle is parked in any area other than that designated after prior notice. Tenant hereby authorizes Landlord at Tenant's sole expense to tow away from the Property any vehicle belonging to Tenant or Tenant's employees parked in violation of these provisions, or to attach violation stickers or notices to such vehicles. Tenant shall use the parking areas for vehicle parking only, and shall not use the parking areas for storage. 7. EXPENSES OF OPERATION, MANAGEMENT, AND MAINTENANCE. A. OUTSIDE AREA/COMMON AREA. The term "Outside Area" shall mean all areas and facilities within the Property provided and designated by Landlord for the general use and convenience of Tenant and other tenants and occupants of the Property such as access roads, parking areas, sidewalks, landscaped area, service areas, trash disposal facilities, and similar areas and facilities. The term "Common Area" shall refer to those portions of the Building designated by Landlord for the general use and convenience of all tenants of the Building, such as hallways, stairs, elevators, entrances and exits, lobbies, restrooms, the common pipes, wires and appurtenant equipment serving the Building. 6 12 B. TENANT'S PERCENTAGE. The term "Tenant's Building Percentage" shall mean the percentage of the rentable area of the Premises to the total rentable area of the Building. Tenant's Building Percentage is agreed to be Fifty-Three and 43/100ths percent (53.43%) for purposes of this Lease. The total rentable area of the Building is Thirty-Nine Thousand Three Hundred Six) (39,306) square feet. The term "Tenant's Property Percentage" shall mean the percentage of the rentable area of the Premises to the total rentable area of all buildings on the Property. Tenant's Property Percentage is agreed to be Seventeen and 59/100ths percent (17.59%) for purposes of this Lease. The total rentable area of the Property is approximately One Hundred Nineteen Thousand, Four Hundred Three (119,403) square feet. C. PAYMENT BY TENANT. Commencing on January 1, 1999, Tenant shall pay to Landlord, as Additional Rent, Tenant's Building Percentage of the Building Operating Expenses and Tenant's Property Percentage Outside Area Expenses in excess of the Expense Base, as hereinafter defined. D. BUILDING OPERATING EXPENSES. The term "Building Operating Expenses" shall mean all expenses, costs and disbursements (but not capital investment items, except as provided in subparagraph (ix) below, or specific costs especially billed to and paid by specific tenants) of every kind and nature which Landlord shall pay or become obligated to pay because of or in connection with the ownership, management, maintenance, repair and operation of the Building and the Common Area, including, but not limited to, the following: (i) Wages and salaries of all employees engaged in the operation, maintenance and security of the Building and Common Area, including taxes, insurance and benefits relating thereto; and the rental cost and overhead of any office and storage space in the Park used to provide such services; (ii) Cost of all supplies, materials and labor used in the operation, repair, replacement and maintenance of the Building and Common Area; (iii) Cost of all utilities, including surcharges, which are not paid directly by Tenant for the Building and Common Area, including the cost of water, sewer, gas, power, heating, lighting, air conditioning and ventilating; (iv) Cost of all maintenance and service agreements for services not paid directly by Tenant the Building and Common Area and the equipment thereon, including but not limited to, security and energy management services, window cleaning, floor waxing, elevator maintenance, janitorial service, services by engineers and gardeners, and trash removal services; (v) Cost of all insurance which Landlord or Landlord's lender deems necessary for the Building and Common Area such as the cost of "All-Risk" property insurance, including, at Landlord's option, flood coverage, insurance against loss of rents on an "All-Risk" basis, a lender's loss payable endorsement in favor of Landlord's lender and naming Landlord and its subsidiaries, directors, agents, officers, partners and employees as named insureds; and casualty and liability insurance applicable to the Building and Landlord's personal property used in 7 13 connection therewith, naming Landlord and its subsidiaries, directors, agents, officers, partners and employees as additional insureds; (vi) Cost of repairs and general maintenance of the Building and Common Area (excluding repairs and general maintenance paid for by proceeds of insurance or by Tenant or other third parties); (vii) A reasonable management fee of four percent (4%) for the manager of the Building; (viii) The cost of any additional services not provided to the Building and Common Area at the Commencement Date but thereafter provided by Landlord in its management of the same; and (ix) The cost of any capital improvements made to the Building and the Common Area after the Commencement Date that reduce operating expenses, or are required under any governmental law or regulation that was not applicable to the Building at the Commencement Date, such cost thereof to be amortized over the useful life of the improvement, using a market rate of interest, as Landlord shall determine consistent with applicable governmental requirements. The cost of additional or extraordinary services provided to Tenant at Tenant's request and not paid or payable by Tenant pursuant to other provisions of this Lease shall be payable by Tenant and may be included by Landlord with Tenant's Building Percentage of Building Operating Expenses payable by Tenant on a monthly basis or may be billed to Tenant separately, in a lump sum, as Landlord shall elect. Building Operating Expenses shall not include (i) the cost of any additional or extraordinary services provided to other tenants of the Building or the cost of tenant improvements for other tenants in the Building; (ii) costs paid for directly by Tenant or any other tenant; (iii) principal and interest payments on loans secured by deeds of trust recorded against the Building; (iv) real estate sales or leasing brokerage commissions and other marketing costs; (v) capital improvements other than those specified in Paragraph 7.D(ix) above, (vi) any costs reimbursed by insurance or any third-party, (vii) Landlord's general corporate overhead and general administrative expenses and executive salaries of personnel employed by Landlord (not including the management fee referenced in Paragraph 7.D(vii) above) located outside of the Park, (viii) costs, fees, and other expenses arising from the presence or removal of any Hazardous Materials on the Property not brought to the Property by Tenant or Tenant's agents, representatives, or invitees, and (ix) taxes on utilities to the extent that Tenant has paid them directly, including through payment of a flat tax covering governmental services. Tenant agrees to cooperate with Landlord to obtain any exemption on such taxes that Landlord may be entitled to by virtue of Tenant's payment of such flat tax. E. OUTSIDE AREA EXPENSES. The term "Outside Area Expenses" shall mean all expenses, costs and disbursements (except as provided below) of every kind and nature which 8 14 Landlord shall pay or become obligated to pay because of or in connection with the ownership, management, maintenance, repair and operation of the Property and the Outside Area including, but not limited to, the cost of any policies of insurance covering the Outside Area, the Real Property Taxes for the Property, CC&R assessments and dues and the cost of labor, materials, supplies and services used or consumed in owning, managing, maintaining, repairing and operating the Outside Area, including, without limitation, the following: (i) Maintaining and repairing landscaping and sprinkler systems; (ii) Maintaining and repairing concrete walkways, driveways and paved parking areas; (iii) Maintaining and repairing electrical systems and signs and site lighting of the Outside Area; (iv) Providing all utilities to the Outside Areas, and all license, permit and inspection fees in connection therewith; and (v) The rental cost and overhead of any office and storage space in the Park used to provide such service. Outside Area Expenses shall not include: (i) the cost of any additional or extraordinary services provided to other tenants of the Property or the cost of tenant improvements for other tenants in the Property; (ii) costs paid for directly by Tenant or any other tenant; (iii) principal and interest payments on loans secured by deeds of trust recorded against the Property; (iv) real estate sales or leasing brokerage commissions and other marketing costs; (v) capital improvements other than those specified in Paragraph 7.D(ix) above, (vi) any costs reimbursed by insurance or any third-party, (vii) Landlord's general corporate overhead and general administrative expenses and executive salaries of personnel employed by Landlord (not including the management fee referenced in Paragraph 7.D(vii) above) located outside of the Park, (viii) costs, fees, and other expenses arising from the presence or removal of any Hazardous Materials on the Property not brought to the Property by Tenant or Tenant's agents, representatives, or invitees, and (ix) taxes on utilities to the extent that Tenant has paid them directly, including through payment of a flat tax covering governmental services. Tenant agrees to cooperate with Landlord to obtain any exemption on such taxes that Landlord may be entitled to by virtue of Tenant's payment of such flat tax. F. ADJUSTMENT. (i) Expense Base. The Basic Rent referred to in Paragraph 4.A shall include Tenant's Building Percentage of the actual Building Operating Expenses and Tenant's Property Percentage of the actual Outside Area Expenses for the calendar year 1998 (the "Expense Base"). Landlord currently maintains earthquake insurance and such insurance shall be included in the Expense Base. 9 15 (ii) Monthly Payments. Commencing January 1, 1999, Tenant shall pay to Landlord on the first day of each calendar month for the remainder of the term an amount estimated by Landlord to be Tenant's Building Percentage of the monthly Building Operating Expenses and Tenant's Property Percentage of the actual Outside Area Expenses (collectively, the "Expenses") in excess of the Expense Base. The Expenses shall be estimated in good faith by Landlord and Tenant shall be notified of Landlord's estimate at least thirty (30) days prior to the first day such payment is due, and thereafter at least thirty (30) days prior to the beginning of each calendar year. Such estimate may be adjusted by Landlord at the end of any calendar quarter on the basis of Landlord's experience and reasonably anticipated costs. Any such adjustment shall be effective as of the calendar month next succeeding receipt by Tenant of notice of such adjustment to the estimated Expenses; provided that, if such calendar month is earlier than 30 days from the date of such notice, the adjustment shall be effective the second calendar month. (iii) Accounting. If Tenant's Building Percentage of Building Operating Expenses or Tenant's Property Percentage of the actual Outside Area Expenses paid or incurred by Landlord for any calendar year exceeds the Expense Base, Tenant shall pay such excess as Additional Rent. Within one hundred twenty (120) days following the end of each calendar year, Landlord shall furnish Tenant a reasonably detailed statement of Tenant's Building Percentage of the actual Building Operating Expenses and Tenant's Property Percentage of the actual Outside Area Expenses (the "Actual Expenses") for the calendar year and the payments made by Tenant with respect to such period. If the statement furnished by Landlord shows that the amount paid by Tenant as Expenses was less than the Actual Expenses for each category, then Tenant shall pay to Landlord the deficiency within twenty (20) days after delivery of such statement. If the statement shows that the amount paid by Tenant as Expenses exceeded the Actual Expenses, then Landlord shall either offset the excess against the amount next thereafter to become due to Landlord, or shall refund the amount of the overpayment to Tenant, in cash, within twenty (20) days after delivery to Tenant of such statement, as Landlord shall elect. In the event of Tenant's overpayment of Tenant's Percentage of Actual Expenses for the last calendar year of this Lease, Landlord shall refund in cash the amount of the overpayment to Tenant, within twenty (20) days of delivery of such statement to Tenant. All statements provided by Landlord and all determinations of costs and charges that Tenant is required to pay pursuant to this Lease shall be computed in accordance with generally accepted accounting principles consistently applied. (iv) Proration. Tenant's obligation to pay the Expenses shall be prorated on the basis of a three hundred sixty-five (365) day year to account for any fractional portion of a calendar year included at the commencement or expiration of the term of this Lease or for any fractional portion of a calendar year in which Tenant is not liable for payment of Expenses in excess of the Expense Base. (v) Audit. Tenant at its expense shall have the right at all reasonable times and upon reasonable notice to Landlord to audit Landlord's books and records relating to Tenant's obligations to pay Additional Rent for any year of the term of this Lease, provided that Landlord shall not be obligated to retain its books and records for any year for more than three (3) years. If any statement of Additional Rent previously furnished Tenant reflects greater than one hundred 10 16 five percent (105%) of actual Additional Rent expenses shown by such audit, Landlord shall pay the reasonable cost of such audit, up to five hundred dollars ($500). (vi) Survival. Provided that Tenant is furnished a statement in accordance with Paragraph 7.F(iii), Tenant's obligations to pay for any increase above the Expenses paid pursuant to this Paragraph 7.A shall survive any termination of this Lease. Landlord's obligations to refund any excess amounts paid above the Actual Expenses pursuant to this Paragraph 7.A shall survive any termination of this Lease. 8. REPAIR AND MAINTENANCE. A. LANDLORD'S OBLIGATIONS. (i) Building and Common Area. Landlord shall maintain the Building and Common Area in good condition and repair, and shall make all repairs and replacements, including those to the structure and the basic plumbing, heating, ventilating air conditioning and electrical systems installed or furnished by Landlord. There shall be no liability of Landlord by reason of any injury to or interference with Tenant's business arising from the making of any repairs, alterations or improvements in or to or maintenance of any portion of the Building or the Common Area or in or to fixtures, appurtenances and equipment therein. The cost of such repair and maintenance shall be included in the Building Operating Expenses pursuant to Paragraph 7. (ii) Outside Area. Landlord shall maintain the Outside Area in good condition and repair. Landlord shall at all times have exclusive control of the Outside Area subject to Tenant's rights under this Lease to use the Outside Area. In exercising any such rights, Landlord shall make a reasonable effort to minimize any disruption of Tenant's business. The cost of all such maintenance and repair shall be included in the Outside Area Expenses pursuant to Paragraph 7. B. TENANT'S OBLIGATIONS. Tenant shall keep and maintain the Premises, including carpeting, in good and sanitary condition, normal wear and tear and casualty excepted. Carpet areas of excessive wear shall be replaced at Tenant's sole expense upon Lease termination. Tenant hereby waives all rights under and benefits of Subsection I of Section 1932 and Sections 1941 and 1942 of the California Civil Code and under any similar law, statute or ordinance now or hereafter in effect. 9. ACCEPTANCE AND SURRENDER OF PREMISES. By entry hereunder, Tenant accepts the Premises as being in good and sanitary order, condition and repair, and accepts the Building and improvements included in the Premises in their present condition and without representation or warranty by Landlord as to the condition of such Building or as to the use or occupancy which may be made thereof, subject to the punch fist items referred to in the Work Letter and the conditions of this Lease. Any exceptions to the foregoing must be by written agreement executed by Landlord and Tenant. Except as agreed to by Landlord in writing, Tenant agrees on the last day of the Lease term, or on the sooner termination of this Lease, to surrender the Premises promptly and peaceably to Landlord in good condition and repair (damage by acts of 11 17 God, fire, normal wear and tear excepted), with all interior walls painted, or cleaned so that they appear freshly painted, and repaired and replaced if damaged; all floors cleaned and waxed; all carpets cleaned and shampooed; the air conditioning and heating equipment serviced by a reputable and licensed service firm and in good operating condition (provided the maintenance of such equipment has been Tenant's responsibility during the term of this Lease) together with alterations, additions, and improvements which may have been made in, to or on the Premises (except movable trade fixtures installed at the expense of Tenant) except that with respect to any alterations made by Tenant without Landlord's consent, as provided in Section 10, Tenant shall ascertain from Landlord within thirty (30) days before the end of the term of this Lease whether Landlord desires to have the Premises or any part thereof restored to their condition and configuration as when the Premises were delivered to Tenant and if Landlord shall so desire, then Tenant shall restore the Premises or such portion thereof before the end of the term at Tenant's sole cost and expense. Tenant, on or before the end of the term or sooner termination of this Lease shall remove all of Tenant's personal property and trade fixtures from the Premises, and all property not so removed on or before the end of the term or sooner termination of this Lease, may be removed and stored by Landlord, at Tenant's sole cost, and Landlord may repair any damage caused by such removal at Tenant's sole cost. After thirty (30) days, Landlord may sell such personal property and trade fixtures and apply any funds received first to Landlord's costs for the removal, storage, and sale of such property, and then remit the balance to Tenant. Tenant hereby waives any claim or right it may have against Landlord with respect to such removal, storage or sale whether such claim is at law or equity. If the Premises are not surrendered at the end of the term or sooner termination of this Lease, Tenant shall indemnify Landlord against loss or liability resulting from the delay by Tenant in so surrendering the Premises including, without limitation, any claims made by any succeeding tenant founded on such delay. Nothing contained herein shall be construed as an extension of the term hereof or as a consent of Landlord to any holding over by Tenant. The voluntary or other surrender of this Lease or the Premises by Tenant or a mutual cancellation of this Lease shall not work as a merger and, at the option of Landlord, shall either terminate all or any existing subleases or subtenancies or operate as an assignment to Landlord of all or any such subleases or subtenancies. 10. ALTERATIONS AND ADDITIONS. Tenant shall not make, or suffer to be made, any alteration or addition to the Premises, or any part thereof without the prior written consent of Landlord, which consent shall not be unreasonably withheld, and which alteration or addition shall be at the cost of Tenant; provided that, Tenant may make any alteration that does not exceed ten thousand dollars ($10,000) on a per occurrence basis and that does not affect the mechanical or electrical systems in the building, by providing Landlord with reasonable prior written notice of such alteration. Any addition to, or alteration of, the Premises, except moveable furniture and trade fixtures, shall at once become part of the Premises and belong to Landlord, unless otherwise agreed to prior to the installation thereto. Landlord reserves the right to reasonably approve all contractors and mechanics proposed by Tenant to make such alterations and additions. Tenant shall retain title to all moveable furniture and trade fixtures placed in the Premises. All heating, lighting, electrical, air conditioning, partitioning, drapery, carpeting, and floor installations made by Tenant, together with all property that has become an integral part of the Premises, shall not be deemed trade fixtures, unless otherwise agreed to prior to the installation thereto. Tenant agrees that it will not proceed to make any alterations or additions without having obtained consent from 12 18 Landlord to do so which consent shall include notice to Tenant of whether Landlord will require the Premises to be restored at termination of this Lease, and until five (5) days from receipt of such consent, in order that Landlord may post appropriate notices to avoid any liability to contractors or material suppliers for payment for Tenant's improvements. Tenant will at all times permit such notices to be posted and to remain posted until the completion of work. For any alterations requiring consent of the Landlord, Tenant shall, if required by Landlord, secure at Tenant's own cost and expense, a completion and lien indemnity bond, satisfactory to Landlord, for such work. Tenant further covenants and agrees that any mechanic's lien filed against the Premises or against the Property for work claimed to have been done for, or materials claimed to have been furnished to Tenant, will be discharged by Tenant, by bond or otherwise, within ten (10) days after the filing thereof, at the cost and expense of Tenant. Any exceptions to the foregoing must be made in writing and executed by both Landlord and Tenant. 11. UTILITIES AND SERVICES. Tenant shall be responsible for providing janitorial and waste removal services to the Premises. Payment for these services shall be remitted directly to the utility or service provider. Landlord shall pay for the installation of any required separate meter. Tenant shall pay promptly, as the same may become due, all charges for waste removal, janitorial services, water, gas, electricity, telephone, and other electronic communications services furnished directly or used by Tenant during the term of this Lease. Tenant shall have the right to enter the building and use the HVAC system, lighting and any and all other services to the Premises 24 hours per day, seven (7) days per week. Landlord shall not be liable for and Tenant shall not be entitled to any abatement or reduction of Rent by reason of any interruption or failure of utility services to the Building when such interruption or failure, is caused by fire, casualty, acts of God, strike, lockout, other labor troubles or inability to secure materials, governmental law or regulation or other cause of whatever kind beyond Landlord's reasonable control, and Tenant shall not be entitled to any damages nor, shall any such failure relieve Tenant of the obligation to pay Rent provided for herein, or constitute or be construed as a constructive or other eviction of Tenant. In the event that such interruption or failure is the direct result of Landlord's negligence or willful misconduct, and if any portion of the Premises is rendered unusable by Tenant for forty-eight (48) hours or longer, Tenant shall be entitled to an abatement of Rent in proportion to the disturbance to the conduct of Tenant's business until the use of such portion of the Premises is restored to Tenant. 12. TAXES. A. REAL PROPERTY TAXES. Tenant shall pay to Landlord Tenant's proportionate share of all Real Property Taxes, as provided for in Paragraph 7 hereof Tenant's proportionate share of Real Property Taxes shall be Tenant's Building Percentage of the Real Property Taxes levied or assessed against the Building plus Tenant's Complex Percentage of the Real Property Taxes levied or assessed against Outside Area of the Complex. The term "Real Property Taxes", as used herein, shall mean (i) all taxes, assessments, levies and other charges of any kind or nature whatsoever, general and special, foreseen and unforeseen (including all installments of principal and interest required to pay any general or special assessment for public improvements and any increases resulting from reassessments caused by any change in ownership of the Property) now or hereafter imposed by any governmental or quasi-governmental authority or special district 13 19 having the direct or indirect power to tax or levy assessments, which are levied or assessed against, or with respect to the value, occupancy or use of, all or any portion of the Property (as now constructed or as may at any time hereafter be constructed, altered, or otherwise changed) or Landlord's interest therein; any improvements located within the Property (regardless of ownership); the fixtures, equipment and other property of Landlord, real or personal, that are an integral part of and located in the Property; or parking areas or public utilities, within the Property, and (ii) all costs and fees including attorneys' fees, incurred by Landlord in contesting any Real Property Tax and in negotiating with public authorities as to any Real Property Tax. If at any time during the term of this Lease the taxation or assessment of the Property prevailing as of the Commencement Date of this Lease shall be altered so that in lieu of or in addition to any Real Property Tax described above there shall be levied, assessed or imposed (whether by reason of a change in the method of taxation or assessment, creation of a new tax or charge, or any other cause) an alternate or additional tax or charge (i) on the value, use or occupancy of the Property or Landlord's interest therein or (ii) on or measured by the gross receipts, income or rentals from the Property, on Landlord's business of leasing the Property, or computed in any manner with respect to the operation of the Property, then any such tax or charge, however designated, shall be included within the meaning of the term "Real Property Taxes" for purposes of this Lease. If any Real Property Tax is based upon property or rents unrelated to the Property, then only that part of such Real Property Tax that is fairly allocated to the Property shall be included within the meaning of the term "Real Property Taxes." Notwithstanding the foregoing, the term "Real Property Taxes" shall not include estate, inheritance, gift or franchise taxes of Landlord or the federal or state net income tax imposed on Landlord's income from all sources. B. TAXES ON TENANT'S PROPERTY. (i) Tenant shall be liable for and shall pay before delinquency, taxes levied against any personal property or trade fixtures placed by Tenant in or about the Premises. If any such taxes on Tenant's personal property or trade fixtures are levied against Landlord or Landlord's property or if the assessed value of the Premises is increased by the inclusion therein of a value placed upon such personal property or trade fixtures of Tenant and if Landlord, after notice to Tenant, pays the taxes based on such increased assessment, which Landlord shall have the right to do regardless of the validity thereof, but only under proper protest if requested by Tenant, Tenant shall within twenty (20) days of Landlord's written notice to Tenant, such notice to include reasonable documentation of such taxes, as the case may be, repay to Landlord the taxes so levied against Landlord, or the proportion of such taxes resulting from such increase in the assessment; provided that in any such event Tenant shall have the right, in the name of Landlord and with Landlord's full cooperation, to bring suit in any court of competent jurisdiction to recover the amount of any such taxes so paid under protest, and any amount so recovered shall belong to Tenant. (ii) If the Tenant Improvements in the Premises, whether installed and/or paid for by Landlord or Tenant and whether or not affixed to the real property so as to become part thereof, are assessed for real property tax purposes at a valuation higher than the valuation at which standard office improvements in other space in the Building are assessed, then the Real Property Taxes levied against Landlord or the Property by reason of such excess assessed 14 20 valuation shall be deemed to be taxes levied against personal property of Tenant and shall be governed by the provisions of 13.B(i) above. If the records of the County Assessor are available and sufficiently detailed to serve as a basis for determining whether said Tenant Improvements are assessed at a higher valuation than standard office improvements in other space in the Building, such records shall be binding on both Landlord and Tenant. If the records of the County Assessor are not available or sufficiently detailed to serve as a basis for making such determination, the actual cost of construction shall be used. 13. LIABILITY INSURANCE. A. Tenant INSURANCE REQUIREMENTS. Tenant, at Tenant's expense, agrees to keep in force during the term of this Lease a policy of commercial general liability insurance with limits in the amount of One Million Dollars ($1,000,000) per occurrence and Two Million Dollars ($2,000,000) annual aggregate for injuries to or death of persons occurring in, on or about the Premises or the Property, and property damage insurance with limits of Five Hundred Thousand Dollars ($500,000). Tenant shall also procure umbrella excess liability insurance, on an occurrence basis, with minimum limit of Five Million Dollars ($5,000,000) on a per occurrence and annual aggregate basis. Duly executed certificates evidencing such insurance, copies of which shall be furnished to Landlord, shall name Landlord and Landlord's agents and representatives as additional insureds, and shall insure any liability of Landlord, contingent or otherwise, as respects the acts or omissions of Tenant, its agents, employees or invitees or otherwise by any conduct or transactions of any such persons in or about or concerning the Premises, including any failure of Tenant to observe or perform any of its obligations hereunder; shall be issued by an insurance company admitted to transact business in the State of California; and shall provide that the insurance effected thereby shall not be canceled, except upon thirty (30) days' prior notice to Landlord. If, during the term of this Lease, in the reasonable opinion of Landlord's lender, insurance advisor or counsel, the amount of insurance described in this Paragraph 13 is not adequate, Tenant agrees to increase such coverage to such reasonable amount as Landlord's tender, insurance advisor or counsel shall deem adequate. B. TENANT INSURER REQUIREMENTS. All of Tenant's insurance shall be carried with companies acceptable to Landlord that have a general policy holder's rating of not less than "A" and a financial rating of not less than Class "X" in the most current edition of Best's Insurance Reports; shall provide that such policies shall not be subject to material alteration or cancellation except after at least ten (10) days prior written notice to Landlord; and shall be primary as to Landlord. The policy or policies, or duly executed certificates for them, together with satisfactory evidence of payment of the premium thereon, shall be deposited with Landlord prior to the commencement date of this Lease, and upon renewal of such policies, not less than thirty (30) days prior to the expiration of such policies. If Tenant fails to maintain the insurance required hereunder, Landlord may, but shall not be required to, after three (3) business days notice to Tenant, order such insurance at Tenant's expense and Tenant's reimbursement to Landlord for such amounts shall be deemed Additional Rent. Such reimbursement shall include all sums disbursed, incurred or deposited by Landlord including Landlord's costs and expenses with interest thereon (at the rate of ten percent (10%) per annum, but in no event to exceed the 15 21 maximum rate allowed by law) and any reasonable attorneys' fees for collection if reasonably necessary. C. LANDLORD INSURANCE. Landlord shall procure and maintain commercial general liability insurance. Such insurance shall be in addition to and not in lieu of insurance maintained by Tenant pursuant to this Lease and shall be in an amount not less than that required of Tenant. Landlord shall not name Tenant as an additional insured on any insurance maintained by Landlord. 14. TENANT'S PERSONAL PROPERTY INSURANCE, WORKER'S COMPENSATION INSURANCE AND BUSINESS INCOME INSURANCE. Tenant agrees to maintain, at its own expense, fire and extended coverage, malicious mischief and vandalism insurance in causes of loss - special form with a sprinkler leakage endorsement insuring Tenant's personal property located at the Premises, including inventory and trade fixtures, for the full replacement cost thereof. The proceeds from any of such policies shall be used for the repair or replacement of such items so insured. Tenant shall also maintain a policy or policies of worker's compensation insurance and any other employee benefit insurance sufficient to comply with all laws. 15. PROPERTY INSURANCE. A. BUILDING. Landlord shall purchase and keep in force a policy or policies of insurance covering loss or damage to the Building and the Property, including the Tenant Improvements but excluding Tenant's personal property and any alterations, additions or improvements made by Tenant at its expense, in the amount of the full replacement cost thereof, providing protection against those perils included within the classification of causes of loss - special form property insurance. Landlord shall also purchase rental income insurance. If the cost of the property insurance or rental income insurance is increased due to Tenant's use of the Premises, Tenant agrees to pay to Landlord the full cost of such increase. Tenant shall have no interest in nor any right to the proceeds of any insurance procured by Landlord for the Building or the Property. B. WAIVER OF SUBROGATION. Landlord and Tenant do each hereby respectively release the other, to the extent of insurance coverage of the releasing party, from any liability for loss or damage caused by fire or any of the extended coverage casualties included in the releasing party's insurance policies, irrespective of the cause of such fire or casualty; provided, however, that if the insurance policy of either releasing party prohibits such waiver, then this waiver shall not take effect until consent to such waiver is obtained. If such waiver is so prohibited, the insured party affected shall promptly notify the other party thereof. 16. INDEMNIFICATION. Landlord shall not be liable to Tenant and Tenant hereby waives all claims against Landlord for any injury to or death of any person or damage to or destruction of property in or about the Premises or the Property by or from any cause whatsoever, including, without limitation, gas, fire, oil, electricity or leakage of any character from the roof, walls, basement or other portion of the Premises or the Property, but excluding, however, the negligence or willful misconduct of Landlord, its agents, servants, employees, invitees, or contractors of 16 22 which negligence Landlord has knowledge and reasonable time to correct. Except as to injury to persons or damage to property the principal cause of which is the negligence or willful misconduct of Landlord, Tenant shall indemnify, defend and hold Landlord harmless from and against any and all expenses, including reasonable attorneys' fees, in connection therewith, arising out of any injury to or death of any person or damage to or destruction of property occurring in, on or about the Premises, or any part thereof, from any cause whatsoever. Landlord shall indemnify, defend and hold Tenant harmless from and against any and all expenses, including reasonable attorneys' fees, in connection therewith, arising out of any injury to or death of any person or damage to or destruction of property occurring in, on or about the Premises, or any part thereof, resulting from the negligence or willful misconduct of Landlord. 17. COMPLIANCE. Tenant, at its sole cost and expense, shall promptly comply with all laws, statutes, ordinances and governmental rules, regulations or requirements now or hereafter in effect; with the requirements of any board of fire underwriters or other similar body now or hereafter constituted; and with any direction or occupancy certificate issued pursuant to law by any public officer; provided, however, that no such failure shall be deemed a breach of this provision if Tenant, immediately upon notification, commences to remedy or rectify said failure. The judgment of any court of competent jurisdiction or the admission of Tenant in any action against Tenant, whether Landlord be a party thereto or not, that Tenant has violated any such law, statute, ordinance or governmental rule, regulation, requirement, direction or provision, shall be conclusive of that fact as between Landlord and Tenant. This paragraph shall not be interpreted as requiring Tenant to make structural changes or improvements except to the extent such structural changes or improvements are required as a result of Tenant's use of the Premises. Tenant shall, at its sole cost and expense, comply with any and all requirements pertaining to Tenant's use of the Premises, of any insurance organization or company, necessary for the maintenance of reasonable fire and public liability insurance covering the Premises. Landlord represents and warrants that to the best of Landlord's knowledge, the Building and the Property are in material compliance with all applicable laws, statutes, ordinances, governmental rules and regulations, including the Americans with Disabilities Act, in effect as of the date of this Lease, and Tenant's use of the Premises as office space is permitted under applicable laws and other encumbrances affecting the Property. 18. LIENS. Tenant shall keep the Premises and the Property free from any liens, arising out of any work performed, materials furnished or obligation incurred by Tenant. In the event that Tenant shall not, within ten (10) business days following the imposition of such lien, cause the same to be released of record, Landlord shall have, in addition to all other remedies provided herein and by law, the right, but no obligation, to cause the same to be released by such means as it shall deem proper, including payment of the claim giving rise to such lien. AU sums paid by Landlord for such purpose, and all expenses incurred by it in connection therewith, shall be payable to Landlord by Tenant within twenty (20) days of Landlord's written notice to Tenant, with interest at the prime rate of interest as quoted by the Bank of America. 19. ASSIGNMENT AND SUBLETTING. Tenant shall not assign, transfer, or hypothecate the leasehold estate under this Lease, or any interest therein, and shall not sublet the Premises, or any part thereof, or any right or privilege appurtenant thereto, or suffer any other person or entity 17 23 to occupy or use the Premises, or any portion thereof, without, in each case, the prior written consent of Landlord which consent shall not be unreasonably withheld; provided, however, that Landlord's consent shall not be required for any assignment or sublease to a subsidiary or affiliate of Tenant or to any entity resulting from the merger or consolidation of Tenant with another entity so long as Tenant gives Landlord prior written notice of any such assignment or sublease and, in the event of an assignment (i) the assignee has a net worth, at the time of such assignment, that is equal to or greater than the net worth of Tenant immediately prior to such assignment, and (ii) the assignee assumes, in writing, for the benefit of Landlord all of Tenant's obligations under the Lease. As a condition for granting its consent to any assignment, transfer, or subletting, Landlord may require Tenant to pay to Landlord, as Additional Rent, fifty percent (50%) all rents or additional consideration received by Tenant from its assignees, transferees or subtenants in excess of the rent payable by Tenant to Landlord hereunder. Additionally, in the event of any default hereunder by Tenant, Landlord may require any subtenant or assignee to pay directly to Landlord on a monthly basis the rent and any other sums due to Tenant by such assignee or subtenant. Tenant shall, by sixty (60) days' prior notice, advise Landlord of its intent to assign this Lease or to sublet the Premises or any portion thereof for any part of the term hereof. Within fifteen (15) business days after receipt of Tenant's notice, Landlord may, in its sole discretion, elect to terminate this Lease as to the portion of the Premises described in Tenant's notice on the date specified in Tenant's notice by giving written notice of such election to terminate. If no such notice to terminate is given to Tenant within such fifteen (15) business day period, Tenant may proceed to locate an acceptable subtenant, assignee or other transferee for presentment to Landlord for Landlord's approval, all in accordance with the terms, covenants and conditions of this Paragraph 19. If Tenant intends to sublet the entire Premises and Landlord elects to terminate this Lease, this Lease shall be terminated on the date specified in Tenant's notice. If, however, this Lease shall terminate pursuant to the foregoing with respect to less than all the Premises, the Basic Rent shall be adjusted on a pro rata basis to the area of the Premises retained by Tenant, and this Lease as so amended shall continue in full force and effect. In the event Tenant is allowed to assign, transfer or sublet the whole or any part of the Premises, with the prior written consent of Landlord, no assignee, transferee or subtenant shall assign or transfer this Lease, or either in whole or in part sublet the Premises, without also having obtained the prior written consent of Landlord. A consent of Landlord to one assignment, transfer, hypothecation, subletting, occupation or use by any other person shall not release Tenant from any of Tenant's obligations hereunder or be deemed to be a consent to subsequent similar or dissimilar assignment, transfer, hypothecation, subletting, occupation or use by any other person. Any such assignment, transfer, hypothecation, subletting, occupation or use without such consent shall be void and shall constitute a breach of this Lease by Tenant and shall, at the option of Landlord exercised by written notice to Tenant, terminate this Lease. The leasehold estate under this Lease shall not, nor shall any interest therein, be assignable for any purpose by operation of law without the written consent of Landlord. As a condition to its consent, Landlord may require Tenant to pay all expenses in connection with the assignment, and Landlord may require Tenant's assignee or transferee (or other assignees or transferees) to assume in writing all of the obligations under this Lease. 20. SUBORDINATION, MORTGAGES AND QUIET ENJOYMENT. If Landlord's title or leasehold interest is now or hereafter encumbered by a deed of trust, upon the interest of 18 24 Landlord in the Property, to secure a loan from a lender (hereinafter referred to as "Lender") to Landlord, Tenant shall, at the request of Landlord or Lender, execute in writing an agreement subordinating its rights under this Lease to the lien of such deed of trust, or, if so requested, agree that the lien of Lender's deed of trust shall be or remain subject and subordinate to the rights of Tenant under this Lease, provided that such agreement provides that Tenant's tenancy shall not be disturbed so long as Tenant is not in default under this Lease. Notwithstanding any such subordination, Tenant's possession under this Lease shall not be disturbed if Tenant is not in default and so long as Tenant shall pay all Rent and observe and perform all of the provisions set forth in this Lease. Landlord represents and warrants to Tenant that, as of the date of this Lease, neither the Building nor any portion of the Property is encumbered by any mortgages or deeds of trust. Landlord represents and warrants that (a) it has full right and authority to enter into this Lease, and (b) Tenant, subject to its obligation to pay rent and to perform its other covenants and agreements under this Lease, shall have sole and actual possession of the Premises, from the Commencement Date and shall peaceably and quietly have, hold and enjoy the Premises free from eviction or disturbance until expiration or earlier termination of this Lease. 21. ENTRY BY LANDLORD. Landlord reserves, and shall at all reasonable times have the right to enter the Premises to inspect them; to perform any services provided by Landlord hereunder; to submit the Premises to prospective purchasers, mortgagors or tenants; to post notices of nonresponsibility; and to alter, improve or repair the Premises and any portion of the Building, all without abatement of Rent. Landlord may erect scaffolding and other necessary structures in or through the Premises when reasonably required by the character of the work to be performed; provided, however, that the business of Tenant shall be interfered with to the least extent that is reasonably practical. For each of the foregoing purposes, Landlord shall at all times have and retain a key with which to unlock all of the doors in an emergency in order to obtain entry to the Premises, and any entry to the Premises obtained by Landlord by any of said means, or otherwise, shall not under any circumstances be construed or deemed to be forcible or unlawful entry into or a detainer of the Premises or an eviction, actual or constructive, of Tenant from the Premises or any portion thereof. 22. BANKRUPTCY AND DEFAULT. A. BANKRUPTCY. The commencement of a bankruptcy action or liquidation action or reorganization action or insolvency action or an assignment of or by Tenant for the benefit of creditors, or any similar action undertaken by Tenant, or the insolvency of Tenant, shall, at Landlord 's option, constitute a breach of this Lease by Tenant. If the trustee or receiver appointed to serve during a bankruptcy, liquidation, reorganization, insolvency or similar action elects to reject Tenant's unexpired Lease, the trustee or receiver shall notify Landlord in writing of its election within thirty (30) days after an order for relief in a liquidation action or within thirty (30) days after the commencement of any action. Within thirty (30) days after court approval of the assumption of this Lease, the trustee or receiver shall cure (or provide adequate assurance to the reasonable satisfaction of Landlord that 19 25 the trustee or receiver shall cure) any and all previous defaults under the unexpired Lease and shall compensate Landlord for all actual pecuniary loss and shall provide adequate assurance of future performance under the Lease to the reasonable satisfaction of Landlord. Adequate assurance of future performance, as used herein, includes, but shall not be limited to: (i) assurance of source and payment of Rent, and other consideration due under this Lease; (ii) assurance that the assumption or assignment of this Lease will not breach substantially any provision, such as radius, location, use, or exclusivity provision, in any agreement relating to the Premises. Nothing contained in this section shall affect the existing right of Landlord to refuse to accept an assignment upon commencement of or in connection with a bankruptcy, liquidation, reorganization or insolvency action or an assignment of Tenant for the benefit of creditors or other similar act. Nothing contained in this Lease shall be construed as giving or granting or creating an equity in the demised Premises to Tenant. In no event shall the leasehold estate under this Lease, or any interest therein, be assigned by voluntary or involuntary bankruptcy proceeding without the prior written consent of Landlord. In no event shall this Lease or any rights or privileges hereunder be an asset of Tenant under any bankruptcy, insolvency or reorganization proceedings. B. DEFAULT. The failure to perform or honor any covenant, condition or representation made under this Lease shall constitute a default hereunder by Tenant upon expiration of the appropriate grace period hereinafter provided. Tenant shall have a period of five (5) business days from the date of written notice from Landlord within which to cure any default in the payment of Rent. Tenant shall have a period of ten (10) business days from the date of written notice from Landlord within which to cure any other default under this Lease; provided that, if Tenant such default cannot be cured within such ten business day time period and Tenant is proceeding diligently to cure such default, such cure period shall be extended to 30 days. Any notice given pursuant to this Paragraph 22.B shall be in addition to any notice required under Section 1161 of the California Code of Civil Procedure regarding unlawful detainer actions. Upon an uncured default of this Lease by Tenant, Landlord shall have the following rights and remedies in addition to any other rights or remedies available to Landlord at law or in equity: (i) The rights and remedies provided for by California Civil Code Section 1951.2, including but not limited to, recovery of the worth at the time of award of the amount by which the unpaid rent for the balance of the term after the time of award exceeds the amount of rental loss for the same period that Tenant proves could be reasonably avoided, as computed pursuant to subsection (b) of said Section 1951.2. Any proof by Tenant under subparagraph (2) and (3) of Section 1951.2 of the California Civil Code of the amount of rental loss that could be reasonably avoided shall be made in the following manner: Landlord and Tenant shall each select a licensed real estate broker in the business of renting property of the same type and use as the Premises and in the same geographic vicinity. Such two real estate brokers shall select a third licensed real estate broker, and the three licensed real estate brokers so selected shall determine the amount of the rental loss that could be reasonably avoided from the balance of the term of this Lease after the time of award. The decision of the majority of said licensed real estate brokers shall be final and binding upon the parties hereto. 20 26 (ii) The rights and remedies provided by California Civil Code Section 1951.4 which allows Landlord to continue the Lease in effect and to enforce all of its rights and remedies under this Lease, including the right to recover rent as it becomes due, for so long as Landlord does not terminate Tenant's right to possession; acts of maintenance or preservation, efforts to relet the Premises, or the appointment of a receiver upon Landlord's initiative to protect its interest under this Lease shall not constitute a termination of Tenant's right to possession. (iii) The right to terminate this Lease by giving notice to Tenant in accordance with applicable law. (iv) The right and power, as attorney-in-fact for Tenant, to enter the Premises and remove therefrom all persons and property, to store such property in a public warehouse or elsewhere at the cost of and for the account of Tenant, and to sell such property and apply such proceeds therefrom pursuant to applicable California law. Landlord, as attorney-in-fact for Tenant, may from time to time sublet the Premises or any part thereof for such term or terms (which may extend beyond the term of this Lease) and at such rent and such other terms as Landlord in its sole discretion may deem advisable, with the right to make alterations and repairs to the Premises. Upon each subletting, (a) Tenant shall be immediately liable to pay Landlord, in addition to indebtedness other than rent due hereunder, the cost of such subletting, including, but not limited to, reasonable attorneys' fees, and any real estate commissions actually paid, and the cost of such alterations and repairs incurred by Landlord and the amount, if any, by which the rent hereunder for the period of such subletting (to the extent such period does not exceed the term hereof) exceeds the amount to be paid as rent for the Premises for such period, or (b) at the option of Landlord, rents received from such subletting shall be applied first to payment of indebtedness other than rent due hereunder from Tenant to Landlord; second, to the payment of any costs of such subletting and of such alterations and repairs; third, to payment of rent due and unpaid hereunder; and the residue, if any, shall be held by Landlord and applied in payment of future rent as the same becomes due hereunder. If Tenant has been credited with any rent to be received by such subletting under option (a) and such rent shall not be promptly paid to Landlord by the subtenant(s), or if such rentals received from such subletting under option (b) during any month be less than that to be paid during that month by Tenant hereunder, Tenant shall pay any such deficiency to Landlord. Such deficiency shall be calculated and paid monthly. For all purposes set forth in this Paragraph 22.B(iv), Landlord is hereby irrevocably appointed attorney-in-fact for Tenant, with power of substitution. No taking possession of the Premises by Landlord, as attorney-in-fact for Tenant, shall be construed as an election on its part to terminate this Lease unless a notice of such intention be given to Tenant. Notwithstanding any such subletting without termination, Landlord may at any time hereafter elect to terminate this Lease for such previous breach. 23. ABANDONMENT. Except if Tenant continues to pay Rent and is not in default under this Lease and cooperates with Landlord to maintain the Premises in such a manner that the Premises appear occupied, Tenant shall not vacate or abandon the Premises, at any time during the term of this Lease; and if Tenant shall abandon, vacate or surrender the Premises, or be dispossessed by the process of law, or otherwise, any personal property belonging to Tenant and 21 27 left on the Premises shall be deemed to be abandoned, at the option of Landlord, except such property as may be mortgaged to Landlord. 24. DESTRUCTION. In the event the Premises are destroyed in whole or in part from any cause, except for routine maintenance and repairs and incidental damage and destruction caused from vandalism and accidents for which Tenant is responsible under Paragraph 10, Landlord may, at its option: (a) Rebuild or restore the Premises to their condition prior to the damage or destruction; or (b) Terminate this Lease. Landlord shall give Tenant notice in writing within thirty (30) days from the destruction of the Premises of its election to either rebuild and restore the Premises, or to terminate this Lease. Such notice shall provide an estimate of the time required to complete the required repairs. If such estimate is for a period greater than one hundred eighty (180) days, Tenant may elect to terminate this Lease by giving written notice within ten (10) business days to Landlord. If Landlord elects to rebuild or restore the Premises and Tenant has not elected to terminate as provided herein, Landlord agrees, at its expense, promptly to rebuild or restore the Premises in a timely manner to their condition prior to the damage or destruction. Tenant shall be entitled to a reduction in Rent while such repair is being made in the proportion that the area of the Premises rendered untenantable by such damage bears to the total area of the Premises. If Landlord does not complete the rebuilding or restoration within one hundred eighty (180) days following the date of destruction (such period to be extended for delays caused by the fault or neglect of Tenant or because of acts of God, acts of public agencies, labor disputes, strikes, fires, freight embargoes, rainy or stormy weather, inability to obtain materials, supplies or fuels, acts of contractors or subcontractors, or delay of the contractors or subcontractors due to such causes or other contingencies beyond the control of Landlord), then Tenant shall have the right to terminate this Lease by written notice to Landlord within ten (10) days after the expiration of such one hundred eighty (180) day period. Notwithstanding anything herein to the contrary, Landlord's obligation to rebuild or restore shall be limited to the Building and interior improvements constructed by Landlord as they existed as of the Commencement Date and shall not include restoration of Tenant's trade fixtures, equipment, merchandise, or any improvements, alterations or additions made by Tenant to the Premises, which Tenant shall replace or fully repair at Tenant's sole cost and expense provided this Lease is not terminated according to the provisions above. Unless this Lease is terminated pursuant to the foregoing provisions, this Lease shall remain in full force and effect. Tenant hereby expressly waives the provisions of Section 1932, Subdivision 2 of Section 1933, Subdivision 4 of the California Civil Code. If the Building is damaged or destroyed to the extent of not less than thirty-three percent (33%) of the replacement cost thereof, Landlord may elect to terminate this Lease, whether the Premises be injured or not. If the destruction of the Premises is caused by Tenant, Tenant shall pay the deductible portion of Landlord's insurance proceeds. 22 28 Notwithstanding anything contained herein, in the event of minor damage, such damage to be damage less than 10% of the full insurable value of the Building the repair of which shall be estimated at less than 180 days, and provided that such damage is not caused by Tenant, Landlord shall be obligated to make repairs and shall proceed in a timely manner to make such repairs. 25. EMINENT DOMAIN. If all or any part of the Premises is taken by any public or quasi-public authority under the power of eminent domain or conveyance in lieu thereof, this Lease shall terminate as to any portion of the Premises so taken or conveyed on the date title vests in the condemnor. Landlord shall be entitled to any and all payment, income, rent, award, or any interest therein whatsoever which may be paid or made in connection with such taking or conveyance, and Tenant shall have no claim against Landlord or otherwise for the value of any unexpired term of this Lease. Notwithstanding the foregoing, any compensation specifically awarded to Tenant for loss of business, Tenant's personal property, moving cost or loss of goodwill, shall be and remain the property of Tenant. Tenant shall have the right to appear, claim, prove and receive any award by the condemning authority for loss of business, Tenant's personal property, or moving cost or loss of goodwill, provided that such award does not result in a reduction of the award to Landlord and does not interfere with Landlord's proceedings in connection with such taking or conveyance. If (i) any action or proceeding is commenced for such taking of the Premises or any part thereof, or (ii) any of the foregoing events occur with respect to the taking of any space in the Building not leased hereby, or if any such spaces so taken or conveyed in lieu of such taking and Landlord shall decide to discontinue the use and operation of the Building, or decide to demolish, alter or rebuild the Building, then, in any of such events Landlord shall have the right to terminate this Lease by giving Tenant written notice thereof within sixty (60) days of the date of receipt of such written advice, or commencement of such action or proceeding, or taking conveyance, which termination shall take place as of the first to occur of the last day of the calendar month next following the month in which such notice is given or the date on which title to the Premises shall vest in the condemnor. In the event of such a partial taking or conveyance of the Premises, if the portion of the Premises so taken or conveyed is so substantial that Tenant can no longer reasonably conduct its business, Tenant shall have the privilege of terminating this Lease within sixty (60) days from the date of such taking or conveyance, upon written notice to Landlord of its intention to do so, and upon giving of such notice this Lease shall terminate on the last day of the calendar month next following the month in which such notice is given, upon payment by Tenant of the Rent from the date of such taking or conveyance to the date of termination. If a portion of the Premises is taken by condemnation or conveyance in lieu thereof and neither Landlord nor Tenant shall terminate this Lease as provided herein, this Lease shall continue in full force and effect as to the part of the Premises not taken or conveyed, and the Rent shall be apportioned as of the date of such taking or conveyance so that thereafter the Rent to be paid by Tenant shall be in the ratio that the area of the Premises not taken or conveyed bears to the total area of the Premises prior to such taking or conveyance. 23 29 26. SALE OR CONVEYANCE BY LANDLORD. In the event of a sale or conveyance of the Property or any interest therein, by any owner of the reversion then constituting Landlord, the transferor shall thereby be released from any further liability upon any of the terms, covenants or conditions (express or implied) herein contained in favor of Tenant, and in such event, insofar as such transfer is concerned. Tenant agrees to look solely to the successor in interest of such transferor in and to the Property and this Lease. This Lease shall not be affected by any such sale or conveyance, and Tenant agrees to attorn to the successor in interest of such transferor. 27. ATTORNMENT TO LENDER OR THIRD PARTY. In the event the interest of Landlord in the Property (whether such interest of Landlord is a fee title interest or a leasehold interest) is encumbered by deed of trust, and such interest is acquired by the lender or any third party through judicial foreclosure or by exercise of a power of sale at private trustee's foreclosure sale, Tenant hereby agrees to attorn to the purchaser at any such foreclosure sale and to recognize such purchaser as the Landlord under this Lease. In the event the lien of the deed of trust securing the loan from a lender to Landlord is prior and paramount to the Lease, this Lease shall nonetheless continue in full force and effect for the remainder of the unexpired term hereof, at the same rental herein reserved and upon all the other terms, conditions and covenants herein contained. 28. HOLDING OVER. Any holding over by Tenant after expiration or other termination of the term of this Lease with the written consent of Landlord delivered to Tenant shall not constitute a renewal or extension of the Lease or give Tenant any rights in or to the leased Premises except as expressly provided in this Lease. Any holding over after the expiration or other termination of the term of this Lease, with the consent of Landlord, shall be construed to be a tenancy from month to month, on the same terms and conditions herein specified insofar as applicable except that the monthly Basic Rent shall be increased to an amount equal to one hundred fifty percent (150%) of the monthly Basic Rent required during the last month of the Lease term. 29. CERTIFICATE OF ESTOPPEL. Tenant shall at any time upon not less than ten (10) days prior notice from Landlord execute, acknowledge and deliver to Landlord a statement in writing in such form as requested by Landlord, or Landlord's lender (i) certifying that this Lease is unmodified and in full force and effect (or, if modified, stating the nature of such modification and certifying that this Lease, as so modified, is in full force and effect) and the date to which the Rent and other charges are paid in advance, if any, and (ii) acknowledging that there are not, to Tenant's knowledge, any uncured defaults on the party of Landlord hereunder, or specifying such defaults, if any are claimed. Any such statement may be conclusively relied upon by any prospective purchaser or encumbrancer of the Premises. Tenant's failure to deliver such statement within such time shall be conclusive upon Tenant that this Lease is in full force and effect, without modification except as may be represented by Landlord; that there are no uncured defaults in Landlord's performance, and that not more than one month's Rent has been paid in advance. 30. CONSTRUCTION CHANGES. It is understood that the description of the Premises and the location of the ductwork, plumbing and other facilities therein are subject to such minor 24 30 changes as Landlord or Landlord's architect determines to be desirable in the course of construction of the Premises, and no such changes, or any changes in plans for any other portions of the Property shall affect this Lease or entitle Tenant to any reduction of rent hereunder or result in any liability of Landlord to Tenant. Landlord does not guaranty the accuracy of any drawings supplied to Tenant and verification of the accuracy of such drawings rests with Tenant. 31. RIGHT OF LANDLORD TO PERFORM. All terms, covenants and conditions of this Lease to be performed or observed by Tenant shall be performed or observed by Tenant at Tenant's sole cost and expense and without any reduction of Rent. If Tenant shall fail to pay any sum of money, or other rent, required to be paid by Tenant hereunder or shall fail to perform any other term or covenant hereunder on its part to be performed, and such failure shall continue for five (5) days after written notice from Landlord, Landlord, without waiving or releasing Tenant from any obligation of Tenant hereunder, may, but shall not be obligated to, make any such payment or perform any such other term or covenant on Tenant's part to be performed. All sums so paid by Landlord and all necessary costs of such performance by Landlord together with interest thereon at the rate of the prime rate of interest per annum as quoted by the Bank of America from the date of such payment or performance by Landlord, shall be paid (and Tenant covenants to make such payment) to Landlord on demand by Landlord, and Landlord shall have (in addition to any other right or remedy of Landlord) all the rights and remedies in the event of nonpayment by Tenant as in the case of failure by Tenant in the payment of rent hereunder. 32. ATTORNEYS' FEES. In the event of any legal action or proceeding to enforce or interpret any provision of this Lease or to protect or establish any right or remedy of any party, the unsuccessful party to such action or proceeding, whether settled or prosecuted to final judgment, shall pay to the prevailing party as finally determined, all costs and expenses, including attorneys' fees and costs (including attorneys' fees on appeal, and costs and expenses incurred in out-of-court negotiations, workouts and/or settlements or in seeking relief from stay or otherwise seeking to protect its rights in any bankruptcy proceeding) incurred by such prevailing party in such action or proceeding, in enforcing such judgment, and in connection with any appeal from such judgment. Attorneys' fees and costs incurred in enforcing any judgment or in connection with any appeal shall be recoverable separately from and in addition to any other amount included in such judgment. This Paragraph 32 is intended to be severable from the other provisions of this Lease, and the prevailing party's rights under this Paragraph 32 shall not merge into any judgment and any judgment shall survive until all such fees and costs have been paid. 33. WAIVER. The waiver by either party of the other party's failure to perform or observe any term, covenant or condition herein contained to be performed or observed by such waiving party shall not be deemed to be a waiver of such term, covenant or condition or of any subsequent failure of the party failing to perform or observe the same or any other such term, covenant or condition therein contained, and no custom or practice which may develop between the parties hereto during the term hereof shall be deemed a waiver of, or in any way affect, the right of either party to insist upon performance and observance by the other party in strict accordance with the terms hereof. 25 31 34. NOTICES. All notices, demands, requests, advices or designations which may be or are required to be given by either party to the other hereunder shall be in writing. All notices demands, requests, advices or designations by Landlord to Tenant shall be sufficiently given, made or delivered if personally served on Tenant by leaving the same at the Premises, or if sent by United States certified or registered mail, postage prepaid, addressed to Tenant at the Premises, with a copy to Superior National Insurance, 26601 Agoura Road, Calabasas, California 91302, Attn: General Counsel. All notices, demands, requests, advices or designations by Tenant to Landlord shall be sent by United States certified or registered mail, postage prepaid, or any other nationally recognized reputable delivery service, addressed to Landlord c/o R & B Commercial Real Estate Services, Inc., 4637 Chabot Drive, Suite 100, Pleasanton, CA 94588. Each notice, request, demand, advice or designation referred to in this paragraph shall be deemed received on the date of the personal service or mailing thereof if mailed in the manner herein provided, as the case may be. 35. EXAMINATION OF LEASE. Submission of this instrument for examination or signature by Tenant does not constitute a reservation of or option for a lease, and this instrument is not effective as a lease or otherwise until its execution and delivery by both Landlord and Tenant. 36. DEFAULT BY LANDLORD. Landlord shall not be in default unless Landlord fails to perform obligations required of Landlord within a reasonable time, but in no event earlier than thirty (30) days after written notice by Tenant to Landlord and the holder of any first mortgage or deed of trust covering the Premises whose name and address shall have heretofore been furnished to Tenant in writing, specifying wherein Landlord has failed to perform such obligations; provided, however, that if the nature of Landlord's obligations is such that more than thirty (30) days are required for performance, then Landlord shall not be in default if Landlord commences performing within such thirty (30) day period and thereafter diligently prosecutes the same to completion. In the event that Landlord defaults as provided hereunder, if Landlord shall not in good faith have commenced the curing or remedying of such default within such thirty (30) day period, and shall not thereafter proceed to completion with due diligence, Tenant shall have the right to make such repairs ten (10) business days after providing prior written notice to Landlord of its intent to do so and shall send Landlord an invoice for the cost of such repairs with reasonable supporting documentation. Landlord shall either pay such invoice within thirty (30) days of receipt or provide written notice to Tenant of its objection to such costs. If Landlord objects to such costs, the issue shall be determined by arbitration pursuant to the requirements of Paragraph 44.C. If Landlord does not provide notice to Tenant of its objections to such invoice, Landlord shall be deemed to have accepted such invoice and Tenant may apply the invoice to sums due after 20 days written notice to Landlord of its intent to do so. 37. CORPORATE AUTHORITY. If Tenant is a corporation (or a partnership), Tenant represents that each individual executing this Lease on behalf of said corporation (or partnership) is duly authorized to execute and deliver this Lease on behalf of said corporation (or partnership) in accordance with the by-laws of such corporation (or partnership in accordance with the 26 32 partnership agreement) and that this Lease is binding upon said corporation (or partnership) in accordance with its terms. Tenant shall, within thirty (30) days after execution of this Lease, deliver to Landlord either a certified copy of the resolution of the Board of Directors of said corporation authorizing or ratifying the execution of this Lease or a certificate of its corporate secretary regarding the incumbency and authority of the individual executing this Lease on behalf of Tenant. 38. LIMITATION OF LIABILITY. In consideration of the benefits accruing hereunder, Tenant and all successors and assigns covenant and agree that, in the event of any actual or alleged failure, breach or default hereunder by Landlord: (i) the sole and exclusive remedy shall be against Landlord and Landlord's assets; (ii) no partner, shareholder, director, or officer of Landlord shall be sued or named as a party in any suit or action (except as may be necessary to secure jurisdiction of Landlord); (iii) no service of process shall be made against any partner, shareholder, director, or officer of Landlord (except as may be necessary to secure jurisdiction of Landlord); (iv) no partner, shareholder, director, or officer of Landlord shall be required to answer or otherwise plead to any service of process; (v) no judgment will be taken against any partner, director, or officer of Landlord; (vi) any judgment taken against any partner, shareholder, director, or officer of Landlord may be vacated and set aside at any time without hearing; (vii) no writ of execution will ever be levied against the assets of any partner, director, or officer of Landlord; (viii) these covenants and agreements are enforceable both by Landlord and also by any partner, shareholder, director, or officer of Landlord. Tenant agrees that each of the foregoing covenants and agreements shall be applicable to any covenant or agreement either expressly contained in this Lease or imposed by statute or at common law. 39. BROKERS. Tenant warrants that Corporate Realty Associates, Inc. is the only real estate broker or agent with whom it dealt in connection with the negotiation of this Lease and that Tenant knows of no other real estate broker or agent who is entitled to a commission in connection with this Lease. Landlord warrants that Colliers Parrish is the only real estate broker or agent with whom it dealt in connection with the negotiation of this Lease and that Landlord 27 33 knows of no other real estate broker or agent who is entitled to a commission in connection with this Lease. 40. SIGNS. No sign, placard, picture, advertisement, name or notice shall be inscribed, displayed or printed or affixed on or to any part of the outside of the Premises or to any exterior windows of the Premises without the written consent of Landlord first had and obtained and Landlord shall have the right to remove any such sign, placard, picture, advertisement, name or notice without notice to and at the expense of Tenant. If Tenant is allowed to print or affix or in any way place a sign in, on, or about the Premises, upon expiration or other sooner termination of this Lease, Tenant at Tenant's sole cost and expense, shall both remove such sign and repair all damage in such manner as to restore all aspects of the appearance of the Premises to the condition prior to the placement of said sign. All approved signs or lettering on outside doors shall be printed, painted, affixed or inscribed at the expense of Tenant by a person approved of by Landlord. Tenant shall not place anything or allow anything to be placed near the glass of any window, door, partition or wall which may appear unsightly from outside the Premises. Subject to the conditions of this Section 40, including Landlord's prior written consent of the sign design, which shall not be unreasonably withheld, Tenant shall be permitted to assume the monument sign on West Las Positas at Tenant's sole cost and expense. Any signage shall be in compliance with all applicable laws and regulations and Tenant shall maintain such signage in good repair and condition. 41. ASSESSMENTS. A. ASSESSMENT DISTRICTS. Tenant acknowledges that the Property is subject to assessment districts, including, but not limited to, improvement districts, maintenance districts, public utility districts, special utility districts, special service zones or districts or any combination thereof (collectively "Assessment Districts"), for the construction, alteration, expansion, improvements, completion, repair, operation or maintenance, as the case may be, of on-site or offsite improvements, or services, or any combination thereof, as required by the City of Pleasanton as a condition of approving the development of Hacienda Business Park, of which the Property is a part. These Assessment Districts may provide, among other things, the following improvements or services: streets, curbs, interchanges, highways, traffic noise studies and mitigation measures, traffic control systems and expansion of city facilities to operate same, landscaping and lighting maintenance services, maintenance of flood control facilities, water storage and distribution facilities, and fire apparatus, manpower and other fire safety facilities. B. CONSENT TO FORMATION. Tenant hereby consents to the formation of any and all of the Assessment Districts and waives any and all rights of notice and any and all rights of protest in connection with formation of the Assessment Districts and agrees to execute all documents, including, but not limited to, formal waivers of notice and protest evidencing such consent and waiver upon request of Landlord or the City of Pleasanton. 42. MORTGAGEE PROTECTION CLAUSE. Tenant agrees to give any mortgagees and/or trust deed holders ("Holders"), by registered mail, a copy of any notice of default served upon the Landlord, provided that prior to such notice Tenant has been notified, in writing (by way 28 34 of notice of assignment of rents and leases, or otherwise) of the address of such Holders. Tenant further agrees that if Landlord shall have failed to cure such default within the time provided for in this Lease, then the Holders shall have an additional sixty (60) days within which to cure such default or if such default cannot be cured within that time, then such additional time as may be necessary if within such sixty (60) days, any Holder has commenced and is diligently pursuing the remedies necessary to cure such default (including but not limited to commencement of foreclosure proceedings, if necessary to effect such cure) in which event this Lease shall not be terminated while such remedies are being so diligently pursued. 43. HAZARDOUS MATERIALS. A. "Hazardous Materials" shall mean any substance or material which has been determined by any state, federal or local governmental authority to be capable of posing a risk of injury to health, safety or property, including all of those materials and substances designated as hazardous or toxic by any municipal, county, state or federal rule, law, or regulation. Without limiting the generality of the foregoing, the term "Hazardous Materials" shall include asbestos or asbestos containing material, polychlorinated biphenyls in concentrations greater than 50 parts per million, hazardous waste identified in accordance with Section 3001 of the Federal Resource Conservation and Recovery Act of 1976, as amended, substances defined as "hazardous substances" or "toxic substances" in the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, 42 U.S.C. Sec. 9061; et seq.; Hazardous Materials Transportation Act, 49 U.S.C. Sec. 1802; and Resource Conservation and Recovery Act, 42 U. S.C. Sec. 6901 et seq., and all of those materials and substances defined as "hazardous waste" in California Health and Safety Code Section 25117 and Section 66160 of Title 26 of the California Code of Regulations, Division 22, as the same shall be amended from time to time, or any other materials requiring remediation under federal, state or local statutes, ordinances, regulations or policies. B. Tenant shall not introduce any Hazardous Materials in, on or adjacent to the Premises or the Property without complying with all applicable federal, state and local laws, rules, regulations, and policies relating to the storage, use, release, disposal, and clean-up of Hazardous Materials, including, but not limited to, the obtaining of proper permits. Tenant shall immediately notify Landlord of any inquiry, test, investigation, or enforcement proceeding by or against Tenant or the Premises concerning any Hazardous Materials. If Tenant's storage, use, release or disposal of any Hazardous Materials in, on or adjacent to the Premises or the Property results in any contamination of the Premises, the Property, or the soil or surface or groundwater in or about the Property, Tenant shall remove the contamination at its expense. Tenant further agrees to indemnify, defend and hold Landlord harmless from and against any claims, suits, causes of action, costs, fees, judgments and liabilities, including attorneys' fees and costs, arising out of or in connection with any clean-up work, inquiry or enforcement proceeding in connection therewith, and any Hazardous Materials used, stored or disposed of by Tenant or its agents, employees, contractors or invitees. Tenant's obligations under this Paragraph 43 shall survive termination of this Lease. Tenant shall also pay to Landlord upon demand, the cost of any inspections ordered by Landlord should the results of those inspections indicate that Tenant caused or permitted any of the contamination found in the Premises or the Property. Landlord agrees to indemnify, defend 29 35 and hold Tenant harmless from and against any claims, suits, causes of action, costs, fees, judgments and liabilities, including attorneys' fees and costs, arising out of or in connection with any clean-up work, inquiry or enforcement proceeding in connection and any Hazardous Materials used, stored or disposed of by Landlord or its agents and employees in violation of laws governing Hazardous Materials. Landlord's obligations under this Paragraph 43 shall survive termination of this Lease. C. Landlord warrants and represents that, to the best of its knowledge, there are no Hazardous Materials located on the Premises, and Landlord agrees to indemnify, defend and hold Tenant harmless from and against any claims, suits, causes of action, costs, fees, judgments and liabilities, including attorneys' fees and costs, arising out of or in connection with breach of this warranty. 44. MISCELLANEOUS AND GENERAL PROVISIONS. (a) Tenant shall not, without the written consent of Landlord, use the name of the Building, Property, or Park for any purpose other than as the address of the business conducted by Tenant in the Premises. (b) This Lease shall in all respects be governed by and construed in accordance with the laws of the State of California. If any provision of this Lease shall be invalid or unenforceable or ineffective for any reason whatsoever, all other provisions hereof shall be and remain in full force and effect. (c) The term "Premises" includes the space leased hereby and any improvements now or hereafter installed therein or attached thereto. The term "Landlord" or any pronoun used in place thereof includes the plural as well as the singular and the successors and assigns of Landlord. The term "Tenant" or any pronoun used in place thereof includes the plural as well as the singular and individuals, firms, associations, partnerships, and corporations, and their and each of their respective heirs, executors, administrators, successors and permitted assigns, according to the context hereof, and the provisions of this Lease, shall inure to the benefit of and bind such heirs, executors, administrators, successors and permitted assigns. The term "person" includes the plural as well as the singular and individuals, firms, associations, partnerships and corporations. Words used in any gender include other genders. If there be more than one Tenant the obligations of Tenant hereunder are joint and several. The paragraph headings of this Lease are for convenience or reference only and shall have no effect upon the construction or interpretation of any provision hereof. (d) Time is of the essence of this Lease and of each and all of its provisions. (e) At the expiration or earlier termination of this Lease, Tenant shall execute, acknowledge and deliver to Landlord, within ten (10) days after written demand by Landlord to Tenant, any quitclaim deed or other document required by any reputable title company, licensed to operate in the State of California, to remove the cloud or encumbrance created by this Lease from the real property of which Tenant's Premises are a part. 30 36 (f) This instrument along with any exhibits and attachments hereto constitute the entire agreement between Landlord and Tenant relative to the Premises and this agreement and the exhibits and attachments may be altered, amended or revoked only by an instrument in writing signed by both Landlord and Tenant. Landlord and Tenant agree hereby that all prior or contemporaneous oral agreements between and among themselves and their agents or representatives relative to the leasing of the Premises are merged in or revoked by this agreement. (g) Neither Landlord nor Tenant shall record this Lease or a short form memorandum hereof without the consent of the other. (h) Tenant further agrees to execute any amendments required by a tender to enable Landlord to obtain financing, so long as Tenant's rights hereunder are not substantially affected. (i) Except as provided herein, Landlord and Tenant agree that each has had an opportunity to determine to its satisfaction the actual area of the Premises and the Building. All measurements of area contained in this Lease are conclusively agreed to be correct and binding on the parties, even if a subsequent measurement of one of these areas determines that it is more or less than the area reflected in this Lease. Any such subsequent determination that the area is more or less than the area shown in this Lease shall not result in a change in any of the computations of rent, Tenant's Building Percentage and Tenant's Property Percentage, improvement allowances, or any other matters described in this Lease where area is a factor. (j) Clauses, plats and riders, if any, signed by Landlord and Tenant and endorsed on or affixed to this Lease are a part hereof. (k) Tenant covenants and agrees that no diminution or shutting off of light, air or view by any structure which may be hereafter erected (whether or not by Landlord) shall in any way affect this Lease, entitle Tenant to any reduction of rent hereunder or result in any liability of Landlord to Tenant. 45. LEASE OPTION TO EXTEND. A. OPTION PERIOD. Provided that Tenant is not in default hereunder, either at the time of exercise or at the time the extended term commences, Tenant shall have the option to extend the initial five (5) year term of this Lease for an additional period of three (3) years ("Lease Option Period") on the same terms, covenants and conditions provided herein, except that upon such renewal the Basic Rent due hereunder shall be determined pursuant to Paragraph 46.B. Tenant shall exercise its option by giving Landlord written notice ("Lease Option Notice") no sooner than three hundred (300) days, and no later than one hundred eighty (180) days, prior to the expiration of the initial term of this Lease. B. LEASE OPTION PERIOD BASIC RENT. The Basic Rent for the Lease Option Period shall be the Prevailing Market Rental Rate for comparable space in the Hacienda Business Park determined as of the commencement of the option term. "Prevailing Market Rental Rate" shall 31 37 mean an amount per rentable square foot that shall be determined with reference to the base annual rentals then being charged for space then being offered for rent in the Hacienda Business Park taking into account and adjusting for (i) the term of this Lease with respect to which Prevailing Market Rental Rate is being determined, (ii) the rental structure under this Lease and the leases for such other space, (iii) the size and location of the Premises and the age and quality of construction of the Premises and the leasehold improvements therein compared with such other space, (iv) the load factor consisting of the ratio of the usable area to the rentable area on each floor of the space; (v) an appropriate discount for payments or credits that would be made on such other space with respect to leasing commissions then customarily paid by Landlord for renewals at the time of the commencement of the option term, rental concessions or other inducements or improvement allowances offered on such other space and that are not required to be made by Landlord, and (vi) any other relevant terms and conditions relative to the leases of such other space; provided that in no event shall the Prevailing Market Rental Rate be less than the Basic Rent due in the last month of the initial term of this Lease. C. DETERMINATION OF PREVAILING MARKET RENTAL RATE. Within thirty (30) days after Landlord's receipt of the Lease Option Notice, Landlord shall give Tenant notice of Landlord's determination of the Prevailing Market Rental Rate for the space in question. If Tenant disputes Landlord's determination of the Prevailing Market Rental Rate, Tenant shall so notify Landlord within ten (10) business days following Landlord's notice to Tenant of the Prevailing Market Rental Rate and such dispute shall be resolved as follows: (i) Within thirty (30) days following Landlord's notice to Tenant of the Prevailing Market Rental Rate, Landlord and Tenant shall meet no less than two (2) times, at a mutually agreeable time and place, to attempt to resolve any such disagreement. (ii) If within this thirty (30) day period Landlord and Tenant cannot reach agreement as to the Prevailing Market Rental Rate, they shall each select one appraiser to determine the Prevailing Market Rental Rate. Each such appraiser shall arrive at a determination of the Prevailing Market Rental Rate and submit his conclusions to Landlord and Tenant within thirty (30) days of the expiration of the thirty (30) day consultation period described in (i) above. (iii) If only one appraisal is submitted within the requisite time period, it shall be deemed to be the Prevailing Market Rental Rate. If both appraisals are submitted within such time period, and if the two appraisals so submitted differ by less than ten percent (10%) of the higher of the two, the average of the two shall be the Prevailing Market Rental Rate. If the two appraisals differ by more than ten percent (10%) of the higher of the two, then the two appraisers shall immediately select a third appraiser, acceptable to both Landlord and Tenant, who will within thirty (30) days of his selection make a determination of the Prevailing Market Rental Rate and submit such determination to Landlord and Tenant. This third appraisal will then be averaged with the closer of the two previous appraisals and the result shall be the Prevailing Market Rental Rate. (iv) All appraisers specified pursuant hereto shall be members of the American Institute of Real Estate Appraisers with not less than five (5) years experience appraising 32 38 commercial properties in the vicinity of and in the City of Pleasanton and County of Alameda. Each party shall pay the cost of the appraiser selected by such party and one-half of the cost of the third appraiser plus one-half of any other costs incurred in the arbitration. 46. LEASE OPTION TO EXPAND. Provided that Tenant is not in default hereunder, Tenant shall have the option to expand to space immediately contiguous to the Premises, as follows. In the event that any space contiguous to the Premises becomes available and such space is not subject to any rights of a third party granted by Landlord prior to the date of this Lease, Landlord shall provide Tenant with written notice (the "Expansion Notice Letter") that such space (the "Expansion Space") will be available. Tenant shall have thirty (30) days from the date of the Expansion Notice Letter to determine whether to exercise its option to expand. If Tenant exercises its option in accordance with the foregoing terms, then the Expansion Space shall be incorporated into the Premises by Landlord and the commencement date for Tenant's lease of the Expansion Space shall be as set forth in the Expansion Notice Letter, or as otherwise determined by the parties. Rent for the Expansion Space shall be determined pursuant to Section 45 hereof. 47. LEASE OPTION TO TERMINATE. Provided that Tenant is not in default under this Lease, Tenant shall have the right to terminate this Lease at the end of the thirty-sixth (36th) month by giving Landlord notice prior to March 1, 2000. Tenant shall pay Landlord on the date of such termination the sum equal to all unamortized costs of the lease transaction (including leasing commissions and tenant improvements) plus six month's Basic Rent at the rental rate effective the thirty-seventh (37th) month. If Tenant exercises its option to terminate and does not vacate the Premises by the end of the thirty-sixth (36th ) month, such tenancy shall be treated as a holdover under Section 28 hereof. IN WITNESS WHEREOF, Landlord and Tenant have executed and delivered this Lease as of the day and year first above written. LANDLORD TENANT - -------- ------ PROPERTY CALIFORNIA OB ONE SUPERIOR NATIONAL INSURANCE CORPORATION, an Oregon corporation COMPANY, a California corporation By LASALLE ADVISORS LIMITED, its duly authorized agent By /s/ WILLIAM L. LUNTZ ------------------------------------- By /s/ DIANE R. MCMAHON Its C.E.O. --------------------------------- ----------------------------------- Its VICE PRESIDENT Date 10/17/97 -------------------------------- ----------------------------------- Date 10/29/97 ------------------------------- By /s/ WILLIAM W. BARENDRICK, JR. --------------------------------- Its PRINCIPAL -------------------------------- Date 10/29/97 ------------------------------- 33 39 EXHIBIT A THE PREMISES [SCHEMATIC] 40 EXHIBIT B THE PROPERTY Diablo Center Exhibit B Page 1 of 2 41 Diablo South 5775 West Las Positas Boulevard Pleasanton, California 39,306 Square Feet Exhibit B Page 2 of 2 42 SCHEDULE 1 Final Plans and Specifications for Superior National Insurance Tenant Improvements 5 43 EXHIBIT D RULES AND REGULATIONS 1. No sign, placard, picture, advertisement, name or notice shall be installed or displayed on any part of the outside or inside of the Building without the prior written consent of Landlord. Landlord shall have the right to remove, at Tenant's expense and without notice, any sign installed or displayed in violation of this rule. All approved signs or lettering on doors and walls shall be printed, painted, affixed or inscribed at the expense of Tenant by a person chosen by Landlord. 2. If Landlord objects in writing to any curtains, blinds, shades, screens or hanging plants or other similar objects attached to or used in connection with any window or door of the Premises, Tenant shall immediately discontinue such use. No awning shall be permitted on any part of the Premises. Tenant shall not place anything against or near glass partitions or doors or windows which may appear unsightly from outside the Premises. 3. Tenant shall not obstruct any sidewalks, halls, passages, exits, entrances, elevators, escalators, or stairways of the Building. The halls, passages, exits, entrances, shopping malls, elevators, escalators and stairways are not open to the general public. Landlord shall in all cases retain the right to control and prevent access thereto of all persons whose presence in the judgment of Landlord would be prejudicial to the safety, character, reputation and interest of the Building and its tenants; provided that nothing herein contained shall be construed to prevent such access to persons with whom any tenant normally deals in the ordinary course of its business, unless such persons are engaged in illegal activities. No tenant and no employee or invitee of any tenant shall go upon the roof of the Building. 4. The directory of the Building will be provided exclusively for the display of the name and location of Tenant only, and Landlord reserves the right to exclude any other names therefrom. 5. Tenant may provide cleaning and janitorial services for the Premises. Such cleaning and janitorial service contractors shall be licensed and prior to providing services, such contractors shall provide Landlord with a certificate of insurance, and except with the written consent of Landlord, no person or persons other than those approved by Landlord shall be employed by Tenant or permitted to enter the Building for the purpose of cleaning the same. Tenant shall not cause any unnecessary labor by carelessness or indifference to the good order and cleanliness of the Premises. Landlord shall not in any way be responsible to any tenant for any loss of property on the Premises, however occurring, or for any damage to any Tenant's property by the janitor or any other employee or any other person. 6. Landlord will furnish Tenant, free of charge, with two keys to each door lock in the Premises. Landlord may make a reasonable charge for any additional keys. Tenant shall 1 44 not make or have made additional keys, and Tenant shall not alter any lock or install a new additional lock or bolt on any door of its Premises. Tenant, upon the termination of its tenancy, shall deliver to Landlord the keys of all doors which have been furnished to Tenant, and in the event of loss of any keys so furnished, shall pay Landlord therefor. 7. If Tenant requires telegraphic, telephonic, burglar alarm or similar services, Tenant shall first obtain, and comply with, Landlord's instructions in their installation. 8. Any freight elevator shall be available for use by all tenants in the Building, subject to such reasonable scheduling as Landlord in its discretion shall deem appropriate. No equipment, materials, furniture, packages, supplies, merchandise or other property will be received in the Building or carried in the elevators except between such hours and in such elevators as may be designated by Landlord. 9. Tenant shall not place a load upon any floor of the Premises which exceeds the load per square foot which such floor was designed to carry and which is allowed by law. Landlord shall have the right to prescribe the weight, size and position of all equipment, materials, furniture or other property brought into the Building. Heavy objects shall, if considered necessary by Landlord, stand on such platforms as determined by Landlord to be necessary to properly distribute the weight. Business machines and mechanical equipment belonging to Tenant, which cause noise or vibration that may be transmitted to the structure of the Building or to any space therein to such a degree as to be objectionable to Landlord or to any tenants in the Building, shall be placed and maintained by Tenant, at Tenant's expense, on vibration eliminators or other devices sufficient to eliminate noise or vibration. The persons employed to move such equipment in or out of the Building must be acceptable to Landlord. Landlord will not be responsible for loss of, or damage to, any such equipment or other property from any cause, and all damage done to the Building be maintaining or moving such equipment or other property shall be repaired at the expense of Tenant. 10. Tenant shall not use or keep in the Premises any kerosene, gasoline or other inflammable or combustible fluid or material other than those limited quantities necessary for the operation or maintenance of office equipment. Tenant shall not use or permit to be used in the Premises any foul or noxious gas or substance, or permit or allow the Premises to be occupied or used in a manner offensive or objectionable to Landlord or other occupants of the Building by reason of noise, odors or vibrations, nor shall Tenant bring into or keep in or about the Premises any birds or animals. 11. Tenant shall not use any method of heating or air-conditioning other than that supplied by Landlord. 12. Tenant shall not waste electricity, water or air-conditioning and agrees to cooperate fully with Landlord to assure the most effective operation of the Buildings heating and air-conditioning and to comply with any governmental energy-saving rules, laws or regulations of which Tenant has actual notice, and shall refrain from adjusting controls. 2 45 Tenant shall keep corridor doors closed, and shall close window coverings at the end of each business day. 13. Landlord reserves the right, exercisable without notice and without liability to Tenant, to change the name and street address of the Building. 14. Landlord reserves the right to exclude from the Building between the hours of 6 p.m. and 7 a.m. the following day, or such other hours as may be established from time to time by Landlord, and on Sundays and legal holidays, any person unless that person is known to the person or employee in charge of the Building and has a pass or is properly identified. Tenant shall be responsible for all persons for whom it requests passes and shall be liable to Landlord for all acts of such persons. Landlord shall not be liable for damages for any error with regard to the admission to or exclusion from the Building of any person. Landlord reserves the right to prevent access to the Building in case of invasion, mob, riot, public excitement or other commotion by closing the doors or by other appropriate action. 15. Tenant shall close and lock the doors of its Premises and entirely shut off all water faucets or other water apparatus, and electricity, gas or air outlets before tenant and its employees leave the Premises. Tenant shall be responsible for any damage or injuries sustained by other tenants or occupants of the Building or by Landlord for noncompliance with this rule. 16. Tenant shall not obtain-for use on the Premises ice, drinking water, food, beverage, towel or other similar services or accept barbering or bootblacking service upon the Premises, except at such hours and under such regulations as may be fixed by Landlord. 17. The toilet rooms, toilets, urinals, wash bowls and other apparatus shall not be used for any purpose other than that for which they were constructed and no foreign substance of any kind whatsoever shall be thrown therein. The expense of any breakage, stoppage or damage resulting from the violation of this rule shall be borne by the tenant who, or whose employees or invitees, shall have caused it. 18. Tenant shall not sell, or permit the sale at retail, of newspapers, magazines, periodicals, theater tickets or any other goods or merchandise to the general public in or on the Premises. Tenant shall not make any room-to-room solicitation of business from other tenants in the Building. Tenant shall not use the Premises for any business or activity other than that specifically provided for in Tenant's Lease. 19. Tenant shall not install any radio or television antenna, loudspeaker or other devise on the roof or exterior walls of the Building. Tenant shall not interfere with radio or television broadcasting or reception from or in the Building or elsewhere. 20. Tenant shall not mark, drive nails, screw or drill into the partitions, woodwork or plaster or in any way deface the Premises or any part thereof. Landlord reserves the right to direct electricians as to where and how telephone and telegraph wires are to be introduced to the 3 46 Premises. Tenant shall not cut or bore holes for wires. Tenant shall not affix any floor covering to the floor of the Premises in any manner except as approved by Landlord. Tenant shall repair any damage resulting from noncompliance with this rule. 21. Tenant shall not install, maintain or operate upon the Premises any vending machine without the written consent of Landlord. 22. Canvassing, soliciting and distribution of handbills or any other written material, and peddling in the Building are prohibited, and each tenant shall cooperate to prevent same. 23. Landlord reserves the right to exclude or expel from the Building any person who, in Landlord's judgment, is intoxicated or under the influence of liquor or drugs or who is in violation of any of the Rules and Regulations of this Building. 24. Tenant shall store all its trash and garbage within its Premises. Tenant shall not place in any trash box or receptacle any material which cannot be disposed of in the ordinary and customary manner of trash and garbage disposal. All garbage and refuse disposal shall be made in accordance with directions issued from time to time by Landlord. 25. The Premises shall not be used for the storage of merchandise held for sale to the general public, or for lodging or for manufacturing of any kind, nor shall the Premises be used for any improper, immoral or objectionable purpose. No cooking shall be done or permitted by any tenant on the Premises, except that use by Tenant of Underwriters' Laboratory approved equipment for brewing coffee, tea, hot chocolate and similar beverages shall be permitted, provided that such equipment and use is in accordance with all applicable federal, state, county and city laws, codes, ordinances, rules and regulations. 26. Tenant shall not use in any space or in the public halls of the Building any hand trucks except those equipped with rubber tires and side guards or such other material-handling equipment as Landlord may approve. Tenant shall not bring any other vehicles of any kind into the Building. 27. Without the written consent of Landlord, Tenant shall not use the name of the Building in connection with or in promoting or advertising the business of Tenant except as Tenant's address. 28. Tenant shall comply with all safety, fire protection and evacuation procedures and regulations established by Landlord or any governmental agency. 29. Tenant assumes any and all responsibility for protecting its Premises, from theft, robbery and pilferage, which includes keeping doors locked and other means of entry to the Premises closed. 30. The requirements of Tenant will be attended to only upon appropriate application to the office of the Building by an authorized individual. Employees of Landlord shall not 4 47 perform any work or do anything outside of their regular duties unless under special instructions from Landlord, and no employee of Landlord will admit any person (Tenant or otherwise) to any office without specific instructions from Landlord. 31. Tenant shall not park its vehicles in any parking areas designated by Landlord as areas for parking by visitors to the Building. Tenant shall not leave vehicles in the Building parking areas overnight nor park any vehicles in the Building parking areas other than automobiles, motorcycles, motor driven or non-motor driven bicycles or four-wheeled trucks. 32. Landlord may waive any one or more of these Rules and Regulations for the benefit of Tenant or any other tenant, but no such waiver by Landlord shall be construed as a continuous waiver of such Rules and Regulations against any or all of the tenants of the Building. 33. These Rules and Regulations are in addition to, and shall not be construed to in any way modify or amend in whole or in part, the terms, covenants, agreements and conditions of any lease of premises in the Building 34. Landlord reserves the right to make such other reasonable Rules and Regulations as, in its judgment, may from time to time be needed for safety and security, for care and cleanliness of the Building and for the preservation of good order therein. Tenant agrees to abide by all such Rules and Regulations hereinabove stated and any additional rules and regulations which are adopted. 35. Tenant shall be responsible for the observance of all of the foregoing rules by Tenant's employees, agents, clients, customers, invitees and guests. 5 48 EXHIBIT C WORK LETTER AGREEMENT (TURN KEY) In connection with the improvements to be installed in the Premises (the "Tenant Improvements") the parties hereby agree as follows: 1. Plans and Specifications. Tenant shall prepare and submit to Landlord not later than October 24, 1997, for Landlord's review and approval a space plan for Tenant's proposed Tenant Improvements to the Premises (the "Space Plan"). Within five (5) business days after receipt of Tenant's Space Plan, Landlord shall notify Tenant of Landlord's approval or disapproval thereof, specifying in reasonable detail the basis for Landlord's disapproval, if applicable. Tenant shall cause the Landlord-approved architect (AD Architecture Design) to prepare final working architectural and engineering plans and specifications for the Tenant Improvements ("Final Plans and Specifications") based upon the approved Space Plan and such Final Plans and Specifications shall be reviewed by Landlord's architect. Tenant shall cooperate diligently with Landlord's architect and shall furnish, within five (5) business days after written request therefor, all information required by the architect for the completion of the Final Plans and Specifications. Landlord and Tenant shall indicate their approval of the Final Plans and Specifications by initialing them and attaching them hereto as Schedule 1. 2. Landlord to Construct. Landlord shall complete construction of the Tenant Improvements in a good and workmanlike manner, substantially in accordance with the Final Plans and Specifications approved by Landlord and Tenant. (a) Selection of Contractor. A contractor acceptable to Landlord shall be the contractor, and as of the date of this Work Letter Agreement, P.D. Larson Company shall be designated as the "Contractor" selected to complete the Tenant Improvements. Landlord shall endeavor to instruct the Contractor to use competitive bidding for completion of the Tenant Improvements. Landlord shall use its best efforts to enter into a "cost plus 12%" agreement with Contractor for completion of the Tenant Improvements which provides that the Contractor's overhead, insurance, general conditions, supervision and profit are included in the 12% amount. Landlord shall pay, without reimbursement from Tenant or the Tenant Improvements Allowance, all fees charged by Contractor in excess of such 12%. Landlord and Tenant may mutually agree to select an alternate Contractor to complete the Tenant Improvements. 3. Payment of Tenant Improvement Costs. Landlord shall provide Tenant with an allowance of Three Hundred Fifteen Thousand and no/100 Dollars ($315,000.00) ($15 per rentable square foot) for the design and construction of the Tenant Improvements ("Tenant Improvements Allowance"). The Tenant Improvements Allowance shall be the maximum 1 49 contribution by Landlord for the Tenant Improvement Cost (defined below) and shall be applied as primary payment. Any Tenant Improvement Cost in excess of the Tenant Improvements Allowance shall be paid to Landlord by Tenant within thirty (30) days after Landlord's written request therefor accompanied by itemized invoices evidencing the excess costs to be paid by Tenant along with prior written acceptance of such costs by Tenant. If Tenant pays any Tenant Improvement Costs directly, Landlord shall reimburse Tenant for such costs, subject to the Tenant Improvements Allowance limits. 4. Tenant Improvements Cost. The Tenant Improvements cost ("Tenant Improvement Cost") shall include all costs of designing and constructing the Tenant Improvements, including but not limited to: (a) All costs of preliminary and final architectural and engineering plans, if any, and specifications for the Tenant Improvements, including review by Landlord's architect, design build costs, and engineering costs associated with completion of the State of California energy utilization calculations under Title 24 legislation. (b) All costs of obtaining building permits and other necessary authorizations from the City of Pleasanton. (c) All costs of interior design and finish schedule plans and specifications, including as-built drawings. (d) All direct and indirect costs of procuring, constructing and installing the Tenant Improvements in the Premises, including but not limited to the construction fee for overhead and profit and the cost of on-site supervisory and administrative staff, office, equipment and temporary services rendered by Landlord's Contractor in connection with construction of the Tenant Improvements. (e) All fees payable to Tenant's architect and engineering firm if they are required by Tenant to redesign any portion of the Tenant Improvements. (f) A construction management fee, such fee not to exceed three percent (3%) of the first $315,000.00 of Tenant Improvement Cost. Tenant agrees to pay Landlord a construction management fee of 1.5% of any Tenant Improvement Costs exceeding $315,000.00. (g) Landlord agrees to pay its architect, outside of the Tenant Improvement Allowance, for any architectural review fee of the Final Plans and Specifications. (h) Tenant agrees to pay one-half of the total costs of separating the mechanical systems related to the Premises and Landlord agrees to pay one-half of the total costs of separating the mechanical systems and all costs associated with separating or sub-metering the electrical systems relating to the Premises. The Landlord's cost under this subsection (h) shall be outside the Tenant Improvement Allowance. 2 50 (i) All costs of furnishing and installing cabling for Tenant's voice and data systems; provided that Tenant shall observe all covenants set forth in Section 10 of the Lease regarding installation of Tenant's cabling (and any other alterations), and shall ensure that all work performed by Tenant or at Tenant's direction is carried out expeditiously and in a good and workmanlike manner, is uniformly of high quality, complies with all applicable government codes and regulations, and Tenant shall remain liable for any damage to the Premises or Building in connection therewith. In no event shall the Tenant Improvements Cost include any costs of procuring, constructing or installing in the Premises any of Tenant's personal property. 5. Change Requests. No revisions to the approved Space Plan or the Final Plans and Specifications shall be made by either Landlord or Tenant unless approved in writing by both parties. Landlord agrees to make all changes: (i) required by any public agency to conform with governmental regulations or (ii) requested in writing by Tenant and approved in writing by Landlord, which approval shall not be unreasonably withheld. Any costs related to such changes in (ii) above in excess of the Tenant Improvements Allowance shall be paid for by Tenant as set forth in Paragraph 3. The billing for such additional costs shall be accompanied by evidence of the amounts billed as is customarily used in the business. Costs related to such changes shall include, without limitation, any architectural or design fees and Landlord's Contractor's price for effecting the change. 6. Termination. If the Lease is terminated prior to completion of the Tenant Improvements due to the default of the Tenant, Tenant shall pay to Landlord, within five (5) days after receipt of a statement therefor, any costs incurred by Landlord through the date of such termination in connection with the Tenant Improvements. 7. Tenant Delays. The Commencement Date shall not be delayed due to delays caused by Tenant, including (i) Tenant's failure to furnish information for the preparation of plans and drawings; (ii) Tenant's request for special materials, finishes or installations which are not readily available; (iii) Tenant's changes in plans and/or working drawings after their approval by Landlord; (iv) Tenant's failure to complete its own improvement work to the extent Tenant delays completion by the City of Pleasanton of its final inspection and approval of the Tenant Improvements; or (v) interference with Landlord's work caused by Tenant or Tenant's contractors or subcontractors. 8. Punch-List. Within ten (10) days after completion of the Tenant Improvements, Tenant shall conduct a walk-through inspection of the Premises with Landlord and complete a punch-list of items needing additional work. Landlord shall complete all items on the punch-list as soon as reasonably possible. Upon completion of such punch-list items, Tenant shall approve such completed items in writing to Landlord. If Tenant fails to reject such items within seven (7) days of completion, such items shall be deemed approved by Tenant. If Tenant fails to submit a punch-list to Landlord within such ten (10) day period, it shall be deemed that there are no items needing additional work or repair. 3 51 9. Landlord agrees to adopt and to pursue a plan intended to comply with the Americans with Disabilities Act ("A.D.A.") as applicable to the Tenant Improvements being completed on the Premises. Landlord shall be responsible for all expenses relating to A.D.A. compliance with the Tenant Improvements. Tenant acknowledges that (a) compliance of the Premises with the A.D.A. depends upon the uses of the Premises, the location of each use within the Premises, and changes to these factors over time, and (b) Tenant may have obligations under the A.D.A. as an employer which may differ from its obligations as the operator of the Premises. Tenant agrees that after completion of the Tenant Improvements and delivery of the Premises by Landlord to Tenant, Tenant shall comply with all requirements of the A.D.A. related to any subsequent alterations and improvements to the Premises at the expense of Tenant and that Tenant shall make only such uses of the Premises in a manner that comply with the A.D.A. LANDLORD TENANT PROPERTY CALIFORNIA OB ONE SUPERIOR NATIONAL INSURANCE CORPORATION, an Oregon corporation COMPANY, a California corporation By LASALLE ADVISORS LIMITED, its duly authorized agent By /s/ [SIG] -------------------------------- By /s/ [SIG] Its Corporate Secretary ---------------------------- -------------------------------- Its Vice President Date October 28, 1997 ---------------------------- -------------------------------- Date October 29, 1997 ---------------------------- By /s/ [SIG] ---------------------------- Its Principal ---------------------------- Date October 29, 1997 ---------------------------- 4 EX-27.1 5 FINANCIAL DATA SCHEDULE
7 1,000 U.S. DOLLARS YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 1 205,214 0 0 1,526 0 0 242,116 35,376 3,927 5,879 416,569 201,255 12,913 0 0 30 101,277 0 34,301 25,517 416,569 140,920 12,674 44 0 90,447 19,977 17,718 17,261 6,437 10,824 0 (12,896) 0 (5,141) (0.98) (0.00) 195,131 95,826 (5,379) 37,945 95,533 152,100 (5,379) Reserves for unpaid claims, provision for insured events, and payments of claims are stated net of reinsurance. Reserves for unpaid claims - beginning of year include Pac Rim reserves at acquisition.
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