The Company's principal office is located on the 5th Floor, Anderson Square in Grand Cayman, Cayman Islands, B.W.I. Chandler Barbados' principal office is located in the Stevmar House, Rockley, Christ Church, Barbados. The Company and Chandler Barbados have no offices in the United States.
The selected financial data has been derived from the consolidated financial statements of the Company and subsidiaries, which appear in Item 14(a). The consolidated balance sheets of the Company and its subsidiaries as of December 31, 1996 and 1997, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997, have been audited by Deloitte & Touche, independent auditors. 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.
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 unreported losses under their previously issued insurance policies and/or 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 are 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, 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 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. Chandler Barbados reinsures a portion of those risks. The Company 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 insureds of the Company, and current data regarding the limited severity and infrequency of such matters, it appears that potential environmental risks are not a significant portion of claims reserves and therefore would not likely have a material impact, if any, on the financial condition of the Company.
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 redefinitions 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 re-pricing, if permitted by applicable regulations, of coverages or limitations or cessation of the affected business.
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 effect of inflation on the operations of the Company was not significant during the period from 1995 through 1997.
Computer software, hardware, microprocessor chips and other computer equipment use two digits to identify a particular year, and therefore may not recognize the number "00" or may recognize it as a year prior to 1999. Unless computer equipment and software programs are modified to correct these problems ("Year 2000 Problems") errors could result. These errors could cause damage to personal property and disrupt business practices and functions.
It is possible, however, that future court interpretation of policy language based on specific facts could result in coverage for losses attributable to Year 2000 Problems. Such decisions could have a material adverse impact on the Company. It is also possible that the Company may incur expenses defending claims for which it is ultimately determined there is no insurance coverage.
Likewise, the Company cannot predict the adverse impact, if any, of Year 2000 Problems upon its agents, customers, reinsurers and others who are or may be indebted to the Company. It is possible that the credit or ability of others with whom the Company maintains commercial relationships may be adversely affected by one or more unforeseen circumstances caused by Year 2000 Problems.
During 1993, NAICO expanded the standard property-casualty program by offering automobile liability and physical damage, general and umbrella liability and property coverages in addition to workers compensation and increased its marketing activity in Oklahoma and contiguous states, principally Texas. Excluding the effects of the commutations described above, net premiums earned for the standard property-casualty program increased 28%, 34% and 44% in 1995, 1996 and 1997, respectively, generally due to the product and territory expansion described above.
During late 1993, NAICO began writing nonstandard private-passenger automobile liability and automobile physical damage in Oklahoma. During mid- 1994, NAICO began writing these coverages in California and Arizona. Net premiums earned in each state were as follows:
The 1997 decreases in Oklahoma and Arizona were generally a result of premium rate increases, reductions in the number of retail agents offering these programs and the discontinuance of these programs during 1997.
During the second quarter of 1997, management reviewed the underwriting performance of the California portion of the program and concluded that it would be in the Company's best interest to substantially reduce its underwriting risk. Effective July 1, 1997, NAICO entered into a 100% quota share reinsurance agreement with Underwriters Reinsurance Company to fully reinsure the risk. In December 1997, the reinsurance contract was amended and Jefferson Insurance Company of New York replaced Underwriters Reinsurance Company.
In the second quarter of 1996, NAICO began writing excess accident and health coverage for small and medium sized employers generally in Oklahoma and Texas. Net premiums earned in this program were $316,000 and $2.3 million in 1996 and 1997, respectively.
Net realized capital gains were $412,000, $140,000 and $764,000 in 1995, 1996 and 1997, respectively. The average net yield on the portfolio, including net realized capital gains, was 6.5% in 1995, 6.1% in 1996 and 6.6% in 1997. The 1997 net realized capital gains resulted primarily from NAICO shifting a portion of its fixed maturities portfolio from taxable to tax exempt bonds and NAICO's sale of Century Business Services, Inc. common stock. The Century Business Services stock was received in early 1997 as a part of a 1996 settlement with a former underwriting manager. The average net yield excluding net realized capital gains for these years was 6.1%, 6.0% and 5.9%, respectively.
The percentage of losses and loss adjustment expenses to net premiums earned was 62.3%, 59.8% and 60.7% in 1995, 1996 and 1997, respectively. In 1996, the Company decreased the estimated ultimate loss ratio of a substantial portion of the surety bond program, which decreased the loss ratio by 3.1 percentage points. This decrease was offset by corresponding adjustments to policy acquisition costs. In addition, the loss commutations discussed previously decreased the 1995, 1996 and 1997 loss ratios by 1.8, 0.5 and 1.1 percentage points, respectively.
Indirect expenses were 10.6%, 13.7% and 10.9% of total direct written and assumed premiums in 1995, 1996 and 1997, 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. The Company incurred $1,534,000 in indirect underwriting expenses related to the Midwest termination settlement, which was 1.4% of direct written and assumed premiums in 1996. Commissions received from reinsurers increased in 1997 as a result of the 100% quota share reinsurance arrangement for the California portion of the nonstandard private-passenger automobile program which was effective July 1, 1997. NAICO ceded premiums of $7,473,000 and received commissions totaling $1,868,000 under this quota-share reinsurance arrangement.
The Company is a holding company receiving cash principally through equity sales, borrowings and subsidiary dividends, subject to various regulatory restrictions described in "Regulation" and Notes to Consolidated Financial Statements. The capacity of insurance and reinsurance companies to underwrite insurance and reinsurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for the Company's subsidiaries are funds generated from insurance and reinsurance premiums, investment income, capital contributions from the Company and proceeds from sales and maturities of portfolio investments. The principal expenditures are payment of losses and loss adjustment expenses, insurance operating expenses and commissions.
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 tax as a separate component of shareholders' equity until realized.
During 1996, Chandler USA borrowed $4.5 million from a bank on a three year note payable. The note had a floating interest rate at Wall Street Journal Prime and principal and interest are payable monthly. Proceeds from the note were used to repay intercompany advances from Chandler Barbados. During the fourth quarter of 1997, the related loan agreement was amended to provide for additional borrowings up to $8.5 million and to revise the term to five years with interest payable at a floating rate equal to 1% over Wall Street Journal Prime, which was 8.5% at December 31, 1997. The note is collateralized by the shares of NAICO stock owned by Chandler USA and includes certain loan covenants. The outstanding balance of the note was $2,646,000 at December 31, 1997.
All or a portion of the available borrowing capacity under the note may be used to post needed bonds or to discharge judgments entered in the CenTra litigation. The Company is considering a number of options to deal with these issues and believes it has made appropriate provision based upon known facts.
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. NAICO also has deposited funds pursuant to a trust arrangement securing reinsurance obligations it has assumed from an unrelated primary carrier. At December 31, 1997, the total amount of cash and investments restricted for Chandler Barbados and NAICO as a result of these arrangements was $16.7 million and $8.5 million, respectively.
CENTRA LITIGATION In 1992, the Company became involved in certain legal proceedings beyond the ordinary course of business. These proceedings generally involve CenTra. The Company has incurred approximately $2.5 million, $2.1 million, $1.9 million, $1.1 million, $857,000 and $7.5 million in costs attributable to these legal proceedings during 1992, 1993, 1994, 1995, 1996 and 1997, respectively, before recoveries from the Company's directors and officers policy insurer. The amount for 1997 includes approximately $1.4 million for the Oklahoma Federal Court judgments, $2.9 million for litigation expenses and $462,000 related to the settlement of certain litigation and arbitration proceedings. As a result of various events in 1995, the Company recorded an $818,000 estimated recovery of costs from its directors and officers policy 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 Federal Court judgments, the Company recorded an additional estimated recovery of $2.7 million from the Company's directors and officers policy insurer. The Company is entitled to a total of $5 million under the applicable insurance policy. Some amounts have been previously paid without dispute and the Company is negotiating with the 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 Company's management believes that adequate financial resources are available to post a supersedeas bond if the judgments are appealed, and the Company is pursuing various financing arrangements in the event that the judgments are not reduced or overturned. As a holding company, the Company may receive cash through equity sales, borrowings and dividends from its subsidiaries. Chandler Barbados and NAICO are subject to various regulations which restrict their ability to pay shareholder dividends. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Liquidity and Capital Resources". A reduction in the amount of invested assets, or an increase in borrowings resulting from potential payment of these judgments would reduce investment earnings or increase operating expenses in future periods.
During 1996, the IRS conducted a field examination of the U.S. Federal income tax returns of Chandler USA and its wholly owned subsidiaries for the years 1993 and 1994. The IRS completed the examination in the fourth quarter of 1996, and there were no proposed adjustments to tax liabilities.
Some of the statements made in this Form 10-K report, as well as statements made by the Company in periodic press releases, oral statements made by the Company's officials to analysts and shareholders in the course of presentations about the Company 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 the Company 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 the Company operates; (iv) claims frequency; (v) claims severity; (vi) the number of new and renewal policy applications submitted by the Company's agents; and (vii) other factors such as the ongoing litigation matters involving a significant concentration of ownership of common stock.