Chandler USA and its subsidiaries own and occupy four office buildings with approximately 127,000 square feet of usable space in Chandler, Oklahoma. NAICO also leases approximately 1,500 square feet for a branch office in Richardson, Texas. Chandler USA believes such space is sufficient for its operations for the foreseeable future.
The selected financial data has been derived from the consolidated financial statements of Chandler USA and its subsidiaries, which appear in Item 15(a). The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 2000, and the related consolidated statement of operations, comprehensive income, shareholder's equity and cash flows for the years ended December 31, 2000 were audited by Deloitte & Touche LLP, independent auditors, whose independent auditors' report expressed an unqualified opinion and included an explanatory paragraph relating to litigation. The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 2001, 2002 and 2003 and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for the years ended December 31, 2001, 2002 and 2003 have been audited by Tullius Taylor Sartain & Sartain LLP, independent auditors, whose independent auditors' report expresses an unqualified opinion. The selected financial data should be read in conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and the consolidated financial statements of Chandler USA and the notes thereto appearing in Item 15(a). All periods have been restated to reflect the results of L&W as a discontinued operation.
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 surety bonds (including both construction bonds and bail bonds). 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. 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.
Chandler USA agreed to indemnify Brown & Brown, Inc. for any breach of a representation, warranty or covenant made in connection with the sale for a period of three years, and has deposited cash in the amount of $500,000 into a trust account for the benefit of Brown & Brown, Inc. as security. Prior to completing the sale, L&W transferred its real estate to NAICO, and transferred substantially all of its remaining assets and liabilities, primarily premiums receivable and premiums payable, to Chandler USA through a shareholder dividend. Following the completion of the sale, L&W changed its name to Brown & Brown of Central Oklahoma, Inc.
The preparation of financial statements in conformity with GAAP requires the application of accounting policies that often involve a significant degree of judgment. Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods. If management determines, as a result of its consideration of facts and circumstances, that changes in estimates and assumptions are appropriate, results of operations and financial position as reported in the consolidated financial statements may change significantly. Management has identified the following accounting policies as critical in understanding Chandler USA's reported financial results.
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. Such changes in estimates may be material. 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 $103 million, or 87%, of NAICO's direct written premiums in 2003 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.
Gross premiums earned in the political subdivisions program increased 3% in 2002 and decreased 18% in 2003. Gross premiums earned in the school districts portion of the program increased $4.5 million in 2002 and decreased $3.9 million in 2003. Gross premiums earned for the municipalities portion of the program decreased $3.5 million and $2.3 million in 2002 and 2003, respectively, as NAICO discontinued writing most of these accounts. Net premiums earned increased 10% in 2002 and decreased 41% in 2003. The quota share reinsurance reduced net premiums earned by $1.8 million and $835,000 in this program in 2001 and 2002, respectively. The decrease in 2003 was due to the decrease in gross premiums earned, and to Chandler Insurance assuming a portion of the risk for the property and automobile physical damage coverages.
At December 31, 2003, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Government and high-quality corporate bonds, with approximately 10% 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 interest income from continuing operations, excluding interest income from related parties, decreased 30% and 15% in 2002 and 2003, respectively. The decreases were due primarily to lower interest rates. Interest income from related parties was $380,000 and $412,000 during 2002 and 2003, respectively. See Liquidity and Capital Resources.
Net realized investment gains were $2,654,000, $794,000 and $2,351,000 in 2001, 2002 and 2003, respectively. The net realized investment gains in 2001 and 2002 resulted primarily from sales of fixed maturity investments available for sale to provide cash for operating activities due to the decrease in written premiums. Realized investment gains in 2003 included a gain of $1.7 million from the sale of 19,371 shares of common stock of Insurance Services Office, Inc. ("ISO") that was recorded during the second quarter of 2003. NAICO received these shares in 1997 as a result of ISO converting to a for-profit corporation.
The average net yield on the portfolio, including net realized investment gains, was 7.7%, 4.8% and 6.7% in 2001, 2002 and 2003, respectively. The average net yield on the portfolio, excluding net realized investment gains, was 4.4%, 3.7% and 3.2% for 2001, 2002 and 2003, respectively. 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, 2003 was approximately $11 million. The average yield on the portfolio before deducting investment expenses was 5.9%, 4.4% and 3.6% in 2001, 2002 and 2003, respectively, excluding capital gains.
During 2003, Chandler USA's other income included a $3.1 million gain on the purchase and cancellation of $16.7 million of its Debentures. In addition, the amortization of a deferred gain related to a sale and leaseback transaction increased other income by $1.7 million. The deferred gain is being amortized into income over the final year of the lease following the exercise of the option for Chandler USA to repurchase the equipment at the end of the lease.
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 75.1%, 75.7% and 65.7% in 2001, 2002 and 2003, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $2.0 million, $1.5 million and $1.9 million in 2001, 2002 and 2003, respectively, and increased the respective loss ratios by 2.9, 2.2 and 3.4 percentage points.
During 2002, NAICO experienced incurred losses related to prior accident years totaling $15.8 million primarily in the standard property and casualty program including both liability lines and workers compensation. This adverse development is generally the result of ongoing analysis of recent loss development trends that reflect an increase in loss severity within the 1997-2000 accident years. The adverse loss development included approximately $2.0 million for provisions for potentially uncollectible reinsurance and deductibles.
Reliance reinsured NAICO for certain workers compensation risks during 1998. At December 31, 2003, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses of approximately $3.1 million. During October 2001, the Commonwealth of Pennsylvania placed Reliance in liquidation. At this time, NAICO is unable to determine the amount of its reinsurance recoverables from Reliance that will ultimately be collected and has fully reserved the carrying value of such amounts as of December 31, 2003. 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 2001, 2002 and 2003, NAICO incurred charges of $454,000, $1.7 million and $604,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.7%, 23.8% and 25.1% in 2001, 2002 and 2003, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 14.6%, 14.4% and 14.9%. The increase in commission expense was primarily due to an increase in contingent commissions to agents that resulted from lower loss ratios than had been projected for these agents. Premium taxes decreased $1.5 million in 2002 due to the decrease in written premiums, a decrease in expenses associated with guaranty fund assessments and the elimination of a 2% tax on workers compensation premiums written in Oklahoma. However, an increase in premium related assessments in Oklahoma offset part of this savings. Expenses associated with guaranty fund assessments, net of applicable premium tax credits, were approximately $489,000, $31,000 and $32,000 in 2001, 2002 and 2003, respectively. NAICO may receive additional guaranty fund assessments in the future related to insolvent insurance companies. At this time, NAICO is unable to estimate the amount of such assessments.
NAICO maintains a liquid operating position and follows investment guidelines that are intended to provide for an acceptable return on investment while preserving capital, maintaining sufficient liquidity to meet obligations and keeping a sufficient margin of capital and surplus to ensure unimpaired ability to write insurance. As of December 31, 2003, all of NAICO's fixed-maturity investments were rated Aa3 or AA or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively.
Chandler USA used $27.8 million, $7.5 million and $6.0 million in cash from operations during 2001, 2002 and 2003, respectively. During this time, written premiums decreased from $197.2 million in 2000 to $159.0 million in 2001, $140.2 million in 2002 and $118.4 million in 2003. The decreases in written premiums were due to NAICO's re-underwriting its book of business, and discontinuing certain accounts and classes of business where premium rates were not believed to be adequate. Cash flow from operations is negatively impacted during times when premiums decline since claim payments for any given year will include payments for claims on insurance policies written in prior years. The cash used by operations was largely funded from sales and maturities of investments and certain financing activities described below.
Cash flows from investing activities during 2003 were primarily the result of normal purchases and sales of investment securities. Net realized investment gains before income taxes were $2,654,000, $794,000 and $2,351,000 during 2001, 2002 and 2003, respectively, from the sale of investments. NAICO received proceeds of $73.1 million, $31.5 million and $24.5 million during 2001, 2002 and 2003, respectively, from the sale of available for sale securities prior to their maturity. The proceeds and related net realized investment gains in 2001, 2002 and 2003 provided cash for operating activities due to the decrease in written premiums. During 2003, the market value of NAICO's available for sale fixed-income investments decreased by $500,000 due primarily to changes in interest rates experienced during this time. The average maturity of NAICO's investments was 3.1 years and 5.0 years at December 31, 2002 and 2003, respectively. Cash flows from investing activities also included $3.8 million from a sale and leaseback transaction for certain equipment owned by Chandler USA during 2001. During 2003, Chandler USA exercised its option to repurchase the equipment at the end of the lease for approximately $3.0 million. The deferred gain is being amortized into income over the final year of the lease, resulting in other income of $1.7 million in 2003. See Note 12 to Consolidated Financial Statements. Cash flows from investing activities also included proceeds from the sale of L&W in 2002 of $3.1 million net of cash disposed of as part of the sale. See Note 4 to Consolidated Financial Statements for more information.
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. In accordance with its Articles of Association, Chandler Insurance and its subsidiaries have advanced the litigation expenses of these persons in exchange for undertakings to repay such expenses if those persons are later determined to have breached the standard of conduct provided in the Articles of Association. These expenses together with certain other expenses may be recovered from Chandler Insurance's director and officer liability insurance policy (the "D&O Insurer"). As a result of various events in 1995, 1996 and 1997, Chandler Barbados and Chandler USA recorded estimated recoveries of costs from its D&O Insurer totaling $3,456,000 and $1,044,000, respectively, for reimbursable amounts previously paid that relate to allowable defense and litigation costs for such parties. Chandler Barbados and Chandler USA received payment for a 1995 claim during 1996 in the amount of $636,000 and $159,000, respectively. The balance of $2,820,000 and $885,000 is included in other assets in Chandler Insurance's and Chandler USA's respective balance sheets. Chandler Insurance assumed this receivable from Chandler Barbados during December 2003 under the reorganization of these companies. Chandler Insurance and its subsidiaries contend they are entitled to a total of $5 million under the applicable insurance policy to the extent they have advanced reimbursable expenses. The D&O Insurer contends that certain policy provisions exclude coverage for these claims. On August 22, 2001, Chandler Insurance and its subsidiaries, including Chandler USA, filed an action in the State District Court in Oklahoma City, Oklahoma ("Oklahoma State Court") alleging that the director and officer liability insurance policies should be rescinded and seeking repayment of more than $5 million in premiums they previously paid. Chandler Insurance and its subsidiaries are currently involved in litigation with the insurer for payment of the policy balance or rescission and repayment of premiums previously paid. The litigation is pending in the Oklahoma State Court. The case is still in the early pleading stages and Chandler USA cannot predict the date of resolution or the outcome of this case. Chandler Insurance and its subsidiaries may or may not recover the remaining policy limits or the previously paid premiums and could incur significant costs in resolving this matter.