Chandler USA is engaged in various property and casualty insurance operations through its wholly owned subsidiaries, NAICO and CIMI. NAICO writes various property and casualty insurance products through three separate marketing programs: standard property and casualty, political subdivisions and homeowners. The lines of insurance written by NAICO are commercial coverages consisting of workers compensation, automobile liability, other liability (including general liability, products liability and umbrella liability), automobile physical damage, property, surety and inland marine. Beginning in 2005, NAICO also writes homeowner and dwelling fire and allied lines policies in the state of Texas through a managing general agent. NAICO markets these products through a network of independent insurance agents. A portion of the insurance written by NAICO is reinsured by Chandler USA's parent Chandler Insurance. CIMI maintains certain wholesale operations related to NAICO's school districts and trucking insurance.
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, 2005, NAICO's case reserves and IBNR for each line of business are shown in the following table.
The following table shows the recorded reserves and the high and low point estimates based on the results of the various actuarial methods described above as of December 31, 2005.
Management believes that its unpaid losses and related reinsurance recoverables are fairly stated as of December 31, 2005. 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, 2005, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $54.2 million which expire in the years 2006 through 2025. At December 31, 2005, Chandler USA also had a capital loss carryforward for U.S. Federal income taxes of $3.1 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.
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 $100.1 million, or 83%, of NAICO's direct written and assumed premiums in 2005 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 the equity mutual funds 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.
Net investment income, excluding interest income from related parties, increased 48% in 2004 and decreased 12% in 2005. The increase in 2004 was due primarily to NAICO receiving $577,000 in interest from an arbitration award in addition to an increase in fixed maturity investments during the year. The interest received from the arbitration award in 2004 attributed to the decrease in 2005. Excluding the arbitration interest, Chandler USA's net investment income increased 7% in 2005. Interest income from related parties was $412,000, $491,000 and $670,000 during 2003, 2004 and 2005, respectively. The increase in 2004 was due primarily to an increase in the amount loaned to Chandler Insurance. The 2005 increase was due primarily to higher interest rates. See Liquidity and Capital Resources.
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2001- 2005 calendar years. The loss development occurred primarily in the 1997-2001 accident years. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. The development was primarily a function of more adverse frequency and severity patterns than previously anticipated. Since such development patterns were not present in the loss history available at the time the earlier estimates were prepared, they could therefore not be anticipated. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results.
During 2005, NAICO experienced adverse loss development totaling $6.3 million primarily in the standard property and casualty and political subdivisions programs. A portion of the adverse development was offset by favorable development of $1.8 million in the surety bond program, primarily in accident years 1994 and 2001 that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the workers compensation, other liability and automobile liability lines of business in the 2000, 2002 and 2003 accident years. The adverse loss development included approximately $108,000 for provisions for potentially uncollectible reinsurance.
In the last five years, management has undertaken several initiatives to improve the quality and profitability of business. These initiatives included significant rate increases, changes in coverage forms that limit or eliminate coverage, reduction or elimination of classes of business that have not been profitable, reduction or elimination of business in geographic areas that have not been profitable and increased emphasis on risk selection. Management has also improved case reserving which improves the overall reserving accuracy and also leads to better underwriting decisions.
Indirect underwriting expenses were 6.5%, 6.1% and 5.3% of total direct written and assumed premiums in 2003, 2004 and 2005, respectively. The decrease in 2005 was 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 28.0%, 33.3% and 31.6% in 2003, 2004 and 2005, respectively.
General and administrative expenses were 10.7%, 10.5% and 11.0% of gross premiums earned in 2003, 2004 and 2005, respectively. General and administrative expenses decreased $1.1 million in 2004 due primarily to a reduction in employee related expenses and to 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.
Interest expense decreased 2% in 2004 and increased 6% in 2005. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. The increase in 2005 was due primarily to the increase in interest rates during 2005, as a portion of Chandler USA's junior subordinated debentures were issued with a floating interest rate.
As of December 31, 2005, NAICO had statutory earned surplus of $9.6 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2006 without the approval of the Oklahoma Department of Insurance is $5.7 million. NAICO paid shareholder dividends to Chandler USA totaling $3.4 million in June of 2004.
Cash flows from investing activities during 2003 and 2004 were primarily the result of normal purchases and sales of investment securities. During 2004, NAICO purchased $8.1 million of mutual funds that invest in equity securities. Net realized investment gains before income taxes were $2,351,000, $652,000 and $383,000 during 2003, 2004 and 2005, respectively, from the sale of investments. NAICO received proceeds of $24.5 million, $23.8 million and $2.5 million during 2003, 2004 and 2005, respectively, from the sale of available for sale securities prior to their maturity. The proceeds and related net realized investment gains in 2003 provided cash for operating activities due to the decrease in written premiums. During 2003, 2004 and 2005, the market value of NAICO's available for sale fixed-income investments decreased by $500,000, $581,000 and $1.6 million, respectively, due primarily to changes in interest rates experienced during this time. The average maturity of NAICO's fixed maturity investments was 4.9 years and 4.0 years at December 31, 2004 and 2005, respectively.
Cash flows from financing activities during 2003 included $19.3 million in proceeds from the issuance of junior subordinated debentures net of related issuance costs and purchase of common securities of related trusts, less $12.8 million for payments to purchase $16.7 million principal amount of Chandler USA's Debentures. See Note 5 to Consolidated Financial Statements.
Certain officers and directors of Chandler USA and Chandler Insurance were named as defendants in certain litigation involving CenTra, Inc. ("CenTra"). This litigation was concluded in 2002. As a result of various events in 1995, 1996 and 1997 related to the CenTra litigation, Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") and Chandler USA recorded estimated recoveries of costs from its Director and Officer Liability Insurance policy totaling $3,456,000 and $1,044,000, respectively, for reimbursable amounts previously paid that relate to allowable defense and litigation costs. Chandler Barbados and Chandler USA received payment for a 1995 claim during 1996 in the amount of $636,000 and $159,000, respectively. Chandler Insurance assumed Chandler Barbados' remaining receivable in December 2003 under the reorganization of these companies. During June 2004, Chandler Insurance and Chandler USA received payment in the amount of $558,000 and $167,000, respectively, in exchange for releasing certain insurers with respect to policies covering periods from June 28, 1997 up to June 28, 2002. During the third quarter of 2004, Chandler Insurance and its subsidiaries settled the remaining litigation with the insurer for policy periods from June 28, 1992 to June 28, 1997. Based on the terms of the settlement, Chandler Insurance and Chandler USA recorded additional estimated recoveries of $1,204,000 and $359,000, respectively, during the third quarter of 2004. Chandler Insurance and Chandler USA received payment of $3,527,000 and $1,053,000, respectively, during December 2004 and received payment of the remaining settlement funds of $497,000 and $192,000 during the first quarter of 2005.