The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury and workers compensation claims have a much longer loss settlement period and may be paid out over several years. It is often necessary to adjust estimates of liability on a loss either upward or downward between the time a claim arises and the time of payment. Workers compensation indemnity benefit reserves are determined based on statutory benefits prescribed by state law and are estimated based on the same factors generally discussed above, which may include, where state law permits, inflation adjustments for rising benefits over time. Generally, the more costly automobile liability claims involve one or more severe bodily injuries or deaths. The ultimate cost of these types of claims is dependent on various factors including the relative liability of the parties involved, the number and severity of injuries, and the legal jurisdiction where the incident occurred.
NAICO also insures independent oil and gas producers who may purchase coverage for the escape of oil, saltwater, or other substances which may be harmful to persons or property, but may not generally be classified as pollutants. CIB reinsures a portion of those risks. NAICO maintains claims records which segregate this type of risk for the purpose of evaluating environmental risk exposure. Based upon the nature of such lines of business with NAICO's insureds, and current data regarding the limited severity and infrequency of such matters, it appears that potential environmental risks are not a significant portion of claims reserves and therefore would not likely have a material adverse impact, if any, on the financial condition of the Company.
The Company's subsidiaries report their reserves on the basis of U.S. GAAP. 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 U.S. GAAP. Neither NAICO nor CIB discounts its reserves for unpaid losses and loss adjustment expenses. See Notes to Consolidated Financial Statements.
Periods of inflation have varying effects on the Company's 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. Premium rates and commissions, however, are not significantly affected by inflation since competitive forces generally control such rates.
The following tables summarize the net premiums earned and the financial year (losses incurred and recognized by the Company regardless of the year in which the claim occurred) and accident year (losses incurred by the Company for a particular year regardless of the period in which the Company recognizes the costs) loss and loss adjustment expense ("LAE") ratios (computed by dividing losses and loss adjustment expenses by net premiums earned) in each of the years presented. The first table is summarized by major insurance program and includes all lines of insurance written in each program. The second table is summarized by line of insurance written and includes all net premiums earned and net losses and loss adjustment expenses incurred from all insurance programs for that particular line:
Gross premiums earned in the standard property and casualty program increased 31%, 39% and 22% in 1996, 1997 and 1998, respectively. The increases are primarily attributable to increased production in Oklahoma and contiguous states, principally Texas. Net premiums earned increased 30% and 45% in 1996 and 1997, respectively, and decreased 25% in 1998, due primarily to the purchase of additional reinsurance in 1998 as previously described.
Nonstandard private-passenger automobile gross premiums decreased 14% and 58% in 1997 and 1998, respectively. Net premiums earned in the nonstandard private-passenger automobile premiums decreased 47% and 95% in 1997 and 1998, 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.
At December 31, 1998, the Company's investment portfolio consisted primarily of fixed income U.S. Government, high-quality corporate and tax exempt bonds, with approximately 9% invested in cash and money market instruments. Income generated from this portfolio is largely dependent upon prevailing levels of interest rates. The Company's portfolio contains no junk bonds or real estate investments.
Net interest income decreased 6% in 1996, and increased 1% in 1997. Net interest income decreased 11% in 1998, 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). Income from tax exempt securities was $1.0 million in 1998 as compared to $112,000 in 1997.
Net realized investment gains were $140,000, $764,000 and $1,163,000 in 1996, 1997 and 1998, respectively. Increased net realized investment gains in 1997 resulted primarily from NAICO shifting a portion of its fixed maturities portfolio from taxable to tax exempt bonds (which generally have a lower yield) and NAICO's sale of common stock of Century Business Services, Inc. The Century Business Services stock was received by NAICO in early 1997 as a part of a 1996 settlement with a former underwriting manager.
The average net yield on the portfolio, including net realized investment gains, was 6.1%, 6.6% and 6.1% in 1996, 1997 and 1998, respectively. The average net yield on the portfolio, excluding net realized investment gains, was 6.0%, 5.9% and 5.2% for 1996, 1997 and 1998, respectively.
Fees generated by Network Administrators, Inc. ("Network"), a wholly owned subsidiary of the Company, were $722,000 in 1996 and $435,000 in 1997. Network no longer functions as a third-party administrator and did not generate any fee income in 1998.
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 59.8%, 60.7% and 68.3% in 1996, 1997 and 1998, respectively. The increase in the 1998 loss ratio was primarily the result of additional loss development from prior accident years which was recognized in 1998, and an increase in storm-related losses. The prior year loss development recognized in 1998 totaled $5.2 million and increased the loss ratio by 7.3 percentage points. Storm-related losses from wind and hail totaled $1.5 million in 1998 compared to $459,000 in 1997, and increased the loss ratio for 1998 by 2.2 percentage points.
The following table sets forth the Company's policy acquisition costs for each of the three years ended December 31, 1996, 1997 and 1998:
Indirect underwriting expenses were 13.7%, 10.9% and 10.3% of total direct written and assumed premiums in 1996, 1997 and 1998, 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 the Company's overall premium volume. The Company incurred approximately $1.5 million in indirect underwriting expenses related to the termination of an arrangement with a surety bond underwriting manager and settlement of associated litigation, which was 1.4% of direct written and assumed premiums in 1996. Commissions received from reinsurers increased in 1997 as a result of the 100% quota-share reinsurance arrangement for the California portion of the nonstandard private-passenger automobile program which was effective July 1, 1997. NAICO received commissions totaling approximately $1.9 million and $909,000 during 1997 and 1998, respectively, under this quota-share reinsurance arrangement. During 1998, NAICO received commissions from reinsurers totaling approximately $13.8 million related to the purchase of additional reinsurance under its workers compensation and casualty reinsurance programs. See "Purchase of Additional Reinsurance."
All significant Company subsidiaries maintain liquid operating positions and follow 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 and assume reinsurance.
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 in 1997 and 1998 were $764,000 and $1,163,000, respectively, from the sale of investments. In addition, in 1998, CIB and NAICO received proceeds of $12.8 million and $36.2 million, respectively, from the sale of fixed-income securities that were available for sale prior to their maturity. The average maturity of the Company's investments was 4.6 years and 4.0 years at December 31, 1997 and 1998, respectively.
CIB is required as a foreign reinsurer to secure reserves for unpaid losses and loss adjustment expenses and unearned premiums for the benefit of the primary insurer ceding such amounts. CIB secures such amounts by trust arrangements whereby securities are deposited into a trust account for the benefit of the primary insurer. NAICO is required to deposit securities with regulatory agencies in several states in which it is licensed as a condition of conducting operations in the state. At December 31, 1998, the total amount of cash and investments restricted for CIB and NAICO as a result of these arrangements was $25.3 million and $8.2 million, respectively.
In February 1998, Chandler USA entered into a five-year loan agreement with a bank having a principal amount of $2.3 million and an interest rate of 7.75%. In September 1998, the interest rate was reduced to 7.5%. Monthly payments are approximately $46,000 including principal and interest. The outstanding balance of the note was $1.9 million at December 31, 1998. The loan is collateralized by certain equipment which was purchased with the proceeds of the loan. The equipment had previously been leased by Chandler USA.
While the Company believes that it is likely that the Company and its affiliates will ultimately prevail as to all material claims asserted in the CenTra litigation, should the CenTra litigation be modified, reversed or decided adversely to the Company, such event could have a material adverse effect on the Company.
The Company is heavily dependent upon complex information technology computer systems for the Company's operations. The Company has taken action to attempt to identify the nature and extent of the work required to assess and remediate Year 2000 Problems with respect to its systems, products and infrastructures (including non-information technology systems, none of which are considered critical to operations). The Company began work in 1995 to prepare its financial, information and other computer-based systems for the year 2000, including updating existing legacy systems, and such work as currently planned is substantially complete at this time. The Company estimates that it has spent $350,000 updating these systems to address Year 2000 Problems, and such costs were expensed as they were incurred, primarily in 1996 and 1997.
- Increased operational costs due to manual processing, data corruption or disaster recovery;
The Company cannot predict the adverse impact, if any, of Year 2000 Problems upon its agents, reinsurers and others with whom it does business. It is possible that the credit or operating ability of others with whom the Company maintains commercial relationships may be adversely affected by one or more unforeseen circumstances caused by Year 2000 Problems. However, the Company 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, the Company is developing plans to attempt to minimize identified third-party exposures.
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 130, REPORTING COMPREHENSIVE INCOME, which establishes standards for reporting and displaying comprehensive income and its components (revenues, expenses, gains and losses) in financial statements. In addition, SFAS No. 130 requires the Company to classify items of other comprehensive income by their nature in a separate financial statement or as a component of the consolidated statements of operations or the consolidated statements of shareholders' equity and display the accumulated balance of other comprehensive income separately in the shareholders' equity section of the consolidated balance sheets. The Company adopted SFAS No. 130 on January 1, 1998 as required. The adoption of SFAS No. 130 resulted in revised and additional disclosures but had no effect on the financial position, results of operations or liquidity of the Company.
Also in June 1997, the FASB issued SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. SFAS No. 131 establishes reporting standards for public companies concerning annual and interim financial statements of their operating segments and related information. Operating segments are components of a company about which separate financial information is available that is regularly evaluated by the chief operating decision maker(s) in deciding how to allocate resources and assess performance. The Standard sets criteria for reporting disclosures about a company's products and services, geographic areas and major customers. The Company adopted SFAS No. 131 on January 1, 1998 as required.
In June 1998, the FASB issued SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that the Company recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. The Company will adopt SFAS No. 133 on January 1, 2000 as required. Management of the Company believes that adoption of SFAS No. 133 will not have a material impact on the Company's consolidated financial condition or results of operations.