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, 2001, 2002, 2003, 2004 and 2005 and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for the years ended December 31, 2001, 2002, 2003, 2004 and 2005 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 2001 and 2002 have been restated to reflect the results of LaGere & Walkingstick Insurance Agency, Inc. ("L&W") as a discontinued operation.
For the year ended December 31, 2005, Chandler USA had a net income of $4.4 million compared to a net loss of $7.0 million for 2004 and net income of $2.0 million for 2003. Net income for 2003 included $3.1 million in gains on the purchase and cancellation of $16.7 million principal amount of Debentures, and $1.7 million for the amortization of the deferred gain on a sale and leaseback transaction. These transactions are discussed in more detail under "Other Income" and "Liquidity and Capital Resources." The net loss in 2004 is primarily due to the adverse loss development experienced by Chandler USA. See "Losses and Loss Adjustment Expenses."
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 incurred but not reported losses under their previously issued insurance policies and 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 is 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 expenses, 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. In recent years, certain of these factors have contributed to incurred amounts that were significantly higher than original estimates. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims.
For the workers compensation portion of the standard property and casualty program, NAICO's actuaries selected the results of the incurred loss development method for the 2002 and prior accident years. The 2003 and 2004 accident years were based on the loss ratios that resulted from using the incurred loss development method before the application of certain quota share reinsurance. The 2005 accident year selection was based on a judgmentally selected loss ratio. For the casualty portion of this program, the actuaries used an average of the incurred loss development method and the corresponding selections from the prior quarter for all accident years prior to 2003. The 2003, 2004 and 2005 accident year selections were based on judgmentally selected loss ratios. The estimation methods chosen are those that are believed to produce the most reliable indication at that particular evaluation date for the losses being evaluated. The point estimates for the political subdivisions, homeowners and surety bond programs are less volatile as portions of these programs are in a run-off mode and can be estimated with more certainty. Surety bond reserves are actually a net receivable due to anticipated subrogation recoveries. Certain involuntary pools provided their own estimates and NAICO records these estimates plus an accrual to account for the lag time in reporting to NAICO. Changes in actuarial methods were made in the 2005 loss reserve analysis for the standard property and casualty program. In the 2004 loss reserve analysis, additional weight was given to paid loss indications for certain accident year selections for this program. The 2005 loss reserve analysis used only the incurred loss development method, adjusted as described above, with judgmentally selected loss ratios for the more recent accident years.
At December 31, 2005, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $5.7 million which begins to expire in 2023. 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.
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 have improved. The pricing environment during 2005 experienced downward pressure, particularly for larger accounts. NAICO has been able to increase its pricing for most coverages from 2001 through 2005. However, 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.
Gross premiums earned decreased 7% and 1% in 2004 and 2005, respectively. These decreases were primarily the result of NAICO's continued efforts to improve underwriting profitability and increased competition within the Oklahoma school districts portion of the political subdivisions program. In 2005, the gross earned premium from the new homeowners program offset the decreases in gross earned premiums in the political subdivision and surety bond programs. Gross premiums earned in Texas decreased 3% and 4% in 2004 and 2005, respectively, and gross premiums earned in Oklahoma decreased 8% and 4% in 2004 and 2005. Net premiums earned increased 13% and 3% in 2004 and 2005, respectively. The increase in 2004 was due primarily to changes in NAICO's reinsurance programs for certain excess of loss and quota share reinsurance. Effective January 1, 2004, NAICO discontinued a quota share reinsurance arrangement that covered casualty, workers compensation and physical damage risks produced by certain agents. Effective, April 1, 2004, NAICO increased its net retention to include 56% of the layer covering $500,000 excess of $500,000 of loss per occurrence for its casualty and workers compensation risks, and effective July 1, 2004, NAICO increased its net retention to include 70% of this layer. During 2005, the only significant change in NAICO's reinsurance retention was that effective July 1, 2005, NAICO increased its net retention for the casualty reinsurance program to include 70% of each loss occurrence up to $2 million. These changes increased NAICO's net retention for these lines of business and also increased net premiums earned. The new homeowners program also contributed to the increase in net premiums earned in 2005.
Gross premiums earned in the standard property and casualty program decreased less than 1% in 2004 and 2005. Gross premiums earned in Texas decreased $685,000 and $4.9 million in 2004 and 2005, respectively, and gross premiums earned in Oklahoma increased $1.7 million and $906,000 in 2004 and 2005. NAICO offset the decrease in Texas by expanding its standard property and casualty program in several midwestern states, including New Mexico and Colorado. NAICO has also increased premiums from trucking accounts in 2004 and 2005. Gross premiums earned from trucking accounts increased $4.9 million and $6.4 million in 2004 and 2005, respectively, while net premiums earned increased $2.8 million and $3.3 million in these periods. Net premiums earned increased 19% and 1% in 2004 and 2005, respectively. The increases are primarily due to reinsurance changes described above.
Gross premiums earned in the political subdivisions program decreased 25% and 14% in 2004 and 2005, respectively. The decrease in gross premiums earned is due primarily to increased competition related to Oklahoma school districts. Net premiums earned decreased 10% and 8% in 2004 and 2005, respectively. The decrease in 2004 and 2005 was due to a decrease in gross premiums earned and was partially offset by the reinsurance changes described above.
In the second quarter of 2005, NAICO began writing homeowner and dwelling policies in the state of Texas through a managing general agent. Gross and net earned premiums for 2005 were $4.2 million and $3.3 million, respectively. NAICO is currently reviewing this program and may modify or discontinue this program during 2006.
At December 31, 2005, 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 6% 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 realized investment gains were $2,351,000, $652,000 and $383,000 in 2003, 2004 and 2005, respectively. Realized investment gains in 2003 included a gain of $1.7 million from the sale of 19,371 shares of common stock of Insurance Services Office, Inc. ("ISO"). NAICO received these shares in 1997 as a result of ISO converting to a for-profit corporation.
The average net yield on the fixed maturity portfolio, including net realized investment gains, was 6.7%, 4.0% and 3.4% in 2003, 2004 and 2005, respectively. The average net yield on the fixed maturity portfolio, excluding net realized investment gains, was 3.2% for 2003 and 2004 and 3.4% for 2005. Chandler USA excludes interest income from related parties when calculating its average net yield on the portfolio. Chandler USA's average net yield has been reduced by investment expenses to subsidize a premium finance program for certain insureds of NAICO. While such expenses reduce Chandler USA's average net yield, the premium finance program enhances cash flow by providing cash which is available for investment earlier than conventional deferred payment plans. Based on information provided by the premium finance company, the outstanding balance of premiums financed at December 31, 2005 was approximately $10.5 million. The average yield on the fixed maturity portfolio before deducting investment expenses was 3.6% in 2003 and 2004 and 3.8% in 2005, excluding net realized capital gains.
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 65.7%, 84.0% and 56.5% in 2003, 2004 and 2005, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $1.9 million, $761,000 and $475,000 in 2003, 2004 and 2005, respectively, and increased the respective loss ratios by 3.4, 1.2 and 0.7 percentage points. NAICO did not experience any losses related to Hurricane Katrina, but did experience approximately $315,000 in net incurred losses from Hurricane Rita.
In 2003 and 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, the majority of the adverse loss development was in the automobile liability line of business, as reserves were strengthened in the 1999-2004 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 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. Adverse loss development for workers compensation was $4.2 million and adverse loss development for other liability was $5.5 million. A reduction in losses for the 2002 accident year partially offset this adverse development. This reduction was based on more favorable development patterns in the standard property and casualty program including the workers compensation, other liability and automobile liability lines of business. However, the patterns experienced during 2003 worsened during 2004 and approximately half of this reserve reduction had to be added back to the 2002 accident year. The adverse loss development included approximately $1.3 million for provisions for potentially uncollectible reinsurance and deductibles relating primarily to the workers compensation line of business.
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 2003, 2004 and 2005, NAICO incurred charges of $604,000, $282,000 and $108,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
The following table sets forth Chandler USA's policy acquisition costs for each of the three years ended December 31, 2003, 2004 and 2005:
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 25.1%, 23.0% and 23.0% in 2003, 2004 and 2005, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 14.9%, 13.2% and 14.3%. The decrease in 2004 in commission expense was primarily due to a decrease in contingent commissions to agents that resulted from higher loss ratios than had been projected for these agents. The increase in 2005 in commission expense was due primarily to the new homeowners program that began during 2005. This new 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.
Chandler USA's federal income tax benefit (provision) as a percentage of income (loss) before income taxes was 8.9%, 33.8% and 35.6% for 2003, 2004 and 2005, respectively. The low percentage in 2003 was primarily due to offsetting taxable realized gains of $2.4 million against Chandler USA's capital loss carryforward which is fully reserved due to its realization not being considered more likely than not.
At December 31, 2005, Chandler USA had a net deferred tax asset of $5.6 million including $1.9 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.
In addition to the statutory limits described above, the amount of shareholder dividends and other payments to affiliates can be further limited by contractual or regulatory restrictions or other agreements with regulatory authorities restricting dividends and other payments, including regulatory restrictions that are imposed as a matter of administrative policy. If insurance regulators determine that payment of a shareholder dividend or other payments to an affiliate (such as payments under a tax sharing agreement, payments for employee or other services, or payments pursuant to a surplus note) would be hazardous to such insurance company's policyholders or creditors, the regulators may block such payments that would otherwise be permitted without prior approval.
Historically, NAICO has played a significant role in the servicing of debt and other obligations of Chandler USA through the payment of shareholder dividends. Management's expectation is that Chandler Insurance or other subsidiaries will be able to meet these obligations in the future. It is possible that dividends from NAICO may be necessary to service Chandler USA's debt obligations. To the extent that the restrictions discussed previously limit NAICO's ability to pay shareholder dividends or other payments to Chandler USA, Chandler USA's ability to satisfy the debt obligations may also be limited.
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, 2005, 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.
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, 2005 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.
Chandler USA used $6.0 million in cash from operations during 2003, provided $20.2 million in cash from operations in 2004 and used $131,000 in cash from operations in 2005. Cash flow from operations was negatively impacted during 2003 due to the decline in written premiums during this year since claim payments for any given year will include payments for claims on insurance policies written in prior years. The cash used by operations was largely funded from sales and maturities of investments and certain financing activities described below. The cash provided by operations in 2004 was due primarily to the decrease in reinsurance purchased in 2004 which resulted in an increase in net premiums written of $18.6 million. Cash flow from operations is positively impacted during times when net premiums written increase since a substantial portion of the claim payments for any given year will be made in future years. The cash provided by operations was used primarily to fund purchases of investments and loans to related parties. During 2005, net premiums written decreased slightly which attributed to Chandler USA using only $131,000 in cash from operations. In 2005, the increase in premium receivables and reinsurance recoverables on unpaid losses were offset by Chandler USA's net income and an increase in unearned premium.
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, 2005, the total amount of cash and investments restricted as a result of these arrangements was $7.8 million. In addition, NAICO deposited $3.7 million into a trust account during 2005 as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer.
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, 2004 and 2005, Chandler USA had a receivable of $10.9 million and $9.4 million, respectively, under the Credit Agreement, and Chandler USA earned $412,000, $439,000 and $614,000 in interest income under the Credit Agreement during 2003, 2004 and 2005, 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, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest, which was 8.25% at December 31, 2005, on the unpaid lease balance which is a floating interest rate of 1% over JP Morgan Chase Bank prime. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $2.4 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 $1.9 million. See Note 11 to Consolidated Financial Statements.
The following table provides the future payments due by period under contractual obligations as of December 31, 2005, aggregated by type of obligation: