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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, 2004
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, 2004, 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 28, 2005 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.
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
130 at December 31, 2004, 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.
CIMI is an underwriting manager for certain wholesale operations related
to NAICO's school districts and trucking insurance. CIMI was established in
December 2002.
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.
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.
PAGE 2
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, trucking, and
retail industries. NAICO writes this business principally in Oklahoma and
Texas.
POLITICAL SUBDIVISIONS PROGRAM
Under the political subdivisions program, NAICO writes insurance policies
primarily for school districts in Oklahoma. As of December 31, 2004 NAICO
insured 232 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 and did not write any premiums during
2004.
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 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 2002, 2003 and 2004. 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 2002 2003 2004 2002 2003 2004
- ----------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Standard property and casualty .... $106,051 $ 93,193 $ 92,894 $ 49,570 $ 45,521 $ 54,278
Political subdivisions ............ 35,159 28,926 21,679 13,829 8,093 7,269
Surety bonds ...................... 5,104 3,908 2,788 3,310 2,724 1,993
Other (1) ......................... 249 252 507 248 245 502
-------- -------- -------- -------- -------- --------
TOTAL ............................. $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042
======== ======== ======== ======== ======== ========
- -------------------------------
(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 3
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 and inland marine. 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,
----------------------------------------------------
2000 2001 2002 2003 2004
-------- -------- -------- -------- --------
Automobile liability .............. 20% 19% 25% 27% 28%
Other liability ................... 25% 25% 25% 23% 28%
Workers compensation .............. 25% 24% 22% 29% 27%
Automobile physical damage ........ 13% 17% 14% 10% 9%
Property .......................... 4% 7% 8% 5% 4%
Surety ............................ 8% 6% 5% 5% 3%
Inland marine ..................... 1% 2% 1% 1% 1%
Accident and health ............... 4% -% -% -% -%
-------- -------- -------- -------- --------
Total .......................... 100% 100% 100% 100% 100%
======== ======== ======== ======== ========
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'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 claims 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, 2005 reinsurance programs. At the present time, NAICO
expects to renew the reinsurance programs that renew on July 1, 2005.
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.
PAGE 4
Under the 2002 workers compensation reinsurance program, NAICO's net
retention was 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. Effective April 1, 2004, NAICO added 56% of the $500,000
excess of $500,000 of loss per occurrence layer to its net retention, and
effective July 1, 2004, NAICO's net retention increased to 70% of the first
$1,000,000 of loss per occurrence.
Under the 2002 casualty reinsurance program, NAICO's net retention was 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. Effective
April 1, 2004, NAICO added 56% of the $500,000 excess of $500,000 of loss per
occurrence layer to its net retention, and effective July 1, 2004, NAICO's net
retention increased to 70% of the first $1,000,000 of loss per occurrence.
Effective July 1, 2004, NAICO increased its net retention for umbrella
liability losses from 3.5% of the first $2,000,000 of loss per occurrence to
17.5% of the first $4,000,000 of loss per occurrence.
Under the 2002 construction surety bond reinsurance program, NAICO's net
retention was 50% of the first $1,000,000 plus 10% of $4,000,000 excess of
$1,000,000 per principal (e.g., contractor). 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 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 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 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.
NAICO purchased quota share reinsurance for its deductible under the Act
limiting NAICO's retention to 10% for 2003 and 15% for 2004 and 2005 of such
deductible, subject to a reinsurance limit of $9,450,000 for 2003 and
$10,625,000 for 2004 and 2005 for each loss occurrence. The reinsurance
coverage is also limited to $9,450,000 for 2003 and $10,625,000 for 2004 and
2005 for all loss 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 for 2003, $10 million excess of $12.5 million for
2004 and $15 million excess of $12.5 million for 2005 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, 2004.
CEDED REINSURANCE
NET PREMIUMS FOR A.M. BEST
REINSURANCE THE YEAR ENDED COMPANY
NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2004 RATING
- -------------------------------------------- --------------- ----------------- ------------
(Dollars in thousands)
Chandler Insurance ......................... $ 25,555 $ 30,055 -(2)
Employers Reinsurance Corporation .......... 23,955 9,731 A
Swiss Reinsurance America Corporation ...... 22,640 52 A+
Odyssey America Reinsurance Corporation .... 3,958 5,489 A
GE Reinsurance Corporation ................. 3,605 (27) A
--------------- -----------------
Top five reinsurers ..................... $ 79,713 $ 45,300
=============== =================
All reinsurers .......................... $ 87,945 $ 51,187
=============== =================
Percentage of total represented by top
five reinsurers .......................... 91% 88%
- --------------------------------------------
(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, 2004.
(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, 2004, Chandler Insurance had cash and investments
with a fair value of $28.6 million deposited in a trust account for the benefit of NAICO.
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. On March 15, 2004, an arbitration panel
ordered Transamerica to pay the losses and loss adjustment expenses owed to
NAICO in the amount of $1,607,704 plus interest at 6%, or approximately
$577,000, plus $25,000 in costs. NAICO has received payment for these amounts.
Reliance Insurance Company ("Reliance") reinsured NAICO for certain
workers compensation risks during 1998. At December 31, 2004, NAICO had
reinsurance recoverables from Reliance for paid and unpaid losses of
approximately $3.3 million. During October 2001, the Commonwealth of
Pennsylvania placed Reliance in liquidation. 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 and 2004.
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 $1.7 million, $604,000 and $282,000 during 2002, 2003 and 2004,
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,
--------------------------------------------
2000 2001 2002 2003 2004
-------- -------- -------- -------- --------
(Dollars in thousands)
Other liability:
Net premiums earned ........................ $ 20,992 $ 17,470 $ 16,458 $ 12,870 $ 18,044
Loss ratio ................................. 56% 57% 80% 94% 121%
Automobile liability:
Net premiums earned ........................ $ 17,517 $ 13,386 $ 16,526 $ 15,624 $ 17,742
Loss ratio ................................. 78% 70% 81% 49% 61%
Workers compensation:
Net premiums earned ........................ $ 21,161 $ 16,449 $ 14,808 $ 16,378 $ 17,371
Loss ratio ................................. 70% 105% 99% 72% 85%
Automobile physical damage:
Net premiums earned ........................ $ 11,434 $ 12,174 $ 9,552 $ 5,508 $ 5,933
Loss ratio ................................. 85% 52% 35% 36% 43%
Property:
Net premiums earned ........................ $ 3,377 $ 4,806 $ 5,543 $ 3,072 $ 2,611
Loss ratio ................................. 179% 93% 50% 74% 47%
Surety:
Net premiums earned ........................ $ 6,760 $ 4,125 $ 3,310 $ 2,723 $ 1,993
Loss ratio ................................. 33% 57% 59% 34% 134%
Inland marine:
Net premiums earned ........................ $ 1,088 $ 1,256 $ 760 $ 408 $ 348
Loss ratio ................................. 142% 143% 100% 54% 29%
Accident and health:
Net premiums earned ........................ $ 3,190 $ 319 $ - $ - $ -
Loss ratio ................................. 161% 281% -% -% -%
Total:
Net premiums earned ........................ $ 85,519 $ 69,985 $ 66,957 $ 56,583 $ 64,042
Loss ratio ................................. 76% 75% 76% 66% 84%
Underwriting expense ratio (1) ............. 30% 33% 34% 47% 34%
-------- -------- -------- -------- --------
Combined ratio (1) ......................... 106% 108% 110% 113% 118%
======== ======== ======== ======== ========
- ----------------------------------------------
(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 $5.7 million and $3.7 million at December 31, 2003 and 2004,
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. The consolidated financial statements reflect
the reserves for unpaid losses and loss adjustment expenses and net premiums
earned from its participation in the pools.
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,
-------------------------------------------------
2000 2001 2002 2003 2004
--------- --------- --------- --------- ---------
(In thousands)
Net balance at beginning of year .............. $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343
--------- --------- --------- --------- ---------
Net losses and loss adjustment expenses incurred
related to:
Current year .............................. 60,020 39,881 34,928 26,108 27,436
Prior years ............................... 4,979 12,669 15,784 11,092 26,345
--------- --------- --------- --------- ---------
Total ................................... 64,999 52,550 50,712 37,200 53,781
--------- --------- --------- --------- ---------
Net paid losses and loss adjustment expenses
related to:
Current year .............................. (33,661) (22,646) (13,283) (10,626) (10,222)
Prior years ............................... (36,009) (43,799) (37,050) (30,422) (28,207)
--------- --------- --------- --------- ---------
Total ................................... (69,670) (66,445) (50,333) (41,048) (38,429)
--------- --------- --------- --------- ---------
Net balance at end of year .................... $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695
========= ========= ========= ========= =========
NAICO has experienced a significant amount of incurred losses related to
prior accident years during the 2001, 2002, 2003 and 2004 calendar years. The
loss development occurred primarily in the 1997-2001 accident years. The
adverse loss development is generally the result of ongoing analysis of loss
development trends for both liability and workers compensation lines of
business, and includes provisions for potentially uncollectible reinsurance
and deductibles. NAICO adjusts reserves as experience develops and new
information becomes known. Such adjustments are reflected in the results of
operations in the periods in which the estimates are changed. The adverse
development of losses from prior accident years results in higher calendar
year loss ratios and reduced calendar year operating results.
During 2001, NAICO experienced adverse loss development 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 adverse loss development totaling $15.8
million primarily in the standard property and casualty program including both
liability lines and workers compensation. This adverse development was
primarily due to an increase in loss severity within the 1997-2000 accident
years. The adverse development included approximately $2.0 million for
provisions for potentially uncollectible reinsurance and deductibles.
During 2003, NAICO experienced adverse loss development 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.
During 2004, NAICO experienced adverse loss development totaling $26.3
million primarily in the standard property and casualty and political
subdivisions programs. This adverse development was due primarily to an
increase in losses in the workers compensation and other liability lines of
business in the 1997-2002 accident years. The adverse development in the 2002
accident year partially offset the reduction in losses for this accident year
that was recorded during 2003. The adverse loss development included
approximately $409,000 for provisions for potentially uncollectible reinsurance
and deductibles. Reserves for unpaid losses and loss adjustment expenses, net
of related reinsurance recoverables, were $44.7 million at December 31, 2004
compared to $29.3 million at December 31, 2003, an increase of $15.4 million
or 52%.
PAGE 9
The following table represents the development of net balance sheet
reserves for 1995 through 2004. 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.
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 1998 for claims
that occurred in 1995 will be included in the cumulative deficiency amount for
years 1995, 1996, 1997 and 1998. 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,
-----------------------------------------------------------------------------------------------------
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
--------- --------- --------- --------- --------- ---------- ---------- ---------- --------- --------
(In thousands)
Net reserve for unpaid losses
and loss adjustment
expenses .................... $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695
Net paid (cumulative) as of
One year later .............. 31,768 28,572 30,330 23,896 36,009 43,799 37,050 30,422 28,207
Two years later ............. 44,471 40,857 42,934 34,966 58,979 66,141 60,560 51,375
Three years later ........... 49,262 45,668 49,735 45,390 72,052 81,635 77,413
Four years later ............ 51,101 47,995 56,306 51,364 80,860 91,403
Five years later ............ 52,126 50,700 58,843 55,445 86,257
Six years later ............. 54,040 51,878 60,821 58,062
Seven years later ........... 54,574 52,964 62,720
Eight years later ........... 55,294 54,407
Nine years later ............ 56,364
Net liability re-estimated as of
One year later .............. 59,644 55,713 55,772 43,441 56,357 59,376 48,596 44,283 55,688
Two years later ............. 59,605 55,599 56,362 45,373 67,469 74,325 67,903 70,058
Three years later ........... 59,155 54,528 58,176 50,146 77,842 86,377 89,608
Four years later ............ 58,247 54,834 61,096 55,303 83,860 100,408
Five years later ............ 58,445 55,615 62,750 58,060 91,704
Six years later ............. 58,567 56,347 63,629 62,995
Seven years later ........... 59,013 56,879 67,608
Eight years later ........... 59,296 59,243
Nine years later ............ 61,152
Net cumulative (deficiency)
redundancy .................. $ (2,812) $ (5,398) $(13,573) $(23,074) $(40,326) $ (53,701) $ (56,796) $ (36,867) $(26,345) $ -
Supplemental gross data:
Gross liability ............. $116,149 $ 78,114 $ 73,721 $ 80,701 $ 98,460 $ 100,173 $ 84,756 $ 92,606 $ 87,768 $108,233
Reinsurance recoverable ..... 57,809 24,269 19,686 40,780 47,082 53,466 51,944 59,415 58,425 63,538
--------- --------- --------- --------- --------- ---------- ---------- ---------- --------- --------
Net liability - end of year.. $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695
========= ========= ========= ========= ========= ========== ========== ========== ========= ========
Gross re-estimated
liability - latest ....... $124,032 $ 98,346 $102,442 $131,420 $182,532 $ 244,570 $ 264,809 $ 203,881 $141,038
Re-estimated recoverable -
latest .................... 62,924 39,147 34,878 68,425 90,828 144,162 175,201 133,823 85,350
--------- --------- --------- --------- --------- ---------- ---------- ---------- ---------
Net re-estimated
liability - latest ........ $ 61,108 $ 59,199 $ 67,564 $ 62,995 $ 91,704 $ 100,408 $ 89,608 $ 70,058 $ 55,688
========= ========= ========= ========= ========= ========== ========== ========== =========
Gross cumulative (deficiency)
redundancy .................. $ (7,883) $(20,232) $(28,721) $(50,719) $(84,072) $(144,397) $(180,053) $(111,275) $(53,270)
========= ========= ========= ========= ========= ========== ========== ========== =========
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.
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 in
debt securities 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. Debt securities not
classified as held to maturity or trading and equity securities 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 securities below their carrying value that are other than
temporary are recognized in earnings.
As of December 31, 2004, all of the investments of NAICO were in
fixed-maturity investments (rated Aa3 or A+ or better by Moody's Investors
Service, Inc. or Standard & Poor's, respectively), mutual funds that invest in
equity securities, 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. Chandler USA purchased and cancelled $16.7
million and $275,000 principal amount of the Debentures during 2003 and 2004,
respectively, and at December 31, 2004, there was $6,979,000 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 additional 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")
by purchasing all of its common securities for $403,000. Trust I is a Delaware
statutory business trust and is a wholly owned non-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. Trust I used the proceeds from the issuance to purchase
$13,403,000 of 9.75% junior subordinated debentures (the "Junior Debentures I")
of Chandler USA. Distributions on the Junior Debentures I are payable
quarterly at a fixed annual rate of 9.75%. 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.
The Junior Debentures I are the sole assets of Trust I and Trust I will
distribute any cash payments it receives thereon to the holders of its
preferred and common securities. Distributions on the Trust I Preferred
Securities are payable quarterly at a fixed annual rate of 9.75%. 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
In December 2003, Chandler USA established Chandler Capital Trust II
("Trust II") by purchasing all of its common securities for $217,000.
Trust II is a Delaware statutory business trust and is a wholly owned
non-consolidated subsidiary of Chandler USA. On December 16, 2003, Trust II
issued $7.0 million of capital securities (the "Trust II Preferred Securities")
to InCapS Funding II, Ltd., an unaffiliated company established under the laws
of the Cayman Islands, in a private transaction. Trust II used the proceeds
from the issuance to purchase $7,217,000 of floating rate junior subordinated
debentures (the "Junior Debentures II") of Chandler USA. 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). The interest rate was 6.17% at December 31,
2004. 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 Junior Debentures II are the sole assets of Trust II and Trust II
will distribute any cash payments it receives thereon to the holders of its
preferred and common securities. 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). The interest rate was 6.17% at December 31, 2004. 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.
The sale of the Trust I Preferred Securities and the Trust II Preferred
Securities during 2003 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 are being 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 during 2003. 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
during 2003, 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.
In December 2003, the Financial Accounting Standards Board issued Revised
Interpretation No. 46 ("FIN 46R"), CONSOLIDATION OF VARIABLE INTEREST ENTITIES.
FIN 46R provides guidance on the identification of, and financial reporting
for, entities over which control is achieved through means other than voting
rights. FIN 46R is used to determine whether consolidation is required or,
alternatively, whether the variable-interest model under FIN 46R should be
used to account for existing and new entities. Chandler USA adopted FIN 46R
effective January 1, 2004. The result of adoption was the deconsolidation of
the two capital trusts that were created during 2003 in connection with the
issuance of trust preferred securities. Chandler USA now reports the $20.6
million of junior subordinated debentures that were issued to the capital
trusts on its consolidated balance sheet, and the December 31, 2003 balances
were restated accordingly. The adoption of FIN 46R had no effect on net
earnings.
EMPLOYEES AND ADMINISTRATION
At December 31, 2004, Chandler USA and its subsidiaries had approximately
260 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 from 2000 through 2004, 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, 2004, NAICO had statutory earned surplus of $3.8
million. Applying the Oklahoma statutory limits described above, the maximum
shareholder dividend NAICO may pay in 2005 without the approval of the Oklahoma
Department of Insurance is $3.8 million. NAICO paid shareholder dividends to
Chandler USA totaling $3.5 million in 2002 and $3.4 million in 2004.
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 6.7:1 and 4.8:1 at December 31, 2003 and 2004, 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
seven 2004 ratios that were outside of the "usual values," five of which
resulted primarily from adverse loss development as explained below.
NAICO's "change in net writings" for 2004 was 36% compared to a usual
value of greater than (33%) and less than 33%. The increase was due primarily
to the decrease in reinsurance purchased in 2004 which resulted in an increase
in net premiums written of $18.6 million.
NAICO's "two-year overall operating ratio" for 2004 was 107% 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 2004, and to adverse loss
development recorded during 2003 and 2004 for accident years prior to 2003.
Excluding this loss development, the two-year overall operating ratio would
have been 77% for 2004.
NAICO's "investment yield" as calculated using the IRIS formula was 3.6%
during 2004 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). 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 "change in policyholders' surplus" for 2004 was (16%) compared to
a usual value of greater than (10%) and less than 50%. The decrease in surplus
was due to the adverse loss development experienced during 2004, and to the
payment of a shareholder dividend in the amount of $3.4 million to Chandler USA.
NAICO's "one-year reserve development to policyholders' surplus" and
"two-year reserve development to policyholders' surplus" for 2004 were 50% and
78%, 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 2003 and 2004 related to the 1997 - 2002 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 $1.3 million and $409,000 during 2003 and 2004,
respectively. Statutory accounting requires that these write-downs of
receivables and recoverables be reflected as prior year loss development.
PAGE 15
NAICO's "estimated current reserve deficiency to policyholders' surplus"
was 44% at December 31, 2004 compared to a usual value of less than 25%. The
adverse loss development experienced in 2003 and 2004 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.
Since 2000, NAICO has 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
$122 million in 2004. 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.
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.
Chandler USA believes such space is sufficient for its operations for the
foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
See Note 11 to Consolidated Financial Statements for a discussion of
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, 2004.
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 year 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, 2003 and 2004 and the related consolidated statements of operations,
comprehensive income, shareholder's equity and cash flows for the years ended
December 31, 2001, 2002, 2003 and 2004 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,
------------------------------------------------------
2000 2001 2002 2003 2004
---------- ---------- ---------- ---------- ----------
OPERATING DATA (1) (Dollars in thousands)
Revenues
Direct premiums written and assumed .......... $ 197,196 $ 158,964 $ 140,162 $ 118,444 $ 121,651
========== ========== ========== ========== ==========
Net premiums earned .......................... $ 85,519 $ 69,985 $ 66,957 $ 56,583 $ 64,042
Investment income, net ....................... 4,281 3,632 2,540 2,148 3,186
Interest income, net from related parties .... - 371 380 412 491
Realized investment gains, net ............... 144 2,654 794 2,351 652
Other income (2) ............................. 301 101 261 5,077 640
---------- ---------- ---------- ---------- ----------
Total revenues .................................... 90,245 76,743 70,932 66,571 69,011
---------- ---------- ---------- ---------- ----------
Operating expenses
Losses and loss adjustment expenses .......... 64,999 52,550 50,712 37,200 53,781
Policy acquisition costs ..................... 16,882 10,869 10,239 11,278 11,039
General and administrative expenses .......... 10,557 11,549 12,473 13,486 12,380
Interest expense ............................. 2,255 2,240 2,234 2,441 2,397
---------- ---------- ---------- ---------- ----------
Total operating expenses .......................... 94,693 77,208 75,658 64,405 79,597
---------- ---------- ---------- ---------- ----------
Income (loss) from continuing operations before
income taxes ................................ (4,448) (465) (4,726) 2,166 (10,586)
Federal income tax benefit (provision) ............ 1,347 (16) 1,680 (192) 3,582
---------- ---------- ---------- ---------- ----------
Income (loss) from continuing operations .......... (3,101) (481) (3,046) 1,974 (7,004)
Income (loss) from discontinued operations ........ (894) (622) 284 - -
Gain on sale of subsidiary ........................ - - 671 - -
---------- ---------- ---------- ---------- ----------
Net income (loss) ................................. $ (3,995) $ (1,103) $ (2,091) $ 1,974 $ (7,004)
========== ========== ========== ========== ==========
Combined loss and underwriting expense ratio (3) .. 106% 108% 110% 113% 118%
BALANCE SHEET DATA
Cash and investments .............................. $ 104,760 $ 73,378 $ 68,276 $ 69,198 $ 86,913
Amounts due from related parties .................. - 7,880 10,582 9,642 10,891
Total assets ...................................... 273,498 234,809 229,855 218,213 237,297
Unpaid losses and loss adjustment expenses ........ 100,173 84,756 92,606 87,768 108,233
Amounts due to related parties .................... 717 - - - -
Debentures ........................................ 24,000 24,000 24,000 7,254 6,979
Junior subordinated debentures issued to affiliated
trusts ....................................... - - - 20,620 20,620
Total liabilities ................................. 228,647 191,067 186,855 174,374 201,105
Shareholder's equity .............................. 44,851 43,742 43,000 43,839 36,192
- -----------------------------------------------------
(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 included a $3.1 million gain on the purchase and cancellation of $16.7 million principal
amount of Debentures in 2003, and $1.7 million and $368,000 for the amortization of the deferred gain on
a sale and leaseback transaction in 2003 and 2004, respectively. For additional information, see "MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
(3) Interest expense and certain litigation expenses are not considered underwriting expenses and have 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. 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
For the year ended December 31, 2004, Chandler USA had a net loss of $7.0
million compared to net income of $2.0 million for 2003 and a net loss of $2.1
million for 2002. For 2004 and 2003, the income (loss) from continuing
operations was the same as the net income (loss). Loss from continuing
operations was $3.0 million during 2002. 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." The
net loss in 2004 is primarily due to the adverse loss development experienced
by Chandler USA. See "Losses and Loss Adjustment Expenses."
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 $3.6 million. Chandler USA recorded
an after-tax gain of $671,000 on the sale in 2002 based on the minimum purchase
price for the transaction. The gain on the sale may be increased depending on
certain adjustments to the purchase price as defined in the terms of the
transaction. Following the completion of the sale, L&W changed its name to
Brown & Brown of Central Oklahoma, Inc. ("B&B"). L&W previously functioned as
Chandler USA's agency segment and is presented as discontinued operations.
B&B continues to be a significant producer of business for NAICO. Retail
business produced by B&B and placed with NAICO constituted approximately 13% of
NAICO's direct premiums written and assumed in 2004. 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
established a letter of credit in the amount of $500,000 for the benefit of
Brown & Brown, Inc. as security.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with U.S. 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 significantly 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
DEFERRED INCOME TAXES
Chandler USA uses an asset and liability approach for accounting for
income taxes. Deferred income taxes are recognized for the tax consequences
of temporary differences and carryforwards by applying enacted tax rates
applicable to future years to differences between the financial statement
amounts and the tax bases of existing assets and liabilities. A valuation
allowance is established if it is more likely than not that some portion of
the deferred tax asset will not be realized. The determination of whether a
valuation allowance is appropriate requires the exercise of management judgment.
At December 31, 2004, Chandler USA had a net operating loss carryforward
available for U.S. Federal income taxes of $11.8 million which begins to expire
in 2023. Chandler USA has concluded that the deferred tax asset including the
federal net operating loss carryforwards are more likely than not to be
realized. Chandler USA anticipates that its future U.S. consolidated income
tax will be sufficient to utilize the federal net operating losses within the
required time. Chandler USA will continue to evaluate income generated in
future periods in determining the reasonableness of its position. If Chandler
USA determines that future income is insufficient to cause the realization of
the federal net operating losses within the required time, a valuation
allowance will be established.
In addition, Chandler USA, at December 31, 2004, had net operating loss
carryforwards available for Oklahoma state income taxes totaling approximately
$53.2 million which expire in the years 2005 through 2024. At December 31,
2004, Chandler USA also had a capital loss carryforward for U.S. Federal income
taxes of $1.1 million which expires in 2007. A valuation allowance has been
provided for the tax effect of the state net operating loss and the net capital
loss carryforwards since realization of such amounts is not considered more
likely than not.
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 $108 million,
or 89%, of NAICO's direct written premiums in 2004 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 or a decrease in the value of the equity
mutual funds 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.
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 from 2000 through 2004, 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 20
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.
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 re-pricing, if permitted by
applicable regulations, or limitations or cessation of the affected business.
PAGE 21
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,
----------------------------------
2002 2003 2004
---------- ---------- ----------
(Dollars in thousands)
INSURANCE PROGRAMS
- ----------------------------------------
STANDARD PROPERTY AND CASUALTY
Net premiums earned .................. $ 49,570 $ 45,521 $ 54,278
Financial year loss ratio ............ 81.1% 65.1% 79.0%
Accident year loss ratio ............. 50.5% 48.4% 43.6%
POLITICAL SUBDIVISIONS
Net premiums earned .................. $ 13,829 $ 8,093 $ 7,269
Financial year loss ratio ............ 55.9% 70.7% 98.0%
Accident year loss ratio ............. 34.7% 43.8% 37.9%
SURETY BONDS
Net premiums earned .................. $ 3,310 $ 2,724 $ 1,993
Financial year loss ratio ............ 59.4% 33.5% 134.4%
Accident year loss ratio ............. 24.0% 31.1% 37.2%
OTHER (1)
Net premiums earned .................. $ 248 $ 245 $ 502
Financial year loss ratio ............ 332.7% 374.0% 215.3%
Accident year loss ratio ............. 73.5% 110.1% 51.3%
TOTAL
Net premiums earned .................. $ 66,957 $ 56,583 $ 64,042
Financial year loss ratio ............ 75.7% 65.7% 84.0%
Accident year loss ratio ............. 46.0% 47.1% 42.8%
- --------------------------------
(1) This category is comprised primarily of the run-off of discontinued programs
and NAICO's participation in various mandatory workers compensation pools.
PAGE 22
YEAR ENDED DECEMBER 31,
----------------------------------
2002 2003 2004
---------- ---------- ----------
(Dollars in thousands)
LINES OF INSURANCE
- ---------------------------------------
OTHER LIABILITY
Net premiums earned ................. $ 16,458 $ 12,870 $ 18,044
Financial year loss ratio ........... 80.2% 94.0% 120.9%
Accident year loss ratio ............ 50.2% 44.5% 34.8%
AUTOMOBILE LIABILITY
Net premiums earned ................. $ 16,526 $ 15,624 $ 17,742
Financial year loss ratio ........... 81.2% 49.4% 61.2%
Accident year loss ratio ............ 49.3% 41.6% 55.1%
WORKERS COMPENSATION
Net premiums earned ................. $ 14,808 $ 16,378 $ 17,371
Financial year loss ratio ........... 99.4% 71.8% 85.5%
Accident year loss ratio ............ 53.5% 58.3% 41.8%
AUTOMOBILE PHYSICAL DAMAGE
Net premiums earned ................. $ 9,552 $ 5,508 $ 5,933
Financial year loss ratio ........... 35.3% 36.0% 42.9%
Accident year loss ratio ............ 35.8% 35.0% 39.6%
PROPERTY
Net premiums earned ................. $ 5,543 $ 3,072 $ 2,611
Financial year loss ratio ........... 49.9% 73.7% 46.8%
Accident year loss ratio ............ 33.9% 64.4% 36.3%
SURETY
Net premiums earned ................. $ 3,310 $ 2,723 $ 1,993
Financial year loss ratio ........... 59.4% 33.5% 134.4%
Accident year loss ratio ............ 24.1% 31.1% 37.2%
INLAND MARINE
Net premiums earned ................. $ 760 $ 408 $ 348
Financial year loss ratio ........... 99.7% 54.1% 29.5%
Accident year loss ratio ............ 46.2% 34.8% 21.6%
TOTAL
Net premiums earned ................. $ 66,957 $ 56,583 $ 64,042
Financial year loss ratio ........... 75.7% 65.7% 84.0%
Accident year loss ratio ............ 46.0% 47.1% 42.8%
PAGE 23
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 2002 2003 2004 2002 2003 2004
- ----------------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Standard property and casualty .......... $106,051 $ 93,193 $ 92,894 $ 49,570 $ 45,521 $ 54,278
Political subdivisions .................. 35,159 28,926 21,679 13,829 8,093 7,269
Surety bonds ............................ 5,104 3,908 2,788 3,310 2,724 1,993
Other ................................... 249 252 507 248 245 502
-------- -------- -------- -------- -------- --------
TOTAL ................................... $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042
======== ======== ======== ======== ======== ========
GROSS PREMIUMS EARNED NET PREMIUMS EARNED
-------------------------- --------------------------
LINES OF INSURANCE 2002 2003 2004 2002 2003 2004
- ----------------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Other liability ......................... $ 36,078 $ 34,715 $ 35,438 $ 16,458 $ 12,870 $ 18,044
Automobile liability .................... 27,143 27,538 26,660 16,526 15,624 17,742
Workers compensation .................... 41,958 29,821 26,995 14,808 16,378 17,371
Automobile physical damage .............. 10,745 9,146 9,154 9,552 5,508 5,933
Property ................................ 22,722 19,359 15,130 5,543 3,072 2,611
Surety .................................. 5,104 3,908 2,788 3,310 2,723 1,993
Inland marine ........................... 2,813 1,792 1,703 760 408 348
-------- -------- -------- -------- -------- --------
TOTAL ................................... $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042
======== ======== ======== ======== ======== ========
Gross premiums earned decreased 14% and 7% in 2003 and 2004,
respectively. These decreases were primarily the result of NAICO's
continued efforts to improve underwriting profitability and increased
competition within the Oklahoma school districts portion of the political
subdivision program. Gross premiums earned in Texas decreased 18% and 3% in
2003 and 2004, respectively, and gross premiums earned in Oklahoma decreased
15% and 8% in 2003 and 2004. The workers compensation and property lines of
business accounted for a significant portion of the decreases. A majority of
NAICO's property premiums is written in the political subdivisions program.
Net premiums earned decreased 15% in 2003 and increased 13% in 2004. The
decrease in 2003 is primarily the result of the decrease in gross earned
premiums during this period. The increase in 2004 is due primarily to changes
in NAICO's reinsurance programs for certain excess of loss and quota share
reinsurance. Effective January 1, 2004, NAICO discontinued a quota share
reinsurance arrangement that covered casualty, workers compensation and
physical damage risks produced by certain agents. Effective April 1, 2004,
NAICO increased its net retention to include 56% of the layer covering $500,000
excess of $500,000 of loss per occurrence for its casualty and workers
compensation risks, and effective July 1, 2004, NAICO increased its net
retention to include 70% of this layer. These changes increased NAICO's net
retention for these lines of business and also increased net premiums earned.
Gross premiums earned in the standard property and casualty program
decreased 12% and less than 1% in 2003 and 2004, respectively. The decrease in
2003 was 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 $9.9
million and $685,000 in 2003 and 2004, respectively, and gross premiums earned
in Oklahoma decreased $6.0 million in 2003 and increased $1.7 million in 2004.
Net premiums earned decreased 8% in 2003 and increased 19% in 2004. The
increase in 2004 is due primarily to reinsurance changes described above.
Gross premiums earned in the political subdivision program decreased 18%
and 25% in 2003 and 2004, respectively. The decrease in gross premiums earned
is due primarily to increased competition in the school districts portion of
the program in Oklahoma. Gross premiums earned for the municipality portion
of the program decreased $2.3 million and $529,000 in 2003 and 2004,
respectively, as NAICO discontinued writing most of these accounts in 2003 and
did not write any in 2004. Net premiums earned decreased 41% and 10% in 2003
and 2004, 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. The decrease in 2004
was due to a decrease in gross premiums earned and was partially offset by the
reinsurance changes described above.
PAGE 24
Gross premiums earned in the surety bond program decreased 23% and 29% in
2003 and 2004, respectively. The decreases are primarily due to stricter
underwriting policies as NAICO continues to focus on improving underwriting
profitability in this program and to the bail bond portion of the program that
was discontinued in 2003. Gross premiums earned for the bail bond portion of
the program decreased $1.1 million and $1.0 million in 2003 and 2004,
respectively. Net premiums earned decreased 18% and 27% in 2003 and 2004,
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 and 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.
NET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS
At December 31, 2004, Chandler USA's investment portfolio consisted
primarily of fixed income U.S. Treasury and government agency bonds,
high-quality corporate bonds and mutual funds that invest in equity securities,
with approximately 8% 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 investment income from continuing operations, excluding interest
income from related parties, decreased 15% in 2003 and increased 48% in 2004.
The decrease in 2003 was due primarily to lower interest rates. The increase
in 2004 was due primarily to NAICO receiving $577,000 in interest from an
arbitration award in addition to an increase in fixed maturity investments
during the year. Interest income from related parties was $380,000, $412,000
and $491,000 during 2002, 2003 and 2004, respectively. See Liquidity and
Capital Resources.
Net realized investment gains were $794,000, $2,351,000 and $652,000 in
2002, 2003 and 2004, respectively. 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"). NAICO received these shares in 1997
as a result of ISO converting to a for-profit corporation.
The average net yield on the fixed maturity portfolio, including net
realized investment gains, was 4.8%, 6.7% and 4.0% in 2002, 2003 and 2004,
respectively. The average net yield on the fixed maturity portfolio, excluding
net realized investment gains, was 3.7%, 3.2% and 3.2% for 2002, 2003 and 2004,
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, 2004 was
approximately $11.0 million. The average yield on the fixed maturity portfolio
before deducting investment expenses was 4.4%, 3.6% and 3.6% in 2002, 2003 and
2004, 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 in 2003. During 2004, the remaining
$368,000 of deferred gain was amortized into income. The deferred gain was
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."
The percentage of losses and loss adjustment expenses to net premiums
earned ("loss ratio") was 75.7%, 65.7% and 84.0% in 2002, 2003 and 2004,
respectively. Weather-related losses (net of applicable reinsurance) from wind
and hail were $1.5 million, $1.9 million and $761,000 in 2002, 2003 and 2004,