Chandler USA and its subsidiaries own and occupy three office buildings with approximately 81,000 square feet of usable space in Chandler, Oklahoma, and an additional office building with approximately 46,000 square feet of usable space is being constructed in Chandler, Oklahoma. Chandler USA's subsidiaries also lease approximately 10,000 square feet in the aggregate for its branch offices. Chandler USA believes such space is sufficient for its operations for the foreseeable future.
Chandler USA is engaged in various property and casualty insurance operations through its wholly owned subsidiaries, NAICO and L&W. NAICO writes various property and casualty insurance products through four separate marketing programs: standard property and casualty, political subdivisions, surety bonds (including both bail bonds and construction bonds) and group accident and health. The lines of insurance written by NAICO are commercial coverages consisting of automobile liability, workers compensation, surety, automobile physical damage, accident and health, property, inland marine and other liability lines, which include general and professional liability lines. L&W represents various personal and commercial lines insurance companies in marketing property and casualty insurance. L&W also markets individual and group life, medical and disability income coverage. L&W places the majority of its business with NAICO. Business produced by L&W and placed with NAICO constituted approximately 23% of NAICO's direct premiums written and assumed in 1999.
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.
Insurance companies are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include the redefinition of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through coverage repricing, if permitted by applicable regulations, or limitations or cessation of the affected business.
Gross premiums earned in the standard property and casualty program increased 39%, 22% and 30% in 1997, 1998 and 1999, respectively. The increases are primarily attributable to increased written premium production in Texas. Net premiums earned increased 41% in 1997, decreased 35% in 1998 and increased 94% in 1999. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance in 1998 as previously described. The rescission of the reinsurance treaties increased net premiums earned in 1999 by $17.3 million in this program.
Gross premiums earned in the political subdivisions program increased 11%, 17% and 20% in 1997, 1998 and 1999, respectively, due primarily to expansion of the school districts portion of the program in Texas and Missouri and increased written premium production in Oklahoma. Net premiums earned increased 7% in 1997, decreased 16% in 1998 and increased 37% in 1999. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance in 1998 as previously described. The rescission of the reinsurance treaties increased net premiums earned in 1999 by $2.3 million in this program.
Gross premiums earned in the surety bond program increased 8% in 1997, decreased 3% in 1998 and increased 15% in 1999. The increase in 1999 was due primarily to increased written premium production in California. Net premiums earned in the surety bond program increased 12% in 1997, decreased 29% in 1998 and increased 5% in 1999. Increased competition, higher reinsurance costs and/or changes in risk retained contributed to the decline in 1998.
Gross premiums earned in the group accident and health program increased 560%, 80% and 50% in 1997, 1998 and 1999, respectively, and net premiums earned increased 626%, 100% and 78% in 1997, 1998 and 1999, respectively. The significant increases in premiums in 1997 and 1998 are primarily the result of the growth expected in start-up programs. In January 1999, NAICO began a new program covering primarily Oklahoma employers on a fully insured basis. Gross and net premiums earned for this program were $6.0 million and $5.6 million, respectively, during 1999. NAICO discontinued writing new policies for the excess portion of its group accident and health program effective April 1, 1999. NAICO expects that premiums in its fully insured program will decline during 2000 due to the effect of rate increases and other changes in the program which were put in effect in late 1999. NAICO is currently evaluating the fully insured program and may modify or discontinue it during 2000.
Other programs in the preceding table include premiums from NAICO's participation in various mandatory pools covering workers compensation for insureds that were unable to purchase this coverage from an insurance company on a voluntary basis, and direct assignments to write workers compensation for such insureds in certain states in lieu of participating in related pools, in addition to the runoff of various programs which are no longer offered by NAICO. The majority of the decrease in net premiums earned during the periods is attributable to participation in the pools covering workers compensation and from direct assignments. The declines 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.
At December 31, 1999, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Government, high-quality corporate and tax exempt bonds, with approximately 5% 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.
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 60.1%, 68.8% and 78.8% in 1997, 1998 and 1999, respectively. The rescission of the reinsurance treaties increased losses and loss adjustment expenses in 1999 by $17.0 million. Excluding the effect of the reinsurance rescission, the loss ratio was 76.6% in 1999. Weather-related losses (net of applicable reinsurance) from wind and hail were $459,000, $1.4 million and $4.3 million in 1997, 1998 and 1999, respectively, and increased the respective loss ratios by 0.6, 2.7 and 6.4 percentage points (excluding the effect of the reinsurance rescission in 1999).
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 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. NAICO considers anticipated interest income in determining if a premium deficiency exists.
The following table sets forth Chandler USA's policy acquisition costs for each of the three years ended December 31, 1997, 1998 and 1999:
NAICO received commissions totaling approximately $1.9 million and $909,000 during 1997 and 1998, respectively, under the quota-share reinsurance arrangement for the California portion of the nonstandard private-passenger automobile program which was effective July 1, 1997. During 1998 and 1999, NAICO received commissions from reinsurers totaling approximately $13.8 million and $4.6 million, respectively, related to the purchase of additional reinsurance under its workers compensation and casualty reinsurance programs. Commissions received from reinsurers included the return of $9.7 million in ceding commissions during the fourth quarter of 1999 related to the rescission of the reinsurance treaties discussed previously. Net policy acquisition costs increased $7.0 million in 1999 due to the rescission of the reinsurance treaties, net of the adjustment for deferred acquisition costs. See "Purchase of Additional Reinsurance."
As a result of the factors described above, Chandler USA reported a net loss of $87,000 in 1999 compared to net income of $433,000 in 1998 and $3.0 million in 1997.
In 1997, Chandler USA provided $8.1 million in cash from operations. During 1998, Chandler USA used $10.3 million in cash from operations due primarily to the purchase of additional reinsurance described previously. During 1999, Chandler USA provided $5.2 million in cash from operations.
NAICO is required to deposit securities with regulatory agencies in several states in which it is licensed as a condition of conducting operations in the state. At December 31, 1999, the total amount of cash and investments restricted as a result of these arrangements was $7.2 million.
Cash flows from financing activities are affected by the level of activity related to transactions with affiliates and bank borrowings. In February 1998, Chandler USA entered into a five-year loan agreement with a bank having a principal amount of $2.3 million. The loan was collateralized by certain equipment which was purchased with the proceeds of the loan. The equipment had previously been leased by Chandler USA. In March 1998, Chandler USA borrowed an additional $6.2 million under an existing loan agreement with a bank and the proceeds were used to repay amounts due to Chandler Barbados. The bank note was collateralized by shares of NAICO stock owned by Chandler USA. In July 1999, both bank notes were repaid from the proceeds of the debenture offering.
Chandler USA is heavily dependent upon complex information technology computer systems for its operations. Chandler USA has taken action to attempt to identify the nature and extent of the work required to assess and remediate Year 2000 Problems with respect to its systems, products and infrastructures, including non-information technology systems, none of which are considered critical to operations. Chandler USA began work in 1995 to prepare its financial, information and other computer-based systems for the year 2000, including updating existing legacy systems, and such work is complete at this time. Chandler USA estimates that it has spent $350,000 updating these systems to address Year 2000 Problems, and such costs were expensed as they were incurred, primarily in 1996 and 1997.
During the fourth quarter of 1998, Chandler USA retained an independent consultant to prepare a plan for testing its information technology systems. In late 1998, Chandler USA determined that the testing would be performed by its employees, and this testing was completed during the first half of 1999. During the fourth quarter of 1998, Chandler USA incurred approximately $150,000 in additional expenses to evaluate its information systems and in preparation of plans to test its information systems.
Chandler USA incurred additional costs of approximately $125,000 to complete its testing during the first six months of 1999. These costs included the use of internal employees, cost of external software to enhance testing efforts and computer rental costs. These costs were expensed during 1999 as incurred. Chandler USA could incur costs in the future if additional efforts are needed to perform modifications to Chandler USA's information technology systems. Chandler USA has established a contingency plan for all critical business operations. The contingency plan includes possible manual operations and the implementation of alternative information processing procedures.
Any previously mentioned Year 2000 Problems could have a material adverse effect on Chandler USA, including the financial condition of Chandler USA's subsidiaries and their ability to pay dividends or other payments to Chandler USA and its subsidiaries.
Chandler USA continues to study the complex issues related to insurance coverage for losses arising from the myriad potential fact situations connected with Year 2000 Problems and NAICO's liability to its insureds. Chandler USA believes that the coverages NAICO provides do not extend to the types of losses which are most likely to occur as a result of Year 2000 Problems, and NAICO has made no provisions for loss reserves based on potential Year 2000 Problems. NAICO expects to utilize coverage exclusion endorsements based on the individual underwriting of commercial accounts, and it has adopted endorsements to its policies based on forms provided and filed for approval with various regulatory authorities by Insurance Services Office, Inc., an insurance services company which provides regulatory research and filing support to insurance companies. Use of these special endorsements is governed by the law and regulatory policies of states in which NAICO is authorized to do business.
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that Chandler USA recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. Chandler USA will adopt SFAS No. 133 when required. Chandler USA's management does not expect that adoption of SFAS No. 133 will have a material impact on Chandler USA's consolidated financial condition or results of operations.
Some of the statements made in this Form 10-K report, as well as statements made by Chandler USA in periodic press releases, oral statements made by Chandler USA's officials to analysts and shareholders in the course of presentations about Chandler USA and conference calls following earnings releases, 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 operates; (iv) claims frequency; (v) claims severity; (vi) the number of new and renewal policy applications submitted by Chandler USA's agents; (vii) the ability of NAICO to obtain adequate reinsurance in amounts and at rates that will not adversely affect its competitive position; (viii) the ability of NAICO to maintain favorable insurance company ratings; (ix) the ability of Chandler USA and its third party providers, agents and reinsurers to adequately address year 2000 issues; and (x) other factors including the ongoing litigation matters involving a significant concentration of ownership of Chandler USA's indirect parent's common stock.