The selected financial data has been derived from the consolidated financial statements of Chandler USA and its subsidiaries, which appear in Item 14(a). The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 1998 and 1999, and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for each of the three years in the period ended December 31, 1999, have been audited by Deloitte & Touche LLP, independent auditors, whose independent auditors report expresses an unqualified opinion and includes an explanatory paragraph relating to litigation. The Operating Data for the year ended December 31, 1995 and the Balance Sheet Data at December 31, 1995 and 1996 have been derived from Chandler USA and its subsidiaries financial accounts; such accounts having been included in the consolidated financial statements of Chandler Insurance. The selected financial data should be read in conjunction with "LEGAL PROCEEDINGS," "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS" and the consolidated financial statements of Chandler USA and the notes thereto appearing in Item 14(a). See Notes to Consolidated Financial Statements for various litigation and contingency matters.
NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Any changes in the estimates are reflected in current operating results. See Notes to Consolidated Financial Statements.
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 $145 million, or 86%, of NAICO's direct written premiums in 1999 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 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.
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. During 1999, the market value of NAICO's available for sale investments declined by $3.7 million due primarily to higher interest rates experienced during this time. 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. Since the late 1980's, the industry has generally had excess underwriting capacity. This condition has resulted in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO continues to experience pricing competition as the conditions of heightened price competition and impaired underwriting performance continue in the industry as a whole.
In 1998, NAICO believed that reinsurance market conditions were conducive to the purchase of additional reinsurance. During the first quarter of 1998, NAICO purchased additional reinsurance under its workers compensation and casualty reinsurance programs. During the second quarter of 1998, NAICO purchased additional reinsurance for its construction surety bond reinsurance program. The purchase of the additional reinsurance coverages in 1997 and 1998 substantially reduced the per occurrence retention for NAICO's workers compensation, casualty, surety bond and nonstandard private-passenger automobile lines of business, but resulted in significantly lower net premiums earned, losses and loss adjustment expenses and policy acquisition costs. The purchase of additional reinsurance also resulted in an increase in reinsurance recoverables on unpaid losses, prepaid reinsurance premiums and premiums payable and a decrease in deferred policy acquisition costs. See "Premiums Earned" and "Policy Acquisition Costs." During the fourth quarter of 1999, NAICO agreed to rescind two reinsurance treaties which covered a portion of its workers compensation business and which had been in effect since January 1, 1999. The reinsurer agreed to return the reinsurance premiums that had been paid by NAICO during 1999, less losses and ceding commissions that had been paid by the reinsurer. The reinsurer also agreed to pay NAICO a fee of $10.0 million as additional compensation for entering into the agreement. In January 2000, NAICO received payment in the amount of $12.9 million relating to the transaction.
Gross premiums earned, before reductions for premiums ceded to reinsurers, increased 13%, 8% and 21% in 1997, 1998 and 1999, respectively. The increases are primarily attributable to an increase in written premium production in Texas and Oklahoma, which we believe resulted from increased marketing efforts in these states and new insurance programs in Texas. Net premiums earned, after such reductions, increased 3% in 1997, decreased 35% in 1998 and increased 66% in 1999. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance for NAICO's workers compensation, casualty and nonstandard private-passenger automobile insurance programs described previously. The rescission of two reinsurance treaties increased net premiums earned in 1999 by $19.6 million. See "Purchase of Additional Reinsurance."
Nonstandard private-passenger automobile gross premiums earned decreased 14%, 58% and 98% in 1997, 1998 and 1999, respectively. Net premiums earned in the nonstandard private-passenger automobile program decreased 47%, 95% and 99% in 1997, 1998 and 1999, respectively. During 1997, NAICO discontinued the Oklahoma and Arizona portions of its nonstandard private-passenger automobile program. Effective July 1, 1997, NAICO entered into a 100% quota share reinsurance agreement to fully reinsure the risk in the California portion of the program. NAICO has discontinued the California program.
Net interest income increased 8% in 1997 and decreased 20% and 19% in 1998 and 1999, respectively. The decrease in 1998 was due primarily to lower interest rates in 1998 and a reduction in invested assets due to the purchase of additional reinsurance in 1998. In addition, during the fourth quarter of 1997, NAICO shifted a portion of its fixed maturities portfolio from taxable to tax exempt bonds (which generally have a lower before-tax yield). In late 1998 and the first quarter of 1999, NAICO shifted approximately half of its investment in tax exempt bonds to taxable bonds. Net income from tax exempt securities was $112,000, $1.0 million and $483,000 in 1997, 1998 and 1999, respectively. The decrease in net interest income in 1999 was due primarily to a reduction in invested assets due to the purchase of additional reinsurance. Net realized investment gains were $790,000, $1 million and $57,000 in 1997, 1998 and 1999, respectively.
The average net yield on Chandler USA's portfolio, including net realized investment gains, was 6.5%, 5.9% and 4.3% in 1997, 1998 and 1999, respectively. The average net yield on the portfolio, excluding net realized investment gains, was 5.9%, 5.5% and 4.2% for 1997, 1998 and 1999, respectively. The decrease in the average net yield in 1999 was due primarily to an increase in 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, 1999 was approximately $14 million. The average yield on the portfolio before deducting investment expenses was 6.3%, 5.7% and 5.6% in 1997, 1998 and 1999, respectively, excluding capital gains.
Chandler USA's income from commissions, fees and other income decreased 31%, 26% and 15% for 1997, 1998 and 1999, respectively. The majority of Chandler USA's income from commissions, fees and other income are from L&W's brokerage commissions and fees.
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 27.9%, 25.2% and 24.8% in 1997, 1998 and 1999, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 12.9%, 11.5% and 12.1%. Indirect underwriting expenses were 10.5%, 10.3% and 9.6% of total direct written and assumed premiums in 1997, 1998 and 1999, respectively. 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 NAICO's overall premium volume.
General and administrative expenses were 10.1%, 8.8% and 7.0% of gross premiums earned and commissions, fees and other income (excluding the fee related to the rescission of the reinsurance treaties) in 1997, 1998 and 1999, respectively. 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. General and administrative expenses decreased 5.9% in 1998, due primarily to a reduction in costs attributable to Network. Network ceased functioning as a third party administrator during 1997. General and administrative expenses decreased 4.3% in 1999.
Interest expense increased 203%, 101% and 69% 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."
Litigation expenses reflect expenses related to the ongoing legal proceedings involving the CenTra Group. Litigation expenses were $923,000 in 1997 compared to $423,000 in 1998 and $207,000 in 1999. Increased or renewed activity could result in greater litigation expenses in 2000 or future years.
Certain litigation expenses may be recovered from Chandler Insurance's directors and officers liability insurer ("D&O Insurer"). As a result of various events in 1995, Chandler Barbados and Chandler USA recorded $654,000 and $164,000, respectively, estimated recoveries of costs from the D&O Insurer related to a $1 million claim for reimbursable amounts previously paid that relate to allowable defense and litigation costs for such parties. In 1996, Chandler Barbados and Chandler USA recorded additional estimated recoveries of $102,000 and $880,000, respectively. Chandler Barbados and Chandler USA received payments for the 1995 claim during 1996 in the amount of $636,000 and $159,000, respectively. In connection with the U.S. District Court in Oklahoma City, Oklahoma ("Oklahoma Court") judgments, Chandler Barbados recorded an additional estimated recovery of $2.7 million from the D&O Insurer. Chandler Insurance and its subsidiaries are entitled to a total of $5 million under the applicable insurance policy to the extent they have advanced reimbursable expenses. Some amounts have been previously paid without dispute and Chandler Insurance is negotiating with the D&O Insurer for payment of the policy balance. Chandler Insurance and its subsidiaries could recover the remaining policy limits or could compromise their claim, and could incur significant costs in either case. The estimated insurance recovery is based upon these variable factors.
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 $790,000, $1.0 million and $57,000 during 1997, 1998 and 1999, respectively, from the sale of investments. In addition, NAICO received proceeds of $36.2 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 its portfolio, NAICO chose to liquidate certain fixed maturity securities that were available for sale prior to their maturities. The average maturity of NAICO's investments was 4.5 years and 4.0 years at December 31, 1998 and 1999, respectively.
In 1992, Chandler USA and its affiliates became involved in certain legal proceedings beyond the ordinary course of business. Note 10 to Consolidated Financial Statements describes the extensive CenTra litigation related to Chandler USA and its affiliates and the CenTra Group.
During December 1999, Chandler Insurance acquired 1,989,200 shares of its own stock in exchange for payment of $15,204,758 to CenTra and its affiliates pursuant to a divestiture plan proposed by NAICO and approved by the U.S. District Court for the District of Nebraska ("Nebraska Court"). All shares were canceled upon their return to Chandler Insurance. Based on an April 22, 1997 judgment by the Oklahoma Court, Chandler Insurance had previously recorded the return of 517,500 of the 1,989,200 shares as a decrease to shareholders' equity during 1997. The Nebraska Court had ordered CenTra to divest all shares of Chandler Insurance owned or controlled by it or its affiliates. An additional share block owned by CenTra and affiliates consists of 1,142,625 shares which will be divested following a ruling on CenTra's appeal of a judgment entered by an Oklahoma Court in April 1997. That judgment requires CenTra to transfer the shares to Chandler Insurance in exchange for payment of $6,882,500. Based on the April 22, 1997 judgment and subsequent actions by the Oklahoma Court, Chandler Insurance previously recorded the return of the 1,142,625 shares as a decrease to shareholders' equity during 1997. Following the conclusion of the appeal, the Nebraska Court will determine the method of divestiture of these shares. The appellate court heard oral arguments on November 15, 1999. Chandler Insurance cannot predict when the appellate court will rule on the appeal.
Through the first two months of the year 2000, Chandler USA had not experienced any significant problems or disruptions related to Year 2000 Problems (as described below). Chandler USA 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 Chandler USA. While it is possible that certain Year 2000 Problems may exist but have not yet materialized, Chandler USA 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 Chandler USA.
Chandler USA believes, based on the information currently available, that the most reasonably likely worst case scenarios resulting from Year 2000 Problems include:
- Legal risks arising from failure of NAICO or L&W to provide contracted services, deal with claims on a timely basis, provide pertinent data to those dependent upon the data and similar risks; - Increased operational costs due to manual processing, data corruption or disaster recovery; - Inability to bill or invoice; - Lost revenue resulting from the inability to render accurate billings and from the inability to efficiently market insurance products; - Increased legal and accounting expenses; - Fines and associated expenses resulting from inability to comply with regulatory requirements; and - Failure of management controls.
It is possible that the credit or operating ability of agents, reinsurers and others with whom Chandler USA maintains commercial relationships may be adversely affected by one or more unforeseen circumstances caused by Year 2000 Problems. However, Chandler USA 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, Chandler USA has developed plans to attempt to minimize identified third-party exposures. Chandler USA has requested information from its major vendors and service providers to assess their year 2000 readiness. Chandler USA cannot predict the adverse impact, if any, of Year 2000 Problems upon parties with whom it does business.
It is possible that future court interpretations of policy language based on specific facts, or legislation mandating coverage, could result in coverage for losses attributable to Year 2000 Problems. Such decisions or legislation could have a material adverse impact on Chandler USA. It is also possible that NAICO may incur expenses defending claims for which it is ultimately determined there is no insurance coverage.