The Company's United States-based subsidiaries own and occupy three office buildings with approximately 81,000 square feet of usable space at the home office in Chandler, Oklahoma. The Company's subsidiaries also lease approximately 10,600 square feet in the aggregate for its branch offices. The Company believes such space will suffice for the foreseeable future.
The long-term success of an insurance company depends on its ability to carve out markets and maintain a competitive advantage in those markets. Many factors determine the profitability of an insurance company including rate competition; the frequency and severity of claims; the cost, availability and collectibility of reinsurance; interest rates; inflation; general business conditions; jury awards, court decisions and legislation expanding the extent of coverage and the amount of compensation due for injuries and losses.
The property-casualty insurance industry is very competitive. Insurers compete on the basis of marketing effort, product, price, service and financial strength. The Company's competitors range from smaller regional independent insurance companies to major worldwide insurance companies. Many of the Company's competitors have substantially greater financial and other resources, and some offer a broader variety of coverages than those offered by the Company.
NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO and Chandler Barbados 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 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 described by state law and are estimated based on the same factors generally discussed above, with actuarial input, 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. The Company's subsidiaries report their reserves on the basis of U.S. GAAP. NAICO's statutory-based reserves do not differ from its U.S. GAAP reserves. Neither NAICO nor Chandler Barbados discounts its reserves for unpaid losses and loss adjustment expenses.
NAICO does not ordinarily insure against environmental matters as that term is commonly used. However, in some cases, regulatory filings made on behalf of an insured can make NAICO directly liable to the regulatory authority for property damage, which could include environmental pollution. In those cases NAICO ordinarily has recourse against the insured or the surety bond principal for amounts paid. NAICO has insured certain trucking companies and pest control operators who are required to provide proof of insurance which in some cases assures payment for clean-up and restoration of damage resulting from sudden and accidental release or discharge of contaminants or other substances which may be classified as pollutants. NAICO also provides surety bonds for construction contractors who use or have control of such substances and for contractors who remove and dispose of asbestos as a part of their contractual obligations.
The Company's insurance subsidiaries are subject to regulation by government agencies in the jurisdictions in which they do business. The nature and extent of such regulation vary from jurisdiction to jurisdiction, but typically involve prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company, regulation of certain transactions entered into by an insurance company with any of its affiliates, approval of premium rates, forms and policies used for many lines of insurance, standards of solvency and minimum amounts of capital and surplus which must be maintained, establishment of reserves required to be maintained for unearned premiums, losses and loss adjustment expenses or for other purposes, limitations on types and amounts of investments, restrictions on the size of risks which may be insured by a single company, licensing of insurers and agents, deposits of securities for the benefit of policyholders, and the filing of periodic reports with respect to financial condition and other matters. In addition, regulatory examiners perform periodic examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than security holders.
In addition to the regulatory oversight of the Company's insurance subsidiaries, the Company is also subject to regulation under the laws of the Cayman Islands and the Nebraska Insurance Holding Company System Act (the "Holding Company Act"). The Holding Company Act contains certain reporting requirements including those requiring the Company, as the ultimate parent company, to file information relating to its capital structure, ownership, and financial condition and general business operations of its insurance subsidiaries. The Holding Company Act contains special reporting and prior approval requirements with respect to transactions among affiliates. The Holding Company Act also imposes certain requirements upon any person controlling or seeking to control an insurance company domiciled in Nebraska. Persons owning any securities of the Company must comply with the Holding Company Act (see "BUSINESS - Regulation").
The impact on the Company of a recession 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 $89.7 million, or 73% of NAICO's direct written premiums in 1997 were in the states of Oklahoma and Texas. An economic downturn in these regions could have a significant impact on the Company. A recession might also cause defaults on fixed-income securities. 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.
The Company has taken action to understand the nature and extent of the work required to make its systems, products and infrastructures Year 2000 compliant. NAICO 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 is substantially complete at this time. NAICO continues to evaluate the estimated costs associated with future efforts based on actual experience. While these efforts may involve additional costs, the Company believes, based on available information, that it will be able to manage any significant effect on its business operations, products or financial prospects without incurring significant additional costs.
The Company continues to study the complex issues related to insurance coverage for losses arising from the myriad potential fact situations connected with Year 2000 Problems. The Company believes that the coverages it provides do not extend to the types of losses which are most likely to occur as a result of Year 2000 Problems. The Company has made no provisions for reserves nor has it undertaken any modifications of its policy forms based on potential Year 2000 Problems. The Company may utilize coverage exclusion endorsements based on the individual underwriting of commercial accounts.
A net loss of $1,065,000 resulted in 1997 compared to net income of $972,000 in 1996 and $3,778,000 in 1995. In 1997, the Company recorded a net charge totaling approximately $1.4 million ($1.6 million including provision for federal income tax) for the litigation matters related to the legal proceedings involving the CenTra Group. The ultimate actual amounts allowed by the Court to all parties could vary significantly from the Company's estimate. The net charge has been reduced by an estimated recovery of $2.7 million from the Company's directors and officers policy insurer for costs associated with the defense and litigation of these matters. See "LEGAL PROCEEDINGS". In addition, significant litigation expenses were incurred in 1997 due to the trial which began on February 13, 1997. The Company has also resolved various issues resulting in settlement of litigation and arbitration proceedings among subsidiaries of the Company and CenTra affiliates and recorded litigation and settlement expenses of approximately $462,000 in 1997. Excluding the effects of the litigation expenses and the estimated recovery, net income would have been approximately $3.4 million in 1997.
In 1996, the Company recorded a $982,000 estimated recovery of costs from its directors and officers liability insurer related to the Company's claim for reimbursable amounts previously paid for defense and litigation costs associated with the litigation involving the CenTra Group. Excluding the effects of the unusual charges and related expenses and the estimated recovery, net income would have been approximately $2.7 million for 1996. In 1995, the Company recorded an estimated recovery of $818,000 from the Company's directors and officers liability insurer.
Net premiums earned increased 1%, 10% and 6% in 1995, 1996 and 1997, respectively, compared to the prior years.
In 1995, NAICO elected to commute the unpaid losses and loss adjustment expenses related to reinsurance contracts covering certain business written in 1993, 1994 and 1995 which resulted in an increase in net premiums earned of $2,285,000. Beginning in 1996, NAICO reviewed the historical results for reinsurance contracts with similar commutation provisions and began accruing for such commutations where a commutation election was considered likely. Excluding the effects of these commutation accruals and elections, net premiums earned decreased 2% in 1995, and increased 12% and 5% in 1996 and 1997, respectively. The effect of the commutation accruals and elections was to increase net premiums earned for each insurance program as follows:
Excluding the effects of the commutations described above, net premiums earned for the political subdivisions program increased 10%, 15% and 4% in 1995, 1996 and 1997, respectively, from the prior years. Net premiums earned for the municipalities portion of this program increased 44%, 81% and 4% in 1995, 1996 and 1997, respectively. NAICO expanded its book of business through local agents in Oklahoma and expanded its coverage for municipalities to include workers compensation in 1995. NAICO also began insuring counties in 1995. Net premiums earned for the school districts portion of the program increased 3% in 1995, decreased 1% in 1996 and increased 4% in 1997. Expansion of the school districts program in Texas accounted for most of the 1997 increase.
NAICO participates in various mandatory pools covering workers compensation for insureds that were unable to purchase this coverage from an insurance company on a voluntary basis. In addition, NAICO receives assignments to write workers compensation for such insureds in certain states in lieu of participation in related pools. Net premiums earned from these direct assignments and participation in related pools were $6.8 million in both 1995 and 1996 and $1.3 million in 1997. The decline in 1997 was attributable to decreased activity from the pools and fewer assignments in certain states. Both the size of the involuntary market and NAICO's relative participation in states having a mandatory pool mechanism declined in 1996 and 1997.
NAICO's largest underwriting manager was responsible for underwriting $11.5 million, $11.9 million and $12.3 million of NAICO's direct written and assumed premiums for the California and Arizona portions of the nonstandard private-passenger automobile program during 1995, 1996 and 1997, respectively. Premiums receivable and currently due from this underwriting manager were $596,000 and $612,000 at December 31, 1996 and 1997, respectively.
During the first quarter of 1994, management reviewed the underwriting performance of the transportation programs and concluded that it would be in the Company's best interest to discontinue writing transportation automobile liability business based on the underwriting results and other related factors. As a result, net premiums earned declined substantially from that point. The Company continues to service the transportation industry in its retail and risk brokerage operations and all risk management services provided by NAICO are available.
L&W's brokerage commissions and fees before intercompany eliminations were $8.2 million in 1995, $8.5 million in 1996 and $9.0 million in 1997. A large portion of the brokerage commission and fees for L&W is incurred by NAICO and thus eliminated in the consolidation of the Company's subsidiaries.
The Company estimates losses and loss adjustment expenses based on historical experience and payment and reporting patterns for the type of risk involved. These estimates are based on data available at the time of the estimate and independent professional actuaries periodically review such estimates.
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 27.3%, 33.5% and 28.4% in 1995, 1996 and 1997, respectively. For these periods, the average commission rates were 11.6%, 15.3% and 12.9%. The commission rate for a substantial portion of the surety bond program varies inversely with the loss ratio pursuant to a commission arrangement contingent on the loss experience of the program. The expected loss ratio for that portion of the surety bond program was lowered in 1996 and that decrease increased the percentage of net policy acquisition costs to net premiums earned by 3.1 percentage points.
The Company incurred $440,000, $2,078,000 and $527,000 in indirect underwriting expenses for uncollectible ceded reinsurance in 1995, 1996 and 1997, respectively, which was 0.4%, 1.9% and 0.4% of direct written and assumed premiums in those periods. The 1996 amount includes an arbitration award which was made against New York Life Insurance Company, Security Benefit Life Insurance Company and Standard Insurance Company and in favor of NAICO but for $1.1 million less than had been expected. NAICO reduced its reinsurance recoverables accordingly. See Notes to Consolidated Financial Statements.
General and administrative expenses were 15.2%, 15.3% and 14.0% of revenues exclusive of net investment income in 1995, 1996 and 1997, respectively. General and administrative expenses have historically not varied in direct proportion to the Company'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 the Company's overall premium volume. In 1996, the Company incurred $441,000 in legal expenses related to the Midwest termination settlement, and $527,000 in legal expenses related to the reinsurance arbitration discussed above.
See "Liquidity and Capital Resources", "LEGAL PROCEEDINGS" and Notes to Consolidated Financial Statements.
NAICO and NAICO Indemnity provided insurance coverage and risk management services for CenTra and certain of its affiliates. All such policies were canceled effective September 5, 1992 or expired as of September 30, 1992. As of December 31, 1997, the unpaid premiums and other amounts due from CenTra to the Company's subsidiaries were $788,625 as reflected by the April 22, 1997 jury verdicts. The Company intends to seek payment of all amounts due and believes a reserve for collection is not necessary at December 31, 1997. In addition, the Company's subsidiaries reflected a payable to certain affiliates of CenTra in the amount of $505,000 at December 31, 1997 in connection with the settlement of certain litigation and arbitration proceedings. See "LEGAL PROCEEDINGS".
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 financial statement and display the accumulated balance of other comprehensive income separately in the shareholders' equity section of the consolidated balance sheets. The Company will adopt SFAS No. 130 on January 1, 1998 as required.
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 will adopt SFAS No. 131 on January 1, 1998 as required.