The selected financial data has been derived from the consolidated financial statements of Chandler USA and its subsidiaries, which appear in Item 15(a). The consolidated balance sheets of Chandler USA and its subsidiaries and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for each of the five years in the period ended December 31, 2007 have been audited by Tullius Taylor Sartain & Sartain LLP, independent auditors, whose independent auditors' report expresses an unqualified opinion. The selected financial data should be read in conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and the consolidated financial statements of Chandler USA and the notes thereto appearing in Item 15(a).
References to Chandler USA which follow within this Item 7 refer to Chandler USA and its subsidiaries on a consolidated basis unless otherwise indicated.
The following table shows the recorded reserves and the high and low point estimates based on the results of the various actuarial methods described above as of December 31, 2007.
At December 31, 2007, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $1.3 million which begins to expire in 2025. Chandler USA has concluded that the deferred tax asset including the federal net operating loss carryforwards is more likely than not to be realized. Chandler USA anticipates that its future U.S. consolidated income will be sufficient to utilize the federal net operating losses within the required time. Chandler USA will continue to evaluate income generated in future periods in determining the reasonableness of its position. If Chandler USA determines that future income is insufficient to cause the realization of the federal net operating losses within the required time, a valuation allowance will be established.
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 have improved. The pricing environment during 2005 through 2007 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 including workers compensation during 2006 and 2007. 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 new 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. Management believes this new arrangement will allow Chandler USA's subsidiaries to offer more competitive property and inland marine programs for its agents. In addition, NAICO is no longer required to purchase reinsurance for the significant insured values associated with this business.
Net premiums earned decreased 1% in 2006 and increased 1% in 2007. An increase in net premiums earned in the homeowners program in 2006 partially offset the decreases in net premiums earned in the political subdivisions, standard lines and surety bond programs. 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.
In 2005, NAICO began writing homeowner and dwelling policies in the state of Texas through a managing general agent. NAICO discontinued this program during 2006 due primarily to increased catastrophic exposures.
Gross premiums earned in the surety bond program decreased 70% and 4% in 2006 and 2007, respectively. Net premiums earned decreased 71% and 4% in 2006 and 2007, respectively. NAICO is no longer actively marketing its surety bond program.
NAICO experienced a significant amount of incurred losses related to prior accident years during the 2005 and 2006 calendar years. Incurred losses related to prior accident years decreased $2.5 million or 40% in 2006 and decreased $2.6 million or 69% in 2007. 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.
During 2005, NAICO experienced adverse loss development totaling $6.3 million primarily in the standard lines and political subdivisions programs. A portion of the adverse development was offset by favorable development of $1.8 million in the surety bond program, primarily in accident years 1994 and 2001 that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the workers compensation, other liability and automobile liability lines of business in the 2000, 2002 and 2003 accident years. The adverse loss development included approximately $108,000 for provisions for potentially uncollectible reinsurance.
During 2006, NAICO experienced adverse loss development totaling $3.8 million primarily in the standard lines program. A portion of the adverse development was offset by favorable development of $1.0 million in the surety bond program, primarily in the 2001 accident year, that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the automobile liability line of business in the 2005 accident year and in the workers compensation line of business in the 1997 and 1999 accident years. The adverse loss development included approximately $97,000 for provisions for potentially uncollectible reinsurance.
During 2007, NAICO experienced adverse loss development totaling $1.2 million primarily in the surety bond program. During 2007, a portion of the estimated recoveries that were recorded in the surety bond program during 2006 were reduced based on a final judgment entered by the court regarding certain surety bond claims. The reduction of the estimated recoveries accounted for $1.8 million of the loss development during 2007. The adverse loss development included approximately $356,000 for provisions for potentially uncollectible reinsurance.
The following table sets forth Chandler USA's policy acquisition costs for each of the three years ended December 31, 2005, 2006 and 2007:
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.0% in 2005, 23.3% in 2006 and 24.0% in 2007. For these periods, commission expense as a percentage of gross written and assumed premiums was 14.3%, 14.1% and 14.0%.
General and administrative expenses were 10.9%, 10.8% and 11.8% of gross premiums earned and other income in 2005, 2006 and 2007, 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. 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.
At December 31, 2007, Chandler USA had a net deferred tax asset of $3.4 million including $455,000 related to federal net operating loss carryforwards which begin to expire in 2025. Chandler USA believes it is more likely than not that the deferred income tax asset including the federal net operating loss carryforwards will be realized through future earnings. As a result, a valuation allowance has not been recorded. Chandler USA used the same assumptions as in internal financial projections to estimate future taxable income. If Chandler USA's results are not as profitable as anticipated, a valuation allowance may have to be established for the federal net operating loss carryforwards and the other remaining deferred tax assets.
As of December 31, 2007, NAICO had statutory earned surplus of $12.5 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2008 without the approval of the Oklahoma Department of Insurance is $5.0 million. NAICO paid shareholder dividends to Chandler USA totaling $1.6 million during 2007.
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. As of December 31, 2007, all of NAICO's fixed-maturity investments were rated A2 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively.
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, 2007, the total amount of cash and investments restricted as a result of these arrangements was $8.0 million. In addition, NAICO has deposited $24.9 million of cash and investments into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer.
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. 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 as of December 31, 2006 as a result of increasing the estimated recovery. NAICO also recorded $6.6 million of interest income for its estimate of prejudgment interest through December 31, 2006, including a recovery for a pre-verdict settlement with certain other parties.
In the fourth quarter of 2007, as a result of this final judgment, NAICO decreased the estimated recovery on the surety bond claims related to the construction of the two gas processing plants which resulted in an increase in losses and loss adjustment expenses incurred of $1.8 million. Unpaid losses and loss adjustment expenses increased $12.7 million and reinsurance recoverable on unpaid losses and loss adjustment expenses increased $10.9 million as of December 31, 2007 as a result of decreasing the estimated recovery. NAICO also decreased accrued interest income by $4.5 million for its estimate of prejudgment interest income.