Chandler USA and its subsidiaries own and occupy four office buildings with approximately 127,000 square feet of usable space in Chandler, Oklahoma. Chandler USA's subsidiaries also lease approximately 3,800 square feet in the aggregate for its branch offices. Chandler USA believes such space is sufficient for its operations for the foreseeable future.
Chandler USA is engaged in various property and casualty insurance operations through its wholly owned subsidiaries, NAICO and L&W. NAICO writes various property and casualty insurance products through three separate marketing programs: standard property and casualty, political subdivisions and surety bonds (including both bail bonds and construction bonds). The lines of insurance written by NAICO are commercial coverages consisting of automobile liability, workers compensation, surety, automobile physical damage, property, inland marine and other liability lines, which include general and professional liability lines. L&W represents various personal and commercial lines insurance companies in marketing property and casualty insurance. L&W also markets individual and group life, medical and disability income coverage. L&W places a large portion of its business with NAICO. Business produced by L&W and placed with NAICO constituted approximately 26% of NAICO's direct premiums written and assumed in 2001.
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 resulted in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO continues to experience competition, however, NAICO was able to increase its pricing for most coverages during 2000 and 2001, which has generally been the trend industry wide. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates.
Gross premiums earned in the political subdivisions program increased 20% and 15% in 1999 and 2000, respectively, and decreased 1% in 2001. The increases in 1999 and 2000 were due primarily to expansion of the school districts portion of the program in Texas and Missouri during 1998 and 1999, and to rate increases in the school districts portion of the program during 2000. Net premiums earned increased 37% in 1999, decreased 10% in 2000 and decreased 2% in 2001. The rescission of the reinsurance treaties increased net premiums earned in 1999 by $2.3 million in this program. The purchase of the quota share reinsurance reduced net premiums earned by $504,000 and $1.8 million in this program in 2000 and 2001, respectively.
Gross premiums earned in the surety bond program increased 15% in 1999, increased less than 1% in 2000 and decreased 36% in 2001. The decrease in 2001 was due primarily to decreased written premium production in California, Louisiana and Wisconsin. Net premiums earned in the surety bond program increased 5% in 1999, decreased 17% in 2000 and decreased 36% in 2001. NAICO experienced a significant increase in the cost of reinsurance for its construction surety bond program during 2000 and 2001 due to an increase in losses in the program.
Net interest income, excluding interest income from Chandler Barbados, decreased 19% in 1999, increased 9% in 2000 and decreased 15% in 2001. The decrease in net interest income in 1999 was due primarily to a reduction in invested assets due to the purchase of additional reinsurance. The increase in 2000 was due primarily to an increase in average invested assets and an increase in the average net yield on the portfolio. The decrease in 2001 was due primarily to lower interest rates in 2001 and a reduction in invested assets due primarily to the decrease in written premiums. During 2001, Chandler USA's interest income from Chandler Barbados was $371,000 due primarily to an intercompany loan to provide financing for the going private transaction. Chandler USA did not have any interest income from Chandler Barbados during 1999 or 2000. See Liquidity and Capital Resources.
Net realized investment gains were $57,000, $144,000 and $2,654,000 in 1999, 2000 and 2001, respectively. The net realized investment gains in 2001 resulted primarily from sales of fixed maturity investments available for sale to provide cash for operating activities due to the decrease in written premiums.
During the fourth quarter of 1999, NAICO and Reliance rescinded two reinsurance treaties which covered a portion of its workers compensation business and which had been in effect since January 1, 1999. The reinsurer returned the reinsurance premiums that had been paid by NAICO during 1999, less losses and ceding commissions that had been paid by the reinsurer, and NAICO reassumed certain losses as a result of the rescission. The reinsurer also paid NAICO a fee of $10.0 million as additional compensation for rescinding the treaties.
Chandler USA 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 are periodically reviewed by independent professional actuaries. See "Business - Reserves."
The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 78.8%, 76.0% and 75.1% in 1999, 2000 and 2001, respectively. The rescission of the reinsurance treaties increased losses and loss adjustment expenses in 1999 by $17.0 million. Excluding the effect of the reinsurance rescission, the loss ratio was 76.6% in 1999. Weather-related losses (net of applicable reinsurance) from wind and hail were $4.3 million, $2.9 million and $2.0 million in 1999, 2000 and 2001, respectively, and increased the respective loss ratios by 6.4, 3.4 and 2.9 percentage points (excluding the effect of the reinsurance rescission in 1999). The 1999 year included $1.8 million in weather-related losses which resulted from the tornadoes, strong winds and hail that caused significant damage in Oklahoma on May 3, 1999. The decrease in weather-related losses in 2000 was largely offset by adverse loss experience in the group accident and health program and higher than normal losses in NAICO's surety bond program. During 2001, NAICO experienced a further decline in weather-related losses, and increases in premium rates resulted in improved loss ratios for its standard property and casualty and political subdivisions programs for the 2001 accident year. However, these improvements were offset by adverse loss development experienced during 2001 related to prior accident years totaling $12.7 million. This adverse loss development was due primarily to increased loss severity in the standard property and casualty and political subdivisions programs. A substantial part of this loss development was for workers compensation losses in the 1999 accident year. NAICO's net retention for workers compensation losses increased substantially in 1999 due to the rescission of certain reinsurance treaties covering this line of business. Also contributing to the adverse loss development were provisions for potentially uncollectible reinsurance and deductibles of approximately $1.2 million during 2001, an increase in losses in the surety bond program and approximately $878,000 in losses for the runoff of the discontinued group accident and health program.
The following table sets forth Chandler USA's policy acquisition costs for each of the three years ended December 31, 1999, 2000 and 2001:
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 24.8%, 23.6% and 23.8% in 1999, 2000 and 2001, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 12.1%, 11.6% and 11.4%. Indirect underwriting expenses were 9.6%, 8.9% and 9.0% of total direct written and assumed premiums in 1999, 2000 and 2001, 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 Chandler USA's overall premium volume. Premium taxes increased $1.3 million in 2000 due to the increase in written premiums and to a refund of $392,000 which was received in 1999 for premium taxes paid in a prior year. Expenses associated with guaranty fund assessments, net of applicable premium tax credits, were approximately $63,000, $252,000 and $489,000 in 1999, 2000 and 2001, respectively, and are included in premium taxes. NAICO may receive additional guaranty fund assessments in the future related to Reliance or other insolvent insurance companies. At this time, NAICO is unable to estimate the amount of such assessments.
Interest expense increased 69% and 51% and decreased 1% in 1999, 2000 and 2001, respectively. The increases in 1999 and 2000 were 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 and related litigation with Chandler Insurance's director and officer liability insurer (the "D&O Insurer"). Litigation expenses were $207,000, $71,000 and $65,000 in 1999, 2000 and 2001, respectively. Increased or renewed activity could result in greater litigation expenses in the future. See "CenTra Litigation" and Note 9 to Consolidated Financial Statements.
As a result of the factors described above, Chandler USA reported a net loss of $87,000, $4.0 million and $1.1 million in 1999, 2000 and 2001, respectively.
The rescission of the reinsurance treaties resulted in a net after tax gain of $3.8 million during 1999. The rescission of the reinsurance treaties increased net premiums earned by $19.6 million in the fourth quarter of 1999. The rescission also increased losses and loss adjustment expenses by $17.0 million, and increased expenses for policy acquisition costs by $7.0 million. NAICO received a fee of $10.0 million as additional compensation for entering into the rescission. The provision for federal income taxes increased by $1.9 million in 1999 due to the rescission of the reinsurance treaties.
Cash flows from investing activities were primarily the result of normal purchases and sales of investment securities. Net realized investment gains before income taxes were $57,000, $144,000 and $2,654,000 during 1999, 2000 and 2001, respectively, from the sale of investments. NAICO received proceeds of $4.2 million, $14.2 million and $73.1 million during 1999, 2000 and 2001, respectively, from the sale of available for sale fixed-income securities prior to their maturity. The proceeds and related net realized investment gains in 2001 provided cash for operating activities due to the decrease in written premiums. The average maturity of NAICO's investments was 4.6 years and 3.3 years at December 31, 2000 and 2001, 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. The sale and leaseback transaction resulted in a reduction of property and equipment of $1.8 million and a deferred gain of $2.0 million which is included in accrued taxes and other payables. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $3.0 million. See Note 10 to Consolidated Financial Statements.
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, 2001, the total amount of cash and investments restricted as a result of these arrangements was $6.0 million.
During 2001, Chandler USA and Chandler Barbados entered into an Intercompany Credit Agreement (the "Credit Agreement") covering intercompany loans between the parties. The Credit Agreement requires interest to be paid at the prime interest rate published in The Wall Street Journal each month, and balances owed by either party are payable at any time upon demand. At December 31, 2001, Chandler Barbados owed approximately $7.9 million to Chandler USA, and Chandler USA earned $371,000 in interest income from Chandler Barbados during 2001.
Reliance reinsured NAICO for certain workers compensation risks during 1998 and 1999. During the fourth quarter of 1999, NAICO and Reliance rescinded two reinsurance treaties which had been in effect since January 1, 1999. NAICO received a return of ceded premiums and reassumed certain losses as a result of the rescission. At December 31, 2001, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses relating to the 1998 treaties of approximately $2.2 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.
While Chandler USA believes that it is likely that Chandler Insurance and its subsidiaries, including Chandler USA, will ultimately prevail as to all material claims asserted in the CenTra litigation, should the CenTra litigation be decided adversely to either Chandler USA or NAICO, such event could have a material adverse effect on Chandler USA, and impair the ability of NAICO to pay dividends or other payments to Chandler USA.
In June 2001, the FASB issued SFAS No. 141, BUSINESS COMBINATIONS, which supercedes Accounting Principles Board ("APB") Opinion No. 16, BUSINESS COMBINATIONS. The most significant changes made by SFAS No. 141 are requiring the purchase method of accounting for all business combinations initiated after June 30, 2001, establishing specific criteria for the recognition of intangible assets separately from goodwill, and requiring that unallocated negative goodwill be written off immediately as an extraordinary gain. The provisions of SFAS No. 141 apply to all business combinations initiated after June 30, 2001, and to all business combinations accounted for using the purchase method for which the date of acquisition is July 1, 2001 or later. The adoption of SFAS No. 141 did not have a material impact on Chandler USA's consolidated financial condition, results of operations or cash flows since Chandler USA has not entered into a business combination subsequent to June 30, 2001.
In June 2001, the FASB issued SFAS No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS, and SFAS No. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS.
SFAS No. 142 supercedes APB Opinion No. 17, INTANGIBLE ASSETS, and primarily addresses accounting for goodwill and intangible assets subsequent to acquisition. Under SFAS No. 142, goodwill and separately identified intangible assets with indefinite lives will no longer be amortized but reviewed annually (or more frequently if impairment indicators arise) for impairment. Separately identified intangible assets not deemed to have indefinite lives will continue to be amortized over their useful lives. SFAS No. 142 applies to all goodwill and intangible assets acquired after June 30, 2001. For goodwill and intangible assets acquired prior to July 1, 2001, Chandler USA is required to adopt SFAS No. 142 effective January 1, 2002. Chandler USA is currently evaluating the impact of SFAS No. 142 on its consolidated financial statements.
In August 2001, the FASB issued SFAS No. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS. SFAS No. 144 supercedes SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, and APB Opinion No. 30, REPORTING THE RESULTS OF OPERATIONS - REPORTING THE EFFECTS OF DISPOSAL OF A SEGMENT OF A BUSINESS, AND EXTRAORDINARY, UNUSUAL AND INFREQUENTLY OCCURRING EVENTS AND TRANSACTIONS. SFAS No. 144 establishes an accounting model based on SFAS No. 121 for long-lived assets to be disposed of by sale, previously accounted for under APB Opinion No. 30. This Statement is effective for fiscal years beginning after December 15, 2001. Chandler USA, which will adopt SFAS No. 144 on January 1, 2002, does not expect a material impact from the adoption of SFAS No. 144 on its consolidated financial statements.