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 and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for each of the five years in the period ended December 31, 2008 have been audited by HoganTaylor LLP, independent auditors, whose independent auditors' report expresses an unqualified opinion. Tullius Taylor Sartain & Sartain LLP merged with Hogan & Slovacek, P.C. to form HoganTaylor LLP effective January 7, 2009. 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).
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 two separate marketing programs: standard lines and political subdivisions. 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. During 2005, NAICO began writing homeowner and dwelling fire and allied lines policies in the state of Texas through a managing general agent. NAICO discontinued its homeowners program during 2006, and has also transferred its property and inland marine business for the standard lines and political subdivisions programs to Praetorian effective January 1, 2007 through an arrangement between Praetorian and CIMI. CIMI and Praetorian have agreed to terminate this arrangement effective June 29, 2009. At the present time, CIMI expects that a similar arrangement with another insurance company will be completed prior to the termination of the current arrangement. See "Insurance Programs" for more information. 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 is an underwriting manager and wholesaler that offers multiple insurance products for businesses in various industries and political subdivisions.
For the year ended December 31, 2008, Chandler USA had net income of $525,000 compared to a net loss of $662,000 for 2007 and net income of $3.4 million for 2006. The net loss in 2007 was primarily due to the reversal of a portion of the prejudgment interest income that was accrued during 2006 on a favorable jury verdict. This is discussed in more detail under "Litigation" and in Note 11 to Consolidated Financial Statements.
NAICO's loss reserves consist of case reserves and reserves for incurred but not reported ("IBNR") claims. Case reserves are established by claims personnel based on a review of the facts known at the time the claim is reported, and are subsequently revised as more information about a claim becomes known. IBNR is computed using various actuarial methods and techniques and includes reserves for losses that have occurred but for which claims have not yet been reported, including provision for expected future development on case reserves. As of December 31, 2008, NAICO's case reserves and IBNR for each line of business are shown in the following table.
Reserves for losses and loss adjustment expenses are developed using multiple estimation methods that result in various point estimates for each line of business. The estimate recorded by management is a function of detailed analysis of the historical trends and development factors resulting from the different methods. As a result of the variety of factors that must be considered by management there is a significant risk that actual incurred losses will develop differently from these estimates.
The following table shows the recorded reserves and the high and low point estimates based on the results of the various actuarial methods described above as of December 31, 2008.
For the workers compensation net reserves, NAICO's actuaries selected an average of the case incurred and cumulative paid projections for accident years 1999 through 2004. Results of the cumulative paid projection were relied upon for accident years 2005 and 2006, and the 2007 and 2008 accident year selections were based on judgmentally selected loss ratios. Workers compensation gross reserve selections were made on the same basis as the net reserves except that the 1999, 2002 and 2005 selections were based on judgmentally selected IBNR amounts. For the automobile liability net reserves, the actuaries relied on the mean of the results of all methods examined for accident years prior to 2008. The 2008 accident year selection was based on a judgmentally selected loss ratio. Automobile liability gross reserves were made on the same basis except that the 1999 and 2002 selections were based on judgmentally selected IBNR amounts. For the general liability net reserves, the actuaries relied on judgmentally selected loss ratios for all accident years except for the 1999 and 2001 accident years, which were based on judgmentally selected IBNR amounts. General liability gross reserves were based on judgmentally selected IBNR amounts for the 1999 through 2002 accident years, on cumulative paid projections for the 2003 through 2007 accident years, and on a judgmentally selected loss ratio for the 2008 accident year. The loss settlement period for automobile physical damage claims is relatively short, and the actuaries used case incurred losses for their selection for all accident years. Surety bond reserves are actually a net receivable due to anticipated subrogation recoveries. Certain involuntary workers compensation pools provided their own estimates and NAICO records these estimates plus an accrual to account for the lag time in reporting to NAICO.
Reinsurance recoverables on unpaid losses and loss adjustment expenses a re similarly subject to changes in estimates and assumptions. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In addition to factors noted above, estimates of reinsurance recoverables may prove uncollectible if the reinsurer is unable or unwilling to meet its responsibilities under the reinsurance contracts. Reinsurance contracts do not relieve an insurer from its obligation to policyholders.
At December 31, 2007, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $1.3 million, which was fully utilized during 2008.
In addition, at December 31, 2008, Chandler USA had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $35.0 million which expire in the years 2009 through 2028. A valuation allowance has been provided for the tax effect of the state net operating loss since realization of such amount is not considered more likely than not.
Gross premiums earned in the standard lines program increased 11% in 2007 and decreased 4% in 2008. Gross premiums earned for workers compensation business in this program increased $5.1 million or 22% in 2007, and increased $3.7 million or 13% in 2008. NAICO also increased premiums from trucking accounts in 2006 and 2007. Gross premiums earned from trucking accounts increased $12.0 million in 2007, but decreased $8.2 million in 2008. Net premiums earned in the standard lines program increased 15% in 2007 and decreased 2% in 2008. Net premiums earned from trucking accounts increased $7.7 million in 2007 and decreased $4.6 million in 2008.
Gross premiums earned in the political subdivisions program decreased 65% and 18% in 2007 and 2008, respectively. The decrease in gross premiums earned is due primarily to the transfer of the property and inland marine business in this program to Praetorian as described previously, and to increased competition related to Oklahoma school districts. Net premiums earned decreased 35% and 20% in 2007 and 2008, respectively. The decrease in net premiums earned in 2007 was significantly less than the decrease in gross premiums earned because of the significant amounts of reinsurance that NAICO had purchased for the property and inland marine lines of business in this program.
Net investment income, excluding interest income from related parties and the prejudgment interest, increased 13% in 2007 and decreased 6% in 2008. Interest income from related parties was $792,000, $941,000 and $647,000 during 2006, 2007 and 2008, respectively. The increase in 2007 was due primarily to higher interest rates and to an increase in the amount loaned to Chandler Insurance, while the decrease in 2008 was due to lower interest rates. See Liquidity and Capital Resources.
The average net yield on the fixed maturity portfolio, including net realized investment gains, was 3.6%, 4.0% and 3.4% in 2006, 2007 and 2008, respectively. The average net yield on the fixed maturity portfolio, excluding net realized investment gains, was 3.6% for 2006, 3.8% for 2007 and 3.3% for 2008. 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, 2008 was approximately $12.0 million. The average yield on the fixed maturity portfolio before deducting investment expenses was 4.0% in 2006, 4.2% in 2007 and 3.6% in 2008, excluding net realized capital gains.
Other income was $317,000, $1,916,000 and $2,069,000 during 2006, 2007 and 2008, respectively. Approximately $1.1 million of the increase in 2007 was due to the transfer of NAICO's property and inland marine business in the standard lines and political subdivisions programs to Praetorian under an arrangement effective January 1, 2007. Under this arrangement, CIMI receives commission income for the business it produces for Praetorian. The increase in 2008 was due to an increase in commission income related to business produced by CIMI for insurance companies other than NAICO.
In 2006, the majority of the adverse loss development was in the automobile liability line of business, as reserves were strengthened in the 1999-2005 accident years for this line of business. A portion of this adverse development was offset by favorable development in the surety line of business that resulted from an increase in estimated recoveries primarily in the 1994 and 2001 accident years. During 2007, a portion of these estimated recoveries were reduced based on a final judgment entered by the court regarding certain surety bond claims. The reduction of the estimated recoveries accounted for $1.8 million of the loss development for surety business during 2007. During 2008, workers compensation losses developed adversely by $3.5 million, but the automobile liability line of business offset approximately $1.7 million of this. The 1997-2001 accident years have clearly been the problematic years where the loss development was so significant. During those years, NAICO's premium volume grew from $123 million in 1997 to $197 million in 2000, before dropping to $159 million in 2001. Much of that growth was attributable to the planned expansion of NAICO's Texas business. This growth occurred at a time when premium rates were very soft. The expansion into Texas began in the last half of 1996. NAICO had written business in Texas for many years with reasonably good experience. Based on this experience, management believed the economic and tort climates were similar to Oklahoma. This did not turn out as expected, especially in regards to business in south and east Texas. Because this expansion was primarily a casualty driven book of business, it took several years to realize that claims in many areas of Texas were more severe and emerged differently than Oklahoma claims. As the historical loss data picked up the development of these claims, the projections of ultimate losses became more accurate.
During 2008, NAICO experienced adverse loss development totaling $2.1 million primarily in the workers compensation line of business in the standard lines program. A portion of the adverse loss development was offset by favorable development in the automobile liability line of business in this program. The adverse loss development included approximately $166,000 for provisions for potentially uncollectible reinsurance.
In the last six years, management has undertaken several initiatives to improve the quality and profitability of business. These initiatives included significant rate increases, changes in coverage forms that limit or eliminate coverage, reduction or elimination of classes of business that have not been profitable, reduction or elimination of business in geographic areas that have not been profitable and increased emphasis on risk selection. Management has also improved case reserving which improves the overall reserving accuracy and also leads to better underwriting decisions.
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 2006, 2007 and 2008, NAICO incurred charges of $97,000, $356,000 and $166,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
The following table sets forth Chandler USA's policy acquisition costs for each of the three years ended December 31, 2006, 2007 and 2008:
Chandler USA's federal income tax benefit (provision) as a percentage of income (loss) before income taxes was 32.9%, 11.6% and 56.4% for 2006, 2007 and 2008, respectively. The 2007 percentage decreased due primarily to the impact of nondeductible expenses on the net loss before income taxes. The 2008 percentage increased due primarily to the impact of nondeductible expenses on net income before income taxes.
At December 31, 2008, Chandler USA had a net deferred tax asset of $2.7 million. Chandler USA believes it is more likely than not that the deferred income tax asset will be realized through future earnings. As a result, a valuation allowance has not been recorded. Chandler USA used the same assumptions as in internal financial projections to estimate future taxable income. If Chandler USA's results are not as profitable as anticipated, a valuation allowance may have to be established for the remaining deferred tax assets.
Chandler USA provided $4.4 million, $8.7 million and $6.0 million in cash from operations in 2006, 2007 and 2008, respectively. The cash provided by operations in 2006 included a decrease in reinsurance recoverable on unpaid losses of $29.2 million, but this was largely offset by a decrease in unpaid losses and loss adjustment expenses of $26.3 million. These decreases were primarily the result of recording additional estimated recoveries related to a favorable jury verdict in civil litigation regarding certain surety bond claims during 2006. The cash provided by operations in 2007 included an increase in unpaid losses and loss adjustment expenses of $17.3 million, but this was offset in part by an increase in reinsurance recoverable on unpaid losses of $10.6 million. These increases were primarily the result of reducing the estimated recoveries on certain surety bond claims based on a final judgment entered by the court. See "Litigation." The cash provided by operations in 2008 included a decrease in reinsurance recoverable on unpaid losses of $2.3 million, a decrease in premiums receivable of $1.7 million, a decrease in prepaid reinsurance premiums of $948,000 and an increase in unpaid losses of $869,000. These were partially offset by a decrease in unearned premiums of $2.7 million.
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 $745,000, $214,000 and $95,000 during 2006, 2007 and 2008, respectively, from the sale of investments. NAICO received proceeds of $21.3 million, $17.6 million and $6.7 million during 2006, 2007 and 2008, respectively, from the sale of available for sale securities prior to their maturity. The market value of NAICO's available for sale fixed- income investments decreased by $1,000 in 2006 and increased $2.2 million and $1.9 million in 2007 and 2008, respectively, due primarily to changes in interest rates and other economic conditions experienced during this time. The average maturity of NAICO's fixed maturity investments was 2.6 years and 3.7 years at December 31, 2007 and 2008, respectively.
Cash flows from financing activities were primarily the result of payments and loans between Chandler USA and Chandler Insurance. 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, 2007 and 2008, Chandler USA had a receivable of $11.5 million and $11.9 million, respectively, under the Credit Agreement, and Chandler USA earned $733,000, $881,000 and $590,000 in interest income under the Credit Agreement during 2006, 2007 and 2008, respectively.
In October 1999, NAICO provided surety bonds for Gulsby Engineering, Inc. ("Gulsby") in connection with contracts between Gulf Liquids New River Project, LLC ("Gulf Liquids") and Gulsby for the construction of two gas processing plants in Louisiana. During 2001, Gulsby became unable to pay various vendors resulting in payments to vendors by NAICO totaling $20,182,499. In August 2001, NAICO filed suit in federal court in Louisiana alleging that Gulf Liquids had breached its obligations under the bonds by materially altering certain contracts and that as a result, NAICO was exonerated on the bonds and should recover the amounts paid to vendors. In the fall of 2001, Gulsby and Bay Limited, another contractor with whom Gulsby had entered into a joint venture for the construction of other gas processing plants for Gulf Liquids, filed lawsuits relating to those plants in Houston, Texas. Gulf Liquids filed original actions and counterclaims. NAICO intervened in the Texas lawsuits and, in addition, sued Williams Energy Marketing and Trading (which later became Williams Power Company, Inc.) ("Williams") alleging fraud, breach of contract, tortious interference with contractual relations, conspiracy and alter ego. These claims were asserted against both Gulf Liquids and Williams. Gulf Liquids asserted counterclaims alleging breach of contract against NAICO and requesting contractual and statutory damages ranging from $40 million to $80 million. The cases were consolidated for trial in the 215th Judicial District Court in Harris County, Texas. On August 1, 2006, the jury trial concluded in Harris County, Texas, related to the construction of two gas processing plants in Louisiana. The amounts the jury found owing to NAICO included approximately $20.2 million in actual damages and $70.0 million in punitive damages. See Note 11 of Notes to Consolidated Financial Statements for a discussion of this jury verdict.