The Company's United States-based subsidiaries own and occupy three office buildings with approximately 81,000 square feet of usable space at the home office in Chandler, Oklahoma. The Company's subsidiaries also lease approximately 15,000 square feet in the aggregate for its branch offices. The Company believes such space will suffice for the foreseeable future.
As previously reported, on February 13, 1997 trial commenced in the United States District Court in Oklahoma City, Oklahoma ( the "Court") in consolidated cases involving CenTra and certain of its affiliates, officers and directors (the "CenTra Group") and the Company and certain of its affiliates, officers and directors (more fully described in "Item 3. LEGAL PROCEEDINGS"). On April 1, 1997, at the close of all of the evidence, the Court dismissed CenTra's claims against National American Insurance Company ("NAICO") and an affiliate for alleged wrongful cancellation of CenTra's insurance with NAICO and the affiliate in 1992. The remaining issues were submitted to a jury.
On April 9, 1997 the jury returned verdicts on all claims. One verdict against the Company requires the CenTra Group to return stock it purchased in 1990 to the Company in return for a payment of $5,099,133 from the Company. Another verdict was against both the Company and its affiliate Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") and in favor of CenTra and its affiliate Ammex, Inc. Based upon an alleged breach of a stock purchase agreement in 1988, CenTra and Ammex were awarded $6,882,500. Both verdicts related to alleged failures by the Company to adequately disclose the fact that ownership of the Company's stock may be subject to regulation by the Nebraska Insurance Department under certain circumstances. The jury also found in favor of CenTra and against certain officers and/or directors of the Company on the securities claims relating to CenTra's 1990 purchases and the failure to disclose the application of the Nebraska insurance law, but only awarded damages of $1 against each individual defendant on those claims. On ten derivative claims brought by CenTra on behalf of all shareholders, the jury found in CenTra's favor on only three. Certain officers were directed to repay bonuses received for the years 1988 and 1989 totaling $711,629 and a total of $25,000 for personal use of corporate aircraft to the Company. On the remaining claim relating to the acquisition of certain insurance agencies in 1988, the jury awarded only $1 each against six officers and/or directors.
The Company's legal counsel, management, and Board of Directors are reviewing the Court rulings and jury verdicts and considering whether to appeal. Several motions will likely be filed by all parties relating to the verdicts, interest, costs and attorney fees. In view of these matters, final rulings on such motions and the related ultimate judgments are not likely to occur until after May, 1997.
Because the verdicts are so recent and the final judgments are not yet defined, the Company is unable to presently assess the ultimate outcome of these matters. In view of the amount awarded to CenTra and affiliates, the significant attorney fees incurred during the first quarter of 1997, estimated in excess of $1.7 million, and other unresolved matters such as collection of the awards and advancement of litigation expenses to certain Company defendants, unfavorable results regarding these issues would have a material adverse effect on the Company and negatively impact earnings in 1997.
On March 27, 1997 the Nebraska Court declined to exercise jurisdiction over 550,329 shares of Chandler stock held in security by Chandler subsidiaries for debts owed by two former agents but in which CenTra claimed to have option rights. The Nebraska Court's ruling cleared the way for the Company's subsidiaries to begin the process of disposing of these shares to retire the agents' debts to the subsidiaries.
[References to the "Company" which follow within this Item 7 refer to the Company and its subsidiaries on a consolidated basis unless otherwise indicated.]
In general, premium rates for most lines of business remain relatively soft at this time. Management does not foresee any material increases in premium rates for these lines unless the underwriting capacity of the industry declines by virtue of a decrease in surplus. Continued underwriting losses, catastrophic losses, uncollectible reinsurance recoverables, reduced availability of reinsurance, higher reinsurance costs and investment portfolio writedowns would likely contribute to any decrease in the underwriting capacity of any insurer or the industry as a whole. Underwriting results for workers compensation have improved in several states in recent years primarily as a result of premium rate increases and/or legislative reform. Because of these factors, the Company had increased competition for workers compensation business in 1996 and expects such competition will continue in the future.
The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury and workers compensation claims have a much longer loss settlement period and may be paid out over several years. It is often necessary to adjust estimates of liability on a loss either upward or downward between the time a claim arises and the time of payment. Workers compensation indemnity benefit reserves are determined based on statutory benefits described by state law and are estimated based on the same factors generally discussed above, with actuarial input, which may include, where state law permits, inflation adjustments for rising benefits over time.
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 are 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, 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.
NAICO does not ordinarily insure against environmental matters as that term is commonly used. However, in some cases, regulatory filings made on behalf of an insured can make NAICO directly liable to the regulatory authority for property damage which could include environmental pollution. In those cases NAICO ordinarily has recourse against the insured or the surety bond principal for amounts paid. NAICO has insured certain trucking companies and pest control operators who are required to provide proof of insurance which in some cases assures payment for clean-up and restoration of damage resulting from sudden and accidental release or discharge of contaminants or other substances which may be classified as pollutants. NAICO also provides surety bonds for construction contractors who use or have control of such substances and for contractors who remove and dispose of asbestos as a part of their contractual obligations. NAICO also insures independent oil and gas producers who may purchase coverage for the escape of oil, saltwater, or other substances which may be harmful to persons or property, but may not generally be classified as pollutants. Chandler Barbados reinsures a portion of those risks. The Company maintains claims records which segregate this type of risk for the purpose of evaluating environmental risk exposure. Based upon the nature of such lines of business with insureds of the Company, and current data regarding the limited severity and infrequency of such matters, it appears that potential environmental risks are not a significant portion of claims reserves and therefore would not likely have a material impact, if any, on the financial condition of the Company.
Over the last three years there has been an increased level of state and federal legislative and executive proposals which could have significant long- term effects on the insurance industry. This attention has applied both to U.S. domiciled companies concerning the manner in which they operate and to foreign reinsurance companies that reinsure U.S. insurance companies. These proposals and initiatives have included risk-based capital, funding of superfund liabilities, and healthcare reform. As a result, it is possible that additional regulations could be enacted in the future that could directly or indirectly affect the manner in which the Company's insurance and reinsurance subsidiaries do business.
The National Association of Insurance Commissioners has adopted risk-based capital ("RBC") standards for domestic property-casualty insurance companies. The RBC standards are designed to assist insurance regulators in analytically determining a level of capital and surplus that would be sufficient to withstand reasonably foreseeable adverse events associated with underwriting risk, investment risk, credit risk and loss reserve risk. NAICO is subject to the RBC standards. Based on available information, management believes NAICO complied with the RBC standards.
The impact on the Company of a recession 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. Many of NAICO's insurance products are concentrated in the Southwest and Midwest areas of the U.S. An economic downturn in these regions could have a significant impact on the Company. A recession might also cause defaults on fixed-income securities. 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.
Periods of inflation have varying effects on the Company's 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. The effect of inflation on the operations of the Company was not significant during the period from 1994 through 1996.
The following tables summarize the net premiums earned and the financial year (losses incurred and recognized by the Company regardless of the year in which the claim occurred) and accident year (losses incurred by the Company for a particular year regardless of the period in which the Company recognizes the costs) loss and loss adjustment expense ("LAE") ratios (computed by dividing losses and loss adjustment expenses by net premiums earned) in each of the three years ended December 31, 1996. 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:
Due to the effects of a number of unusual charges, net income for 1996 totaled $972,000 compared to a net income of $3,778,000 for 1995. A net loss of $495,000 resulted in the fourth quarter of 1996 compared to net income of $1,312,000 in the fourth quarter of 1995. Earnings for 1996 were affected by charges totaling $1.5 million (including $534,000 in the fourth quarter of 1996) for the settlement attributed to legal proceedings and related matters arising from the termination of an underwriting and production contract with the Company's former underwriting manager for a portion of the Company's surety bond program. In addition, legal expenses related to these matters were $441,000 for 1996, including $240,000 in the fourth quarter of 1996. The Company's results for 1996 also reflect a charge totaling $1.1 million from a second quarter arbitration award that was lower than expected. Legal expenses related to the arbitration award were $527,000 in 1996.
Net premiums earned decreased 1% in 1995 and increased 10% in 1996, compared to the prior years.
During late 1993, NAICO began writing nonstandard private-passenger automobile liability and automobile physical damage in Oklahoma. During mid- 1994, NAICO began writing these coverages in California and Arizona. The combined net premiums earned for these programs was $4.1 million, $15.2 million and $16.6 million in 1994, 1995 and 1996, respectively. NAICO's largest underwriting manager was responsible for underwriting $5.9 million, $11.5 million and $11.9 million of NAICO's direct written and assumed premiums for the California and Arizona portions of the nonstandard private-passenger automobile program during 1994, 1995 and 1996, respectively. Premiums receivable and currently due from this underwriting manager were $690,000 and $596,000 at December 31, 1995 and 1996. Management will continue to review the underwriting performance of these programs in 1997.
Brokerage commissions and fees before intercompany eliminations were $8.6 million in 1994, $8.2 million in 1995 and $8.5 million in 1996. The decrease in 1995 was primarily attributable to the decrease in net premiums earned for the transportation programs and certain non-transportation programs during 1995 . A large portion of the brokerage commission and fees for L&W is incurred by NAICO and thus eliminated in the consolidation of the Company's subsidiaries.
Commissions and fees generated by Network were $148,000 in 1995 and $722,000 in 1996. Network is a third-party administrator of partially self- insured group accident and health plans. Network was acquired by the Company in the fourth quarter of 1995.
Included in other income is a settlement of approximately $343,000 which was received in the second quarter of 1996 from a legal firm.
As a result of NAICO's reduced book of business over the past few years, Chandler Barbados used $10.3 million cash in operations in 1996. To augment maturities and reposition their portfolios, Chandler Barbados and NAICO chose to liquidate certain securities that were available for sale prior to their maturities. The Company realized net capital gains before income taxes in 1996 in the amount of $140,000 from the sale of investments. In 1996, Chandler Barbados and NAICO received proceeds of $10.1 million and $6.8 million, respectively, from the sale of fixed-income securities that were available for sale prior to their maturity. The average maturity of the Company's investments was 4.73 years and 4.81 years at December 31, 1995 and 1996, respectively.
During the third quarter of 1996, Chandler USA borrowed $4.5 million from a bank on a three year note payable. The note has a floating interest rate at Wall Street Journal Prime (8.25% at December 31, 1996), and principal and interest are payable monthly. The note is collateralized by the shares of NAICO stock owned by Chandler USA and includes certain loan covenants. Proceeds from the note were used to repay intercompany advances from Chandler Barbados.
NAICO and NAICO Indemnity provided insurance coverage and risk management services for CenTra and certain of its affiliates. All such policies were canceled effective September 5, 1992 or expired as of September 30, 1992. As of December 31, 1996, the unpaid premiums and other amounts due from CenTra to the Company's subsidiaries were approximately $6.9 million. NAICO and NAICO Indemnity have certain reinsurance agreements with DuraRock that require payment of a substantial portion of the premiums collected from CenTra and its affiliates to DuraRock in consideration for DuraRock assuming a portion of the insurance risk. Amounts due to DuraRock from NAICO and NAICO Indemnity as of December 31, 1996, were approximately $6.7 million and such amounts are not payable to DuraRock until the related premiums due from CenTra are collected. Liberty Bell Agency, Inc., an affiliate of CenTra, has administered claims under the CenTra insurance program. Amounts due to Liberty Bell from NAICO and NAICO Indemnity as of December 31, 1996 were approximately $1.3 million for claims that Liberty Bell has reported to have paid. NAICO and NAICO Indemnity are obligated to pay claim administration fees to Liberty Bell only out of claim payments received from DuraRock. See "LEGAL PROCEEDINGS - CenTra Litigation".
Chandler Barbados has recorded a payable of approximately $2.0 million for losses and loss adjustment expenses, net of related premiums receivable, attributable to reinsurance business assumed from DuraRock based on information provided by CenTra or its affiliates. Liberty Bell has reported that the claims have been paid and has billed Chandler Barbados accordingly. Chandler Barbados had previously reserved $2.6 million for these claims, net of the related premiums, as of December 31, 1995. Such losses were not a part of the litigation described above. The parties have disagreed over certain issues and a separate arbitration proceeding is pending. See "LEGAL PROCEEDINGS - CenTra Litigation".
On October 25, 1994 the IRS proposed increases in federal income tax and the imposition of federal withholding tax and penalties payable by Chandler USA for calendar years 1989 through 1992 in the approximate amount of $2.5 million plus interest. With the exception of the increase in Chandler USA's income for a proposed amount of subpart F income (see "United States Taxation of Shareholders") the remaining proposed increase in income tax arises from the disallowance of deductions for certain expenses (primarily litigation costs - see "CENTRA LITIGATION") incurred by Chandler USA in calendar years 1991 and 1992, and the subsequent disallowance of a net operating loss carryback to calendar years 1989 through 1991. The proposed withholding tax assessment arises out of an assertion by the IRS that certain of the non-deductible expenses were incurred for the benefit of the Company, that they should be treated as a deemed distribution by Chandler USA to the Company, and as such should be subject to a 30% U.S. withholding tax. Chandler USA disagreed with the proposed adjustments and filed a written protest of the proposed adjustments on December 23, 1994.
During the fourth quarter of 1995, after numerous discussions and preliminary consensus with the IRS, Chandler USA made a provision for possible assessments of additional taxes through 1992 and additional taxes attributable to amended returns for 1993 and 1994 in the amount of $536,000. During 1996, the IRS and Chandler USA executed a formal closing agreement, Chandler USA paid the taxes for the open tax years (1989 through 1994) and the IRS closed its examination.
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; and (vii) other factors including the ongoing litigation matters over which the Company has little or no control.