Net income was $2.0 million for the year ended December 31, 2003, compared to a net loss of $2.1 million for 2002 and $1.1 million for 2001. Income from continuing operations was $2.0 million for 2003 compared to a loss from continuing operations of $3.0 million and $481,000 during 2002 and 2001, respectively. 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."
In December 2002, Chandler USA completed the sale of its wholly owned subsidiary L&W to Brown & Brown, Inc. for $3,247,000 in cash and a $361,000 note receivable that was paid in December 2003. Chandler USA recorded an after-tax gain of $671,000 on the sale in 2002 based on the minimum purchase price for the transaction, after deducting Chandler USA's goodwill related to L&W of $2,350,000, equity in L&W of $224,000 and approximately $400,000 of expenses in connection with the sale. The gain on the sale may be increased over the next three years depending on certain adjustments to the purchase price as defined in the terms of the transaction, with a maximum purchase price of $6.0 million.
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 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.
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. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates.
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. During much of the last decade, the industry has generally had excess underwriting capacity resulting in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO has been able to increase its pricing for most coverages during 2002 and 2003, which has generally been the trend industry wide. 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.
The following tables summarize the net premiums earned and the financial year (losses incurred and recognized by Chandler USA regardless of the year in which the claim occurred) and accident year (losses incurred by Chandler USA for a particular year regardless of the period in which Chandler USA recognizes the costs) loss ratios (computed by dividing losses and loss adjustment expenses by net premiums earned) in each of the years presented. 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 15% and 14% in 2002 and 2003, respectively, as NAICO continued to focus on improving underwriting profitability in its core programs through stricter underwriting policies, a reduction in the number of appointed agents and by discontinuing certain accounts where rates were not believed to be adequate. Gross premiums earned in Texas decreased 23% and 18% in 2002 and 2003, respectively, and gross premiums earned in Oklahoma decreased 5% and 15% in 2002 and 2003. The workers compensation line of business accounted for a significant portion of the decreases. Net premiums earned decreased 4% and 15% in 2002 and 2003, respectively. During 2001 and 2002, NAICO had quota share reinsurance in effect that reduced NAICO's net retention for its casualty and workers compensation lines of business and reduced its net premiums earned by $11.3 million and $4.6 million, respectively. NAICO elected not to renew this reinsurance upon expiration.
Gross premiums earned in the standard property and casualty program decreased 18% and 12% in 2002 and 2003, respectively. The decreases were due primarily to discontinuing certain accounts where rates were not believed to be adequate. Increases in premium rates partially offset the decrease in premium production. Gross premiums earned in Texas decreased $13.7 million and $9.9 million in 2002 and 2003, respectively, and gross premiums earned in Oklahoma decreased $7.2 million and $6.0 million in 2002 and 2003, respectively. Net premiums earned decreased 7% and 8% in 2002 and 2003, respectively. The quota share reinsurance reduced net premiums earned by $9.5 million and $3.8 million in this program in 2001 and 2002, respectively.
During 2001, NAICO experienced incurred losses related to prior accident years totaling $12.7 million due primarily to increased loss severity in the standard property and casualty and political subdivisions programs. A substantial part of this loss development was for workers compensation losses in the 1999 accident year. NAICO's net retention for workers compensation losses increased substantially in 1999 due to the rescission of certain reinsurance treaties covering this line of business. Also contributing to the adverse loss development were provisions for potentially uncollectible reinsurance and deductibles of approximately $1.2 million during 2001, an increase in losses in the surety bond program and approximately $878,000 in losses for the runoff of a discontinued group accident and health program.
During 2003, NAICO experienced incurred losses related to prior accident years 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.
The following table sets forth Chandler USA's policy acquisition costs from continuing operations for each of the three years ended December 31, 2001, 2002 and 2003:
General and administrative expenses from continuing operations were 6.7%, 8.5% and 10.7% of gross premiums earned in 2001, 2002 and 2003, respectively. General and administrative expenses for 2002 included $297,000 for settlement of certain litigation, and $736,000 for a reserve for receivables related to certain derivative claims. An increase in employee related expenses and fees paid to state insurance departments contributed to the increase in expense in 2003. 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.
NAICO purchases fixed-maturity 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. 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. Securities not classified as held to maturity or trading 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 financing activities during 2003 included $19.3 million in proceeds from the issuance of trust preferred securities, net of related issuance costs, less $12.8 million for payments to purchase $16.7 million principal amount of Chandler USA's Debentures. See Note 6 to Consolidated Financial Statements.
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. Chandler USA has deposited cash into a trust account as security related to certain indemnification provisions related to its sale of L&W. At December 31, 2003, the total amount of cash and investments restricted as a result of these arrangements was $8.3 million.
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, 2002 and 2003, Chandler USA had a receivable of $10.6 million and $9.6 million, respectively, under the Credit Agreement, and Chandler USA earned $371,000, $380,000 and $412,000 in interest income under the Credit Agreement during 2001, 2002 and 2003, respectively.
Transamerica reinsured NAICO for certain workers compensation risks during 1989, 1990 and 1991. Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed under the reinsurance treaties. Transamerica owes NAICO approximately $1.6 million for reinsurance recoverables on paid losses and loss adjustment expenses as of December 31, 2003. NAICO is currently engaged in arbitration in order to enforce the terms of the reinsurance treaties.
Chandler USA and its subsidiaries are not parties to any other material litigation other than as is routinely encountered in their respective business activities. While the outcome of these matters cannot be predicted with certainty, Chandler USA does not expect these matters to have a material adverse effect on its financial condition, results of operations or cash flows.