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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
COMMISSION FILE NUMBER: 1-15135
CHANDLER (U.S.A.), INC.
(Exact name of registrant as specified in its charter)
OKLAHOMA 73-1325906
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1010 MANVEL AVENUE, CHANDLER, OKLAHOMA 74834
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (405) 258-0804
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
-------------------------------- ---------------------------------------------
8.75% SENIOR DEBENTURES DUE 2014 AMERICAN STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act: NONE
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 Regulation 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. X
---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). YES NO X
--- ---
Aggregate market value of the voting stock held by non-affiliates of the
registrant on June 30, 2003, the last business day of the registrant's most
recently completed second fiscal quarter: None.
The number of common shares, $1.00 par value, of the registrant
outstanding on February 29, 2004 was 2,484, which are owned by Chandler
Insurance Company, Ltd.
DOCUMENTS INCORPORATED BY REFERENCE
Registrant does not incorporate by reference in this report any annual
report, proxy statement, or Rule 424 prospectus.
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PAGE 1
PART I
FORWARD-LOOKING STATEMENTS
Some of the statements made in this Form 10-K report, as well as
statements made by Chandler (U.S.A.), Inc. ("Chandler USA") in periodic press
releases and oral statements made by Chandler USA's officials constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Such forward-looking statements involve known
and unknown risks, uncertainties and other factors that may cause the actual
results, performance or achievements of Chandler USA to be materially different
from any future results, performance or achievements expressed or implied by
the forward-looking statements. Such factors include, among other things,
(i) general economic and business conditions; (ii) interest rate changes;
(iii) competition and regulatory environment in which Chandler USA and its
subsidiaries operate, including the ability to implement price increases;
(iv) claims frequency; (v) claims severity; (vi) catastrophic events of
unanticipated frequency or severity; (vii) the number of new and renewal policy
applications submitted to National American Insurance Company ("NAICO") by its
agents; (viii) the ability of NAICO to obtain adequate reinsurance in amounts
and at rates that will not adversely affect its competitive position; (ix) the
ability of NAICO to collect reinsurance recoverables; (x) the ability of NAICO
to maintain favorable insurance company ratings; and (xi) various other factors.
ITEM 1. BUSINESS
GENERAL
Chandler USA is an insurance holding company that provides administrative
services to its wholly owned subsidiaries NAICO and Chandler Insurance
Managers, Inc. ("CIMI"). Chandler USA is an Oklahoma corporation which is
wholly owned by Chandler Insurance Company, Ltd. ("Chandler Insurance"), a
privately owned Cayman Islands company. Chandler USA is headquartered in
Chandler, Oklahoma, in facilities also occupied by NAICO and CIMI.
Prior to December 2003, Chandler USA was a wholly owned subsidiary of
Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") which, in turn, was a
wholly owned subsidiary of Chandler Insurance. In December 2003, Chandler
Barbados was dissolved following the transfer of its assets, liabilities and
business to Chandler Insurance. Chandler Insurance assumed the obligations of
Chandler Barbados including those under its reinsurance agreements with NAICO
pursuant to a Distribution Agreement and a General Conveyance. The
reorganization of Chandler Barbados and Chandler Insurance was approved by the
Cayman Islands Monetary Authority, the Supervisor of Insurance in Barbados and
the Oklahoma Insurance Department.
NAICO is one of the leading commercial business insurance writers in
Oklahoma, providing property and casualty coverage for businesses in various
industries. NAICO has a network of independent agents, totaling approximately
159 at December 31, 2003, that market NAICO's insurance products. Independent
agents originate substantially all of NAICO's business. NAICO is licensed to
write property and casualty coverage in 45 states and the District of Columbia
and is authorized by the United States Department of the Treasury to write
surety bonds for contractors on federal projects. NAICO is currently rated as
B++ (Very Good) by A.M. Best Company, an insurance rating agency. This rating
is an independent opinion of a company's financial strength, operating
performance and ability to meet its obligations to policyholders.
In December 2002, Chandler USA completed the sale of its wholly owned
subsidiary, LaGere & Walkingstick Insurance Agency, Inc. ("L&W"), to Brown &
Brown, Inc. L&W previously functioned as Chandler USA's agency segment and is
presented as discontinued operations. See Note 4 to Consolidated Financial
Statements for more information on the sale of L&W.
INSURANCE PROGRAMS
NAICO writes various property and casualty insurance products through
three primary marketing programs. The programs are standard property and
casualty, political subdivisions and surety bonds.
STANDARD PROPERTY AND CASUALTY PROGRAM
NAICO offers workers compensation, automobile liability and physical
damage, other liability (including general liability, products liability and
umbrella liability) and property coverages under its standard property and
casualty program. In marketing these products, NAICO targets companies in the
construction, manufacturing, wholesale, service, oil and gas, and retail
industries. NAICO writes this business principally in Oklahoma and Texas.
PAGE 2
POLITICAL SUBDIVISIONS PROGRAM
Under the political subdivisions program, NAICO writes insurance policies
primarily for school districts in Oklahoma. As of December 31, 2003 NAICO
insured 298 school districts primarily in Oklahoma. The coverages offered
include workers compensation, automobile liability, automobile physical damage,
general liability, property and school board legal liability. NAICO has also
written property and casualty insurance for municipalities, primarily in
Oklahoma. During 2002 and 2003, NAICO significantly reduced its premium
writings in this portion of the program.
SURETY BOND PROGRAM
NAICO writes surety bonds, commonly referred to as contract performance
bonds, to secure the performance of contractors and suppliers on construction
projects. A substantial portion of this business is written in Texas and
Oklahoma. NAICO has also written bail bonds, which guarantee that the
principal will discharge obligations set by the court, as well as other types
of miscellaneous bonds. NAICO reduced the underwriting authority for the bail
bond portion of the program in 2003, and discontinued the bail bond portion of
the program as of the end of 2003.
The following table shows gross premiums earned and net premiums earned by
insurance program for the years 2001, 2002 and 2003. The term "gross premiums
earned" means gross premiums written (before reductions for premiums ceded to
reinsurers) less the increases or plus the decreases in the gross unearned
premium reserve for the unexpired portion of the policy term beyond the current
accounting period. The term "net premiums earned" means gross premiums earned
less reductions for earned premiums ceded to reinsurers. See "MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
GROSS PREMIUMS EARNED NET PREMIUMS EARNED
-------------------------- --------------------------
INSURANCE PROGRAMS 2001 2002 2003 2001 2002 2003
- ----------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Standard property and casualty .... $128,554 $106,051 $ 93,193 $ 53,130 $ 49,570 $ 45,521
Political subdivisions ............ 34,178 35,159 28,926 12,534 13,829 8,093
Surety bonds ...................... 8,796 5,104 3,908 4,125 3,310 2,724
Other (1) ......................... 71 249 252 196 248 245
-------- -------- -------- -------- -------- --------
TOTAL ............................. $171,599 $146,563 $126,279 $ 69,985 $ 66,957 $ 56,583
======== ======== ======== ======== ======== ========
- -------------------------------
(1) This category is comprised primarily of the run-off of discontinued programs and NAICO's
participation in various mandatory workers compensation pools and assigned risks.
LINES OF INSURANCE
The lines of insurance written by NAICO through its programs are workers
compensation, automobile liability, other liability (including general
liability, products liability and umbrella liability), automobile physical
damage, property, surety, inland marine and accident and health. The following
table shows net premiums earned as a percentage of total net premiums earned by
each line of insurance written by NAICO during the period indicated.
YEAR ENDED DECEMBER 31,
----------------------------------------------------
1999 2000 2001 2002 2003
-------- -------- -------- -------- --------
Workers compensation ............. 34% 25% 24% 22% 29%
Automobile liability ............. 17% 20% 19% 25% 27%
Other liability .................. 19% 25% 25% 25% 23%
Automobile physical damage ....... 8% 13% 17% 14% 10%
Property ......................... 3% 4% 7% 8% 5%
Surety ........................... 9% 8% 6% 5% 5%
Inland marine .................... 1% 1% 2% 1% 1%
Accident and health .............. 9% 4% -% -% -%
-------- -------- -------- -------- --------
Total .......................... 100% 100% 100% 100% 100%
======== ======== ======== ======== ========
PAGE 3
UNDERWRITING AND CLAIMS
Independent insurance agents submit applications for insurance coverage
for prospective customers to NAICO. NAICO reviews a prospective risk in
accordance with its specific underwriting guidelines. If the risk is approved
and coverage is accepted by the insured, NAICO issues an insurance policy.
NAICO has maintained a continuous contractual relationship with an
underwriting manager for the bail bond portion of the surety bond program.
During 2001, 2002 and 2003, the gross and net premiums earned for bail bonds
were $2.3 million, $2.3 million and $1.2 million, respectively. This
underwriting manager is an independent contractor and is responsible for
collection of all premiums and payment of all commissions to bail bond agents.
Additionally, it is responsible for all claims and recoveries and is required
to maintain collateral security for each bond. NAICO reduced the underwriting
authority for this underwriting manager in 2003, and discontinued the bail bond
portion of the surety bond program at the end of 2003.
NAICO's claims department reviews and administers all claims. When a
claim is received, it is reviewed and assigned to an in-house claim adjuster
based on the type and geographic location of the claim, its severity and its
class of business. NAICO's claim department is responsible for reviewing each
claim, obtaining necessary documentation and establishing loss and loss
adjustment expense reserves. NAICO's in-house claims staff handles and
supervises the claims, coordinates with outside legal counsel and independent
claims adjusters if necessary, and processes the claims to conclusion.
REINSURANCE
In the ordinary course of business, NAICO cedes insurance risks and a
portion of the insurance premiums to its reinsurers under various reinsurance
contracts that cover individual risks (facultative reinsurance) or entire
classes of business (treaty reinsurance). Reinsurance provides greater
diversification of insurance risk associated with business written and also
reduces NAICO's exposure from high policy limits or from catastrophic events
and hazards of an unusual nature. Amounts recoverable from reinsurers are
estimated in a manner consistent with the claim liability associated with the
reinsured policies. In formulating its reinsurance programs, NAICO considers
numerous factors, including the financial stability of the reinsurer, the
reinsurer's ability to provide sufficient collateral (if required), reinsurance
coverage offered and price.
Treaty reinsurance may be ceded under treaties on both a pro rata or
proportional basis (where the reinsurer shares proportionately in premiums and
losses) and an excess of loss basis (where only losses above a specific amount
are reinsured). The availability, costs and limits of reinsurance purchased
varies from year to year based upon prevailing market conditions, reinsurers'
underwriting results and NAICO's desired risk retention levels. A majority of
NAICO's reinsurance programs renew on January 1 or July 1 of each year. NAICO
renewed all January 1, 2004 reinsurance programs. At the present time, NAICO
expects to renew the reinsurance programs that renew on July 1, 2004.
NAICO has structured separate reinsurance programs for property (including
inland marine), workers compensation, casualty (including automobile liability,
general and products liability, umbrella liability and related professional
liability), automobile physical damage and construction surety bonds. NAICO
also purchases facultative reinsurance when it writes a risk with limits of
liability exceeding the maximum limits of its treaties or when it otherwise
considers such action appropriate. Chandler Insurance reinsures NAICO for a
portion of the risk on NAICO's reinsurance programs.
Under the 2001 workers compensation reinsurance program, NAICO's net
retention was 34% of the first $10,000 of loss per occurrence plus 30% of
$90,000 excess of $10,000 of loss per occurrence. Effective July 1, 2001,
NAICO added 28% of the $100,000 excess of $100,000 of loss per occurrence layer
to its net retention. Effective January 1, 2002, NAICO's net retention
increased to 50% of the first $200,000 of loss per occurrence. Effective
July 1, 2002, NAICO's net retention increased to 50% of the first $250,000 of
loss per occurrence. Effective January 1, 2003, NAICO's net retention
increased to 70% of the first $250,000 of loss per occurrence, and effective
July 1, 2003, NAICO's net retention increased to 70% of the first $500,000 of
loss per occurrence.
Under the 2001 casualty reinsurance program, NAICO retained 64% of the
first $100,000 of loss per occurrence. Effective July 1, 2001, NAICO added
60% of $150,000 excess of $100,000 of loss per occurrence plus 40% of $250,000
excess of $250,000 of loss per occurrence to its net retention. Effective
January 1, 2002, NAICO's net retention increased to 80% of the first $250,000
of loss per occurrence plus 40% of $250,000 excess of $250,000 of loss per
occurrence. Effective July 1, 2002, NAICO's net retention decreased to 80% of
the first $250,000 of loss per occurrence. Effective January 1, 2003, NAICO's
net retention decreased to 70% of the first $250,000 of loss for occurrence,
and effective July 1, 2003, NAICO's net retention increased to 70% of the first
$500,000 of loss per occurrence.
PAGE 4
Under the 2001 construction surety bond reinsurance program, NAICO's net
retention was 50% of the first $350,000 plus 5% of $6,000,000 excess of
$4,000,000 per principal (e.g., contractor). Effective April 1, 2002, NAICO's
net retention increased to 50% of the first $1,000,000 plus 10% of $4,000,000
excess of $1,000,000 per principal. Effective January 1, 2003, NAICO increased
its retention for the first $1,000,000 of loss per principal from 50% to 70%.
NAICO elected not to renew its construction surety bond excess of loss
reinsurance effective April 1, 2003 due to the decreased premium volume in
this program and to the current market for this reinsurance. Effective April
1, 2003, NAICO retains 70% of the losses in this program.
Under the 2001 and 2002 property reinsurance program, NAICO retained 33%
of the first $1,500,000 of risk for each loss per risk or location. Effective
January 1, 2003, NAICO retains 23.1% of the first $1,500,000 of risk for each
loss per risk or location. Effective January 1, 2004, NAICO retains 23.1% of
the first $3,000,000 of risk for each loss per risk or location. Under the
2001 and 2002 automobile physical damage reinsurance program, NAICO retained
the first $500,000 of each loss per occurrence, plus 5% of amounts exceeding
$500,000 of each loss per occurrence up to $1 million of each loss per
occurrence. Effective January 1, 2003, NAICO retains 70% of the first $500,000
of each loss per occurrence, plus 3.5% of amounts exceeding $500,000 of each
loss per occurrence up to $1 million of each loss per occurrence. Effective
January 1, 2004, NAICO retains 70% of each loss per occurrence on automobile
physical damage risks. NAICO purchases catastrophe protection for its
automobile physical damage and certain property coverages to limit its
retention for single loss occurrences involving multiple policies and/or
policyholders resulting from perils such as floods, winds and severe storms.
This catastrophe protection limits NAICO's net retained loss for both
automobile physical damage and property losses to $1,000,000 for 2001 and 2002,
$700,000 for 2003 and $1,400,000 effective January 1, 2004 for each loss
occurrence.
On November 26, 2002, President Bush signed the Terrorism Risk Insurance
Act of 2002 (the "Act"), establishing a program for commercial property and
casualty losses, including workers compensation, resulting from foreign acts of
terrorism. The Act requires commercial insurers to offer terrorism coverage on
its commercial property and casualty lines of business. Each insurance company
will be responsible for a deductible based on a percentage of direct earned
premiums from the previous calendar year, which rises from 7% for losses
occurring in 2003 to 10% in 2004 and 15% in 2005. The Federal Government will
pay 90% of covered terrorism losses that exceed company deductibles. The
Federal Government will be required to recoup the portion of any federal
compensation paid to the extent that industry retentions are less than $10
billion for events in 2003, $12.5 billion for 2004 and $15 billion for 2005.
The recoupment will be accomplished through a surcharge on all policyholders,
not to exceed 3% of premiums in a given year. The Act is scheduled to expire
on December 31, 2005.
Effective January 1, 2003, NAICO purchased quota share reinsurance for its
deductible under the Act limiting NAICO's retention to 10% of such deductible
subject to a reinsurance limit of $9,450,000 for each loss occurrence. The
reinsurance coverage is also limited to $9,450,000 for all occurrences for any
year. NAICO also purchased excess of loss reinsurance covering acts of
terrorism that provides coverage of $20 million excess of $10 million of loss
per occurrence based on NAICO's net retention.
PAGE 5
The following table sets forth certain information related to NAICO's five
largest reinsurers determined on the basis of net reinsurance recoverables as
of December 31, 2003.
CEDED REINSURANCE
NET PREMIUMS FOR A.M. BEST
REINSURANCE THE YEAR ENDED COMPANY
NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2003 RATING
- -------------------------------------------- --------------- ----------------- ------------
(Dollars in thousands)
Swiss Reinsurance America Corporation ...... $ 28,649 $ 130 A+
Chandler Insurance ......................... 19,529 25,992 -(2)
Employers Reinsurance Corporation .......... 18,385 18,907 A
Red River Reinsurance, Ltd. ................ 5,904 5,016 -(3)
GE Reinsurance Corporation ................. 5,109 (113) A
--------------- -----------------
Top five reinsurers ...................... $ 77,576 $ 49,932
=============== =================
All reinsurers ........................... $ 92,522 $ 66,604
=============== =================
Percentage of total represented by top
five reinsurers .......................... 84% 75%
- --------------------------------------------
(1) Includes losses and loss adjustment expenses paid and outstanding, unpaid losses and
loss adjustment expenses and prepaid reinsurance premiums recoverable from reinsurers
as of December 31, 2003.
(2) Chandler Insurance owns 100% of the common stock of Chandler USA, which in turn owns
100% of the common stock of NAICO. Although Chandler Insurance is not subject to the
minimum capital, audit, reporting and other requirements imposed by regulation upon
United States reinsurance companies, as a foreign reinsurer, it is required to secure
its reinsurance obligations by depositing acceptable securities in trust for NAICO's
benefit. At December 31, 2003, Chandler Insurance had cash and investments with a fair
value of $19.7 million deposited in a trust account for the benefit of NAICO. Chandler
Insurance includes amounts assumed from Chandler Barbados that resulted from the transfer
of its business to Chandler Insurance in December 2003.
(3) Red River Reinsurance, Ltd. ("Red River") is required to secure its reinsurance obligations
by depositing acceptable securities in trust for NAICO's benefit. At December 31, 2003,
Red River's reinsurance recoverables were collateralized by cash and investments with a
fair value of $6.2 million deposited in a trust account for the benefit of NAICO and by
premiums payable to Red River of approximately $730,000.
Transamerica Occidental Life Insurance Company ("Transamerica") reinsured
NAICO for certain workers compensation risks during 1989, 1990 and 1991.
Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed
under the reinsurance treaties. Transamerica owes NAICO approximately $1.6
million for reinsurance recoverables on paid losses and loss adjustment
expenses as of December 31, 2003. NAICO is currently engaged in arbitration
in order to enforce the terms of the reinsurance treaties.
Reliance Insurance Company ("Reliance") reinsured NAICO for certain
workers compensation risks during 1998. At December 31, 2003, NAICO had
reinsurance recoverables from Reliance for paid and unpaid losses of
approximately $3.1 million. During October 2001, the Commonwealth of
Pennsylvania placed Reliance in liquidation. At this time, NAICO is unable
to determine the amount of its reinsurance recoverables from Reliance that will
ultimately be collected and has fully reserved the carrying value of such
amounts as of December 31, 2003.
Reinsurance contracts do not relieve an insurer from its obligation to
policyholders. Failure of reinsurers to honor their obligations could result
in losses to Chandler USA; consequently, adjustments to ceded losses and loss
adjustment expenses are made for amounts deemed uncollectible. NAICO incurred
charges of $454,000, $1.7 million and $604,000 during 2001, 2002 and 2003,
respectively, in adjustments to ceded losses and loss adjustment expenses for
amounts deemed uncollectible.
PAGE 6
LOSS AND UNDERWRITING EXPENSE RATIOS
The combined loss and underwriting expense ratio ("Combined Ratio") is
the traditional measure of underwriting experience for property and casualty
insurance companies. It is the sum of the ratios of (i) incurred losses and
loss adjustment expenses to net premiums earned ("loss ratio") and (ii)
underwriting expenses to net premiums written and assumed ("underwriting
expense ratio").
The following table shows the underwriting experience of Chandler USA for
the periods indicated by line of insurance written. Adjustments to reserves
made in subsequent periods are reflected in the year of adjustment. In the
following table, incurred losses include paid losses and loss adjustment
expenses, net changes in case reserves for losses and loss adjustment expenses
and net changes in reserves for incurred but not reported losses and loss
adjustment expenses. See also "Reserves" and "MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
YEAR ENDED DECEMBER 31,
--------------------------------------------
1999 2000 2001 2002 2003
-------- -------- -------- -------- --------
(Dollars in thousands)
Workers compensation:
Net premiums earned ............................ $ 29,244 $ 21,161 $ 16,449 $ 14,808 $ 16,378
Loss ratio ..................................... 77% 70% 105% 99% 72%
Automobile liability:
Net premiums earned ............................ $ 15,027 $ 17,517 $ 13,386 $ 16,526 $ 15,624
Loss ratio ..................................... 78% 78% 70% 81% 49%
Other liability:
Net premiums earned ............................ $ 15,785 $ 20,992 $ 17,470 $ 16,458 $ 12,870
Loss ratio ..................................... 70% 56% 57% 80% 94%
Automobile physical damage:
Net premiums earned ............................ $ 7,039 $ 11,434 $ 12,174 $ 9,552 $ 5,508
Loss ratio ..................................... 104% 85% 52% 35% 36%
Property:
Net premiums earned ............................ $ 2,972 $ 3,377 $ 4,806 $ 5,543 $ 3,072
Loss ratio ..................................... 203% 179% 93% 50% 74%
Surety:
Net premiums earned ............................ $ 8,061 $ 6,760 $ 4,125 $ 3,310 $ 2,723
Loss ratio ..................................... 6% 33% 57% 59% 34%
Inland marine:
Net premiums earned ............................ $ 775 $ 1,088 $ 1,256 $ 760 $ 408
Loss ratio ..................................... 138% 142% 143% 100% 54%
Accident and health:
Net premiums earned ............................ $ 8,195 $ 3,190 $ 319 $ - $ -
Loss ratio ..................................... 104% 161% 281% -% -%
Total:
Net premiums earned ............................ $ 87,098 $ 85,519 $ 69,985 $ 66,957 $ 56,583
Loss ratio ..................................... 79% 76% 75% 76% 66%
Underwriting expense ratio (1) ................. 32% 30% 33% 34% 47%
-------- -------- -------- -------- --------
Combined ratio (1) ............................. 111% 106% 108% 110% 113%
======== ======== ======== ======== ========
- ---------------------------------------------------
(1) Interest expense and certain litigation expenses are not considered underwriting expenses;
therefore, such costs have been excluded from these ratios. The underwriting expense ratio
for 2003 was impacted by a 23% decrease in net premiums written and assumed during 2003.
Certain types of expenses are fixed in nature, resulting in an increased ratio for this
period. See also "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS."
PAGE 7
RESERVES
Insurance companies provide in their financial statements reserves for
unpaid losses and loss adjustment expenses which are estimates of the expense
of investigation and settlement of all reported and incurred but not reported
losses under their previously issued insurance policies and/or reinsurance
contracts. In estimating reserves, insurance companies use various
standardized methods based on historical experience and payment and reporting
patterns for the type of risk involved. The application of these methods
involves subjective determinations by the personnel of the insurance company.
Inherent in the estimates of the ultimate liability for unpaid claims are
expected trends in claim severity, claim frequency and other factors that may
vary as claims are settled. The amount of and uncertainty in the estimates is
affected by such factors as the amount of historical claims experience relative
to the development period for the type of risk, knowledge of the actual facts
and circumstances and the amount of insurance risk retained. The ultimate cost
of insurance claims can be adversely affected by increased costs, such as
medical expenses, repair expenses, costs of providing legal defense for
policyholders, increased jury awards and court decisions and legislation that
expand insurance coverage after the insurance policy was priced and sold. In
recent years, certain of these factors have contributed to incurred amounts
that were higher than original estimates. Accordingly, the loss and loss
adjustment expense reserves may not accurately predict an insurance company's
ultimate liability for unpaid claims.
NAICO periodically reviews the reserve estimates relating to insurance
business written or assumed by NAICO, and the methods used to arrive at such
reserve estimates. NAICO also retains independent professional actuaries who
review such reserve estimates and methods. Any changes in the estimates are
reflected in current operating results. Such changes in estimates may be
material. Salvage and subrogation recoverables are accrued using the "case
basis" method for large recoverables and statistical estimates based on
historical experience for smaller recoverables. Recoverable amounts deducted
from Chandler USA's net liability for losses and loss adjustment expenses were
approximately $5.6 million and $5.7 million at December 31, 2002 and 2003,
respectively. NAICO's statutory-based reserves (reserves calculated in
accordance with an insurer's domiciliary state insurance regulatory
authorities) do not differ from its reserves reported on the basis of
accounting principles generally accepted in the United States of America
("GAAP"). NAICO does not discount its reserves for unpaid losses or loss
adjustment expenses.
NAICO participates in various pools covering workers compensation risks
for insureds who were unable to purchase this coverage from an insurance
company on a voluntary basis. In addition, NAICO receives direct assignments
to write workers compensation for such insureds in lieu of participating in
the pools. The consolidated financial statements reflect the reserves for
unpaid losses and loss adjustment expenses and net premiums earned from its
participation in the pools and from these direct assignments.
There may be significant reporting lags between the occurrence of the
insured loss and the time it is actually reported to the insurer. The inherent
uncertainties in estimating insurance reserves are generally greater for
casualty coverages, such as workers compensation, general and automobile
liability, than for property coverages primarily due to the longer period of
time that typically elapses before a definitive determination of ultimate loss
can be made, which is also affected by changing theories of legal liability and
changing political climates.
There are significant additional uncertainties in estimating the amount of
reserves required for environmental, asbestos-related and other latent exposure
claims, including a lack of historical data, long reporting delays and complex
unresolved legal issues regarding policy coverage and the extent and timing of
any such contractual liability. Courts have reached different and frequently
inconsistent conclusions as to when the loss occurred, what claims are covered,
under what circumstances the insurer has an obligation to defend, how policy
limits are determined and how policy exclusions are applied and interpreted.
The loss settlement period on insurance claims for property damage is
relatively short. The more severe losses for bodily injury and workers
compensation claims have a much longer loss settlement period and may be paid
out over several years. It is often necessary to adjust estimates of liability
on a loss either upward or downward from the time a claim arises to the time of
payment. Workers compensation indemnity benefit reserves are determined based
on statutory benefits described by state law and are estimated based on the
same factors generally discussed above which may include, where state law
permits, inflation adjustments for rising benefits over time. Generally, the
more costly automobile liability claims involve one or more severe bodily
injuries or deaths. The ultimate cost of these types of claims is dependent on
various factors including the relative liability of the parties involved, the
number and severity of injuries and the legal jurisdiction where the incident
occurred.
PAGE 8
The following table sets forth a reconciliation of the beginning and
ending reserves for losses and loss adjustment expenses which are net of
reinsurance deductions for the years indicated.
YEAR ENDED DECEMBER 31,
-------------------------------------------------
1999 2000 2001 2002 2003
--------- --------- --------- --------- ---------
(In thousands)
Net balance at beginning of year ............. $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191
--------- --------- --------- --------- ---------
Net losses and loss adjustment expenses incurred
related to:
Current year ............................. 65,139 60,020 39,881 34,928 26,108
Prior years .............................. 3,520 4,979 12,669 15,784 11,092
--------- --------- --------- --------- ---------
Total .................................. 68,659 64,999 52,550 50,712 37,200
--------- --------- --------- --------- ---------
Net paid losses and loss adjustment expenses
related to:
Current year ............................. (33,306) (33,661) (22,646) (13,283) (10,626)
Prior years .............................. (23,896) (36,009) (43,799) (37,050) (30,422)
--------- --------- --------- --------- ---------
Total .................................. (57,202) (69,670) (66,445) (50,333) (41,048)
--------- --------- --------- --------- ---------
Net balance at end of year ................... $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343
========= ========= ========= ========= =========
During 2001, NAICO experienced incurred losses related to prior accident
years totaling $12.7 million due primarily to increased loss severity in the
standard property and casualty and political subdivisions programs. A
substantial part of this loss development was for workers compensation losses
in the 1999 accident year. NAICO's net retention for workers compensation
losses increased substantially in 1999 due to the rescission of certain
reinsurance treaties covering this line of business. Also contributing to the
adverse loss development were provisions for potentially uncollectible
reinsurance and deductibles of approximately $1.2 million during 2001, an
increase in losses in the surety bond program and approximately $878,000 in
losses for the runoff of a discontinued group accident and health program.
During 2002, NAICO experienced incurred losses related to prior accident
years totaling $15.8 million primarily in the standard property and casualty
program including both liability lines and workers compensation. This adverse
development is generally the result of ongoing analysis of recent loss
development trends that reflect an increase in loss severity within the
1997-2000 accident years. The adverse loss development included approximately
$2.0 million for provisions for potentially uncollectible reinsurance and
deductibles.
During 2003, NAICO experienced incurred losses related to prior accident
years totaling $11.1 million primarily in the standard property and casualty
program. This adverse development was due primarily to an increase in losses
in the workers compensation and other liability lines of business in the
1998-2001 accident years. A reduction in losses for the 2002 accident year
partially offset this adverse development. The adverse loss development
included approximately $1.3 million for provisions for potentially
uncollectible reinsurance and deductibles.
The following table represents the development of net balance sheet
reserves for 1994 through 2003. The top line of the table shows the net
reserves at the balance sheet date for each of the indicated years. This
represents the estimated amounts of claims and claim expenses, net of
reinsurance deductions, arising in the current and all prior years that are
unpaid at the balance sheet date, including the net reserve for incurred but
not reported claims. The upper portion of the table shows the cumulative net
amounts paid as of successive years with respect to that reserve liability.
The estimate for unpaid losses and loss adjustment expenses changes as more
information becomes known about the frequency and severity of claims for
individual years. The next portion of the table shows the revised estimated
amount of the previously recorded net reserve based on experience as of the end
of each succeeding year. The heading "net cumulative (deficiency) redundancy"
represents the cumulative aggregate change in the estimates over all prior
years. The last portion of the table provides a reconciliation of the net
amounts to the gross amounts before any deductions for reinsurance. The gross
cumulative deficiency or redundancy results from the same factors as those
described above for the net amounts, and is also impacted by development of
large claims that exceed NAICO's net retention including umbrella and surety
per principal losses where NAICO has little or no net retention.
PAGE 9
In evaluating the information in the following table, it should be noted
that each amount includes the effects of all changes in amounts for prior
periods. For example, the amount of the deficiency recorded in 1997 for claims
that occurred in 1994 will be included in the cumulative deficiency amount for
years 1994, 1995, 1996 and 1997. This table does not present accident or
policy year development data. Conditions and trends that have affected
development of the liability in the past may not necessarily occur in the
future. Accordingly, it may not be appropriate to extrapolate future
deficiencies or redundancies based on this table.
DEVELOPMENT OF RESERVES
AS OF DECEMBER 31,
-----------------------------------------------------------------------------------------------------
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
--------- --------- --------- --------- --------- --------- ---------- ---------- --------- ---------
(In thousands)
Net reserve for unpaid
losses and loss adjustment
expenses .................... $ 64,308 $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343
Net paid (cumulative) as of
One year later ............. 30,771 31,768 28,572 30,330 23,896 36,009 43,799 37,050 30,422
Two years later ............ 45,321 44,471 40,857 42,934 34,966 58,979 66,141 60,560
Three years later .......... 51,985 49,262 45,668 49,735 45,390 72,052 81,635
Four years later ........... 54,825 51,101 47,995 56,306 51,364 80,860
Five years later ........... 55,691 52,126 50,700 58,843 55,445
Six years later ............ 56,278 54,040 51,878 60,821
Seven years later .......... 57,826 54,574 52,964
Eight years later .......... 58,378 55,294
Nine years later ........... 59,143
Net liability re-estimated as of
One year later ............. 62,757 59,644 55,713 55,772 43,441 56,357 59,376 48,596 44,283
Two years later ............ 61,924 59,605 55,599 56,362 45,373 67,469 74,325 67,903
Three years later .......... 62,737 59,155 54,528 58,176 50,146 77,842 86,377
Four years later ........... 62,636 58,247 54,834 61,096 55,303 83,860
Five years later ........... 62,195 58,445 55,615 62,750 58,060
Six years later ............ 62,295 58,567 56,347 63,629
Seven years later .......... 62,630 59,013 56,879
Eight years later .......... 63,026 59,296
Nine years later ........... 63,302
Net cumulative (deficiency)
redundancy ................. $ 1,006 $ (956) $ (3,034) $ (9,594) $(18,139) $(32,482) $ (39,670) $ (35,091) $(11,092) $ -
Supplemental gross data:
Gross liability ............ $143,437 $116,149 $ 78,114 $ 73,721 $ 80,701 $ 98,460 $ 100,173 $ 84,756 $ 92,606 $ 87,768
Reinsurance recoverable .... 79,129 57,809 24,269 19,686 40,780 47,082 53,466 51,944 59,415 58,425
--------- --------- --------- --------- --------- --------- ---------- ---------- --------- ---------
Net liability-end of year... $ 64,308 $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343
========= ========= ========= ========= ========= ========= ========== ========== ========= =========
Gross re-estimated
liability - latest ....... $143,266 $120,526 $ 94,132 $ 96,398 $122,620 $169,673 $ 216,197 $ 222,553 $156,078
Re-estimated recoverable -
latest ................... 79,964 61,230 37,253 32,769 64,560 85,813 129,820 154,650 111,795
--------- --------- --------- --------- --------- --------- ---------- ---------- ---------
Net re-estimated
liability - latest........ $ 63,302 $ 59,296 $ 56,879 $ 63,629 $ 58,060 $ 83,860 $ 86,377 $ 67,903 $ 44,283
========= ========= ========= ========= ========= ========= ========== ========== =========
Gross cumulative (deficiency)
redundancy ................. $ 171 $ (4,377) $(16,018) $(22,677) $(41,919) $(71,213) $(116,024) $(137,797) $(63,472)
========= ========= ========= ========= ========= ========= ========== ========== =========
PAGE 10
INVESTMENTS
Funds available for investment include Chandler USA's present capital as
well as premiums received and retained under insurance policies and reinsurance
agreements issued by NAICO. Until these funds are required to be used for the
settlement of claims and the payment of operating expenses, they are invested
with the objective of generating income, preserving principal and maintaining
liquidity.
Fixed-maturity investments are purchased to support the investment
strategies of Chandler USA and its subsidiaries, which are developed based on
many factors including rate of return, maturity, credit risk, tax
considerations, regulatory requirements and their mix of business. At the
time of purchase, investments in debt securities that Chandler USA has the
positive intent and ability to hold to maturity are classified as held to
maturity and reported at amortized cost; all other debt securities are reported
at fair value. Investments classified as trading are actively and frequently
bought and sold with the objective of generating income on short-term
differences in price. Realized and unrealized gains and losses on securities
classified as trading account assets are recognized in current operations.
Chandler USA has not classified any investments as trading account assets.
Securities not classified as held to maturity or trading are classified as
available for sale, with the related unrealized gains and losses excluded from
earnings and reported net of deferred income tax as a separate component of
other comprehensive income until realized. Realized gains and losses on sales
of securities are based on the specific identification method. Declines in the
fair value of investment securities below their carrying value that are other
than temporary are recognized in earnings.
As of December 31, 2003, all of the investments of NAICO were in
fixed-maturity investments (rated Aa3 or AA or better by Moody's Investors
Service, Inc. or Standard & Poor's, respectively), interest-bearing money
market accounts, collateralized repurchase agreements and common stock received
in connection with an unaffiliated entity's conversion to a for-profit
corporation. NAICO's investment portfolio is managed by the Investment
Committee of its Board of Directors. For additional information, see Notes to
Consolidated Financial Statements.
DEBENTURES
On July 16, 1999, Chandler USA completed a public offering of $24 million
principal amount of senior debentures (the "Debentures") with a maturity date
of July 16, 2014. The Debentures were priced at $1,000 each with an interest
rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009
without penalty or premium. The indenture governing the Debentures was amended
during 2003 to clarify that purchases of Debentures by Chandler USA through
private treaty or on the open market for an agreed price of less than the sum
of the principal amount and accrued interest are not considered to be a
redemption of the Debentures, and that any such Debentures purchased by
Chandler USA will be cancelled. During 2003, Chandler USA purchased and
cancelled $16.7 million principal amount of the Debentures, and at December 31,
2003, there was $7,254,000 principal amount of the Debentures outstanding.
Chandler USA's subsidiaries and affiliates are not obligated by the Debentures.
Accordingly, the Debentures are effectively subordinated to all existing and
future liabilities and obligations of Chandler USA's existing and future
subsidiaries. For addition information, see "MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
TRUST PREFERRED SECURITIES
In May 2003, Chandler USA established Chandler Capital Trust I ("Trust
I"). Trust I is a Delaware statutory business trust and is a wholly owned
consolidated subsidiary of Chandler USA. On May 22, 2003, Trust I issued
$13.0 million of capital securities (the "Trust I Preferred Securities") to
InCapS Funding I, Ltd., an unaffiliated company established under the laws of
the Cayman Islands, in a private transaction. Distributions on the Trust I
Preferred Securities are payable quarterly at a fixed annual rate of 9.75%
beginning August 23, 2003. Trust I may defer these payments for up to 20
consecutive quarters, but not beyond the maturity of the Trust I Preferred
Securities, with such deferred payments accruing interest compounded quarterly.
The Trust I Preferred Securities are subject to a mandatory redemption on May
23, 2033, but they may be redeemed after five years at a premium of half the
fixed rate coupon declining ratably to par in the 10th year. All payments by
Trust I regarding the Trust I Preferred Securities are guaranteed by Chandler
USA.
PAGE 11
Trust I used the proceeds from the sale of the Trust I Preferred
Securities to purchase 9.75% junior subordinated debentures (the "Junior
Debentures I") of Chandler USA in like amount, and will distribute any cash
payments it receives thereon to the holders of its preferred and common
securities. The Junior Debentures I are the sole assets of Trust I.
Distributions on the Junior Debentures I are payable quarterly at a fixed
annual rate of 9.75% beginning August 23, 2003. Chandler USA may defer these
payments for up to 20 consecutive quarters, but not beyond the maturity of the
Junior Debentures I, with such deferred payments accruing interest compounded
quarterly. The Junior Debentures I are subject to a mandatory redemption on
May 23, 2033, but they may be redeemed after five years at a premium of half
the fixed rate coupon declining ratably to par in the 10th year.
In December 2003, Chandler USA established Chandler Capital Trust II
("Trust II"). Trust II is a Delaware statutory business trust and is a wholly
owned consolidated subsidiary of Chandler USA. On December 16, 2003, Trust II
issued $7.0 million of capital securities ("Trust II Preferred Securities") to
InCapS Funding II, Ltd., an unaffiliated company established under the laws of
the Cayman Islands, in a private transaction. Distributions on the Trust II
Preferred Securities are payable quarterly at a floating rate of 4.10% over
LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed
12.5% prior to January 8, 2009) beginning April 8, 2004. The interest rate for
the initial quarterly period was determined to be 5.26813%. Trust II may defer
these payments for up to 20 consecutive quarters, but not beyond the maturity
of the Trust II Preferred Securities, with such deferred payments accruing
interest compounded quarterly. The Trust II Preferred Securities are subject
to a mandatory redemption on January 8, 2034, but they may be redeemed after
five years without penalty or premium. All payments by Trust II regarding the
Trust II Preferred Securities are guaranteed by Chandler USA.
Trust II used the proceeds from the sale of the Trust II Preferred
Securities to purchase floating rate junior subordinated debentures (the
"Junior Debentures II") of Chandler USA in like amount, and will distribute
any cash payments it receives thereon to the holders of its preferred and
common securities. The Junior Debentures II are the sole assets of Trust II.
Distributions on the Junior Debentures II are payable quarterly at a floating
rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate
may not exceed 12.5% prior to January 8, 2009) beginning April 8, 2004. The
interest rate for the initial quarterly period was determined to be 5.26813%.
Chandler USA may defer these payments for up to 20 consecutive quarters, but
not beyond the maturity of the Junior Debentures II, with such deferred
payments accruing interest compounded quarterly. The Junior Debentures II are
subject to a mandatory redemption on January 8, 2034, but they may be redeemed
after five years without penalty or premium.
The sale of the Trust I Preferred Securities and the Trust II Preferred
Securities issued by Trust I and Trust II resulted in net proceeds of $19.3
million to Chandler USA, net of placement costs. Issuance costs in the amount
of $711,000 have been capitalized and will be amortized over the stated
maturity periods of thirty years. Chandler USA used $13.3 million of the
proceeds to purchase $16.7 million principal amount of its outstanding
Debentures. The Debentures purchased by Chandler USA were cancelled. The
purchase and cancellation of the Debentures resulted in a pre-tax gain of $3.1
million, net of an adjustment to unamortized issuance costs, which is included
in other income in the consolidated statement of operations. Chandler USA also
contributed $5.0 million of the proceeds to NAICO to be used for general
corporate purposes. The Junior Debentures I and Junior Debentures II and
related interest expense are eliminated in Chandler USA's consolidated
financial statements.
EMPLOYEES AND ADMINISTRATION
At December 31, 2003, Chandler USA and its subsidiaries had approximately
279 full-time employees. Chandler USA and its subsidiaries generally have
enjoyed good relations with their employees.
COMPETITION
NAICO operates in a highly competitive industry and faces competition
from domestic and foreign insurers, many of which are larger, have greater
financial, marketing and management resources, have more favorable ratings by
ratings agencies and offer more diversified insurance coverages than NAICO.
An insurance company's capacity to write insurance policies is dependent
on a variety of factors including its net worth or "surplus," the lines of
business written, the types of risk insured and its profitability. During much
of the last decade, the industry has generally had excess underwriting capacity
resulting in depressed premium rates and expanded policy terms, which generally
occur when excess underwriting capacity exists. NAICO has been able to
increase its pricing for most coverages during 2002 and 2003, which has
generally been the trend industry wide. However, NAICO continues to experience
competition in all of its programs. NAICO's underwriting philosophy is to
forego underwriting risks from which it is unable to obtain what it believes to
be adequate premium rates.
PAGE 12
REGULATION
REGULATION IN GENERAL
NAICO is subject to regulation by government agencies in the jurisdictions
in which it does business. The nature and extent of such regulation vary from
jurisdiction to jurisdiction, but 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, approval of premium rates, forms
and policies used for many lines of insurance, standards of solvency and
minimum amounts of capital and surplus which must be maintained, establishment
of reserves required to be maintained for unearned premiums, unpaid losses and
loss adjustment expenses or for other purposes, limitations on types and
amounts of investments, restrictions on the size of risks which may be insured
by a single company, licensing of insurers and agents, deposits of securities
for the benefit of policyholders and the filing of periodic reports with
respect to financial condition and other matters. In addition, regulatory
examiners perform periodic financial and market conduct examinations of
insurance companies. Such regulation is generally intended for the protection
of policyholders rather than shareholders or creditors.
NAICO is required to deposit securities with regulatory agencies in
several states in which it is licensed as a condition of conducting operations
in those states.
In addition to the regulatory oversight of NAICO, Chandler Insurance is
also subject to regulation under the laws of the Cayman Islands and Chandler
USA and all of its affiliates are subject to regulation under the insurance
laws of Oklahoma (the "Oklahoma Insurance Code"). The Oklahoma Insurance Code
contains certain reporting requirements including those requiring Chandler
Insurance, as the ultimate parent company, to file information relating to
its capital structure, ownership, and financial condition and the general
business operations of its insurance subsidiaries. The Oklahoma Insurance Code
contains special reporting and prior approval requirements with respect to
transactions among affiliates.
NAICO is also affected by a variety of state and federal legislative and
regulatory measures and judicial decisions that define and extend the risks
and benefits for which insurance is sought and provided. These include
redefinitions of risk exposure in areas such as product liability,
environmental damage and workers compensation. In addition, individual state
insurance departments may prevent premium rates for some classes of insureds
from reflecting the level of risk assumed by the insurer for those classes.
Such developments may adversely affect the profitability of various lines of
insurance. In some cases, these adverse effects on profitability can be
minimized through re-pricing, if permitted by applicable regulations, of
coverages or limitations or cessation of the affected business.
INSURANCE REGULATION CONCERNING CHANGE OR ACQUISITION OF CONTROL
NAICO is a domestic property and casualty insurance company organized
under the Oklahoma Insurance Code. The Oklahoma Insurance Code provides that
the acquisition or change of "control" of a domestic insurer or of any person
that controls a domestic insurer cannot be consummated without the prior
approval of the Oklahoma Department of Insurance. A person seeking to acquire
control, directly or indirectly, of a domestic insurance company or of any
person controlling a domestic insurance company must generally file with the
relevant insurance regulatory authority an application for change of control
containing certain information required by statute and published regulations
and provide a copy of such to the domestic insurer. In Oklahoma, control is
generally presumed to exist if any person, directly or indirectly, owns,
controls, holds with the power to vote or holds proxies representing 10% or
more of the voting securities of the insurance company or of any other person
or entity controlling the insurance company. The 10% presumption is not
conclusive and control may be found to exist at less than 10%.
In addition, many state insurance regulatory laws contain provisions that
require pre-notification to state agencies of a change in control of a
non-domestic insurance company admitted in that state. While such
pre-notification statutes do not authorize the state agency to disapprove the
change of control, such statutes do authorize issuance of a cease and desist
order with respect to the non-domestic insurer if certain conditions exist such
as undue market concentration.
Any future transactions that would constitute a change in control of
Chandler Insurance or Chandler USA would also generally require prior approval
by the Oklahoma Department of Insurance and would require pre-acquisition
notification in those states which have adopted pre-acquisition notification
provisions and in which the insurers are admitted. Because such requirements
are primarily for the benefit of policyholders, they may deter, delay or
prevent certain transactions that could be advantageous to the shareholders or
creditors of Chandler USA.
PAGE 13
RESTRICTIONS ON SHAREHOLDER DIVIDENDS
A significant portion of Chandler USA's consolidated assets represents
assets of NAICO that may not be immediately transferable to Chandler USA in the
form of shareholder dividends, loans, advances or other payments.
Statutes and regulations governing NAICO and other insurance companies
domiciled in Oklahoma regulate the payment of shareholder dividends and other
payments by NAICO to Chandler USA. Under applicable Oklahoma statutes and
regulations, NAICO is permitted to pay shareholder dividends only out of
statutory earned surplus. To the extent NAICO has statutory earned surplus,
NAICO may pay shareholder dividends only to the extent that such dividends are
not defined as extraordinary dividends or distributions. If the dividends are,
under applicable statutes and regulations, extraordinary dividends or
distributions, regulatory approval must be obtained. Under the applicable
Oklahoma statute, and subject to the availability of statutory earned surplus,
the maximum shareholder dividend that may be declared (or cash or property
distribution that may be made) by NAICO in any one calendar year without
regulatory approval is the greater of (i) NAICO's statutory net income,
excluding realized capital gains, for the preceding calendar year; or (ii) 10%
of NAICO's statutory policyholders' surplus as of the preceding calendar year
end, not to exceed NAICO's statutory earned surplus.
As of December 31, 2003, NAICO had statutory earned surplus of $12.5
million. Applying the Oklahoma statutory limits described above, the maximum
shareholder dividend NAICO may pay in 2004 without the approval of the Oklahoma
Department of Insurance is $5.0 million. NAICO paid shareholder dividends
totaling $7.0 million and $3.5 million to Chandler USA in 2001 and 2002,
respectively. The Oklahoma Department of Insurance approved the payment of the
extraordinary dividend by NAICO to Chandler USA in 2001.
In addition to the statutory limits described above, the amount of
shareholder dividends and other payments to affiliates permitted can be further
limited by contractual or regulatory restrictions or other agreements with
regulatory authorities restricting dividends and other payments, including
regulatory restrictions that are imposed as a matter of administrative policy.
If insurance regulators determine that payment of a shareholder dividend or
other payments to an affiliate (such as payments under a tax sharing agreement,
payments for employee or other services, or payments pursuant to a surplus
note) would be hazardous to such insurance company's policyholders or
creditors, the regulators may block such payments that would otherwise be
permitted without prior approval.
RISK-BASED CAPITAL
The National Association of Insurance Commissioners has adopted a
methodology for assessing the adequacy of statutory surplus of domestic
property and casualty insurers. This methodology is described in the Risk
Based Capital Model Act (the "RBC Model Act"). The RBC Model Act includes a
risk-based capital requirement that requires insurance companies to calculate
and report information under a risk-based formula which attempts to measure
statutory capital and surplus needs based on the risks in the insurance
company's mix of products and investment portfolio. The formula is designed
to allow state insurance regulators to identify potential under-capitalized
companies. Under the formula, an insurer determines its "risk-based capital"
("RBC") by taking into account certain risks related to the insurer's assets
(including risks related to its investment portfolio and ceded reinsurance) and
the insurer's liabilities (including underwriting risks related to the nature
and experience of its insurance business). The RBC rules provide for different
levels of regulatory attention depending on the ratio of a company's total
adjusted capital to its "authorized control level" of RBC. Insurers below the
specific ratios are classified within certain levels, each of which requires
specific corrective action. The levels and ratios are as follows:
Ratio of Total Adjusted Capital to
Authorized Control Level RBC
(Less than or equal to)
----------------------------------
Regulatory Event (1)
--------------------
Company Action Level (2) ...... 2.0
Regulatory Action Level (3) ... 1.5
Authorized Control Level (4) .. 1.0
Mandatory Control Level (5) ... 0.7
- ----------------------------------
(1) When an insurer's ratio exceeds 2.0, it is not subject to regulatory attention
under the RBC Model Act.
(2) "Company Action Level" requires an insurer to prepare and submit an RBC Plan to
the insurance commissioner of its state of domicile. After review, the insurance
commissioner will notify the insurer if the Plan is satisfactory.
PAGE 14
(3) "Regulatory Action Level" requires the insurer to submit an RBC Plan, or if applicable,
a Revised RBC Plan to the insurance commissioner of its state of domicile. After
examination or analysis, the insurance commissioner will issue an order specifying
corrective actions to be taken.
(4) "Authorized Control Level" authorizes the insurance commissioner to take such regulatory
actions considered necessary to protect the best interest of the policyholders and
creditors of an insurer which may include the actions necessary to cause the insurer to
be placed under regulatory control (i.e., rehabilitation or liquidation).
(5) "Mandatory Control Level" authorizes the insurance commissioner to take actions necessary
to place the insurer under regulatory control (i.e., rehabilitation or liquidation).
The ratios of total adjusted capital to authorized control level RBC for NAICO
were 5.8:1 and 6.7:1 at December 31, 2002 and 2003, respectively. Therefore,
NAICO's total adjusted capital exceeds the level that would trigger regulatory
attention pursuant to the risk-based capital requirement.
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS-IRIS RATIOS
The National Association of Insurance Commissioners 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 12
industry ratios and specifies "usual values" for each ratio. Departure from the
"usual values," which fluctuate annually, on four or more ratios generally
leads to inquiries from individual state insurance commissioners. NAICO had
five 2003 ratios that were outside of the "usual values," four of which
resulted primarily from adverse loss development as explained below.
NAICO's "two-year overall operating ratio" for 2003 was 103% compared to a
usual value of less than 100%. Factors that contributed to NAICO's ratio
include a lower ratio of investment income to net premiums earned due primarily
to lower interest rates experienced during 2003, and to adverse loss
development recorded during 2002 and 2003 for accident years prior to 2002.
Excluding this loss development, the two-year overall operating ratio would
have been 75% for 2003.
NAICO's "investment yield" as calculated using the IRIS formula was 2.8%
during 2003 compared to a usual value of greater than 4.5% and less than 10.0%.
NAICO maintains a high-quality investment portfolio, with no non-investment
grade bonds, derivative instruments or real estate investments (other than real
estate occupied by the company), and NAICO holds only a small investment in
equity securities. NAICO's investment yield is largely dependent upon
prevailing levels of interest rates. The significant decline in interest
rates in recent years had a significant impact on NAICO's investment yield.
Moreover, in periods of relatively low interest rates, NAICO generally shortens
maturities and accepts lower yields to reduce market risk for future rate
increases.
NAICO's "one-year reserve development to policyholders' surplus" and
"two-year reserve development to policyholders' surplus" for 2003 were 22% and
67%, respectively, compared to usual values of less than 20% for each ratio.
The primary reason for these unusual values was adverse loss development
experienced during 2002 and 2003 related to the 1997 - 2001 accident years.
This adverse loss development relates primarily to the workers compensation and
other liability lines of business in NAICO's standard property and casualty and
political subdivisions programs. Also contributing to the adverse loss
development were provisions for potentially uncollectible reinsurance
recoverables and deductibles of $1.9 million and $1.3 million during 2002 and
2003, respectively. Statutory accounting requires that these write-downs of
receivables and recoverables be reflected as prior year loss development.
NAICO's "estimated current reserve deficiency to policyholders' surplus"
was 31% at December 31, 2003 compared to a usual value of less than 25%. The
adverse loss development experienced in 2002 and 2003 related to prior accident
years was primarily responsible for this ratio being outside of the normal
range. NAICO experienced significant growth from 1996 through 2000, with gross
premiums written increasing from $108 million in 1996 to $197 million in 2000.
During 2001, 2002 and 2003, NAICO implemented substantial price increases on
most lines of business. NAICO also exited some classes of business and
non-renewed accounts with unfavorable frequency and/or severity
characteristics. These actions resulted in a reduction in gross premiums
written from $197 million in 2000 to $118 million in 2003. Management
believes that while the insured exposure base has been significantly reduced,
the premium for that exposure has increased significantly. The calculation of
this ratio assumes that factors that led to past under reserving will cause
current under reserving without regard to changes in premium volume, premium
rates, product mix, the amount of risk retained by NAICO and current reserving
practices.
PAGE 15
EFFECT OF FEDERAL LEGISLATION
Although the Federal Government does not directly regulate the business of
insurance, federal initiatives often affect the insurance business in a variety
of ways. Current and proposed federal measures which may significantly affect
the insurance business include Federal Government participation in asbestos and
other product liability claims, claims related to acts of terrorism, pension
and other employee benefit plan regulation (ERISA), examination of the taxation
of insurers and reinsurers, minimum levels of liability insurance and
automobile safety regulations. Federal regulation of the health care industry
may directly and indirectly impact the business of insurance.
ITEM 2. PROPERTIES
Chandler USA and its subsidiaries own and occupy four office buildings
with approximately 127,000 square feet of usable space in Chandler, Oklahoma.
NAICO also leases approximately 1,500 square feet for a branch office in
Richardson, Texas. Chandler USA believes such space is sufficient for its
operations for the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
Chandler Insurance and certain of its subsidiaries and affiliates,
including Chandler USA, are involved in litigation with their director and
officer liability insurer. See Note 11 to Consolidated Financial Statements
for a discussion of this and other litigation matters.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the quarter
ended December 31, 2003.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
All of the common stock of Chandler USA, its sole class of common equity
on the date hereof, is owned by Chandler Insurance. Chandler USA has never
paid cash dividends on its common shares.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data has been derived from the consolidated
financial statements of Chandler USA and its subsidiaries, which appear in Item
15(a). The consolidated balance sheets of Chandler USA and its subsidiaries as
of December 31, 2000, and the related consolidated statement of operations,
comprehensive income, shareholder's equity and cash flows for the years ended
December 31, 2000 were audited by Deloitte & Touche LLP, independent auditors,
whose independent auditors' report expressed an unqualified opinion and
included an explanatory paragraph relating to litigation. The consolidated
balance sheets of Chandler USA and its subsidiaries as of December 31, 2001,
2002 and 2003 and the related consolidated statements of operations,
comprehensive income, shareholder's equity and cash flows for the years ended
December 31, 2001, 2002 and 2003 have been audited by Tullius Taylor Sartain &
Sartain LLP, independent auditors, whose independent auditors' report expresses
an unqualified opinion. The selected financial data should be read in
conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS" and the consolidated financial statements of
Chandler USA and the notes thereto appearing in Item 15(a). All periods have
been restated to reflect the results of L&W as a discontinued operation.
PAGE 16
ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
YEAR ENDED DECEMBER 31,
------------------------------------------------------
1999 2000 2001 2002 2003
---------- ---------- ---------- ---------- ----------
OPERATING DATA (1) (Dollars in thousands)
Revenues
Direct premiums written and assumed ............. $ 169,569 $ 197,196 $ 158,964 $ 140,162 $ 118,444
========== ========== ========== ========== ==========
Net premiums earned ............................. $ 87,098 $ 85,519 $ 69,985 $ 66,957 $ 56,583
Interest income, net ............................ 3,927 4,281 3,632 2,540 2,148
Interest income, net from related parties ....... - - 371 380 412
Realized investment gains, net .................. 57 144 2,654 794 2,351
Fee for rescinded reinsurance treaties .......... 10,000 - - - -
Other income (2) ................................ 164 301 101 261 5,077
---------- ---------- ---------- ---------- ----------
Total revenues .................................... 101,246 90,245 76,743 70,932 66,571
---------- ---------- ---------- ---------- ----------
Operating expenses
Losses and loss adjustment expenses ............. 68,659 64,999 52,550 50,712 37,200
Policy acquisition costs ........................ 21,195 16,882 10,869 10,239 11,278
General and administrative expenses ............. 9,126 10,557 11,549 12,473 13,486
Interest expense ................................ 1,494 2,255 2,240 2,234 2,441
---------- ---------- ---------- ---------- ----------
Total operating expenses .......................... 100,474 94,693 77,208 75,658 64,405
---------- ---------- ---------- ---------- ----------
Income (loss) from continuing operations before
income taxes .................................... 772 (4,448) (465) (4,726) 2,166
Federal income tax benefit (provision) ............ (326) 1,347 (16) 1,680 (192)
---------- ---------- ---------- ---------- ----------
Income (loss) from continuing operations .......... 446 (3,101) (481) (3,046) 1,974
Income (loss) from discontinued operations ........ (533) (894) (622) 284 -
Gain on sale of subsidiary ........................ - - - 671 -
---------- ---------- ---------- ---------- ----------
Net income (loss) ................................. $ (87) $ (3,995) $ (1,103) $ (2,091) $ 1,974
========== ========== ========== ========== ==========
Combined loss and underwriting expense ratio (3) .. 111% 106% 108% 110% 113%
BALANCE SHEET DATA
Cash and investments .............................. $ 93,666 $ 104,760 $ 73,378 $ 68,276 $ 69,198
Amounts due from related parties .................. - - 7,880 10,582 9,642
Total assets ...................................... 256,836 273,498 234,809 229,855 217,593
Unpaid losses and loss adjustment expenses ........ 98,460 100,173 84,756 92,606 87,768
Amounts due to related parties .................... 533 717 - - -
Debentures ........................................ 24,000 24,000 24,000 24,000 7,254
Trust preferred securities ........................ - - - - 20,000
Total liabilities ................................. 210,097 228,647 191,067 186,855 173,754
Shareholder's equity .............................. 46,739 44,851 43,742 43,000 43,839
- ---------------------------------------------------
(1) All periods have been restated to reflect the results of L&W as a discontinued operation. See Note
4 to Consolidated Financial Statements for more information.
(2) Other income for 2003 included a $3.1 million gain on the purchase and cancellation of $16.7 million
principal amount of Debentures, and $1.7 million for the amortization of the deferred gain on a sale
and leaseback transaction. For additional information, see "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
(3) Interest expense is not considered an underwriting expense and has been excluded from this ratio.
PAGE 17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
References to Chandler USA which follow within this Item 7 refer to
Chandler USA and its subsidiaries on a consolidated basis unless otherwise
indicated.
Chandler USA is engaged in various property and casualty insurance
operations through its wholly owned subsidiaries, NAICO and CIMI. NAICO writes
various property and casualty insurance products through three separate
marketing programs: standard property and casualty, political subdivisions
and surety bonds (including both construction bonds and bail bonds). The
lines of insurance written by NAICO are commercial coverages consisting of
workers compensation, automobile liability, other liability (including general
liability, products liability and umbrella liability), automobile physical
damage, property, surety and inland marine. NAICO markets these products
through a network of independent insurance agents. A portion of the insurance
written by NAICO is reinsured by Chandler USA's parent Chandler Insurance.
CIMI maintains certain wholesale operations related to NAICO's school districts
and trucking insurance.
SUMMARY OF RESULTS
Net income was $2.0 million for the year ended December 31, 2003, compared
to a net loss of $2.1 million for 2002 and $1.1 million for 2001. Income from
continuing operations was $2.0 million for 2003 compared to a loss from
continuing operations of $3.0 million and $481,000 during 2002 and 2001,
respectively. Net income for 2003 included $3.1 million in gains on the
purchase and cancellation of $16.7 million principal amount of Debentures, and
$1.7 million for the amortization of the deferred gain on a sale and leaseback
transaction. These transactions are discussed in more detail under "Other
Income" and "Liquidity and Capital Resources."
Many factors determine the profitability of an insurance company including
regulation and rate competition; the frequency and severity of claims; the
cost, availability and collectibility of reinsurance; interest rates;
inflation; general business conditions; and jury awards, court decisions and
legislation expanding the extent of coverage and the amount of compensation due
for injuries and losses.
DISCONTINUED OPERATIONS
In December 2002, Chandler USA completed the sale of its wholly owned
subsidiary L&W to Brown & Brown, Inc. for $3,247,000 in cash and a $361,000
note receivable that was paid in December 2003. Chandler USA recorded an
after-tax gain of $671,000 on the sale in 2002 based on the minimum purchase
price for the transaction, after deducting Chandler USA's goodwill related to
L&W of $2,350,000, equity in L&W of $224,000 and approximately $400,000 of
expenses in connection with the sale. The gain on the sale may be increased
over the next three years depending on certain adjustments to the purchase
price as defined in the terms of the transaction, with a maximum purchase price
of $6.0 million.
L&W continues to be a significant producer of business for NAICO. Retail
business produced by L&W and placed with NAICO constituted approximately 9% of
NAICO's direct premiums written and assumed in 2003. Chandler USA maintains
certain wholesale operations related to NAICO's school districts and trucking
insurance through CIMI, an underwriting manager that was established in
December 2002. L&W previously functioned as Chandler USA's agency segment and
is presented as discontinued operations.
Chandler USA agreed to indemnify Brown & Brown, Inc. for any breach of a
representation, warranty or covenant made in connection with the sale for a
period of three years, and has deposited cash in the amount of $500,000 into a
trust account for the benefit of Brown & Brown, Inc. as security. Prior to
completing the sale, L&W transferred its real estate to NAICO, and transferred
substantially all of its remaining assets and liabilities, primarily premiums
receivable and premiums payable, to Chandler USA through a shareholder
dividend. Following the completion of the sale, L&W changed its name to Brown
& Brown of Central Oklahoma, Inc.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with GAAP requires
the application of accounting policies that often involve a significant degree
of judgment. Management is required to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during
the periods. If management determines, as a result of its consideration of
facts and circumstances, that changes in estimates and assumptions are
appropriate, results of operations and financial position as reported in the
consolidated financial statements may change significantly. Management has
identified the following accounting policies as critical in understanding
Chandler USA's reported financial results.
PAGE 18
RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Insurance companies provide in their financial statements reserves for
unpaid losses and loss adjustment expenses which are estimates of the expense
of investigation and settlement of all reported and incurred but not reported
losses under their previously issued insurance policies and reinsurance
contracts. In estimating reserves, insurance companies use various
standardized methods based on historical experience and payment and reporting
patterns for the type of risk involved. The application of these methods
necessarily involves subjective determinations by the personnel of the
insurance company. Inherent in the estimates of the ultimate liability for
unpaid claims are expected trends in claim severity, claim frequency and other
factors that may vary as claims are settled. The amount of and uncertainty in
the estimates is affected by such factors as the amount of historical claims
experience relative to the development period for the type of risk, knowledge
of the actual facts and circumstances, and the amount of insurance risk
retained. The ultimate cost of insurance claims can be adversely affected by
increased costs, such as medical expenses, repair expenses, costs of providing
legal defense for policyholders, increased jury awards and court decisions and
legislation that expand insurance coverage after the insurance policy was
priced and sold. In recent years, certain of these factors have contributed
to incurred amounts that were higher than original estimates. Accordingly,
the loss and loss adjustment expense reserves may not accurately predict an
insurance company's ultimate liability for unpaid claims.
NAICO periodically reviews the reserve estimates relating to insurance
business written or assumed by NAICO and the methods used to arrive at such
reserve estimates. NAICO also retains independent professional actuaries who
review such reserve estimates and methods. Any changes in the estimates are
reflected in current operating results. Such changes in estimates may be
material. See Notes to Consolidated Financial Statements.
The loss settlement period on insurance claims for property damage is
relatively short. The more severe losses for bodily injury and workers
compensation claims have a much longer loss settlement period and may be paid
out over several years. It is often necessary to adjust estimates of liability
on a loss either upward or downward between the time a claim arises and the
time of payment. Workers compensation indemnity benefit reserves are
determined based on statutory benefits prescribed by state law and are
estimated based on the same factors generally discussed above which may
include, where state law permits, inflation adjustments for rising benefits
over time. Generally, the more costly automobile liability claims involve one
or more severe bodily injuries or deaths. The ultimate cost of these types of
claims is dependent on various factors including the relative liability of the
parties involved, the number and severity of injuries and the legal
jurisdiction where the incident occurred.
NAICO does not ordinarily insure against environmental matters as that
term is commonly used. However, in some cases, regulatory filings made on
behalf of an insured can make NAICO directly liable to the regulatory authority
for property damage, which could include environmental pollution. In those
cases, NAICO ordinarily has recourse against the insured or the surety bond
principal for amounts paid. NAICO has insured certain trucking companies and
pest control operators who are required to provide proof of insurance which in
some cases assures payment for cleanup and restoration of damage resulting from
sudden and accidental release or discharge of contaminants or other substances
which may be classified as pollutants. NAICO also provides surety bonds for
construction contractors who use or have control of such substances and for
contractors who remove and dispose of asbestos as a part of their contractual
obligations.
NAICO also insures independent oil and gas producers who may purchase
coverage for the escape of oil, saltwater, or other substances which may be
harmful to persons or property, but may not generally be classified as
pollutants. NAICO maintains claims records which segregate this type of risk
for the purpose of evaluating environmental risk exposure. Based upon the
nature of such lines of business with NAICO's insureds, and current data
regarding the limited severity and infrequency of such matters, it appears that
potential environmental risks are not a significant portion of claim reserves
and therefore would not likely have a material adverse impact, if any, on the
financial condition of Chandler USA.
NAICO's statutory-based reserves (reserves calculated in accordance with
accounting practices prescribed or permitted by an insurer's domiciliary state
insurance regulatory authorities for purposes of financial reporting to
regulators) do not differ from its reserves reported on the basis of GAAP.
NAICO does not discount its reserves for unpaid losses and loss adjustment
expenses.
REINSURANCE RECOVERABLES
Reinsurance recoverables on unpaid losses and loss adjustment expenses are
similarly subject to changes in estimates and assumptions. Amounts recoverable
from reinsurers are estimated in a manner consistent with the claim liability
associated with the reinsured policies. In addition to factors noted above,
estimates of reinsurance recoverables may prove uncollectible if the reinsurer
is unable or unwilling to meet its responsibilities under the reinsurance
contracts. Reinsurance contracts do not relieve an insurer from its obligation
to policyholders.
PAGE 19
OTHER
See Note 1 to Consolidated Financial Statements for information related to
other accounting and reporting policies.
ECONOMIC CONDITIONS
The impact of a recession on Chandler USA would depend on its duration and
severity. A prolonged downturn in the economy could result in decreased demand
for NAICO's insurance products and an increase in uncollectible premiums and/or
reinsurance recoverables. In addition, an economic downturn could result in an
increase in the number of insurance claims if insureds decrease expenditures
that promote safety. Much of NAICO's insurance business is concentrated in the
Southwest and Midwest areas of the United States. Approximately $103 million,
or 87%, of NAICO's direct written premiums in 2003 were in the states of
Oklahoma and Texas. An economic downturn in these states could have a
significant adverse impact on Chandler USA. A recession might also cause
defaults on fixed-income securities owned by NAICO. Management believes it has
mitigated the impact of a recession by employing conservative underwriting
practices and strict credit policies and maintaining a high-quality investment
portfolio.
Periods of inflation have varying effects on Chandler USA and its
subsidiaries as well as other companies in the insurance industry. Inflation
contributes to higher claims and related costs and operating costs as well as
higher interest rates which generally provide for potentially higher interest
rates on investable cash flow and decreases in the market value of existing
fixed-income securities. Premium rates and commissions, however, are not
significantly affected by inflation since competitive forces generally control
such rates. NAICO's underwriting philosophy is to forego underwriting risks
from which it is unable to obtain what it believes to be adequate premium rates.
COMPETITION
NAICO operates in a highly competitive industry and faces competition
from domestic and foreign insurers, many of which are larger, have greater
financial, marketing and management resources, have more favorable ratings by
ratings agencies and offer more diversified insurance coverages than NAICO.
A company's capacity to write insurance policies is dependent on a variety
of factors including its net worth or "surplus," the lines of business written,
the types of risk insured and its profitability. During much of the last
decade, the industry has generally had excess underwriting capacity resulting
in depressed premium rates and expanded policy terms, which generally occur
when excess underwriting capacity exists. NAICO has been able to increase its
pricing for most coverages during 2002 and 2003, which has generally been the
trend industry wide. However, NAICO continues to experience competition in all
of its programs. NAICO's underwriting philosophy is to forego underwriting
risks from which it is unable to obtain what it believes to be adequate premium
rates.
REGULATION
NAICO is subject to regulation by government agencies in the jurisdictions
in which it does business. The nature and extent of such regulations vary from
jurisdiction to jurisdiction, but 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, approval of premium rates, forms
and policies used for many lines of insurance, standards of solvency and
minimum amounts of capital and surplus which must be maintained, establishment
of reserves required to be maintained for unearned premiums, unpaid losses and
loss adjustment expenses or for other purposes, limitations on types and
amounts of investments, restrictions on the size of risks which may be insured
by a single company, licensing of insurers and agents, deposits of securities
for the benefit of policyholders and the filing of periodic reports with
respect to financial condition and other matters. In addition, regulatory
examiners perform periodic examinations of insurance companies. Such regulation
is generally intended for the protection of policyholders rather than
shareholders or creditors.
As an Oklahoma corporation, NAICO and any person controlling NAICO,
directly or indirectly, are subject to the insurance laws of Oklahoma including
laws concerning the change or acquisition of control and payment of shareholder
and policyholder dividends by NAICO.
PAGE 20
In addition to the regulatory oversight of NAICO, Chandler Insurance is
also subject to regulation under the laws of the Cayman Islands and Chandler
USA and all of its affiliates are also subject to regulation under the Oklahoma
Insurance Code. The Oklahoma Insurance Code contains certain reporting
requirements including those requiring Chandler Insurance, as the ultimate
parent company, to file information relating to its capital structure,
ownership and financial condition and general business operations of its
insurance subsidiaries. The Oklahoma Insurance Code contains special reporting
and prior approval requirements with respect to transactions among affiliates.
The Oklahoma Insurance Code also imposes certain requirements upon any person
controlling or seeking to control an insurance company domiciled in Oklahoma.
Control is generally presumed to exist if any person, directly or indirectly,
owns, controls, holds with the power to vote or holds proxies representing 10%
or more of the voting securities of the insurance company or of any other
person or entity controlling the insurance company. The 10% presumption is not
conclusive and control may be found to exist at less than 10%. Persons owning
any securities of Chandler USA or Chandler Insurance must comply with the
Oklahoma Insurance Code. See "BUSINESS - Regulation."
Insurance companies are also affected by a variety of state and federal
legislative and regulatory measures and judicial decisions that define and
extend the risks and benefits for which insurance is sought and provided.
These include the redefinition of risk exposure in areas such as product
liability, environmental damage and workers compensation. In addition,
individual state insurance departments may prevent premium rates for some
classes of insureds from reflecting the level of risk assumed by the insurer
for those classes. Such developments may adversely affect the profitability of
various lines of insurance. In some cases, these adverse effects on
profitability can be minimized through coverage repricing, if permitted by
applicable regulations, or limitations or cessation of the affected business.
ANALYSIS OF INSURANCE PROGRAM RESULTS OF OPERATIONS
The following tables summarize the net premiums earned and the financial
year (losses incurred and recognized by Chandler USA regardless of the year in
which the claim occurred) and accident year (losses incurred by Chandler USA
for a particular year regardless of the period in which Chandler USA recognizes
the costs) loss ratios (computed by dividing losses and loss adjustment
expenses by net premiums earned) in each of the years presented. The first
table is summarized by major insurance program and includes all lines of
insurance written in each program. The second table is summarized by line of
insurance written and includes all net premiums earned and net losses and loss
adjustment expenses incurred from all insurance programs for that particular
line. See "Premiums Earned" and "Losses and Loss Adjustment Expenses."
YEAR ENDED DECEMBER 31,
----------------------------------
2001 2002 2003
---------- ---------- ----------
(Dollars in thousands)
INSURANCE PROGRAMS
- ----------------------------------------
STANDARD PROPERTY AND CASUALTY
Net premiums earned .................. $ 53,130 $ 49,570 $ 45,521
Financial year loss ratio ............ 71.0% 81.1% 65.1%
Accident year loss ratio ............. 65.3% 43.7% 48.1%
POLITICAL SUBDIVISIONS
Net premiums earned .................. $ 12,534 $ 13,829 $ 8,093
Financial year loss ratio ............ 91.1% 55.9% 70.7%
Accident year loss ratio ............. 73.8% 29.8% 43.0%
SURETY BONDS
Net premiums earned .................. $ 4,125 $ 3,310 $ 2,724
Financial year loss ratio ............ 56.7% 59.4% 33.5%
Accident year loss ratio ............. 91.9% 21.7% 20.4%
OTHER (1)
Net premiums earned .................. $ 196 $ 248 $ 245
Financial year loss ratio ............ 555.4% 332.7% 374.0%
Accident year loss ratio ............. 108.4% 77.6% 71.1%
TOTAL
Net premiums earned .................. $ 69,985 $ 66,957 $ 56,583
Financial year loss ratio ............ 75.1% 75.7% 65.7%
Accident year loss ratio ............. 68.5% 39.9% 46.1%
- --------------------------------
(1) This category is comprised primarily of the run-off of discontinued programs
and NAICO's participation in various mandatory workers compensation pools and
assigned risks.
PAGE 21
YEAR ENDED DECEMBER 31,
----------------------------------
2001 2002 2003
---------- ---------- ----------
(Dollars in thousands)
LINES OF INSURANCE
- ---------------------------------------
WORKERS COMPENSATION
Net premiums earned ................. $ 16,449 $ 14,808 $ 16,378
Financial year loss ratio ........... 105.4% 99.4% 71.8%
Accident year loss ratio ............ 77.1% 44.9% 46.3%
AUTOMOBILE LIABILITY
Net premiums earned ................. $ 13,386 $ 16,526 $ 15,624
Financial year loss ratio ........... 70.0% 81.2% 49.4%
Accident year loss ratio ............ 70.0% 46.3% 49.8%
OTHER LIABILITY
Net premiums earned ................. $ 17,470 $ 16,458 $ 12,870
Financial year loss ratio ........... 57.4% 80.2% 94.0%
Accident year loss ratio ............ 56.9% 37.0% 50.9%
AUTOMOBILE PHYSICAL DAMAGE
Net premiums earned ................. $ 12,174 $ 9,552 $ 5,508
Financial year loss ratio ........... 52.0% 35.3% 36.0%
Accident year loss ratio ............ 48.7% 35.6% 32.7%
PROPERTY
Net premiums earned ................. $ 4,806 $ 5,543 $ 3,072
Financial year loss ratio ........... 92.8% 49.9% 73.7%
Accident year loss ratio ............ 97.7% 33.6% 55.9%
SURETY
Net premiums earned ................. $ 4,125 $ 3,310 $ 2,723
Financial year loss ratio ........... 56.7% 59.4% 33.5%
Accident year loss ratio ............ 91.9% 21.8% 20.4%
INLAND MARINE
Net premiums earned ................. $ 1,256 $ 760 $ 408
Financial year loss ratio ........... 143.0% 99.7% 54.1%
Accident year loss ratio ............ 124.8% 45.4% 30.9%
ACCIDENT AND HEALTH
Net premiums earned ................. $ 319 $ - $ -
Financial year loss ratio ........... 281.2% -% -%
Accident year loss ratio ............ -% -% -%
TOTAL
Net premiums earned ................. $ 69,985 $ 66,957 $ 56,583
Financial year loss ratio ........... 75.1% 75.7% 65.7%
Accident year loss ratio ............ 68.5% 39.9% 46.1%
PAGE 22
PREMIUMS EARNED
The following tables set forth premiums earned on a gross basis (before
reductions for premiums ceded to reinsurers) and on a net basis (after such
reductions) for each insurance program as well as each line of insurance for
each year presented:
GROSS PREMIUMS EARNED NET PREMIUMS EARNED
-------------------------- --------------------------
INSURANCE PROGRAMS 2001 2002 2003 2001 2002 2003
- ----------------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Standard property and casualty .......... $128,554 $106,051 $ 93,193 $ 53,130 $ 49,570 $ 45,521
Political subdivisions .................. 34,178 35,159 28,926 12,534 13,829 8,093
Surety bonds ............................ 8,796 5,104 3,908 4,125 3,310 2,724
Other ................................... 71 249 252 196 248 245
-------- -------- -------- -------- -------- --------
TOTAL ................................... $171,599 $146,563 $126,279 $ 69,985 $ 66,957 $ 56,583
======== ======== ======== ======== ======== ========
GROSS PREMIUMS EARNED NET PREMIUMS EARNED
-------------------------- --------------------------
LINES OF INSURANCE 2001 2002 2003 2001 2002 2003
- ----------------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Workers compensation .................... $ 57,585 $ 41,958 $ 29,821 $ 16,449 $ 14,808 $ 16,378
Automobile liability .................... 27,237 27,143 27,538 13,386 16,526 15,624
Other liability ......................... 36,166 36,078 34,715 17,470 16,458 12,870
Automobile physical damage .............. 13,516 10,745 9,146 12,174 9,552 5,508
Property ................................ 22,377 22,722 19,359 4,806 5,543 3,072
Surety .................................. 8,796 5,104 3,908 4,125 3,310 2,723
Inland marine ........................... 5,580 2,813 1,792 1,256 760 408
Accident and health ..................... 342 - - 319 - -
-------- -------- -------- -------- -------- --------
TOTAL ................................... $171,599 $146,563 $126,279 $ 69,985 $ 66,957 $ 56,583
======== ======== ======== ======== ======== ========
Gross premiums earned decreased 15% and 14% in 2002 and 2003,
respectively, as NAICO continued to focus on improving underwriting
profitability in its core programs through stricter underwriting policies,
a reduction in the number of appointed agents and by discontinuing certain
accounts where rates were not believed to be adequate. Gross premiums earned
in Texas decreased 23% and 18% in 2002 and 2003, respectively, and gross
premiums earned in Oklahoma decreased 5% and 15% in 2002 and 2003. The workers
compensation line of business accounted for a significant portion of the
decreases. Net premiums earned decreased 4% and 15% in 2002 and 2003,
respectively. During 2001 and 2002, NAICO had quota share reinsurance in
effect that reduced NAICO's net retention for its casualty and workers
compensation lines of business and reduced its net premiums earned by $11.3
million and $4.6 million, respectively. NAICO elected not to renew this
reinsurance upon expiration.
Gross premiums earned in the standard property and casualty program
decreased 18% and 12% in 2002 and 2003, respectively. The decreases were due
primarily to discontinuing certain accounts where rates were not believed to be
adequate. Increases in premium rates partially offset the decrease in premium
production. Gross premiums earned in Texas decreased $13.7 million and $9.9
million in 2002 and 2003, respectively, and gross premiums earned in Oklahoma
decreased $7.2 million and $6.0 million in 2002 and 2003, respectively. Net
premiums earned decreased 7% and 8% in 2002 and 2003, respectively. The quota
share reinsurance reduced net premiums earned by $9.5 million and $3.8 million
in this program in 2001 and 2002, respectively.
Gross premiums earned in the political subdivisions program increased 3%
in 2002 and decreased 18% in 2003. Gross premiums earned in the school
districts portion of the program increased $4.5 million in 2002 and decreased
$3.9 million in 2003. Gross premiums earned for the municipalities portion of
the program decreased $3.5 million and $2.3 million in 2002 and 2003,
respectively, as NAICO discontinued writing most of these accounts. Net
premiums earned increased 10% in 2002 and decreased 41% in 2003. The quota
share reinsurance reduced net premiums earned by $1.8 million and $835,000 in
this program in 2001 and 2002, respectively. The decrease in 2003 was due to
the decrease in gross premiums earned, and to Chandler Insurance assuming a
portion of the risk for the property and automobile physical damage coverages.
PAGE 23
Gross premiums earned in the surety bond program decreased 42% and 23% in
2002 and 2003, respectively. The decreases are primarily due to stricter
underwriting policies and a reduction in the number of appointed agents that
produce this business as NAICO focuses on improving underwriting profitability
in this program. Net premiums earned in the surety bond program decreased 20%
and 18% in 2002 and 2003, respectively. NAICO elected not to renew its
construction surety bond excess of loss reinsurance effective April 1, 2003 due
to the decreased premium volume in this program and to the current market for
this reinsurance.
Other programs in the preceding table include premiums from the runoff of
various programs which are no longer offered by NAICO, NAICO's participation in
various mandatory pools covering workers compensation for insureds that were
unable to purchase this coverage from an insurance company on a voluntary
basis, and direct assignments to write workers compensation for such insureds
in certain states in lieu of participating in related pools.
NET INTEREST INCOME AND NET REALIZED INVESTMENT GAINS
At December 31, 2003, Chandler USA's investment portfolio consisted
primarily of fixed income U.S. Government and high-quality corporate bonds,
with approximately 10% invested in cash and money market instruments. Income
generated from this portfolio is largely dependent upon prevailing levels of
interest rates. Chandler USA's portfolio contains no non-investment grade
bonds or real estate investments. Chandler USA also receives interest income
from related parties on intercompany loans.
Net interest income from continuing operations, excluding interest income
from related parties, decreased 30% and 15% in 2002 and 2003, respectively.
The decreases were due primarily to lower interest rates. Interest income from
related parties was $380,000 and $412,000 during 2002 and 2003, respectively.
See Liquidity and Capital Resources.
Net realized investment gains were $2,654,000, $794,000 and $2,351,000 in
2001, 2002 and 2003, respectively. The net realized investment gains in 2001
and 2002 resulted primarily from sales of fixed maturity investments available
for sale to provide cash for operating activities due to the decrease in
written premiums. Realized investment gains in 2003 included a gain of $1.7
million from the sale of 19,371 shares of common stock of Insurance Services
Office, Inc. ("ISO") that was recorded during the second quarter of 2003.
NAICO received these shares in 1997 as a result of ISO converting to a
for-profit corporation.
The average net yield on the portfolio, including net realized investment
gains, was 7.7%, 4.8% and 6.7% in 2001, 2002 and 2003, respectively. The
average net yield on the portfolio, excluding net realized investment gains,
was 4.4%, 3.7% and 3.2% for 2001, 2002 and 2003, respectively. Chandler USA
excludes interest income from related parties when calculating its average net
yield on the portfolio. Chandler USA's average net yield has been reduced by
investment expenses to subsidize a premium finance program for certain insureds
of NAICO. While such expenses reduce Chandler USA's average net yield, the
premium finance program enhances cash flow by providing cash which is available
for investment earlier than conventional deferred payment plans. Based on
information provided by the premium finance company, the outstanding balance of
premiums financed at December 31, 2003 was approximately $11 million. The
average yield on the portfolio before deducting investment expenses was 5.9%,
4.4% and 3.6% in 2001, 2002 and 2003, respectively, excluding capital gains.
OTHER INCOME
During 2003, Chandler USA's other income included a $3.1 million gain on
the purchase and cancellation of $16.7 million of its Debentures. In addition,
the amortization of a deferred gain related to a sale and leaseback transaction
increased other income by $1.7 million. The deferred gain is being amortized
into income over the final year of the lease following the exercise of the
option for Chandler USA to repurchase the equipment at the end of the lease.
LOSSES AND LOSS ADJUSTMENT EXPENSES
Chandler USA estimates losses and loss adjustment expenses based on
historical experience and payment and reporting patterns for the type of risk
involved. These estimates are based on data available at the time of the
estimate and are periodically reviewed by independent professional actuaries.
See "BUSINESS - Reserves."
PAGE 24
The percentage of losses and loss adjustment expenses to net premiums
earned ("loss ratio") was 75.1%, 75.7% and 65.7% in 2001, 2002 and 2003,
respectively. Weather-related losses (net of applicable reinsurance) from
wind and hail were $2.0 million, $1.5 million and $1.9 million in 2001, 2002
and 2003, respectively, and increased the respective loss ratios by 2.9, 2.2
and 3.4 percentage points.
During 2001, NAICO experienced incurred losses related to prior accident
years totaling $12.7 million due primarily to increased loss severity in the
standard property and casualty and political subdivisions programs. A
substantial part of this loss development was for workers compensation losses
in the 1999 accident year. NAICO's net retention for workers compensation
losses increased substantially in 1999 due to the rescission of certain
reinsurance treaties covering this line of business. Also contributing to the
adverse loss development were provisions for potentially uncollectible
reinsurance and deductibles of approximately $1.2 million during 2001, an
increase in losses in the surety bond program and approximately $878,000 in
losses for the runoff of a discontinued group accident and health program.
During 2002, NAICO experienced incurred losses related to prior accident
years totaling $15.8 million primarily in the standard property and casualty
program including both liability lines and workers compensation. This adverse
development is generally the result of ongoing analysis of recent loss
development trends that reflect an increase in loss severity within the
1997-2000 accident years. The adverse loss development included approximately
$2.0 million for provisions for potentially uncollectible reinsurance and
deductibles.
During 2003, NAICO experienced incurred losses related to prior accident
years totaling $11.1 million primarily in the standard property and casualty
program. This adverse development was due primarily to an increase in losses
in the workers compensation and other liability lines of business in the
1998-2001 accident years. A reduction in losses for the 2002 accident year
partially offset this adverse development. The adverse loss development
included approximately $1.3 million for provisions for potentially
uncollectible reinsurance and deductibles.
Reliance reinsured NAICO for certain workers compensation risks during
1998. At December 31, 2003, NAICO had reinsurance recoverables from Reliance
for paid and unpaid losses of approximately $3.1 million. During October 2001,
the Commonwealth of Pennsylvania placed Reliance in liquidation. At this time,
NAICO is unable to determine the amount of its reinsurance recoverables from
Reliance that will ultimately be collected and has fully reserved the carrying
value of such amounts as of December 31, 2003. Reinsurance contracts do not
relieve an insurer from its obligation to policyholders. Failure of reinsurers
to honor their obligations could result in losses to Chandler USA;
consequently, adjustments to ceded losses and loss adjustment expenses are made
for amounts deemed uncollectible. During 2001, 2002 and 2003, NAICO incurred
charges of $454,000, $1.7 million and $604,000, respectively, in adjustments