The Company's principal office is located on the 5th Floor, Anderson Square in Grand Cayman, Cayman Islands, B.W.I. CIB's principal office is located in the Stevmar House, Rockley, Christ Church, Barbados. The Company and CIB have no offices in the United States.
The Company's United States-based subsidiaries own and occupy three office buildings with approximately 81,000 square feet of usable space at the home office in Chandler, Oklahoma, and an additional office building with approximately 46,000 square feet of usable space is planned for construction in Chandler, Oklahoma during 1999. The Company's subsidiaries also lease approximately 11,000 square feet in the aggregate for its branch offices. The Company believes such space will suffice for the foreseeable future.
The selected financial data has been derived from the consolidated financial statements of the Company and subsidiaries, which appear in Item 14(a). The consolidated balance sheets of the Company and its subsidiaries as of December 31, 1997 and 1998, and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1998, have been audited by Deloitte & Touche, independent auditors whose independent auditors report expresses an unqualified opinion and includes an explanatory paragraph relating to litigation. The selected financial data should be read in conjunction with "LEGAL PROCEEDINGS," "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and the consolidated financial statements of the Company and the notes thereto appearing in Item 14(a). See Notes to Consolidated Financial Statements for various litigation and contingency matters.
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 are 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. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims.
The impact of a recession on the Company 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 $111 million, or 82%, of NAICO's direct written premiums in 1998 were in the states of Oklahoma and Texas. An economic downturn in these states could have a significant adverse impact on the Company. A recession might also cause defaults on fixed-income securities owned by NAICO or CIB. 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.
NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates. The effect of inflation on the operations of the Company was not significant during the period from 1996 through 1998.
The Company's insurance subsidiaries are subject to regulation by government agencies in the jurisdictions in which they do 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 examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders or creditors.
In 1998, NAICO believed that reinsurance market conditions were conducive to the purchase of additional reinsurance. During the first quarter of 1998, NAICO purchased additional reinsurance under its workers compensation and casualty reinsurance programs. During the second quarter of 1998, NAICO purchased additional reinsurance for its construction surety bond reinsurance program.
During the second quarter of 1997, management concluded that it would be in NAICO's best interest to substantially reduce its underwriting risk in the California portion of the nonstandard private-passenger automobile program. In July 1997, NAICO purchased additional reinsurance for this portion of the program.
The purchase of the additional reinsurance coverages in 1997 and 1998 substantially reduced the per occurrence retention for NAICO's workers compensation, casualty, surety bond and nonstandard private-passenger automobile lines of business, but resulted in significantly lower net premiums earned, losses and loss adjustment expenses and policy acquisition costs. See "Premiums Earned" and "Policy Acquisition Costs."
Gross premiums earned, before reductions for premiums ceded to reinsurers, increased 9%, 13% and 8% in 1996, 1997 and 1998, respectively. The increases are primarily attributable to increased production in Oklahoma and Texas. Net premiums earned, after such reductions, increased 10% and 6% in 1996 and 1997, respectively, and decreased 26% in 1998. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance for NAICO's workers compensation, casualty and nonstandard private-passenger automobile insurance programs described previously. See "Purchase of Additional Reinsurance."
Gross premiums earned in the political subdivisions program increased 13%, 11% and 17% in 1996, 1997 and 1998, respectively, due primarily to expansion of the school districts portion of the program in Texas and Missouri and increased production in Oklahoma. Net premiums earned increased 12% and 7% in 1996 and 1997, respectively, and decreased 13% in 1998, due primarily to the purchase of additional reinsurance in 1998 as previously described.
During 1996, NAICO began writing excess accident and health coverage for small to medium sized employers generally in Oklahoma and Texas. During 1997, NAICO began offering fully insured accident and health coverage on a limited basis. Gross premiums earned in the group accident and health program increased 560% and 81% in 1997 and 1998, respectively. Net premiums earned in the group accident and health program increased 629% and 102% in 1997 and 1998, respectively. The significant increases in group accident and health premiums are primarily the result of the growth expected in start-up programs. NAICO is currently evaluating this program and may modify or discontinue certain portions of this program in 1999.
NAICO participates in various mandatory pools covering workers compensation for insureds that were unable to purchase this coverage from an insurance company on a voluntary basis. In addition, NAICO receives direct assignments to write workers compensation for such insureds in certain states in lieu of participation in related pools. The majority of the change found in the Company's other programs is attributable to participation in the pools covering workers compensation and from direct assignments (included in "Other" in the preceding table). Net premiums earned from the previously mentioned mandatory pools and workers compensation assignments decreased 81% and 93% in 1997 and 1998, respectively. The declines in 1997 and 1998 were attributable to decreased activity from the pools and fewer assignments in certain states. Both the size of the involuntary market and NAICO's relative participation in states having a mandatory pool mechanism declined in these years.
The Company's income from commissions, fees and other income increased 17% in 1996, and decreased 30% and 23% for 1997 and 1998, respectively. The majority of the Company's income from commissions, fees and other income are from L&W's brokerage commissions and fees.
L&W disposed of certain equipment in 1998 that resulted in a gain of approximately $145,000 before provision for federal income tax.
Policy acquisition costs consist of costs associated with the acquisition of new and renewal business and generally include direct costs such as premium taxes, commissions to agents and ceding companies and premium-related assessments and indirect costs such as salaries and expenses of personnel who perform and support underwriting activities. NAICO also receives ceding commissions from certain of the reinsurers who assume premiums from NAICO under certain reinsurance contracts and the ceding commissions are accounted for as a reduction of policy acquisition costs. Direct policy acquisition costs and ceding commissions are deferred and amortized over the terms of the policies. Recoverability of such deferred costs is dependent on the related unearned premiums on the policies being more than expected claim losses.
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 33.5%, 28.4% and 25.3% in 1996, 1997 and 1998, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 15.3%, 12.9% and 11.5%. The commission rate for a portion of the surety bond program varies inversely with the loss ratio pursuant to a commission arrangement contingent on the loss experience of the program. The expected loss ratio for that portion of the surety bond program was lowered in 1996, which increased the percentage of net policy acquisition costs to net premiums earned by 3.1 percentage points. In 1998, the commission rate for a portion of the surety bond program was lowered due to an increase in the expected loss ratio which reduced the percentage of net policy acquisition costs to net premiums earned by 1.6 percentage points. In addition, the 1998 commission rate declined due to the lower proportion of surety bond direct written and assumed premiums to total direct written and assumed premiums. Surety bonds have historically had a higher commission rate than the Company's other lines of business.
The Company incurred approximately $2.1 million, $527,000 and $50,000 in indirect underwriting expenses for uncollectible ceded reinsurance in 1996, 1997 and 1998, respectively. The 1996 amount includes an arbitration award which was made in favor of NAICO against certain reinsurers for $1.1 million less than had been recorded. NAICO reduced its reinsurance recoverables accordingly.
In 1998, the Company adopted a stock option and stock grant plan for certain non-employee directors of the Company. Compensation expense related to the plan in the amount of $272,000 is included in general and administrative expenses in 1998. Excluding the expense related to the plan, general and administrative expenses declined $678,000 or 5.2% in 1998 compared to 1997.
Interest expense increased 217% in 1997 and increased 102% in 1998, due primarily to increased levels of bank debt. See "Liquidity and Capital Resources."
The 1997 expense included a net charge totaling approximately $1.4 million ($1.6 million including provision for federal income tax) for the litigation matters related to the CenTra Group. In addition, significant litigation expenses were incurred in 1997 due to the trial which began on February 13, 1997. The net charge has been reduced by an estimated recovery of $2.7 million from the Company's directors and officers liability insurer for costs associated with the defense and litigation of these matters. The Company also resolved various issues resulting in settlement of litigation and arbitration proceedings among subsidiaries of the Company and CenTra affiliates and recorded litigation and settlement expenses of approximately $462,000 in 1997.
In 1996, the Company recorded a $982,000 estimated recovery of costs from it directors and officers liability insurer related to the Company's claim for reimbursable amounts previously paid for defense and litigation costs associated with the litigation involving the CenTra Group.
As a result of the factors described above, the Company reported net income of $3,442,000 in 1998 compared to a net loss of $1,065,000 in 1997 and net income of $972,000 in 1996. Excluding the effects of the litigation expenses related to legal proceedings involving the CenTra Group, net income would have been $591,000 in 1998 compared to approximately $3.4 million in 1997.
In 1997, the Company provided $3.9 million in cash from operations. During 1998, the Company used $8.8 million in cash from operations due primarily to the purchase of additional reinsurance described previously. To augment maturities and reposition their portfolios, CIB and NAICO chose to liquidate certain fixed maturity securities that were available for sale prior to their maturities.
Cash flows from financing activities were primarily the result of bank borrowings and repayments. During 1996, Chandler USA borrowed $4.5 million in bank debt for a three-year term. During the fourth quarter of 1997, the related loan agreement was amended to provide for additional borrowings up to $8.5 million and to revise the term to five years with interest payable at a floating rate equal to 1% over the prime rate published in the Wall Street Journal, which was 7.75% at December 31, 1998. During March 1998, Chandler USA borrowed an additional $6.2 million on the note and the proceeds were used to repay amounts due to CIB. The outstanding balance of the note was $7.4 million at December 31, 1998. The funds received by CIB may be used to discharge litigation judgments. The bank note is collateralized by shares of NAICO stock owned by Chandler USA.
In April 1998, CIM acquired 69,858 shares of the Company's common stock from an agent for approximately $524,000. These shares had previously been pledged to NAICO to secure certain obligations resulting from insurance business produced by another agent.
The Company has incurred approximately $2.5 million, $2.1 million, $1.9 million, $1.1 million, $857,000, $7.5 million and a credit of $2.7 million in costs attributable to these legal proceedings during 1992, 1993, 1994, 1995, 1996, 1997 and 1998 respectively, before recoveries from the Company's directors and officers liability insurer. The amount for 1997 includes approximately $1.4 million for the Oklahoma Federal Court judgments, $2.9 million for litigation expenses and $462,000 related to the settlement of certain litigation and arbitration proceedings. During the second quarter of 1998 the Oklahoma Federal Court denied the CenTra Group's request for costs and attorney fees. Accordingly, the Company reduced the previous 1997 net charge for litigation matters by $3.8 million in 1998. As a result of various events in 1995, the Company recorded an $818,000 estimated recovery of costs from its directors and officers liability insurer related to a $1 million claim for reimbursable amounts previously paid that relate to allowable defense and litigation costs for such parties. In 1996, the Company recorded an additional estimated recovery of $982,000. The Company received a payment for the 1995 claim during 1996 in the amount of $795,000. In connection with the Oklahoma Federal Court judgments, the Company recorded an additional estimated recovery of $2.7 million from the Company's directors and officers liability insurer. The Company is entitled to a total of $5 million under the applicable insurance policy. Some amounts have been previously paid without dispute and the Company is negotiating with the insurer for payment of the policy balance. The Company could recover the remaining policy limits or could compromise its claim, and could incur significant costs in either case. The estimated insurance recovery is based upon these variable factors.
Computer software, hardware, microprocessor chips and other computer equipment use two digits to identify a particular year, and therefore may not recognize the number "00" or may recognize it as a year prior to 1999. Unless computer equipment and software programs are modified to correct these data recognition problems (the "Year 2000 Problems"), errors could result. These errors could cause damage to personal property and disrupt business practices and functions. In addition to potential problems from computer systems, potential problems could arise from equipment with embedded chips, such as vaults, elevators, aircraft and other systems not generally classified as information technology systems.
During the fourth quarter of 1998, the Company retained an independent consultant to prepare a plan for testing its information technology systems. In late 1998, the Company determined that the testing would be performed by Company employees, and this testing is anticipated to be completed during the first half of 1999. During the fourth quarter of 1998, the Company incurred approximately $150,000 in additional expenses to evaluate its information systems and in preparation of plans to test the Company's information systems.
Evaluation and testing of the Company's efforts to address Year 2000 Problems is ongoing. The Company estimates the additional cost of the testing to be approximately $115,000 which includes the use of internal employees, cost of external software to enhance testing efforts and computer rental costs. These costs will be expensed during 1999 as incurred. This estimate is based on currently available information. The Company continues to evaluate the estimated costs associated with future efforts on actual experience. These efforts may involve additional costs. The Company is also formulating and studying contingency plans with completion expected by mid-1999.
The Company believes, based on the information currently available, that the most reasonably likely worst case scenarios resulting from Year 2000 Problems include:
- Legal risks arising from failure of NAICO or L&W to provide contracted services, deal with claims on a timely basis, provide pertinent data to those dependent upon the data and similar risks;
- Lost revenue resulting from the inability to render accurate billings and from the inability to efficiently market insurance products;
- Fines and associated expenses resulting from inability to comply with regulatory requirements; and
Any previously mentioned Year 2000 Problems could have a material adverse effect on the Company, including the financial condition of the Company's subsidiaries and their ability to pay dividends or other payments to the Company and its subsidiaries.
During 1996, the IRS conducted a field examination of the U.S. Federal income tax returns of Chandler USA and its wholly owned subsidiaries for the years 1993 and 1994. The IRS completed the examination in the fourth quarter of 1996, and there were no proposed adjustments to tax liabilities. During 1998, the IRS conducted an examination of the 1995 U.S. Federal income tax return of CIB. The IRS completed the examination in the third quarter of 1998, and there were no proposed adjustments to tax liabilities.