The process of selecting the point estimate from the set of possible outcomes produced by the various actuarial methods discussed above is based upon the judgment of management. In making its selection, management considers recent trends in claims frequency and severity and other factors including, but not limited to, large loss activity, large case reserve additions, historical loss information, per claim information, NAICO's loss retention, legislative enactments, judicial decisions, and trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. Significant changes in claims development patterns from historical claims development patterns may cause a significant variation between current reserve estimates and the actual future paid amounts. Assumptions used in establishing loss reserves are regularly reviewed and updated by management as new data becomes available. The changes in these estimates, resulting from the review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of operations for the period in which such estimates are changed. Such changes in estimates may be material. See Notes to Consolidated Financial Statements.
The estimation methods chosen are those that are believed to produce the most reliable indication at that particular evaluation date for the losses being evaluated. The actuarial methods used in the 2008 loss reserve analysis were similar to those used in the 2007 analysis. During 2008, NAICO modified the way that the loss data was grouped for analysis purposes so that the data could be analyzed by line of business rather than by insurance program. Management believes that by doing so, the analysis is enhanced since each line of business may produce different loss development trend patterns.
Management believes that its unpaid losses and related reinsurance recoverables are fairly stated as of December 31, 2008. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management's informed estimates, assumptions and judgments using data currently available.
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 $73.9 million, or 75%, of NAICO's direct written and assumed premiums in 2008 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 equity securities owned by NAICO. Management believes it has mitigated the impact of a recession by employing conservative underwriting practices and strict credit policies and maintaining a high-quality investment portfolio.
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 the late 1990's and into 2000, property and casualty insurance companies generally under priced their products, which resulted in poor underwriting results that were partially offset by investment returns. Interest rates decreased in 2000 and underwriting results continued to deteriorate for business written in the late 1990's and into 2000. These factors coupled with additional potential losses due to terrorism and lower investment returns caused the industry to increase pricing beginning in the latter half of 2001. Rate increases continued through 2003 and to a lesser extent in 2004, and the industry's underwriting results improved. The pricing environment during 2005 through 2008 experienced downward pressure, particularly for larger accounts. NAICO was able to increase its pricing for most coverages from 2001 through 2005. However, the recent industry trend has been for insurers to maintain or reduce rate levels, and NAICO has reduced its pricing in certain situations and for certain coverages during 2006, 2007 and 2008. 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.
Effective January 1, 2007, the property and inland marine lines of insurance that were previously written by NAICO in the standard lines and political subdivisions programs are being written by Praetorian through an arrangement between Praetorian and CIMI. NAICO also transferred its existing property and inland marine business in these programs to Praetorian under this arrangement effective January 1, 2007. Under this arrangement, CIMI receives commission income for the business it produces for Praetorian. CIMI is responsible for the payment of commissions to the producing agents, and is also responsible for providing underwriting and loss control services for this business. NAICO handles all claims for this business under a separate claims handling agreement with Praetorian. CIMI and Praetorian have agreed to terminate this arrangement effective June 29, 2009. At the present time, CIMI expects that a similar arrangement with another insurance company will be completed prior to the termination of the current arrangement.
Net premiums earned increased 1% in 2007 and decreased 3% in 2008. Net premiums earned in the standard lines program increased during 2007, but the increase was partially offset by decreases in the political subdivisions and homeowners programs. The decrease in net premiums earned for the business transferred to Praetorian was much less than the decrease in gross premiums earned due to the significant amounts of reinsurance that NAICO had purchased for this business. The reinsurance was also cancelled which resulted in a significant decrease in reinsurance premiums ceded during 2007. During 2008, net premiums earned increased for the workers compensation and other liability lines of insurance, but decreased for automobile liability due to the decrease in gross premiums earned.
Gross premiums earned in the surety bond program decreased 4% and 55% in 2007 and 2008, respectively. Net premiums earned decreased 4% and 55% in 2007 and 2008, respectively. NAICO is no longer actively marketing its surety bond program.
At December 31, 2008, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate bonds and certificates of deposit insured by the FDIC, with approximately 20% 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 included $6.6 million for the accrual of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims in 2006. During 2007, NAICO reversed $4.1 million of the prejudgment interest income based on a final judgment entered by the court. See Litigation and Note 11 of Notes to Consolidated Financial Statements.
Net realized investment gains were $745,000, $214,000 and $95,000 in 2006, 2007 and 2008, respectively.
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 69.2%, 62.5% and 63.9% in 2006, 2007 and 2008, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $727,000, $109,000 and $344,000 in 2006, 2007 and 2008, respectively, and increased the respective loss ratios by 1.1, 0.2 and 0.5 percentage points. Weather-related losses have decreased due in part to the transfer of the property and inland marine lines of business in the standard lines and political subdivisions programs to Praetorian in 2007.
NAICO experienced a significant amount of incurred losses related to prior accident years during the 2006 calendar year. Incurred losses related to prior accident years decreased $2.6 million or 69% in 2007 and increased $872,000 or 73% in 2008. 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. The development was primarily a function of more adverse frequency and severity patterns than previously anticipated. Since such development patterns were not present in the loss history available at the time the earlier estimates were prepared, they could therefore not be anticipated. 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.
The following table sets forth the loss development by line of business during each of the calendar years shown.
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.3% in 2006, 24.0% in 2007 and 24.6% in 2008. For these periods, commission expense as a percentage of gross written and assumed premiums was 14.1%, 14.0% and 14.3%.
Indirect underwriting expenses were 5.6%, 5.9% and 6.4% of total direct written and assumed premiums in 2006, 2007 and 2008, respectively. The increase in the 2007 percentage was due primarily to the transfer of the property and inland marine business in the standard lines and political subdivisions programs to Praetorian. The transfer reduced direct premiums written by approximately $4.5 million in 2007. The increase in indirect underwriting expenses during 2008 was primarily due to increased marketing costs. 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 Chandler USA's overall premium volume. Commissions received from reinsurers as a percentage of ceded reinsurance premiums were 31.1%, 31.4% and 32.4% in 2006, 2007 and 2008, respectively.
General and administrative expenses were 10.8%, 11.8% and 12.7% of gross premiums earned and other income in 2006, 2007 and 2008, respectively. The increase in the 2007 percentage was due primarily to the transfer of the property and inland marine business in the standard lines and political subdivisions programs to Praetorian. Gross premiums earned for property and inland marine business in these programs decreased $10.9 million in 2007. The increase in the 2008 percentage was due to a decrease in gross premiums earned of $5.9 million along with an increase of 2.6% in general and administrative expenses. General and administrative expenses have historically not varied in direct proportion to Chandler USA'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 Chandler USA's revenues.
Interest expense increased less than 1% in 2007 and decreased 5.0% in 2008. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. The decrease in 2008 was due primarily to the decrease in interest rates during the period, as a portion of Chandler USA's junior subordinated debentures were issued with a floating interest rate.
As of December 31, 2008, NAICO had statutory earned surplus of $13.4 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2009 without the approval of the Oklahoma Department of Insurance is $5.1 million. NAICO paid shareholder dividends to Chandler USA totaling $1.6 million and $2.1 million during 2007 and 2008, respectively.
NAICO maintains a liquid operating position and follows investment guidelines that are intended to provide for an acceptable return on investment while preserving capital, maintaining sufficient liquidity to meet obligations and keeping a sufficient margin of capital and surplus to ensure unimpaired ability to write insurance. At December 31, 2008, all but $3.2 million or 4% of total fixed maturity investments were rated AA or better by Moody's Investor Service, Inc. or Standard & Poor's. The remaining fixed maturities were rated A by Moody's Investor Service, Inc., and Baa1 or A2 by Standard & Poor's.
NAICO purchases investments to support its investment strategies which are developed based on many factors including rate of return, maturity, credit risk, tax considerations, regulatory requirements and its mix of business. As of December 31, 2008, all of the investments of NAICO were in fixed- maturity investments, certificates of deposit insured by the FDIC, 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. At the time of purchase, investments in debt securities that NAICO 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. NAICO 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.
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, 2008, the total amount of cash and investments restricted as a result of these arrangements was $8.6 million. In addition, NAICO has deposited $27.0 million of cash and investments into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer.
During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for a three year term. During March 2004, the lease was extended for three years and during March 2007, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $13,834 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime which was 4.25% at December 31, 2008. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.9 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.5 million. See Note 12 to Consolidated Financial Statements.
The following table provides the future payments due by period under contractual obligations as of December 31, 2008, aggregated by type of obligation:
During the third quarter of 2006, NAICO increased the estimated recovery on the surety bond claims related to the construction of the two gas processing plants which resulted in a decrease in losses and loss adjustment expenses incurred of $4.7 million. In addition, unpaid losses and loss adjustment expenses decreased $22.7 million, reinsurance recoverable on unpaid losses and loss adjustment expenses decreased $16.8 million, and reinsurance recoverable on paid losses and loss adjustment expenses decreased $1.2 million. NAICO also recorded $6.6 million of interest income for its estimate of prejudgment interest through December 31, 2006 and recorded an additional $317,000 of prejudgment interest during the first quarter of 2007 including a recovery for a pre-verdict settlement with certain other parties.
On January 28, 2008, the court entered a final judgment denying Gulf Liquid's claims against NAICO and Gulsby, denying all of NAICO's claims against Gulf Liquids and Williams, and entering judgment for Gulsby against Gulf Liquids for $15,651,927 plus interest at 7.25% compounded annually from January 28, 2008 until paid. The court also ordered Gulf Liquids to pay Gulsby's taxable court costs, estimated at $100,000. Gulf Liquids has appealed the judgment entered in favor of Gulsby. NAICO has appealed the trial court's denial of its claims against Gulf Liquids and Williams and seeks entry of judgment upon the jury verdicts for the amounts the jury found should be awarded to NAICO. Gulsby has also appealed the trial court's final judgment, contending that judgment should be entered in its favor against Gulf Liquids and Williams in accordance with the jury verdicts.