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, 1995 and 1996, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1996, 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.
The following events which recently occurred are significant and provide additional information that updates the description of the CenTra, Inc. ("CenTra") litigation included in this Form 10-K. In the accompanying 1996 consolidated financial statements of Chandler Insurance Company, Ltd. (the "Company" or "Chandler"), no provisions have been made for the potential effects, if any, of these subsequent events.
As previously reported the United States District Court for the District of Nebraska (the "Nebraska Court") has entered certain orders relating to sequestration of shares of the Company's stock owned by CenTra. See "Item 3. LEGAL PROCEEDINGS" for a description of this matter. On March 25, 1997 the Nebraska Court, pursuant to the Nebraska Insurance Holding Company Systems Act, ordered CenTra and certain of its affiliates to divest all Chandler shares owned by them, regardless of when purchased. The CenTra defendants own or control 3,131,825 Chandler shares, representing approximately 45% of the outstanding stock. The Nebraska Court directed NAICO, the CenTra defendants and the Nebraska Insurance Department to submit proposals to the Nebraska Court by April 21, 1997 for the "orderly divestiture and disposition of the stock". A hearing will then be scheduled to consider the proposals. Neither the Company nor its affiliate, NAICO, have developed a final proposal at this time.
CenTra has not indicated if it intends to appeal the orders of the Nebraska Court. Because of the uncertainty of whether CenTra will appeal the Nebraska Court's orders, and until the final proposals are submitted and accepted, the Company is unable to predict the effect of the divestiture order on the rights, limitations or other regulation of ownership of the stock of any existing or prospective holders of the Company's common stock, or the effect on the market price of the Company's stock.
The property-casualty insurance industry is very competitive. Insurers compete on the basis of marketing effort, product, price, service and financial strength. The Company's competitors range from smaller regional independent insurance companies to major worldwide insurance companies.
A 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. For the past three years the industry has generally had excess underwriting capacity and premium rates have generally been depressed as a result of the increasing competition that generally occurs when excess underwriting capacity exists.
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. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims. NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO and Chandler Barbados and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Any changes in the estimates are reflected in current operating results. See Notes to Consolidated Financial Statements.
Generally, the more costly automobile liability claims involve one or more severe bodily injuries or deaths. 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.
The Company's subsidiaries report their reserves on the basis of U.S. GAAP. NAICO's statutory-based reserves do not differ from its U.S. GAAP reserves. Neither NAICO nor Chandler Barbados discounts its reserves for unpaid losses and loss adjustment expenses.
As a part of a settlement of certain litigation with CenTra (see Notes to Consolidated Financial Statements), National Union agreed to assume the reinsurance obligations of DuraRock effective March 31, 1993. Since that date NAICO and NAICO Indemnity had been unable to obtain loss information which would allow adjustments to be made to the reinsurance recoverables on unpaid losses, and to the liabilities for unpaid losses and loss adjustment expenses of approximately $32.1 million as previously presented in the consolidated balance sheets. In the fourth quarter of 1996 NAICO and NAICO Indemnity obtained this information and reduced the previous amount of $32.1 million to $7.4 million. The effect of this change on the Company's 1996 consolidated results of operations was not significant.
In the third quarter of 1996, the Company recorded a $982,000 estimated recovery of costs from its directors and officers liability insurer related to the Company's claim for reimbursable amounts previously paid for defense and litigation costs associated with the litigation involving the CenTra group. Excluding the effects of the unusual charges and related expenses and the estimated recovery, net income would have been $2.7 million and $40,000, respectively, for the year and fourth quarter ended December 31, 1996.
In addition, litigation expenses related to an ongoing shareholder legal proceeding involving the CenTra group increased significantly in the fourth quarter of 1996 in preparation of a trial which began on February 13, 1997. Significant litigation expenses are also anticipated in the first quarter of 1997 which will negatively affect earnings. Litigation expenses in the fourth quarter of 1996 were $653,000 versus a credit of $575,000 in the fourth quarter of 1995, which included an estimated recovery of $818,000 from the Company's directors and officers liability insurer. Litigation expenses for the year were a credit of $108,000 in 1996, including an additional estimated recovery of $982,000, which was recorded in the third quarter, versus $285,000 in 1995.
In 1995, NAICO elected to commute the unpaid losses and loss adjustment expenses related to reinsurance contracts covering certain business written in 1993, 1994 and 1995 which resulted in an increase in net premiums earned of $2,285,000. NAICO elected to commute similar reinsurance contracts in 1994 (covering certain business written in 1992 and 1993) which resulted in an increase in net premiums earned of $1,354,000. In 1996, NAICO reviewed the historical results for reinsurance contracts with similar commutation provisions and began accruing for such commutations where a commutation election was considered likely. Excluding the effects of these commutation accruals and elections, net premiums earned increased 4% in 1994, decreased 2% in 1995 and increased 12% in 1996. The effect of the commutation accruals and elections was to increase net premiums earned for each insurance program as follows:
NAICO increased its net unpaid losses and loss adjustment expenses by $400,000 in 1994 as a result of the respective commutations. There was no increase in unpaid losses and loss adjustment expenses for the 1995 commutation elections and the 1996 commutation accrual.
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. Excluding the effects of the commutations described above, net premiums earned for the standard property-casualty program increased 38%, 28% and 34% in 1994, 1995 and 1996 generally due to the product and territory expansion described above and increased premium rates for workers compensation in various states. NAICO's largest independent agent for this program produced $16.1 million, $11.0 million and $5.8 million in gross written and assumed premiums in 1994, 1995 and 1996, respectively. Premiums receivable and currently due from this agent were $1.8 million and $934,000 at December 31, 1995 and 1996.
Net premiums earned in the surety bond program decreased 29% in both 1995 and 1996, compared to the prior years. NAICO and Midwest, the underwriting manager for a large portion of the surety bond program, agreed to terminate the underwriting and production contract effective December 31, 1995. See "POLICY ACQUISITION COSTS" for expenses in 1996 related to the Midwest matter. Midwest produced $1.0 million in gross written and assumed premiums in 1996 during the runoff of that portion of the program. Midwest produced $14.7 million and $8.2 million in gross written and assumed premiums in 1994 and 1995.
Direct surety premiums written for NAICO by L&W personnel were $4.2 million in 1994, $4.8 million in 1995 and $8.0 million in 1996.
Excluding the effects of the commutations described above, net premiums earned for the political subdivisions program increased 14%, 10% and 15% in 1994, 1995 and 1996, respectively, from the prior year. Net premiums earned for the municipalities portion of this program increased 34%, 45% and 79% in 1994, 1995 and 1996. NAICO expanded its book of business through local agents in Oklahoma and expanded its coverage for municipalities to include workers compensation in 1995. NAICO also began insuring counties in 1995.
During the first quarter of 1994, management reviewed the underwriting performance of the transportation programs and concluded that it would be in the Company's best interest to discontinue writing transportation automobile liability business based on the underwriting results and other related factors. As a result, net premiums earned declined 25%, 79% and 63% in 1994, 1995 and 1996, respectively, from the prior year. The Company continues to service the transportation industry in its retail and risk brokerage operations and all risk management services provided by NAICO are available.
Net investment income decreased in 1995 and 1996 compared to prior periods primarily as a result of a reduction in invested assets and a decrease in net realized capital gains. Invested assets declined primarily as a result of the payment of loss and loss adjustment expense reserves corresponding to the planned reduction of certain insurance programs within the Company's book of insurance business during 1991 through 1994.
Net realized capital gains were $493,000, $412,000 and $140,000 in 1994, 1995 and 1996, respectively. The average net yield on the portfolio, including net realized capital gains, was 6.4% in 1994, 6.5% in 1995 and 6.1% in 1996. The average net yield excluding net realized capital gains for these years was 6.0%, 6.1% and 6.0%, respectively.
The Company estimates losses and loss adjustment expenses based on historical experience and payment and reporting patterns for the type of risk involved. These estimates are based on data available at the time of the estimate and such estimates are periodically reviewed by independent professional actuaries.
The following table sets forth the Company's policy acquisition costs for each of the three years ended December 31, 1994, 1995 and 1996:
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 22.1%, 27.3% and 33.5% in 1994, 1995 and 1996, respectively. For these periods, the average commission rates were 7.4%, 11.6% and 15.3%. The commission rate for a substantial portion of the surety bond program varies inversely with the loss ratio pursuant to a commission arrangement contingent on the loss experience of the program. The expected loss ratio for this portion of the program was increased in 1994 and such increase lowered the percentage of net policy acquisition costs to net premiums earned by 5.8 percentage points. The expected loss ratio for that portion of the surety bond program was lowered in 1996 and that decrease increased the percentage of net policy acquisition costs to net earned premiums by 3.1 percentage points.
Indirect expenses were 10.7%, 10.6% and 13.7% of total direct written and assumed premiums in 1994, 1995 and 1996, 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. The Company incurred $474,000, $440,000 and $2,077,000 in indirect underwriting expenses for uncollectible ceded reinsurance in 1994, 1995 and 1996, respectively, which was 0.5%, 0.4% and 1.9% of direct written and assumed premiums in those periods; the 1996 amount includes an arbitration award which was made against New York Life Insurance Company, Security Benefit Life Insurance Company and Standard Insurance Company and in favor of NAICO but for $1.1 million less than had been expected. NAICO reduced its reinsurance recoverables accordingly. See Notes to Consolidated Financial Statements.
General and administrative expenses were 15.0%, 15.2% and 15.3% of revenues exclusive of net investment income in 1994, 1995 and 1996, respectively. General and administrative expenses have historically not varied in direct proportion to the Company's revenues. A portion of such expenses is allocated to policy acquisition costs (indirect expense) 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 the Company's overall premium volume. In 1996, the Company incurred $441,000 in legal expenses related to the Midwest termination settlement, and $527,000 in legal expenses related to the reinsurance arbitration discussed above.
On July 9, 1992, Windsor Acquisition Corporation ("Windsor"), a wholly owned subsidiary of the Company, commenced a cash tender offer for all of the outstanding shares of the Company at $6.50 per share. On July 23, 1992, Windsor terminated the offer. The Company incurred expenses attributable to the tender offer totaling $1.2 million in 1992 for legal and accounting fees, investment banking services and other related expenses. See "LEGAL PROCEEDINGS" and "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS--Tender Offer".
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 and $857,000 in costs attributable to these legal proceedings during 1992, 1993, 1994, 1995 and 1996, respectively. As a result of various events in the fourth quarter of 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 the third quarter of 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. The Company also expects to file additional claims to recover a portion of certain other related costs although such recoveries may not occur, or may be less than all of the costs. The Company is unable to predict the final resolution of these legal proceedings, and accordingly expects to incur higher than normal legal costs in future periods. Due to the inherent uncertainties of such legal proceedings and the unpredictability of CenTra's future actions, the Company cannot predict the outcome of such litigation with certainty or the rate at which such defense and litigation costs will be incurred in the future. However, due to the CenTra trial which began in February 1997, significant legal expenses were incurred in the fourth quarter of 1996 and are also anticipated in the first quarter of 1997. See "Liquidity and Capital Resources", "Certain Tax Matters", "LEGAL PROCEEDINGS" and Notes to Consolidated Financial Statements.
The net amount due from the Company's subsidiaries to DuraRock and Liberty Bell was approximately $3.1 million as of December 31, 1996. Amounts due to DuraRock from NAICO and NAICO Indemnity are not payable to DuraRock until the related premiums due from CenTra are collected. The Company intends to seek payment of all amounts due and believes a reserve for collection is not necessary at December 31, 1996.
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. Chandler USA has been informed by the IRS that there are no proposed adjustments to tax liabilities; however, a formal report has not yet been issued.