For the year ended December 31, 2006, Chandler USA had net income of $3.4 million compared to net income of $4.4 million for 2005 and a net loss of $7.0 million for 2004. The net loss in 2004 is primarily due to the adverse loss development experienced by NAICO. See "Losses and Loss Adjustment Expenses."
Estimating the ultimate loss and loss adjustment expense liability is a complex and judgmental process inasmuch as the amounts are based on management's informed estimates, assumptions and judgments using data currently available. The assumptions used in establishing reserves are regularly reviewed and updated by management as new data becomes available. Changes to estimates of previously established reserves are included in earnings in the period in which the estimate is changed. Such changes in estimates may be material. If the ultimate losses prove to differ substantially from the amounts previously recorded, the related adjustments could have a material adverse effect on Chandler USA's financial condition, results of operations and liquidity.
NAICO's loss reserves consist of case reserves and reserves for incurred but not reported ("IBNR") claims. Case reserves are established by claims personnel based on a review of the facts known at the time the claim is reported, and are subsequently revised as more information about a claim becomes known. IBNR is computed using various actuarial methods and techniques and includes reserves for losses that have occurred but for which claims have not yet been reported, including provision for expected future development on case reserves. As of December 31, 2006, NAICO's case reserves and IBNR for each line of business are shown in the following table.
For the standard lines program, NAICO's actuaries selected the results of the incurred loss development method for the 2004 and prior accident years. The 2005 and 2006 accident years were based on judgmentally selected loss ratios in order to adjust for the effect of case reserve strengthening that was recorded during these years. 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. The actuarial methods used in the 2006 loss reserve analysis were similar to those used in the 2005 analysis.
NAICO's statutory-based reserves (reserves calculated in accordance with accounting practices prescribed or permitted by an insurer's domiciliary state insurance regulatory authorities for purposes of financial reporting to regulators) do not differ from its reserves reported on the basis of GAAP. NAICO does not discount its reserves for unpaid losses and loss adjustment expenses.
In addition, Chandler USA, at December 31, 2006, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $53.8 million which expire in the years 2007 through 2026. At December 31, 2006, Chandler USA also had a capital loss carryforward for U.S. Federal income taxes of $2.4 million which expires in 2007. A valuation allowance has been provided for the tax effect of the state net operating loss and the net capital loss carryforwards since realization of such amounts is not considered more likely than not.
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 and 2006 experienced downward pressure, particularly for larger accounts. NAICO was able to increase its pricing for most coverages from 2001 through 2005. However, the recent industry trend has been for insurers to maintain or reduce rate levels, and NAICO has reduced its pricing in certain situations and for certain coverages including workers compensation during 2006. 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.
Insurance companies are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include the redefinition of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through coverage re-pricing, if permitted by applicable regulations, or limitations or cessation of the affected business.
Gross premiums earned decreased 1% in both 2005 and 2006. These decreases were primarily the result of NAICO's continued efforts to improve underwriting profitability, increased competition within the Oklahoma school districts portion of the political subdivisions program, and a decrease in surety bond premiums as NAICO no longer actively markets this program. The decreases in gross premiums earned were partially offset by premiums earned in the homeowners program which began during 2005. Gross premiums earned in Texas decreased 4% and 12% in 2005 and 2006, respectively, and gross premiums earned in Oklahoma decreased 4% and less than 1% in 2005 and 2006.
Gross premiums earned in the standard lines program decreased less than 1% in 2005 and 1% in 2006. Gross premiums earned in Texas decreased $4.9 million and $9.2 million in 2005 and 2006, respectively, and gross premiums earned in Oklahoma increased $906,000 and $4.6 million in 2005 and 2006. The decrease in Texas premiums was due primarily to a reduction in the number of agents producing this business for NAICO, as NAICO has been focusing on increasing premium production in Oklahoma and several other states. NAICO has also increased premiums from trucking accounts in 2005 and 2006. Gross premiums earned from trucking accounts increased $6.4 million and $8.9 million in 2005 and 2006, respectively, while net premiums earned increased $3.3 million and $5.3 million in these periods. Net premiums earned in the standard lines program increased 1% and decreased 1% in 2005 and 2006, respectively.
Gross premiums earned in the political subdivisions program decreased 14% and 23% in 2005 and 2006, respectively. The decrease in gross premiums earned is due primarily to increased competition related to Oklahoma school districts. Net premiums earned decreased 8% and 21% in 2005 and 2006, respectively. The decrease in net premiums earned was significantly less than the decrease in gross premiums earned because this program has a larger portion of property risks than other programs, and property risks have more reinsurance than other lines of business.
The average net yield on the fixed maturity portfolio, including net realized investment gains, was 4.0%, 3.4% and 3.6% in 2004, 2005 and 2006, respectively. The average net yield on the fixed maturity portfolio, excluding net realized investment gains, was 3.2% for 2004, 3.4% for 2005 and 3.6% for 2006. 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, 2006 was approximately $11.3 million. The average yield on the fixed maturity portfolio before deducting investment expenses was 3.6% in 2004, 3.8% in 2005 and 4.0% in 2006, excluding net realized capital gains.
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 84.0%, 56.5% and 69.2% in 2004, 2005 and 2006, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $761,000, $475,000 and $727,000 in 2004, 2005 and 2006, respectively, and increased the respective loss ratios by 1.2, 0.7 and 1.1 percentage points.
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 2004, 2005 and 2006, NAICO incurred charges of $282,000, $108,000 and $97,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
YEAR ENDED DECEMBER 31, -------------------------------- 2004 2005 2006 ---------- ---------- ---------- (In thousands)
Indirect underwriting expenses were 6.1%, 5.3% and 5.6% of total direct written and assumed premiums in 2004, 2005 and 2006, respectively. The decreases in 2005 and 2006 were due primarily to a reduction in employee related expenses. Indirect expenses include general overhead and administrative costs associated with the acquisition of new and renewal business, some of which is relatively fixed in nature, thus, the percentage of such expenses to direct written and assumed premiums will vary depending on Chandler USA's overall premium volume. Commissions received from reinsurers as a percentage of ceded reinsurance premiums were 33.3%, 31.6% and 31.1% in 2004, 2005 and 2006, respectively.
General and administrative expenses were 10.5%, 11.0% and 10.9% of gross premiums earned in 2004, 2005 and 2006, respectively. General and administrative expenses in 2004 included a recovery of certain litigation expenses of $359,000. 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.
As of December 31, 2006, NAICO had statutory earned surplus of $14.0 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2007 without the approval of the Oklahoma Department of Insurance is $5.2 million. NAICO paid shareholder dividends to Chandler USA totaling $3.4 million in June of 2004.
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, 2006 all of the investments of NAICO were in fixed-maturity investments, equity securities, mutual funds that invest in equity securities, interest-bearing money market accounts and collateralized repurchase agreements. 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 provided $20.2 million in cash from operations in 2004, used $131,000 in cash from operations in 2005 and provided $4.4 million in cash from operations in 2006. 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. 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. See "Litigation."
The following table provides the future payments due by period under contractual obligations as of December 31, 2006, aggregated by type of obligation:
On August 1, 2006, a jury trial concluded in Harris County, Texas, related to the construction of two gas processing plants in Louisiana. NAICO had provided surety bonds in connection with the construction of these plants. The amounts the jury found owing to NAICO include 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 October 30, 2006, NAICO filed its Motion for Entry of Judgment requesting that the Trial Court enter judgment for a total of $100.6 million plus court costs and anticipated attorney fees for appeals. This amount includes $70.0 million in punitive damages, $8.3 million in prejudgment interest through November 1, 2006, and attorney fees of $4.6 million through entry of judgment. The Trial Court denied the request for attorney fees on January 5, 2007. NAICO expects the Trial Court to enter judgment based upon its request during 2007. When entering judgment, the Court may enter judgment based upon NAICO's request or may enter a different judgment. After judgment is entered, all parties may file post-judgment motions. Following the Court's rulings on post-judgment motions, all parties may appeal all or any of those rulings or judgments.