The Company's United States-based 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. The Company's subsidiaries also lease approximately 10,000 square feet in the aggregate for its branch offices. The Company believes such space is sufficient for its operations for the foreseeable future.
The Company 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.
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. 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, Chandler Barbados and the Company 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. 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 1999, the market value of the Company's available for sale investments declined by $4.6 million due primarily to higher 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.
The following tables summarize the net premiums earned and the financial year (losses incurred and recognized by the Company regardless of the year in which the claim occurred) and accident year (losses incurred by the Company for a particular year regardless of the period in which the Company 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:
Net interest income increased 1% in 1997 and decreased 11% and 13% in 1998 and 1999, respectively. 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 $112,000, $1.0 million and $483,000 in 1997, 1998 and 1999, 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. Net realized investment gains were $764,000, $1,163,000 and $55,000 in 1997, 1998 and 1999, respectively.
The average net yield on the portfolio, including net realized investment gains, was 6.6%, 6.1% and 4.7% in 1997, 1998 and 1999, respectively. The average net yield on the portfolio, excluding net realized investment gains, was 5.9%, 5.2% and 4.7% for 1997, 1998 and 1999, 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, 1999 was approximately $14 million. The average yield on the portfolio before deducting investment expenses was 6.3%, 5.8% and 5.7% in 1997, 1998 and 1999, respectively, excluding capital gains.
The Company's income from commissions, fees and other income decreased 30%, 23% and 11% for 1997, 1998 and 1999, respectively. The majority of the Company's income from commissions, fees and other income are from L&W's brokerage commissions and fees.
NAICO is a major insurer of property owned by businesses, cities, towns and school districts in Oklahoma. As a result, NAICO incurs weather-related losses. On May 3, 1999, tornadoes, hail and strong winds caused severe damage to property owned or used by NAICO insureds. NAICO estimates total insured damages from the storms at approximately $26.4 million. Giving effect to NAICO's applicable reinsurance, all of which is with unaffiliated reinsurers, NAICO estimates its net loss before income tax benefit resulting from the May 3, 1999 storms at $1.8 million which was recorded in the second quarter of 1999.
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 and declined $409,000 or 3.3% in 1999 compared to 1998.
Litigation expenses reflect expenses related to the ongoing legal proceedings involving the CenTra Group. Litigation expenses were $4.8 million in 1997 compared to a credit of approximately $2.7 million in 1998, and were an expense of approximately $1.1 million in 1999. During the second quarter of 1998, the U.S. District Court in Oklahoma City, Oklahoma ("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. CenTra did not initially appeal this decision. Accordingly, the Company reduced the previous first quarter of 1997 net charge for CenTra litigation matters by approximately $3.8 million during the second quarter of 1998. In later papers filed with the appellate court, CenTra has attempted to appeal this decision. The Company believes CenTra's appeal of the decision is barred. Increased or renewed activity could result in greater litigation expenses in 2000 or future years.
Certain litigation expenses may be recovered from the Company's directors and officers liability insurer ("D&O Insurer"). As a result of various events in 1995, the Company recorded an $818,000 estimated recovery of costs from the D&O 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 Court judgments, the Company recorded an additional estimated recovery of $2.7 million from the D&O Insurer. The Company is entitled to a total of $5 million under the applicable insurance policy to the extent it has advanced reimbursable expenses. Some amounts have been previously paid without dispute and the Company is negotiating with the D&O 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.
The rescission of the reinsurance treaties resulted in a net after tax gain of $3.8 million during 1999. The rescission of the reinsurance treaties increased net premiums earned by $19.6 million in the fourth quarter of 1999. The rescission also increased losses and loss adjustment expenses by $17.0 million, and increased expenses for policy acquisition costs by $7.0 million. NAICO received a fee of $10.0 million as additional compensation for entering into the agreement. The provision for federal income taxes increased by $1.9 million in 1999 due to the rescission of the reinsurance treaties.
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. During 1999, the Company provided $8.7 million 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, 1999, the total amount of cash and investments restricted for Chandler Barbados and NAICO as a result of these arrangements was $24.1 million and $7.2 million, respectively.
In December 1999, the Company made payments totaling approximately $15.2 million to acquire 1,989,200 shares of its own stock previously owned by CenTra and certain of its affiliates. The shares have been formally canceled. The acquisitions were made in accordance with a divestiture plan which had been proposed by NAICO and adopted by a U.S. District Court in Nebraska ("Nebraska Court").
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 its employees, and this testing was 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 its information systems.
The Company 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. The Company could incur costs in the future if additional efforts are needed to perform modifications to the Company's information technology systems. The Company 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.
It is possible that future court interpretations of policy language based on specific facts, or legislation mandating coverage, could result in coverage for losses attributable to Year 2000 Problems. Such decisions or legislation could have a material adverse impact on the Company. It is also possible that NAICO may incur expenses defending claims for which it is ultimately determined there is no insurance coverage.
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 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 when required. The Company's management does not expect that adoption of SFAS No. 133 will have a material impact on the Company's consolidated financial condition or results of operations.