NAICO's loss reserves consist of case reserves and reserves for incurred but not reported ("IBNR") claims. Case reserves are established by claims personnel based on a review of the facts known at the time the claim is reported, and are subsequently revised as more information about a claim becomes known. IBNR is computed using various actuarial methods and techniques and includes reserves for losses that have occurred but for which claims have not yet been reported, including provision for expected future development on case reserves. As of December 31, 2009, NAICO's case reserves and IBNR for each line of business are shown in the following table.
For the workers compensation gross and net reserves, NAICO's actuaries selected an average of the results of all methods examined for accident years 2000 through 2008. For the 2009 accident year, the actuaries selected the case incurred projection for both gross and net reserves. For the automobile liability gross and net reserves, the actuaries relied on the average of the results of all methods examined for accident years prior to 2009. The 2009 accident year selection was based on a judgmentally selected loss ratio. General liability gross and net reserves were based on the average of all methods examined for all accident years except 2008. The case incurred Bornhuetter-Ferguson projection was selected for the 2008 accident year for both gross and net reserves. The loss settlement period for automobile physical damage claims is relatively short, and the actuaries used case incurred losses for their selection for all accident years. Surety bond reserves are actually a net receivable due to anticipated subrogation recoveries. Certain involuntary workers compensation pools provided their own estimates and NAICO records these estimates plus an accrual to account for the lag time in reporting to NAICO.
The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury, workers compensation and other liability claims have a much longer loss settlement period and may be paid out over several years. It is often necessary to adjust estimates of liability on a loss either upward or downward between the time a claim arises and the time of payment. Workers compensation indemnity benefit reserves are determined based on statutory benefits prescribed by state law and are estimated based on the same factors generally discussed above which may include, where state law permits, inflation adjustments for rising benefits over time. Generally, the more costly automobile liability claims involve one or more severe bodily injuries or deaths. Other liability claims include coverages protecting the insured against legal liability resulting from negligence, carelessness, or a failure to act causing property damage or personal injury to others. The estimation of loss reserves for other liability claims is affected by the timing of claims reporting, the applicable statute of limitations, the litigious climate and magnitude of jury awards, the unpredictability of judicial decisions regarding coverage issues and outside counsel costs. The ultimate cost of these types of claims is dependent on various factors including the relative liability of the parties involved, the number and severity of injuries and the legal jurisdiction where the incident occurred.
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. NAICO 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 NAICO's insureds, and current data regarding the limited severity and infrequency of such matters, it appears that potential environmental risks are not a significant portion of claim reserves and therefore would not likely have a material adverse impact, if any, on the financial condition of Chandler USA.
Management believes that its unpaid losses and related reinsurance recoverables are fairly stated as of December 31, 2009. 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 $71.1 million, or 78%, of NAICO's direct written and assumed premiums in 2009 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 2009 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 from 2006 through 2009. 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.
The following tables summarize the net premiums earned and loss ratios (computed by dividing losses and loss adjustment expenses by net premiums earned) in each of the years presented. The "loss ratio" is based on losses recorded during the calendar year presented regardless of the accident year in which the claim occurred. 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. See "Premiums Earned" and "Losses and Loss Adjustment Expenses."
Gross premiums earned decreased 5% and 11% in 2008 and 2009, respectively. The decrease in 2008 gross premiums earned was due primarily to a decrease in automobile liability premiums in the standard lines program. During 2009, the standard lines and political subdivisions programs experienced significant decreases in gross premiums earned, primarily in the automobile liability and other liability lines of business. Gross premiums earned in the workers compensation line of business increased slightly during 2009. Gross premiums earned in Texas decreased 21% and 14% in 2008 and 2009, respectively, and gross premiums earned in Oklahoma increased 6% in 2008 and decreased 2% in 2009.
From January 2007 to the second quarter of 2009, the property and inland marine lines of insurance that were previously written by NAICO in the standard lines program were written by Praetorian Insurance Company ("Praetorian") through an arrangement between Praetorian and CIMI. Under this arrangement, CIMI received commission income for the business it produced for Praetorian. NAICO handles all claims for this business under a separate claims handling agreement with Praetorian. CIMI and Praetorian terminated this arrangement effective June 29, 2009, and NAICO resumed writing these lines of insurance in this program.
Gross premiums earned in the political subdivisions program decreased 18% and 29% in 2008 and 2009, respectively. Net premiums earned decreased 20% and 30% in 2008 and 2009, respectively. From January 2007 to the second quarter of 2009, the property and inland marine lines of insurance in the political subdivisions program that were previously written by NAICO were written by Praetorian through an arrangement between Praetorian and CIMI. CIMI and Praetorian terminated this arrangement effective June 29, 2009. Effective July 1, 2009, the property, inland marine, automobile liability, automobile physical damage and other liability lines of insurance in the political subdivisions program that were previously written by NAICO are being written by Greenwich Insurance Company ("Greenwich") through an arrangement with CIMI. Under this arrangement, CIMI will receive commission income for the business it produces. 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 Greenwich. NAICO will continue to write workers compensation coverages for the political subdivisions program and has agreed to reinsure on a quota share basis 35% of the first $1,000,000 of loss per occurrence of the other liability business in this program. Because of these changes, NAICO expects its future premiums earned for the political subdivisions program to decrease significantly.
Gross premiums earned in the surety bond program decreased 55% and 15% in 2008 and 2009, respectively. Net premiums earned decreased 55% and 16% in 2008 and 2009, respectively. NAICO is no longer actively marketing its surety bond program.
Net investment income, excluding interest income from related parties and the prejudgment interest, decreased 6% in 2008 and 5% in 2009. Interest income from related parties was $941,000, $647,000 and $438,000 during 2007, 2008 and 2009, respectively. The decreases in 2008 and 2009 were due to lower interest rates. See Liquidity and Capital Resources.
Net realized investment gains were $214,000, $95,000 and $1,527,000 in 2007, 2008 and 2009, respectively.
Other income was $1.9 million, $2.1 million and $2.0 million during 2007, 2008 and 2009, respectively. Other income included net commission income related to business produced by CIMI for insurance companies other than NAICO totaling $1.3 million in 2007, and $1.6 million in 2008 and 2009, respectively.
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 62.5%, 63.9% and 60.7% in 2007, 2008 and 2009, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $109,000, $344,000 and $92,000 in 2007, 2008 and 2009, respectively, and increased the respective loss ratios by 0.2, 0.5 and 0.2 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 from January 2007 through June 2009. Effective July 1, 2009, the property and inland marine lines of business in the political subdivisions program are being written by Greenwich.
NAICO experienced $1.2 million, $2.1 million and $734,000 of incurred losses related to prior accident years during 2007, 2008 and 2009, respectively. 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 2007, certain surety bond estimated recoveries 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 for surety business during 2007. During 2008, workers compensation losses developed adversely by $3.5 million, but the automobile liability line of business offset approximately $1.7 million of this. During 2009, workers compensation losses developed adversely by $4.0 million, but the automobile liability line of business offset approximately $2.0 million of this, and the other liability line offset approximately $1.6 million of this. The 1997-2001 accident years have clearly been the problematic years where the loss development was so significant. During those years, NAICO's premium volume grew from $123 million in 1997 to $197 million in 2000, before dropping to $159 million in 2001. Much of that growth was attributable to the planned expansion of NAICO's Texas business. This growth occurred at a time when premium rates were very soft. The expansion into Texas began in the last half of 1996. NAICO had written business in Texas for many years with reasonably good experience. Based on this experience, management believed the economic and tort climates were similar to Oklahoma. This did not turn out as expected, especially in regards to business in south and east Texas. Because this expansion was primarily a casualty driven book of business, it took several years to realize that claims in many areas of Texas were more severe and emerged differently than Oklahoma claims. As the historical loss data picked up the development of these claims, the projections of ultimate losses became more accurate.
Since 2001, management has undertaken several initiatives to improve the quality and profitability of business. These initiatives included significant rate increases, changes in coverage forms that limit or eliminate coverage, reduction or elimination of classes of business that have not been profitable, reduction or elimination of business in geographic areas that have not been profitable and increased emphasis on risk selection. Management has also improved case reserving which improves the overall reserving accuracy and also leads to better underwriting decisions.
Policy acquisition costs consist of costs associated with the acquisition of new and renewal business and generally include direct costs such as premium taxes, commissions to agents and ceding companies and premium- related assessments and indirect costs such as salaries and expenses of personnel who perform and support underwriting activities. NAICO also receives ceding commissions from reinsurers who assume premiums from NAICO under certain reinsurance contracts and the ceding commissions are accounted for as a reduction of policy acquisition costs. Direct policy acquisition costs and ceding commissions are deferred and amortized over the terms of the policies. When the sum of the anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded.
General and administrative expenses were 11.8%, 12.7% and 12.4% of gross premiums earned and other income in 2007, 2008 and 2009, respectively. 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. During 2009, general and administrative expenses decreased 12.9%. 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, 2009, Chandler USA had a net deferred tax asset of $3.1 million. Chandler USA believes it is more likely than not that the deferred income tax asset 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 remaining deferred tax assets.
As of December 31, 2009, NAICO had statutory earned surplus of $15.5 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2010 without the approval of the Oklahoma Department of Insurance is $5.4 million. NAICO paid shareholder dividends to Chandler USA totaling $2.1 million and $1.4 million during 2008 and 2009, respectively.
Chandler USA provided $8.7 million, $6.0 million and $8.4 million in cash from operations in 2007, 2008 and 2009, respectively. The cash provided by operations in 2007 included an increase in unpaid losses and loss adjustment expenses of $17.3 million, but this was offset in part by an increase in reinsurance recoverable on unpaid losses of $10.6 million. These increases were primarily the result of reducing the estimated recoveries on certain surety bond claims based on a final judgment entered by the court. See "Litigation." The cash provided by operations in 2008 included a decrease in reinsurance recoverable on unpaid losses of $2.3 million, a decrease in premiums receivable of $1.7 million, a decrease in prepaid reinsurance premiums of $948,000 and an increase in unpaid losses and loss adjustment expenses of $869,000. These were partially offset by a decrease in unearned premiums of $2.7 million. The cash provided by operations in 2009 included an increase in unpaid losses and loss adjustment expenses of $5.9 million, an increase in premiums payable of $1.8 million, an increase in policyholder deposits of $1.3 million, an increase in accrued taxes and other payables of $814,000, and a decrease in premiums receivable of $745,000. These were partially offset by an increase in reinsurance recoverables on unpaid losses of $5.6 million.
Cash flows from financing activities were primarily the result of payments and loans between Chandler USA and Chandler Insurance. Chandler USA and Chandler Insurance are parties to an Intercompany Credit Agreement (the "Credit Agreement") covering intercompany loans between the parties. The Credit Agreement requires interest to be paid at the prime interest rate published in The Wall Street Journal each month, and balances owed by either party are payable at any time upon demand. At December 31, 2008 and 2009, Chandler USA had a receivable of $11.9 million and $12.7 million, respectively, under the Credit Agreement, and Chandler USA earned $881,000, $590,000 and $388,000 in interest income under the Credit Agreement during 2007, 2008 and 2009, respectively.
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 and March 2007, the lease was extended for additional three year terms, and during March 2010, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $10,929 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime which was 4.25% at December 31, 2009. The interest rate is subject to a minimum rate of 5.5% beginning in March 2010. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.5 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 $1.2 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, 2009, aggregated by type of obligation: