The Company's United States-based subsidiaries own and occupy four office buildings with approximately 127,000 square feet of usable space in Chandler, Oklahoma. The Company's subsidiaries also lease approximately 3,300 square feet in the aggregate for its branch offices. The Company believes such space is sufficient for its operations for the foreseeable future.
The selected financial data has been derived from the consolidated financial statements of the Company and its subsidiaries, which appear in Item 14(a). The consolidated balance sheets of the Company and its subsidiaries as of December 31, 1999 and 2000, 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, 2000, 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.
References to the "Company" which follow within this Item 7 refer to the Company and its subsidiaries on a consolidated basis unless otherwise indicated.
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 the Company.
The Company and its subsidiaries report their reserves on the basis of U.S. GAAP. 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 U.S. GAAP. The Company and its subsidiaries do not discount their reserves for unpaid losses and loss adjustment expenses. See Notes to Consolidated Financial Statements.
Periods of inflation have varying effects on the Company 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. During 2000, the market value of the Company's available for sale investments increased by $4.2 million due primarily to lower interest rates experienced during this time. Premium rates and commissions, however, are not significantly affected by inflation since competitive forces generally control such rates. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates.
Gross premiums earned, before reductions for premiums ceded to reinsurers, increased 8%, 21% and 25% in 1998, 1999 and 2000, respectively. The increases are primarily attributable to increases in premium production in Texas and Oklahoma, and to increases in premium rates during 2000. Net premiums earned, after such reductions, decreased 26% in 1998, increased 55% in 1999 and increased 11% in 2000. 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. The rescission of two reinsurance treaties increased net premiums earned in 1999 by $19.6 million. During 2000, NAICO purchased additional reinsurance for its workers compensation and casualty lines of business which reduced the Company's net retention for these lines of business and also reduced net premiums earned. Effective October 1, 2000, NAICO purchased quota share reinsurance which reduced the Company's net retention for its casualty and workers compensation lines of business. The purchase of the quota share reinsurance reduced net premiums earned by $4.9 million in 2000.
Gross premiums earned in the political subdivisions program increased 17%, 20% and 15% in 1998, 1999 and 2000, respectively, due primarily to expansion of the school districts portion of the program in Texas and Missouri during 1998 and 1999, and to rate increases in the school districts portion of the program during 2000. Net premiums earned decreased 13% in 1998, increased 33% in 1999 and decreased 3% in 2000. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance in 1998. The rescission of the reinsurance treaties increased net premiums earned in 1999 by $2.3 million in this program. The purchase of the quota share reinsurance reduced net premiums earned in 2000 by $712,000 in this program.
At December 31, 2000, the Company's investment portfolio consisted primarily of fixed income U.S. Government, high-quality corporate and tax exempt bonds, with approximately 10% invested in cash and money market instruments. Income generated from this portfolio is largely dependent upon prevailing levels of interest rates. The Company's portfolio contains no non-investment grade bonds or real estate investments.
Net interest income decreased 11% and 13% in 1998 and 1999, respectively, and increased 9% in 2000. The decrease in 1998 was due primarily to lower interest rates in 1998 and a reduction in invested assets due to the purchase of additional reinsurance in 1998. In addition, during the fourth quarter of 1997, NAICO shifted a portion of its fixed maturities portfolio from taxable to tax exempt bonds (which generally have a lower before-tax yield). In late 1998 and the first quarter of 1999, NAICO shifted approximately half of its investment in tax exempt bonds to taxable bonds. Net income from tax exempt securities was $1.0 million, $483,000 and $509,000 in 1998, 1999 and 2000, respectively. The decrease in net interest income in 1999 was due primarily to a reduction in invested assets due to the purchase of additional reinsurance. The increase in 2000 was due primarily to an increase in average invested assets and an increase in the average net yield on the portfolio. Net realized investment gains were $1.2 million, $55,000 and $180,000 in 1998, 1999 and 2000, respectively.
The average net yield on the portfolio, including net realized investment gains, was 6.1%, 4.7% and 4.8% in 1998, 1999 and 2000, respectively. The average net yield on the portfolio, excluding net realized investment gains, was 5.2%, 4.7% and 4.7% for 1998, 1999 and 2000, respectively. The decrease in the average net yield in 1999 was due primarily to an increase in investment expenses to subsidize a premium finance program for certain insureds of NAICO. While such expenses reduce the Company'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, 2000 was approximately $14 million. The average yield on the portfolio before deducting investment expenses was 5.8%, 5.7% and 6.1% in 1998, 1999 and 2000, respectively, excluding capital gains.
The Company's income from commissions, fees and other income decreased 23%, 11% and 8% for 1998, 1999 and 2000, respectively. The majority of the Company's income from commissions, fees and other income are from the Company's subsidiary L&W.
L&W's brokerage commissions and fees before intercompany eliminations were $8.5 million in 1998, $9.6 million in 1999 and $9.4 million in 2000. A large portion of the brokerage commissions and fees for L&W is incurred by NAICO and thus eliminated in the consolidation of the Company's subsidiaries.
The Company 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."
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 25.3%, 24.8% and 23.6% in 1998, 1999 and 2000, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 11.5%, 12.1% and 11.6%. Indirect underwriting expenses were 10.3%, 9.6% and 8.9% of total direct written and assumed premiums in 1998, 1999 and 2000, respectively. Indirect expenses include general overhead and administrative costs associated with the acquisition of new and renewal business, some of which is relatively fixed in nature, thus, the percentage of such expenses to direct written and assumed premiums will vary depending on the Company's overall premium volume. Premium taxes increased $1.3 million in 2000 due to the increase in written premiums and to a refund of $392,000 which was received in 1999 for premium taxes paid in a prior year.
General and administrative expenses were 9.9%, 7.8% and 7.6% of gross premiums earned and commissions, fees and other income (excluding the fee related to the rescission of the reinsurance treaties) in 1998, 1999 and 2000, respectively. During 2000, the Company incurred expenses related to the going private transaction of approximately $847,000. General and administrative expenses have historically not varied in direct proportion to the Company's revenues. A portion of such expenses is allocated to policy acquisition costs (indirect underwriting expenses) and loss and loss adjustment expenses based on various factors, including employee counts, salaries, occupancy and specific identification. Because certain types of expenses are fixed in nature, the percentage of such expenses to revenues will vary depending on the Company's revenues.
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 and $177,000 is included in general and administrative expenses in 1998 and 2000, respectively.
Interest expense increased 102%, 64% and 49% in 1998, 1999 and 2000, respectively. The increase in 1998 was primarily due to increased levels of bank debt. The increases in 1999 and 2000 were due primarily to interest expense on the $24 million debenture offering which was completed on July 16, 1999 by Chandler USA. See "Liquidity and Capital Resources."
Litigation expenses reflect expenses related to the ongoing legal proceedings involving the CenTra Group. Litigation expenses were a credit of approximately $2.7 million in 1998, and were an expense of approximately $1.1 million and $654,000 in 1999 and 2000, respectively. During the second quarter of 1998, the Oklahoma Court in which the CenTra litigation is pending ordered all parties to pay their own costs and attorney's fees in the case thus denying the CenTra Group's request of approximately $4.7 million for those expenses. Accordingly, the Company reduced the previous 1997 net charge for CenTra litigation matters by approximately $3.8 million during the second quarter of 1998. Increased or renewed activity could result in greater litigation expenses in the future.
Fixed-maturity investments are purchased to support the investment strategies of the Company 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 the Company has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. The Company has not classified any investments as trading account assets. Securities not classified as held to maturity or trading are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of income tax as a separate component of other comprehensive income until realized.
During 1998, the Company used $8.8 million in cash from operations due primarily to the purchase of additional reinsurance described previously. During 1999 and 2000, the Company provided $8.7 million and $19.3 million, respectively, in cash from operations.
Chandler Barbados is required as a foreign reinsurer to secure reserves for unpaid losses and loss adjustment expenses and unearned premiums for the benefit of the primary insurer ceding such amounts. Chandler Barbados secures such amounts by trust arrangements whereby securities are deposited into a trust account for the benefit of the primary insurer. 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, 2000, the total amount of cash and investments restricted for Chandler Barbados and NAICO as a result of these arrangements was $26.9 million and $5.9 million, respectively.
The Company will finance the Recapitalization Plan through (i) a $2.4 million sale of Class A Common Shares to Messrs. LaGere and Paden, (ii) up to an $11.8 million intercompany loan from Chandler Barbados, and (iii) proceeds of approximately $735,000 from the exercise of outstanding options. Chandler USA will loan up to $11.8 million to Chandler Barbados. Up to $8.0 million of Chandler USA's intercompany loan to Chandler Barbados will be from a dividend declared by NAICO and approximately $3.8 million will be from a sale and leaseback transaction for certain equipment owned by Chandler USA. Management believes that the use of the intercompany loan will not impair the financial position of the Company or its subsidiaries.
In 1992, the Company became involved in certain legal proceedings beyond the ordinary course of business. Note 11 to Consolidated Financial Statements describes the extensive CenTra litigation related to the Company and its affiliates and the CenTra Group.
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, as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that the Company 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. The Company will adopt SFAS No. 133 effective January 1, 2001. The adoption of SFAS No. 133 will not have a material impact on the Company's consolidated financial condition, results of operations or cash flows since the Company has no derivative instruments.