Chandler USA and its subsidiaries own and occupy four office buildings with approximately 127,000 square feet of usable space in Chandler, Oklahoma. Chandler USA believes such space is sufficient for its operations for the foreseeable future.
For the year ended December 31, 2007, Chandler USA had a net loss of $662,000 compared to net income of $3.4 million for 2006 and a net income of $4.4 million for 2005. The net loss in 2007 was primarily due to the reversal of a portion of the prejudgment interest income that was accrued during 2006 on a favorable jury verdict. This is discussed in more detail under "Litigation" and in Note 10 to Consolidated Financial Statements.
Management believes that its unpaid losses and related reinsurance recoverables are fairly stated as of December 31, 2007. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management's informed estimates, assumptions and judgments using data currently available.
In addition, Chandler USA, at December 31, 2007, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $34.3 million which expire in the years 2008 through 2027. A valuation allowance has been provided for the tax effect of the state net operating loss since realization of such amount is not considered more likely than not.
The impact of a recession on Chandler USA 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. Much of NAICO's insurance business is concentrated in the Southwest and Midwest areas of the United States. Approximately $70.6 million, or 71%, of NAICO's direct written and assumed premiums in 2007 were in the states of Oklahoma and Texas. An economic downturn in these states could have a significant adverse impact on Chandler USA. A recession might also cause defaults on fixed-income securities or a decrease in the value of equity securities owned by NAICO. 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.
Gross premiums earned decreased 1% and 7% in 2006 and 2007, respectively. The decrease in 2006 was primarily the result of NAICO's continued efforts to improve underwriting profitability and to increased competition within the Oklahoma school districts portion of the political subdivisions program. The decrease in gross premiums earned in 2006 was partially offset by an increase in gross premiums earned in the homeowners program. The homeowners program was discontinued during 2006. The decrease in 2007 gross premiums earned was due primarily to the transfer of property and inland marine business in the standard lines and political subdivisions programs to Praetorian Insurance Company ("Praetorian") as explained further below and to the discontinuation of the homeowners program. The decrease in gross premiums earned in 2007 was partially offset by an increase in gross premiums earned in the standard lines program. Gross premiums earned in Texas decreased 12% and 29% in 2006 and 2007, respectively, and gross premiums earned in Oklahoma decreased less than 1% in 2006 and 14% in 2007.
Gross premiums earned in the standard lines program decreased 1% in 2006 and increased 11% in 2007. Gross premiums earned for workers compensation business decreased $2.3 million or 9% in 2006, but increased $5.1 million or 22% in 2007. NAICO has also increased premiums from trucking accounts in 2006 and 2007. Gross premiums earned from trucking accounts increased $8.9 million and $12.0 million in 2006 and 2007, respectively, while net premiums earned increased $5.3 million and $7.7 million in these periods. Net premiums earned in the standard lines program decreased 1% in 2006 and increased 15% in 2007.
Gross premiums earned in the political subdivisions program decreased 23% and 65% in 2006 and 2007, respectively. The decrease in gross premiums earned is due primarily to the transfer of the property and inland marine business in this program to Praetorian as described previously, and to increased competition related to Oklahoma school districts. Net premiums earned decreased 21% and 35% in 2006 and 2007, respectively. The decrease in net premiums earned was significantly less than the decrease in gross premiums earned because of the significant amounts of reinsurance that NAICO had purchased for the property and inland marine lines of business in this program.
Other programs in the preceding table include premiums from the runoff of various programs which are no longer offered by NAICO and NAICO's participation in various mandatory pools covering workers compensation for insureds that were unable to purchase this coverage from an insurance company on a voluntary basis.
At December 31, 2007, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate bonds and certificates of deposit insured by the FDIC, with approximately 34% 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 investment income included $6.6 million for the accrual of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims in 2006. During 2007, NAICO reversed $4.1 million of the prejudgment interest income based on a final judgment entered by the court. See Litigation and Note 10 of Notes to Consolidated Financial Statements.
Net investment income, excluding interest income from related parties and the prejudgment interest, increased 13% in both 2006 and 2007. Interest income from related parties was $670,000, $792,000 and $941,000 during 2005, 2006 and 2007, respectively. The increases were due primarily to higher interest rates and to an increase in the amount loaned to Chandler Insurance during 2007. See Liquidity and Capital Resources.
Net realized investment gains were $383,000, $745,000 and $214,000 in 2005, 2006 and 2007, respectively.
The average net yield on the fixed maturity portfolio, including net realized investment gains, was 3.4%, 3.6% and 4.0% in 2005, 2006 and 2007, respectively. The average net yield on the fixed maturity portfolio, excluding net realized investment gains, was 3.4% for 2005, 3.6% for 2006 and 3.8% for 2007. 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, 2007 was approximately $12.8 million. The average yield on the fixed maturity portfolio before deducting investment expenses was 3.8% in 2005, 4.0% in 2006 and 4.2% in 2007, excluding net realized capital gains.
Chandler USA 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 are periodically reviewed by independent professional actuaries. See "BUSINESS - Reserves."
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 56.5%, 69.2% and 62.5% in 2005, 2006 and 2007, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $475,000, $727,000 and $109,000 in 2005, 2006 and 2007, respectively, and increased the respective loss ratios by 0.7, 1.1 and 0.2 percentage points.
In 2005 and 2006, the majority of the adverse loss development was in the automobile liability line of business, as reserves were strengthened in the 1999-2005 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. During 2007, a portion of these estimated recoveries were reduced based on a final judgment entered by the court regarding certain surety bond claims. The reduction of the estimated recoveries accounted for $1.8 million of the loss development for surety business during 2007. 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.
The following table sets forth the net reserves at the beginning of each accident year, the loss development incurred during each calendar year, and the re-estimated net reserves as of the beginning of each calendar year.
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 2005, 2006 and 2007, NAICO incurred charges of $108,000, $97,000 and $356,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
Interest expense increased 6% in 2006 and increased less than 1% in 2007. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. The increase in 2006 was due primarily to the increase in interest rates during the period, as a portion of Chandler USA's junior subordinated debentures were issued with a floating interest rate.
Chandler USA's federal income tax benefit (provision) as a percentage of income (loss) before income taxes was 35.6%, 32.9% and 11.6% for 2005, 2006 and 2007, respectively. The 2007 percentage decreased due primarily to the impact of nondeductible expenses on the net loss before income taxes.
Historically, NAICO has played a significant role in the servicing of debt and other obligations of Chandler USA through the payment of shareholder dividends. These obligations include $7.0 million of 8.75% senior debentures due in 2014, $13.4 million of 9.75% junior subordinated debentures due in 2033, $7.2 million of floating rate junior subordinated debentures due in 2034 and the obligations under the sale and leaseback transaction discussed below. 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 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, 2007, all of the investments of NAICO were in fixed-maturity investments, certificates of deposit insured by the FDIC, 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 $131,000 in cash from operations in 2005 and provided $4.4 million and $8.7 million in cash from operations in 2006 and 2007, respectively. 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. The cash provided by operations in 2006 included a decrease in reinsurance recoverable on unpaid losses of $29.2 million, but this was largely offset by a decrease in unpaid losses and loss adjustment expenses of $26.3 million. These decreases were primarily the result of recording additional estimated recoveries related to a favorable jury verdict in civil litigation regarding certain surety bond claims during 2006. The cash provided by operations in 2007 included an increase in unpaid losses and loss adjustment expenses of $17.3 million, but this was offset in part by an increase in reinsurance recoverable on unpaid losses of $10.6 million. These increases were primarily the result of reducing the estimated recoveries on certain surety bond claims based on a final judgment entered by the court. See "Litigation."
Cash flows from investing activities were primarily the result of normal purchases and sales of investment securities. Net realized investment gains before income taxes were $383,000, $745,000 and $214,000 during 2005, 2006 and 2007, respectively, from the sale of investments. NAICO received proceeds of $2.5 million, $21.3 million and $17.6 million during 2005, 2006 and 2007, respectively, from the sale of available for sale securities prior to their maturity. The market value of NAICO's available for sale fixed-income investments decreased by $1.6 million and $1,000 in 2005 and 2006, respectively, and increased $2.2 million in 2007 due primarily to changes in interest rates experienced during this time. The average maturity of NAICO's fixed maturity investments was 3.4 years and 2.6 years at December 31, 2006 and 2007, respectively.
Cash flows from financing activities were primarily the result of payments and loans between Chandler USA and Chandler Insurance. 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, 2006 and 2007, Chandler USA had a receivable of $9.6 million and $11.5 million, respectively, under the Credit Agreement, and Chandler USA earned $614,000, $733,000 and $881,000 in interest income under the Credit Agreement during 2005, 2006 and 2007, respectively.
The following table provides the future payments due by period under contractual obligations as of December 31, 2007, aggregated by type of obligation:
In October 1999, NAICO provided surety bonds for Gulsby Engineering, Inc. ("Gulsby") in connection with contracts between Gulf Liquids New River Project, LLC ("Gulf Liquids") and Gulsby for the construction of two gas processing plants in Louisiana. During 2001, Gulsby became unable to pay various vendors resulting in payments to vendors by NAICO totaling $20,182,499. In August 2001, NAICO filed suit in federal court in Louisiana alleging that Gulf Liquids had breached its obligations under the bonds by materially altering certain contracts and that as a result, NAICO was exonerated on the bonds and should recover the amounts paid to vendors. In the fall of 2001, Gulsby and Bay Limited, another contractor with whom Gulsby had entered into a joint venture for the construction of other gas processing plants for Gulf Liquids, filed lawsuits relating to those plants in Houston, Texas. Gulf Liquids filed original actions and counterclaims. NAICO intervened in the Texas lawsuits and, in addition, sued Williams Energy Marketing and Trading (which later became Williams Power Company, Inc.) ("Williams") alleging fraud, breach of contract, tortious interference with contractual relations, conspiracy and alter ego. These claims were asserted against both Gulf Liquids and Williams. Gulf Liquids asserted counterclaims alleging breach of contract against NAICO and requesting contractual and statutory damages ranging from $40 million to $80 million. The cases were consolidated for trial in the 215th Judicial District Court in Harris County, Texas. On August 1, 2006, the jury trial concluded in Harris County, Texas, related to the construction of two gas processing plants in Louisiana. The amounts the jury found owing to NAICO included approximately $20.2 million in actual damages and $70.0 million in punitive damages. See Note 10 of Notes to Consolidated Financial Statements for a discussion of this jury verdict.
On January 28, 2008, the court entered a final judgment denying Gulf Liquid's claims against NAICO and Gulsby, denying all of NAICO's claims against Gulf Liquids and Williams, and entering judgment for Gulsby against Gulf Liquids for $15,651,927 plus interest at 7.25% compounded annually from January 28, 2008 until paid. The court also ordered Gulf Liquids to pay Gulsby's taxable court costs, estimated at $100,000. All parties may appeal all or any of these judgments.