The selected financial data has been derived from the consolidated financial statements of the Company and its subsidiaries, which appear in Item 14(a). The consolidated balance sheets of the Company and its subsidiaries as of December 31, 1998 and 1999, and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1999, have been audited by Deloitte & Touche, independent auditors whose independent auditors report expresses an unqualified opinion and includes an explanatory paragraph relating to litigation. 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.
Gross premiums earned in the standard property and casualty program increased 39%, 22% and 30% in 1997, 1998 and 1999, respectively. The increases are primarily attributable to increased written premium production in Texas. Net premiums earned increased 45% in 1997, decreased 25% in 1998 and increased 72% in 1999. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance in 1998 as previously described. The rescission of the reinsurance treaties increased net premiums earned in 1999 by $17.3 million in this program.
Gross premiums earned in the political subdivisions program increased 11%, 17% and 20% in 1997, 1998 and 1999, respectively, due primarily to expansion of the school districts portion of the program in Texas and Missouri and increased written premium production in Oklahoma. Net premiums earned increased 7% in 1997, decreased 13% in 1998 and increased 33% in 1999. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance in 1998 as previously described. The rescission of the reinsurance treaties increased net premiums earned in 1999 by $2.3 million in this program.
Gross premiums earned in the surety bond program increased 8% in 1997, decreased 3% in 1998 and increased 15% in 1999. The increase in 1999 was due primarily to increased written premium production in California. Net premiums earned in the surety bond program increased 11% in 1997, decreased 11% in 1998 and increased 10% in 1999. Increased competition, higher reinsurance costs and/or changes in risk retained contributed to the decline in 1998.
Gross premiums earned in the group accident and health program increased 560%, 81% and 50% in 1997, 1998 and 1999, respectively, and net premiums earned increased 629%, 102% and 78% in 1997, 1998 and 1999, respectively. The significant increases in premiums in 1997 and 1998 are primarily the result of the growth expected in start-up programs. In January 1999, NAICO began a new program covering primarily Oklahoma employers on a fully insured basis. Gross and net premiums earned for this program were $6.0 million and $5.6 million, respectively, during 1999. NAICO discontinued writing new policies for the excess portion of its group accident and health program effective April 1, 1999. NAICO expects that premiums in its fully insured program will decline during 2000 due to the effect of rate increases and other changes in the program which were put in effect in late 1999. NAICO is currently evaluating the fully insured program and may modify or discontinue it during 2000.
At December 31, 1999, the Company's investment portfolio consisted primarily of fixed income U.S. Government, high-quality corporate and tax exempt bonds, with approximately 7% invested in cash and money market instruments. Income generated from this portfolio is largely dependent upon prevailing levels of interest rates. The Company's portfolio contains no non-investment grade bonds or real estate investments.
L&W's brokerage commissions and fees before intercompany eliminations were $9.0 million in 1997, $8.5 million in 1998 and $9.6 million in 1999. A large portion of the brokerage commissions and fees for L&W is incurred by NAICO and thus eliminated in the consolidation of the Company's subsidiaries.
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 60.7%, 68.3% and 73.7% in 1997, 1998 and 1999, respectively. The rescission of the reinsurance treaties increased losses and loss adjustment expenses in 1999 by $17.0 million. Excluding the effect of the reinsurance rescission, the loss ratio was 70.9% in 1999. Weather-related losses (net of applicable reinsurance) from wind and hail were $459,000, $1.4 million and $4.3 million 1997, 1998 and 1999, respectively, and increased the respective loss ratios by 0.5, 2.0 and 4.9 percentage points (excluding the effect of the reinsurance rescission in 1999).
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. Recoverability of such deferred costs is dependent on the related unearned premiums on the policies being more than expected claim losses. The Company considers anticipated interest income in determining if a premium deficiency exists.
The following table sets forth the Company's policy acquisition costs for each of the three years ended December 31, 1997, 1998 and 1999:
Interest expense increased 217%, 102% and 64% in 1997, 1998 and 1999, respectively. The increase in 1997 and 1998 were due primarily to increased levels of bank debt. The increase in 1999 was due primarily to interest expense on the $24 million debenture offering which was completed on July 16, 1999 by Chandler USA. See "Liquidity and Capital Resources."
The provision for or benefit from federal income taxes of the consolidated U.S. subsidiaries varies with the level of income or loss before income taxes of such subsidiaries. The provision or benefit relative to the consolidated income before income taxes will also vary dependent on the contribution to income before income taxes by the consolidated U.S. subsidiaries.
As a result of the factors described above, the Company reported net income of $2,151,000 in 1999 compared to $3,442,000 in 1998 and a net loss of $1,065,000 in 1997. Net litigation expenses related to legal proceedings involving the CenTra Group reduced net income by $1.1 million in 1999 compared to an increase of $2.9 million in 1998 and a reduction of $4.5 million in 1997.
Fixed-maturity investments are purchased to support the investment strategies of the Company and its subsidiaries, which are developed based on many factors including rate of return, maturity, credit risk, tax considerations, regulatory requirements and their mix of business. At the time of purchase, investments in debt securities that the Company 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. The Company 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 income tax as a separate component of shareholders' equity until realized.
Cash flows from investing activities were primarily the result of normal purchases and sales of investment securities, and in 1997 NAICO sold the common stock of Century Business Services, Inc. for a total of approximately $2.5 million. The Century Business Services common stock was received as a part of NAICO's 1996 settlement with a former underwriting manager. Net realized investment gains before income taxes were $764,000, $1,163,000 and $55,000 during 1997, 1998 and 1999, respectively, from the sale of investments. In addition, the Company received proceeds of $48.0 million and $4.2 million during 1998 and 1999, respectively, from the sale of available for sale fixed-income securities prior to their maturity. In 1998, to augment maturities and reposition their portfolios, Chandler Barbados and NAICO chose to liquidate certain fixed maturity securities that were available for sale prior to their maturities. The average maturity of the Company's investments was 4.0 years and 3.9 years at December 31, 1998 and 1999, respectively.
Cash flows from financing activities include bank borrowings and repayments, the sale of debentures and purchases of the Company's common stock in accordance with the divestiture of stock owned by the CenTra Group. In February 1998, Chandler USA entered into a five-year loan agreement with a bank having a principal amount of $2.3 million. The loan was collateralized by certain equipment which was purchased with the proceeds of the loan. The equipment had previously been leased by Chandler USA. In March 1998, Chandler USA borrowed an additional $6.2 million under an existing loan agreement with a bank and the proceeds were used to repay amounts due to Chandler Barbados. The bank note was collateralized by shares of NAICO stock owned by Chandler USA. In July 1999, both bank notes were repaid from the proceeds of the debenture offering.
Through the first two months of the year 2000, the Company had not experienced any significant problems or disruptions related to Year 2000 Problems (as described below). The Company is currently not aware of any significant disruptions experienced by its customers, vendors and service providers that would materially affect their ability to do business with the Company. While it is possible that certain Year 2000 Problems may exist but have not yet materialized, the Company does not currently expect any Year 2000 Problems to be encountered for the remainder of the year 2000 that would have a material adverse effect on the operating results of the Company.
The Company is heavily dependent upon complex information technology computer systems for its operations. The Company has taken action to attempt to identify the nature and extent of the work required to assess and remediate Year 2000 Problems with respect to its systems, products and infrastructures, including non-information technology systems, none of which are considered critical to operations. The Company began work in 1995 to prepare its financial, information and other computer-based systems for the year 2000, including updating existing legacy systems, and such work is complete at this time. The Company estimates that it has spent $350,000 updating these systems to address Year 2000 Problems, and such costs were expensed as they were incurred, primarily in 1996 and 1997.
It is possible that the credit or operating ability of agents, reinsurers and others with whom the Company maintains commercial relationships may be adversely affected by one or more unforeseen circumstances caused by Year 2000 Problems. However, the Company does not have control over these third parties and, as a result, it cannot currently determine to what extent future operating results may be adversely affected by the failure of these third parties to successfully address their Year 2000 Problems. However, the Company has developed plans to attempt to minimize identified third-party exposures. The Company has requested information from its major vendors and service providers to assess their year 2000 readiness. The Company cannot predict the adverse impact, if any, of Year 2000 Problems upon parties with whom it does business.
The Company continues to study the complex issues related to insurance coverage for losses arising from the myriad potential fact situations connected with Year 2000 Problems and NAICO's liability to its insureds. The Company believes that the coverages NAICO provides do not extend to the types of losses which are most likely to occur as a result of Year 2000 Problems, and NAICO has made no provisions for loss reserves based on potential Year 2000 Problems. NAICO expects to utilize coverage exclusion endorsements based on the individual underwriting of commercial accounts, and it has adopted endorsements to its policies based on forms provided and filed for approval with various regulatory authorities by Insurance Services Office, Inc., an insurance services company which provides regulatory research and filing support to insurance companies. Use of these special endorsements is governed by the law and regulatory policies of states in which NAICO is authorized to do business.
During 1998, the IRS conducted an examination of the 1995 U.S. Federal income tax return of Chandler Barbados. The IRS completed the examination in the third quarter of 1998, and there were no proposed adjustments to tax liabilities.
Some of the statements made in this Form 10-K report, as well as statements made by the Company in periodic press releases, oral statements made by the Company's officials to analysts and shareholders in the course of presentations about the Company and conference calls following earnings releases, constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such factors include, among other things, (i) general economic and business conditions; (ii) interest rate changes; (iii) competition and regulatory environment in which the Company operates; (iv) claims frequency; (v) claims severity; (vi) the number of new and renewal policy applications submitted by the Company's agents; (vii) the ability of the Company to obtain adequate reinsurance in amounts and at rates that will not adversely affect its competitive position; (viii) the ability of NAICO to maintain favorable insurance company ratings; (ix) the ability of the Company and its third party providers, agents and reinsurers to adequately address year 2000 issues; and (x) other factors including the ongoing litigation matters involving a significant concentration of ownership of the Company's common stock.