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, 2006 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). Amounts for 2002 have been restated to reflect the results of LaGere & Walkingstick Insurance Agency, Inc. ("L&W") as a discontinued operation.
Chandler USA is engaged in various property and casualty insurance operations through its wholly owned subsidiaries, NAICO and CIMI. NAICO writes various property and casualty insurance products through two separate marketing programs: standard lines and political subdivisions. The lines of insurance written by NAICO are commercial coverages consisting of workers compensation, automobile liability, other liability (including general liability, products liability and umbrella liability), automobile physical damage, property, surety and inland marine. During 2005, NAICO began writing homeowner and dwelling fire and allied lines policies in the state of Texas through a managing general agent. NAICO discontinued its homeowners program during 2006, and has also transferred its property and inland marine business for the standard lines and political subdivisions programs to Praetorian effective January 1, 2007 through a new arrangement between Praetorian and CIMI. See "Insurance Programs" for more information. NAICO markets these products through a network of independent insurance agents. A portion of the insurance written by NAICO is reinsured by Chandler USA's parent Chandler Insurance. CIMI is an underwriting manager and wholesaler that offers multiple insurance products for businesses in various industries and political subdivisions.
Reserves for losses and loss adjustment expenses are developed using multiple estimation methods that result in various point estimates for each insurance program. The estimate recorded by management is a function of detailed analysis of the historical trends and development factors resulting from the different methods. As a result of the variety of factors that must be considered by management there is a significant risk that actual incurred losses will develop differently from these estimates.
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, 2006.
At December 31, 2006, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $4.6 million which begins to expire in 2024. 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.
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 $86.4 million, or 76%, of NAICO's direct written and assumed premiums in 2006 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 the equity mutual funds 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.
NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO.
The following tables set forth premiums earned on a gross basis (before reductions for premiums ceded to reinsurers) and on a net basis (after such reductions) for each insurance program as well as each line of insurance for each year presented:
Net premiums earned increased 3% and decreased 1% in 2005 and 2006, respectively. Net premiums earned in the homeowners program offset the decreases in net premiums earned in the political subdivisions and surety bond programs in 2005 and 2006.
In 2005, NAICO began writing homeowner and dwelling policies in the state of Texas through a managing general agent. Gross and net premiums earned in the homeowners program increased 102% and 61% in 2006. The increase in net premiums earned was significantly less than the increase in gross premiums earned due to an increase in the amount and cost of reinsurance covering catastrophic exposures. NAICO discontinued this program during the second quarter of 2006 due primarily to increased catastrophic exposures.
Gross premiums earned in the surety bond program decreased 67% and 70% in 2005 and 2006, respectively. Net premiums earned decreased 66% and 71% in 2005 and 2006, respectively. NAICO is no longer actively marketing its surety bond program, and does not expect premium volume in this program to increase in the future.
At December 31, 2006, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate bonds, equity securities and mutual funds that invest in equity securities, with approximately 24% 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 included $577,000 in interest from an arbitration award in 2004, and $6.6 million for the accrual of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims in 2006. See Litigation and Note 10 of Notes to Consolidated Financial Statements.
Net investment income, excluding interest income from related parties and interest from the arbitration award in 2004 and the prejudgment interest accrual in 2006, increased 7% in 2005 and 13% in 2006. Interest income from related parties was $491,000, $670,000 and $792,000 during 2004, 2005 and 2006, respectively. The increases were due primarily to higher interest rates. See Liquidity and Capital Resources.
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2004-2006 calendar 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. 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.
In 2004, the majority of the adverse loss development was in the other liability and workers compensation lines of business. Other liability claims may not be reported for several years after the occurrence of a loss and may not be settled for several years once reported. Workers compensation claims may be paid out over several years. In 2005 and 2006, the majority of the adverse loss development was in the automobile liability line of business, as reserves were strengthened in the 1999-2005 accident years for this line of business. A portion of this adverse development was offset by favorable development in the surety line of business that resulted from an increase in estimated recoveries primarily in the 1994 and 2001 accident years. 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.
During 2004, NAICO experienced adverse loss development totaling $26.3 million primarily in the standard lines and political subdivisions programs. This adverse development was due primarily to continued increases in losses in the workers compensation and other liability lines of business in the 1997-2002 accident years. Adverse loss development for other liability was $15.5 million. Adverse loss development for workers compensation, surety bonds and automobile liability were $7.6 million, $1.9 million and $1.1 million, respectively. Involuntary workers compensation pools experienced $803,000 in adverse loss development, with $703,000 of this in 1996 and prior accident years. NAICO records losses based on information obtained from the pools plus an accrual for the lag time in reporting. The adverse loss development included approximately $409,000 for provisions for potentially uncollectible reinsurance and deductibles. Reserves for unpaid losses and loss adjustment expenses, net of related reinsurance recoverables, were $44.7 million at December 31, 2004 compared to $29.3 million at December 31, 2003, an increase of $15.4 million or 52%.
The following table sets forth Chandler USA's policy acquisition costs for each of the three years ended December 31, 2004, 2005 and 2006:
Commissions expense ............................. $ 16,078 $ 17,186 $ 15,933 Other premium related assessments ............... 1,137 960 1,061 Premium taxes ................................... 2,562 2,205 2,020 Excise taxes .................................... 301 272 272 Other expense ................................... 458 723 730 ---------- ---------- ---------- Total direct expenses ........................... 20,536 21,346 20,016 Indirect underwriting expenses .................. 7,463 6,384 6,296 Commissions received from reinsurers ............ (17,068) (15,891) (15,026) Adjustment for deferred acquisition costs ....... 108 (1,168) 380 ---------- ---------- ---------- Net policy acquisition costs .................... $ 11,039 $ 10,671 $ 11,666 ========== ========== ==========
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.0% in both 2004 and 2005, and 23.3% in 2006. For these periods, commission expense as a percentage of gross written and assumed premiums was 13.2%, 14.3% and 14.1%. The increase in 2005 in commission expense was due primarily to the homeowners program that began during 2005. This program has a higher average commission rate than most of the other programs due to the use of a managing general agent who performs certain underwriting, claims and administrative functions.
Interest expense increased 6% in both 2005 and 2006. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. The increases in 2005 and 2006 were due primarily to the increase in interest rates during these periods, as a portion of Chandler USA's junior subordinated debentures were issued with a floating interest rate.
Chandler USA's federal income tax benefit (provision) as a percentage of income (loss) before income taxes was 33.8%, 35.6% and 32.9% for 2004, 2005 and 2006, respectively.
At December 31, 2006, Chandler USA had a net deferred tax asset of $4.0 million including $1.6 million related to federal net operating loss carryforwards which begin to expire in 2024. 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 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, 2006, all of NAICO's fixed-maturity investments were rated Aa3 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively.
Cash flows from investing activities were primarily the result of normal purchases and sales of investment securities. Net realized investment gains before income taxes were $652,000, $383,000 and $745,000 during 2004, 2005 and 2006, respectively, from the sale of investments. NAICO received proceeds of $23.8 million, $2.5 million and $21.3 million during 2004, 2005 and 2006, respectively, from the sale of available for sale securities prior to their maturity. During 2004, 2005 and 2006, the market value of NAICO's available for sale fixed-income investments decreased by $581,000, $1.6 million and $1,000, respectively, due primarily to changes in interest rates experienced during this time. The average maturity of NAICO's fixed maturity investments was 4.0 years and 3.4 years at December 31, 2005 and 2006, respectively.
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, 2005 and 2006, Chandler USA had a receivable of $9.4 million and $9.6 million, respectively, under the Credit Agreement, and Chandler USA earned $439,000, $614,000 and $733,000 in interest income under the Credit Agreement during 2004, 2005 and 2006, 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, 2006, the total amount of cash and investments restricted as a result of these arrangements was $7.7 million. In addition, NAICO has deposited $11.9 million of cash and investments into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer.
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, the lease was extended for three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest, which was 9.25% at December 31, 2006, on the unpaid lease balance which is a floating interest rate of 1% over JP Morgan Chase Bank prime. During March 2007, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $13,834 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.9 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 $1.5 million. See Note 11 to Consolidated Financial Statements.
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. In addition, 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. 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. Prejudgment interest will continue to accrue at 8.25%.