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. 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.
For the year ended December 31, 2004, Chandler USA had a net loss of $7.0 million compared to net income of $2.0 million for 2003 and a net loss of $2.1 million for 2002. For 2004 and 2003, the income (loss) from continuing operations was the same as the net income (loss). Loss from continuing operations was $3.0 million during 2002. Net income for 2003 included $3.1 million in gains on the purchase and cancellation of $16.7 million principal amount of Debentures, and $1.7 million for the amortization of the deferred gain on a sale and leaseback transaction. These transactions are discussed in more detail under "Other Income" and "Liquidity and Capital Resources." The net loss in 2004 is primarily due to the adverse loss development experienced by Chandler USA. See "Losses and Loss Adjustment Expenses."
The preparation of financial statements in conformity with U.S. 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.
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.
In addition, Chandler USA, at December 31, 2004, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $53.2 million which expire in the years 2005 through 2024. At December 31, 2004, Chandler USA also had a capital loss carryforward for U.S. Federal income taxes of $1.1 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.
See Note 1 to Consolidated Financial Statements for information related to other accounting and reporting policies.
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 $108 million, or 89%, of NAICO's direct written premiums in 2004 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.
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. During much of the last decade, the industry has generally had excess underwriting capacity resulting in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO has been able to increase its pricing for most coverages from 2000 through 2004, which has generally been the trend industry wide. However, NAICO continues to experience competition in all of its programs. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates.
As an Oklahoma corporation, NAICO and any person controlling NAICO, directly or indirectly, are subject to the insurance laws of Oklahoma including laws concerning the change or acquisition of control and payment of shareholder and policyholder dividends by NAICO.
Gross premiums earned decreased 14% and 7% in 2003 and 2004, respectively. These decreases were primarily the result of NAICO's continued efforts to improve underwriting profitability and increased competition within the Oklahoma school districts portion of the political subdivision program. Gross premiums earned in Texas decreased 18% and 3% in 2003 and 2004, respectively, and gross premiums earned in Oklahoma decreased 15% and 8% in 2003 and 2004. The workers compensation and property lines of business accounted for a significant portion of the decreases. A majority of NAICO's property premiums is written in the political subdivisions program. Net premiums earned decreased 15% in 2003 and increased 13% in 2004. The decrease in 2003 is primarily the result of the decrease in gross earned premiums during this period. The increase in 2004 is due primarily to changes in NAICO's reinsurance programs for certain excess of loss and quota share reinsurance. Effective January 1, 2004, NAICO discontinued a quota share reinsurance arrangement that covered casualty, workers compensation and physical damage risks produced by certain agents. Effective April 1, 2004, NAICO increased its net retention to include 56% of the layer covering $500,000 excess of $500,000 of loss per occurrence for its casualty and workers compensation risks, and effective July 1, 2004, NAICO increased its net retention to include 70% of this layer. These changes increased NAICO's net retention for these lines of business and also increased net premiums earned.
Gross premiums earned in the political subdivision program decreased 18% and 25% in 2003 and 2004, respectively. The decrease in gross premiums earned is due primarily to increased competition in the school districts portion of the program in Oklahoma. Gross premiums earned for the municipality portion of the program decreased $2.3 million and $529,000 in 2003 and 2004, respectively, as NAICO discontinued writing most of these accounts in 2003 and did not write any in 2004. Net premiums earned decreased 41% and 10% in 2003 and 2004, 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. The decrease in 2004 was due to a decrease in gross premiums earned and was partially offset by the reinsurance changes described above.
Gross premiums earned in the surety bond program decreased 23% and 29% in 2003 and 2004, respectively. The decreases are primarily due to stricter underwriting policies as NAICO continues to focus on improving underwriting profitability in this program and to the bail bond portion of the program that was discontinued in 2003. Gross premiums earned for the bail bond portion of the program decreased $1.1 million and $1.0 million in 2003 and 2004, respectively. Net premiums earned decreased 18% and 27% in 2003 and 2004, respectively. NAICO elected not to renew its construction surety bond excess of loss reinsurance effective April 1, 2003 due to the decreased premium volume in this program and to the current market for this reinsurance.
Net realized investment gains were $794,000, $2,351,000 and $652,000 in 2002, 2003 and 2004, respectively. 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"). NAICO received these shares in 1997 as a result of ISO converting to a for-profit corporation.
The average net yield on the fixed maturity portfolio, including net realized investment gains, was 4.8%, 6.7% and 4.0% in 2002, 2003 and 2004, respectively. The average net yield on the fixed maturity portfolio, excluding net realized investment gains, was 3.7%, 3.2% and 3.2% for 2002, 2003 and 2004, 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, 2004 was approximately $11.0 million. The average yield on the fixed maturity portfolio before deducting investment expenses was 4.4%, 3.6% and 3.6% in 2002, 2003 and 2004, 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 in 2003. During 2004, the remaining $368,000 of deferred gain was amortized into income. The deferred gain was 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 75.7%, 65.7% and 84.0% in 2002, 2003 and 2004, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $1.5 million, $1.9 million and $761,000 in 2002, 2003 and 2004, respectively, and increased the respective loss ratios by 2.2, 3.4 and 1.2 percentage points.
During 2002, NAICO experienced adverse loss development totaling $15.8 million primarily in the standard property and casualty program including both liability lines and workers compensation. This adverse development was primarily due to an increase in loss severity within the 1997-2000 accident years. The adverse development included approximately $2.0 million for provisions for potentially uncollectible reinsurance and deductibles.
During 2004, NAICO experienced adverse loss development totaling $26.3 million primarily in the standard property and casualty and political subdivisions programs. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1997-2002 accident years. The adverse development in the 2002 accident year partially offset the reduction in losses for this accident year that was recorded during 2003. The adverse loss development included approximately $409,000 for provisions for potentially uncollectible reinsurance and deductibles. Reserves for unpaid losses and loss adjustment expenses, net of related reinsurance recoverables, were $44.7 million at December 31, 2004 compared to $29.3 million at December 31, 2003, an increase of $15.4 million or 52%.
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.8%, 25.1% and 23.0% in 2002, 2003 and 2004, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 14.4%, 14.9% and 13.2%. The decrease in 2004 in commission expense was primarily due to a decrease in contingent commissions to agents that resulted from higher loss ratios than had been projected for these agents.
General and administrative expenses from continuing operations were 8.5%, 10.7% and 10.5% of gross premiums earned in 2002, 2003 and 2004, respectively. An increase in employee related expenses and fees paid to state insurance departments contributed to the $1.0 million increase in expense in 2003. 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 less than 1% in 2002, increased 9% in 2003 and decreased 2% in 2004. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures.
Chandler USA's federal income tax benefit (provision) as a percentage of income (loss) from continuing operations before income taxes was 35.5%, 8.9% and 33.8% for 2002, 2003 and 2004, respectively. The decrease in 2003 was primarily due to offsetting taxable realized gains of $2.4 million against Chandler USA's capital loss carryforward which is fully reserved due to its realization not being considered more likely than not.
Chandler USA is a holding company receiving cash principally through borrowings, subsidiary dividends and other payments, subject to various regulatory restrictions described in "Regulation" and the Notes to Consolidated Financial Statements. The capacity of insurance companies to write insurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for Chandler USA's subsidiaries are funds generated from insurance premiums, investment income, capital contributions from Chandler USA and proceeds from sales and maturities of portfolio investments. The principal expenditures are payment of losses and loss adjustment expenses, insurance operating expenses and commissions.
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, 2004, all of NAICO's fixed-maturity investments were rated Aa3 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively.
Chandler USA used $7.5 million and $6.0 million in cash from operations during 2002 and 2003, respectively, and provided $20.2 million in cash from operations in 2004. Cash flow from operations was negatively impacted during 2002 and 2003 due to the decline in written premiums during these years 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. The cash provided by operations in 2004 is due primarily to the decrease in reinsurance purchased in 2004 which resulted in an increase in net premiums written of $18.6 million. Cash flow from operations is positively impacted during times when net premiums written increase since a substantial portion of the claim payments for any given year will be made in future years. The cash provided by operations was used primarily to fund purchases of investments and loans to related parties.
Chandler USA and Chandler Insurance are parties to 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, 2003 and 2004, Chandler USA had a receivable of $9.6 million and $10.9 million, respectively, under the Credit Agreement, and Chandler USA earned $380,000, $412,000 and $439,000 in interest income under the Credit Agreement during 2002, 2003 and 2004, respectively.
Transamerica Occidental Life Insurance Company ("Transamerica") reinsured NAICO for certain workers compensation risks during 1989, 1990 and 1991. Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed under the reinsurance treaties. On March 15, 2004, an arbitration panel ordered Transamerica to pay the losses and loss adjustment expenses owed to NAICO in the amount of $1,607,704 plus interest at 6%, or approximately $577,000, plus $25,000 in costs. NAICO has received payment for these amounts.