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 as of December 31, 2000, and the related consolidated statement of operations, comprehensive income, shareholder's equity and cash flows for the year ended December 31, 2000 were audited by Deloitte & Touche LLP, independent auditors, whose independent auditors' report expressed an unqualified opinion and included an explanatory paragraph relating to litigation. The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 2001, 2002, 2003 and 2004 and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for the years ended December 31, 2001, 2002, 2003 and 2004 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). All periods have been restated to reflect the results of L&W as a discontinued operation.
In December 2002, Chandler USA completed the sale of its wholly owned subsidiary L&W to Brown & Brown, Inc. for $3.6 million. Chandler USA recorded an after-tax gain of $671,000 on the sale in 2002 based on the minimum purchase price for the transaction. The gain on the sale may be increased depending on certain adjustments to the purchase price as defined in the terms of the transaction. Following the completion of the sale, L&W changed its name to Brown & Brown of Central Oklahoma, Inc. ("B&B"). L&W previously functioned as Chandler USA's agency segment and is presented as discontinued operations.
B&B continues to be a significant producer of business for NAICO. Retail business produced by B&B and placed with NAICO constituted approximately 13% of NAICO's direct premiums written and assumed in 2004. Chandler USA agreed to indemnify Brown & Brown, Inc. for any breach of a representation, warranty or covenant made in connection with the sale for a period of three years, and has established a letter of credit in the amount of $500,000 for the benefit of Brown & Brown, Inc. as security.
At December 31, 2004, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $11.8 million which begins to expire in 2023. Chandler USA has concluded that the deferred tax asset including the federal net operating loss carryforwards are more likely than not to be realized. Chandler USA anticipates that its future U.S. consolidated income tax 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.
Periods of inflation have varying effects on Chandler USA 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. Premium rates and commissions, however, are not significantly affected by inflation since competitive forces generally control such rates.
At December 31, 2004, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate bonds and mutual funds that invest in equity securities, with approximately 8% 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 from continuing operations, excluding interest income from related parties, decreased 15% in 2003 and increased 48% in 2004. The decrease in 2003 was due primarily to lower interest rates. The increase in 2004 was due primarily to NAICO receiving $577,000 in interest from an arbitration award in addition to an increase in fixed maturity investments during the year. Interest income from related parties was $380,000, $412,000 and $491,000 during 2002, 2003 and 2004, respectively. See Liquidity and Capital Resources.
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2002, 2003 and 2004 calendar years. The loss development occurred primarily in the 1997-2001 accident years. 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. 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 2003, NAICO experienced adverse loss development totaling $11.1 million primarily in the standard property and casualty program. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1998-2001 accident years. A reduction in losses for the 2002 accident year partially offset this adverse development. The adverse loss development included approximately $1.3 million for provisions for potentially uncollectible reinsurance and deductibles.
Reliance reinsured NAICO for certain workers compensation risks during 1998. At December 31, 2004, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses of approximately $3.3 million. During October 2001, the Commonwealth of Pennsylvania placed Reliance in liquidation. NAICO is unable to determine the amount of its reinsurance recoverables from Reliance that will ultimately be collected and has fully reserved the carrying value of such amounts as of December 31, 2003 and 2004. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to Chandler USA; consequently, adjustments to ceded losses and loss adjustment expenses are made for amounts deemed uncollectible. During 2002, 2003 and 2004, NAICO incurred charges of $1.7 million, $604,000 and $282,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
NAICO did not receive any claims related to the September 11, 2001 terrorist attacks on the World Trade Center and does not believe that it has any significant exposure to these and related losses. While several of NAICO's reinsurers did experience significant losses related to these attacks, it currently does not appear that these losses will impair the reinsurers' ability to pay claims.
The following table sets forth Chandler USA's policy acquisition costs from continuing operations for each of the three years ended December 31, 2002, 2003 and 2004:
Indirect underwriting expenses were 5.8%, 6.5% and 6.1% of total direct written and assumed premiums in 2002, 2003 and 2004, 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 Chandler USA's overall premium volume. Commissions received from reinsurers as a percentage of ceded reinsurance premiums were 30.8%, 28.0% and 33.3% in 2002, 2003 and 2004, respectively.
At December 31, 2004, Chandler USA had a net deferred tax asset of $7.4 million including $4.0 million related to federal net operating loss carryforwards which begin to expire in 2023. 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.
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, 2004, all of the investments of NAICO were in fixed-maturity investments, mutual funds that invest in equity securities, 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.
Cash flows from investing activities during 2003 and 2004 were primarily the result of normal purchases and sales of investment securities. During 2004, NAICO purchased $8.1 million of mutual funds that invest in equity securities. Net realized investment gains before income taxes were $794,000, $2,351,000 and $652,000 during 2002, 2003 and 2004, respectively, from the sale of investments. NAICO received proceeds of $31.5 million, $24.5 million and $23.8 million during 2002, 2003 and 2004, respectively, from the sale of available for sale securities prior to their maturity. The proceeds and related net realized investment gains in 2002 and 2003 provided cash for operating activities due to the decrease in written premiums. During 2003 and 2004, the market value of NAICO's available for sale fixed-income investments decreased by $500,000 and $581,000, respectively, due primarily to changes in interest rates experienced during this time. The average maturity of NAICO's fixed maturity investments was 5.0 years and 4.9 years at December 31, 2003 and 2004, respectively. Cash flows from investing activities also included proceeds from the sale of L&W in 2002 of $3.1 million net of cash disposed of as part of the sale. See Note 4 to Consolidated Financial Statements for more information.
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, 2004, the total amount of cash and investments restricted as a result of these arrangements was $8.4 million.
The following table provides the future payments due by period under contractual obligations as of December 31, 2004, aggregated by type of obligation: