ITEM 1. BUSINESS.
GENERAL
Chandler USA is an insurance holding company that provides administrative services to its wholly owned subsidiaries NAICO and Chandler Insurance Managers, Inc. ("CIMI"). Chandler USA is an Oklahoma corporation which is wholly owned by Chandler Insurance Company, Ltd. ("Chandler Insurance"), a privately owned Cayman Islands company. Chandler USA is headquartered in Chandler, Oklahoma, in facilities also occupied by NAICO and CIMI.
NAICO is one of the leading commercial business insurance writers in Oklahoma, providing property and casualty insurance products for businesses in various industries. NAICO has a network of independent agents, totaling approximately 149 at December 31, 2006, that market NAICO's insurance products. Independent agents originate substantially all of NAICO's business. NAICO is licensed to write property and casualty coverage in 45 states and the District of Columbia and is authorized by the United States Department of the Treasury to write surety bonds for contractors on federal projects. NAICO is currently rated as B+ (Very Good) by A.M. Best Company, an insurance rating agency. This rating is an independent opinion of a company's financial strength, operating performance and ability to meet its obligations to policyholders.
CIMI is an underwriting manager and wholesaler that offers multiple insurance products for businesses in various industries and political subdivisions.
INSURANCE PROGRAMS
NAICO writes various property and casualty insurance products through two primary marketing programs. The programs are standard lines and political subdivisions.
STANDARD LINES PROGRAM
NAICO offers workers compensation, automobile liability and physical damage and other liability (including general liability, products liability and umbrella liability) coverages under its standard lines program. In marketing these products, NAICO targets companies in the construction, manufacturing, wholesale, service, oil and gas, trucking, and retail industries. NAICO writes this business principally in Oklahoma and Texas.
NAICO has also written property and inland marine coverages in this program. Effective January 1, 2007, the property and inland marine lines of insurance that were previously written by NAICO in the standard lines and political subdivisions programs will be written by Praetorian Insurance Company ("Praetorian") through an arrangement between Praetorian and CIMI. NAICO also transferred its existing property and inland marine business in these programs to Praetorian under this new arrangement effective January 1, 2007. Under this arrangement, CIMI receives commission income for the business it produces for Praetorian. CIMI is responsible for the payment of commissions to the producing agents, and is also responsible for providing underwriting and loss control services for this business. NAICO handles all claims for this business under a separate claims handling agreement with Praetorian.
Management believes this new arrangement will allow Chandler USA's subsidiaries to offer more competitive property and inland marine programs for its agents. In addition, NAICO will no longer be required to purchase reinsurance for the significant insured values associated with this business.
POLITICAL SUBDIVISIONS PROGRAM
Under the political subdivisions program, NAICO writes insurance policies primarily for school districts in Oklahoma. As of December 31, 2006, NAICO insured 137 school districts in Oklahoma. The coverages offered include workers compensation, automobile liability, automobile physical damage, general liability and school board legal liability. NAICO has also written property and inland marine coverages in this program. Effective January 1, 2007, the property and inland marine lines of insurance will be written by Praetorian.
HOMEOWNERS PROGRAM
In 2005, NAICO began writing homeowners and dwelling fire and allied lines policies in the state of Texas through a managing general agent. NAICO discontinued this program during the second quarter of 2006 due primarily to increased catastrophic exposures.
SURETY BOND PROGRAM
NAICO has written surety bonds, commonly referred to as contract performance bonds, to secure the performance of contractors and suppliers on construction projects. NAICO has also written bail bonds, which guarantee that the principal will discharge obligations set by the court, as well as other types of miscellaneous bonds. NAICO discontinued the bail bond portion of the program as of the end of 2003. NAICO is no longer actively marketing its surety bond program.
The following table shows gross premiums earned and net premiums earned by insurance program for the years 2004, 2005 and 2006. The term "gross premiums earned" means gross premiums written (before reductions for premiums ceded to reinsurers) less the increases or plus the decreases in the gross unearned premium reserve for the unexpired portion of the policy term beyond the current accounting period. The term "net premiums earned" means gross premiums earned less reductions for earned premiums ceded to reinsurers. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
LINES OF INSURANCE
The lines of insurance written by NAICO through its programs are automobile liability, other liability (including general liability, products liability and umbrella liability), workers compensation, automobile physical damage, property (including homeowners multiple peril), surety and inland marine. The following table shows net premiums earned as a percentage of total net premiums earned by each line of insurance written by NAICO during the period indicated.
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 a new arrangement between Praetorian and CIMI. Because of these changes, NAICO expects its 2007 net premiums earned for property and inland marine business to be minimal. See "Insurance Programs" for more information.
AGENCY AND BROKERAGE
CIMI serves as a general agent for certain wholesale insurance operations related to NAICO's school districts and trucking insurance. Under its general agency agreement with NAICO, CIMI was appointed to accept, in accordance with NAICO's underwriting guidelines, certain surety bonds and property and casualty insurance. CIMI is also authorized to secure qualified insurance agents for NAICO and shall assist NAICO in coordinating the agents' activities.
Effective January 1, 2007, CIMI administers certain property and inland marine business for Praetorian under a general agency agreement between the parties. CIMI receives commission income for its services under the agreement, and is responsible for the payment of commissions to the producing agents. CIMI is also responsible for providing underwriting and loss control services for this business. See "Insurance Programs" for more information.
UNDERWRITING AND CLAIMS
Independent insurance agents submit applications for commercial insurance policies for prospective customers to NAICO or CIMI. Prospective risks are reviewed in accordance with specific underwriting guidelines. If the risk is approved and coverage is accepted by the insured, an insurance policy is issued.
NAICO's claims department reviews and administers all claims except claims associated with the homeowners program which are handled by the managing general agent for this program. When a claim is received, it is reviewed and assigned to an in-house claim adjuster based on the type and geographic location of the claim, its severity and its class of business. NAICO's claims department is responsible for reviewing each claim, obtaining necessary documentation and establishing loss and loss adjustment expense reserves. NAICO's in-house claims staff handles and supervises the claims, coordinates with outside legal counsel and independent claims adjusters if necessary, and processes the claims to conclusion. Effective January 1, 2007, NAICO also handles claims for the property and inland marine business placed by CIMI with Praetorian under a claims handling agreement with Praetorian.
REINSURANCE
In the ordinary course of business, NAICO cedes insurance risks and a portion of the insurance premiums to its reinsurers under various reinsurance contracts that cover individual risks (facultative reinsurance) or entire classes of business (treaty reinsurance). Reinsurance provides greater diversification of insurance risk associated with business written and also reduces NAICO's exposure from high policy limits or from catastrophic events and hazards of an unusual nature. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In formulating its reinsurance programs, NAICO considers numerous factors, including the financial stability of the reinsurer, the reinsurer's ability to provide sufficient collateral (if required), reinsurance coverage offered and price.
Treaty reinsurance may be ceded under treaties on both a pro rata basis (where the reinsurer shares proportionately in premiums and losses) and an excess of loss basis (where only losses above a specific amount are reinsured). The availability, costs and limits of reinsurance purchased varies from year to year based upon prevailing market conditions, reinsurers' underwriting results and NAICO's desired risk retention levels. A majority of NAICO's reinsurance programs renew on January 1 or July 1 of each year. NAICO renewed all applicable January 1, 2007 reinsurance programs. At the present time, NAICO expects to renew the reinsurance programs that renew on July 1, 2007.
NAICO has structured separate reinsurance programs for property (including inland marine), workers compensation, casualty (including automobile liability, general and products liability, umbrella liability and related professional liability), automobile physical damage, homeowners and construction surety bonds. NAICO also purchases facultative reinsurance when it writes a risk with limits of liability exceeding the maximum limits of its treaties or when it otherwise considers such action appropriate. Chandler Insurance reinsures NAICO for a portion of the risk on NAICO's reinsurance programs except for the homeowners program. NAICO discontinued its property reinsurance program effective January 1, 2007 due to the transfer of its property business for the standard lines and political subdivisions programs to Praetorian.
Effective July 1, 2003, NAICO's net retention under the workers compensation reinsurance program was 70% of the first $500,000 of loss per occurrence, plus 56% of $500,000 excess of $500,000 of loss per occurrence. Effective July 1, 2004, NAICO's net retention increased to 70% of the first $1,000,000 of loss per occurrence.
Effective July 1, 2003, NAICO's net retention under the casualty reinsurance program was 70% of the first $500,000 of loss per occurrence, plus 56% of $500,000 excess of $500,000 of loss per occurrence. Effective July 1, 2004, NAICO's net retention increased to 70% of the first $1,000,000 of loss per occurrence. Effective July 1, 2005, NAICO increased its net retention to 70% of the first $2,000,000 of loss per occurrence. Effective July 1, 2004, NAICO's net retention for umbrella liability losses was 17.5% of the first $4,000,000 of loss per occurrence. Effective July 1, 2006, NAICO decreased its net retention for umbrella liability losses to 10.5% of the first $4,000,000 of loss per occurrence.
Effective April 1, 2003, NAICO retains 70% of the losses in the construction surety bond portion of the surety bond program.
Under the 2004, 2005 and 2006 property reinsurance programs, NAICO retained 23.1% of the first $3,000,000 of risk for each loss per risk or location. NAICO discontinued its property reinsurance program effective January 1, 2007 due to the transfer of its property business for the standard lines and political subdivisions programs to Praetorian. Under the 2004, 2005 and 2006 automobile physical damage reinsurance programs NAICO retained 70% of each loss per occurrence. NAICO has purchased catastrophe protection for its automobile physical damage and certain property coverages to limit its retention for single loss occurrences involving multiple policies and/or policyholders resulting from perils such as floods, winds and severe storms. This catastrophe protection limits NAICO's net retained loss for both automobile physical damage and property losses to $1,400,000 effective January 1, 2004 for each loss occurrence. NAICO retains 75% of the risk under the homeowners program, with per occurrence excess of loss treaties maintained covering 100% of $28,000,000 excess of $2,000,000.
In December 2005, the Terrorism Risk Insurance Act of 2002 (the "Act") was extended through December 31, 2007. The Act establishes a program for commercial property and casualty losses resulting from foreign acts of terrorism. The Act requires commercial insurers to offer terrorism coverage on its commercial property and casualty lines of business. Effective January 1, 2006, commercial automobile liability and physical damage, professional liability, surety, burglary and theft and farm-owners multi-peril insurance coverages are excluded from the Act. Each insurance company will be responsible for a deductible based on a percentage of direct earned premiums from the previous calendar year, which is 17.5% for losses occurring in 2006 and 20% in 2007. The Federal Government will pay 90% of covered terrorism losses that exceed company deductibles.
NAICO purchased quota share reinsurance for its deductible under the Act limiting NAICO's retention to 15% for 2005 and 2006 of such deductible, subject to a reinsurance limit of $10,625,000 for 2005 and 2006 for each loss occurrence. The reinsurance coverage is also limited to $10,625,000 for 2005 and 2006 for all loss occurrences for any year. NAICO also purchased excess of loss reinsurance covering acts of terrorism that provides coverage of $15 million excess of $12.5 million for 2005 and 2006 of loss per occurrence based on NAICO's net retention. Effective January 1, 2007, NAICO purchased excess of loss reinsurance covering acts of terrorism that provides coverage of $24,900,000 excess of $100,000 for NAICO's deductible under the Act, as well as for acts of terrorism other than those covered under the Act.
The following table sets forth certain information related to NAICO's five largest reinsurers determined on the basis of net reinsurance recoverables as of December 31, 2006.
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. NAICO incurred charges of $282,000, $108,000 and $97,000 during 2004, 2005 and 2006, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
LOSS AND UNDERWRITING EXPENSE RATIOS
The combined loss and underwriting expense ratio ("Combined Ratio") is the traditional measure of underwriting experience for property and casualty insurance companies. It is the sum of the ratios of (i) incurred losses and loss adjustment expenses to net premiums earned ("loss ratio") and (ii) underwriting expenses to net premiums written and assumed ("underwriting expense ratio").
The following table shows the underwriting experience of Chandler USA for the periods indicated by line of insurance written. Adjustments to reserves made in subsequent periods are reflected in the year of adjustment. In the following table, incurred losses include paid losses and loss adjustment expenses, net changes in case reserves for losses and loss adjustment expenses and net changes in reserves for incurred but not reported losses and loss adjustment expenses. See also "Reserves" and "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
RESERVES
Insurance companies provide in their financial statements reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under their previously issued insurance policies and/or reinsurance contracts. In estimating reserves, insurance companies use various standardized methods based on historical experience and payment and reporting patterns for the type of risk involved. The application of these methods involves subjective determinations by the personnel of the insurance company. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount of and uncertainty in the estimates is affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs, such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that expand insurance coverage after the insurance policy was priced and sold. In recent years, certain of these factors have contributed to incurred amounts that were higher than original estimates. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims.
NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO, 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. Such changes in estimates may be material. NAICO's statutory-based reserves (reserves calculated in accordance with an insurer's domiciliary state insurance regulatory authorities) do not differ from its reserves reported on the basis of accounting principles generally accepted in the United States of America ("GAAP"). NAICO does not discount its reserves for unpaid losses or loss adjustment expenses.
Salvage and subrogation recoverables are accrued using the "case basis" method for large recoverables and statistical estimates based on historical experience for smaller recoverables. Recoverable amounts deducted from Chandler USA's net liability for losses and loss adjustment expenses were approximately $9.6 million and $13.2 million at December 31, 2005 and 2006, respectively. The increase in estimated recoveries in 2006 is due primarily to NAICO recording net estimated recoveries totaling $5.6 million related to a favorable jury verdict in civil litigation regarding certain surety bond claims during 2006. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" for more information related to this litigation. The gross and net estimated recovery deducted from unpaid losses and loss adjustment expenses related to this litigation at December 31, 2006 is $31.5 million and $10.8 million, respectively. NAICO may or may not recover the above estimated recoveries and could incur significant costs in collecting these recoverables.
NAICO participates in various pools covering workers compensation risks for insureds who were unable to purchase this coverage from an insurance company on a voluntary basis. The consolidated financial statements reflect the reserves for unpaid losses and loss adjustment expenses and net premiums earned from its participation in the pools.
There may be significant reporting lags between the occurrence of the insured loss and the time it is actually reported to the insurer. The inherent uncertainties in estimating insurance reserves are generally greater for casualty coverages, such as workers compensation, general and automobile liability, than for property coverages primarily due to the longer period of time that typically elapses before a definitive determination of ultimate loss can be made, which is also affected by changing theories of legal liability and changing political climates.
There are significant additional uncertainties in estimating the amount of reserves required for environmental, asbestos-related and other latent exposure claims, including a lack of historical data, long reporting delays and complex unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different and frequently inconsistent conclusions as to when the loss occurred, what claims are covered, under what circumstances the insurer has an obligation to defend, how policy limits are determined and how policy exclusions are applied and interpreted.
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 from the time a claim arises to 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 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 following table sets forth a reconciliation of the beginning and ending reserves for losses and loss adjustment expenses which are net of reinsurance deductions for the years indicated.
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2002-2005 calendar years. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results.
During 2002, NAICO experienced adverse loss development totaling $15.8 million primarily in the standard lines 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 2003, NAICO experienced adverse loss development totaling $11.1 million primarily in the standard lines program. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1998-2001 accident years. A reduction in losses for the 2002 accident year partially offset this adverse development. The adverse loss development included approximately $1.3 million for provisions for potentially uncollectible reinsurance and deductibles.
During 2004, NAICO experienced adverse loss development totaling $26.3 million primarily in the standard lines 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%.
During 2005, NAICO experienced adverse loss development totaling $6.3 million primarily in the standard lines and political subdivisions programs. A portion of the adverse development was offset by favorable development of $1.8 million in the surety bond program, primarily in accident years 1994 and 2001 that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the workers compensation, other liability and automobile liability lines of business in the 2000, 2002 and 2003 accident years. The adverse loss development included approximately $108,000 for provisions for potentially uncollectible reinsurance.
During 2006, NAICO experienced adverse loss development totaling $3.8 million primarily in the standard lines program. A portion of the adverse development was offset by favorable development of $1.0 million in the surety bond program, primarily in the 2001 accident year, that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the automobile liability line of business in the 2005 accident year and in the workers compensation line of business in the 1997 and 1999 accident years. The adverse loss development included approximately $97,000 for provisions for potentially uncollectible reinsurance.
The following table represents the development of net balance sheet reserves for 1997 through 2006. The top line of the table shows the net reserves at the balance sheet date for each of the indicated years. This represents the estimated amounts of claims and claim expenses, net of reinsurance deductions, arising in the current and all prior years that are unpaid at the balance sheet date, including the net reserve for incurred but not reported claims. The upper portion of the table shows the cumulative net amounts paid as of successive years with respect to that reserve liability. The estimate for unpaid losses and loss adjustment expenses changes as more information becomes known about the frequency and severity of claims for individual years. The next portion of the table shows the revised estimated amount of the previously recorded net reserve based on experience as of the end of each succeeding year. The heading "net cumulative (deficiency) redundancy" represents the cumulative aggregate change in the estimates over all prior years. The last portion of the table provides a reconciliation of the net amounts to the gross amounts before any deductions for reinsurance. The gross cumulative deficiency or redundancy results from the same factors as those described above for the net amounts, and is also impacted by development of large claims that exceed NAICO's net retention including umbrella and surety per principal losses where NAICO has little or no net retention.
In evaluating the information in the following table, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For example, the amount of the deficiency recorded in 2000 for claims that occurred in 1997 will be included in the cumulative deficiency amount for years 1997, 1998, 1999 and 2000. This table does not present accident or policy year development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future deficiencies or redundancies based on this table.
INVESTMENTS
Funds available for investment include Chandler USA's present capital as well as premiums received and retained under insurance policies and reinsurance agreements issued by NAICO. Until these funds are required to be used for the settlement of claims and the payment of operating expenses, they are invested with the objective of generating income, preserving principal and maintaining liquidity.
Investments are purchased to support the investment strategies of Chandler USA and its subsidiaries, which are developed based on many factors including rate of return, maturity, credit risk, tax considerations, regulatory requirements and their mix of business. At the time of purchase, investments in debt securities that Chandler USA has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments in debt and equity securities classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. Chandler USA has not classified any investments as trading account assets. Debt securities not classified as held to maturity or trading and equity securities are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of deferred income tax as a separate component of other comprehensive income until realized. Realized gains and losses on sales of securities are based on the specific identification method. Declines in the fair value of securities below their carrying value that are other than temporary are recognized in earnings.
As of December 31, 2006, all of the investments of NAICO were in fixed-maturity investments (rated Aa3 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), equity securities, mutual funds that invest in equity securities, interest-bearing money market accounts and collateralized repurchase agreements. NAICO's investment portfolio is managed by the Investment Committee of its Board of Directors. For additional information, see Notes to Consolidated Financial Statements.
DEBENTURES
On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior debentures (the "Debentures") with a maturity date of July 16, 2014. The Debentures were priced at $1,000 each with an interest rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium. The indenture governing the Debentures was amended during 2003 to clarify that purchases of Debentures by Chandler USA through private treaty or on the open market for an agreed price of less than the sum of the principal amount and accrued interest are not considered to be a redemption of the Debentures, and that any such Debentures purchased by Chandler USA will be cancelled. At December 31, 2006, there was $6,979,000 principal amount of the Debentures outstanding. Chandler USA's subsidiaries and affiliates are not obligated by the Debentures. Accordingly, the Debentures are effectively subordinated to all existing and future liabilities and obligations of Chandler USA's existing and future subsidiaries. For additional information, see "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
TRUST PREFERRED SECURITIES
In May 2003, Chandler USA established Chandler Capital Trust I ("Trust I") by purchasing all of its common securities for $403,000. Trust I is a Delaware statutory business trust and is a wholly owned non-consolidated subsidiary of Chandler USA. On May 22, 2003, Trust I issued $13.0 million of capital securities (the "Trust I Preferred Securities") to InCapS Funding I, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust I used the proceeds from the issuance to purchase $13,403,000 of 9.75% junior subordinated debentures (the "Junior Debentures I") of Chandler USA. Distributions on the Junior Debentures I are payable quarterly at a fixed annual rate of 9.75%. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures I, with such deferred payments accruing interest compounded quarterly. The Junior Debentures I are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year.
The Junior Debentures I are the sole assets of Trust I and Trust I will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust I Preferred Securities are payable quarterly at a fixed annual rate of 9.75%. Trust I may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust I Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust I Preferred Securities are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year. All payments by Trust I regarding the Trust I Preferred Securities are guaranteed by Chandler USA.
In December 2003, Chandler USA established Chandler Capital Trust II ("Trust II") by purchasing all of its common securities for $217,000. Trust II is a Delaware statutory business trust and is a wholly owned non- consolidated subsidiary of Chandler USA. On December 16, 2003, Trust II issued $7.0 million of capital securities (the "Trust II Preferred Securities") to InCapS Funding II, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust II used the proceeds from the issuance to purchase $7,217,000 of floating rate junior subordinated debentures (the "Junior Debentures II") of Chandler USA. Distributions on the Junior Debentures II are payable quarterly at a floating rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed 12.5% prior to January 8, 2009). The interest rate was 9.47% at December 31, 2006. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures II, with such deferred payments accruing interest compounded quarterly. The Junior Debentures II are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium.
The Junior Debentures II are the sole assets of Trust II and Trust II will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust II Preferred Securities are payable quarterly at a floating rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed 12.5% prior to January 8, 2009). The interest rate was 9.47% at December 31, 2006. Trust II may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust II Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust II Preferred Securities are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium. All payments by Trust II regarding the Trust II Preferred Securities are guaranteed by Chandler USA.
In December 2003, the Financial Accounting Standards Board issued Revised Interpretation No. 46 ("FIN 46R"), CONSOLIDATION OF VARIABLE INTEREST ENTITIES. FIN 46R provides guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights. FIN 46R is used to determine whether consolidation is required or, alternatively, whether the variable-interest model under FIN 46R should be used to account for existing and new entities. Chandler USA adopted FIN 46R effective January 1, 2004. The result of adoption was the deconsolidation of the two capital trusts that were created during 2003 in connection with the issuance of trust preferred securities. Chandler USA now reports the $20.6 million of junior subordinated debentures that were issued to the capital trusts on its consolidated balance sheet. The adoption of FIN 46R had no effect on net earnings.
EMPLOYEES AND ADMINISTRATION
At December 31, 2006, Chandler USA and its subsidiaries had approximately 216 full-time employees. Chandler USA and its subsidiaries generally have enjoyed good relations with their employees.
COMPETITION
NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO.
An insurance 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 the late 1990's and into 2000, property and casualty insurance companies generally under priced their products, which resulted in poor underwriting results that were partially offset by investment returns. Interest rates decreased in 2000 and underwriting results continued to deteriorate for business written in the late 1990's and into 2000. These factors coupled with additional potential losses due to terrorism and lower investment returns caused the industry to increase pricing beginning in the latter half of 2001. Rate increases continued through 2003 and to a lesser extent in 2004, and the industry's underwriting results have improved. The pricing environment during 2005 and 2006 experienced downward pressure, particularly for larger accounts. NAICO was able to increase its pricing for most coverages from 2001 through 2005. However, the recent industry trend has been for insurers to maintain or reduce rate levels, and NAICO has reduced its pricing in certain situations and for certain coverages including workers compensation during 2006. 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.
REGULATION
REGULATION IN GENERAL
NAICO is subject to regulation by government agencies in the jurisdictions in which it does 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, unpaid 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 financial and market conduct examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders or creditors.
NAICO is required to deposit securities with regulatory agencies in several states in which it is licensed as a condition of conducting operations in those states.
In addition to the regulatory oversight of NAICO, Chandler Insurance is also subject to regulation under the laws of the Cayman Islands and Chandler USA and all of its affiliates are subject to regulation under the insurance laws of Oklahoma (the "Oklahoma Insurance Code"). The Oklahoma Insurance Code contains certain reporting requirements including those requiring Chandler Insurance, as the ultimate parent company, to file information relating to its capital structure, ownership, and financial condition and the general business operations of its insurance subsidiaries. The Oklahoma Insurance Code contains special reporting and prior approval requirements with respect to transactions among affiliates.
NAICO is also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include redefinitions of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through re-pricing, if permitted by applicable regulations, of coverages or limitations or cessation of the affected business.
INSURANCE REGULATION CONCERNING CHANGE OR ACQUISITION OF CONTROL
NAICO is a domestic property and casualty insurance company organized under the Oklahoma Insurance Code. The Oklahoma Insurance Code provides that the acquisition or change of "control" of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Oklahoma Department of Insurance. A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company must generally file with the relevant insurance regulatory authority an application for change of control containing certain information required by statute and published regulations and provide a copy of such to the domestic insurer. In Oklahoma, control is generally presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing 10% or more of the voting securities of the insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%.
In addition, many state insurance regulatory laws contain provisions that require pre-notification to state agencies of a change in control of a non-domestic insurance company admitted in that state. While such pre-notification statutes do not authorize the state agency to disapprove the change of control, such statutes do authorize issuance of a cease and desist order with respect to the non-domestic insurer if certain conditions exist such as undue market concentration.
Any future transactions that would constitute a change in control of Chandler Insurance or Chandler USA would also generally require prior approval by the Oklahoma Department of Insurance and would require pre-acquisition notification in those states which have adopted pre-acquisition notification provisions and in which the insurers are admitted. Because such requirements are primarily for the benefit of policyholders, they may deter, delay or prevent certain transactions that could be advantageous to the shareholders or creditors of Chandler USA.
RESTRICTIONS ON SHAREHOLDER DIVIDENDS
A significant portion of Chandler USA's consolidated assets represents assets of NAICO that may not be immediately transferable to Chandler USA in the form of shareholder dividends, loans, advances or other payments.
Statutes and regulations governing NAICO and other insurance companies domiciled in Oklahoma regulate the payment of shareholder dividends and other payments by NAICO to Chandler USA. Under applicable Oklahoma statutes and regulations, NAICO is permitted to pay shareholder dividends only out of statutory earned surplus. To the extent NAICO has statutory earned surplus, NAICO may pay shareholder dividends only to the extent that such dividends are not defined as extraordinary dividends or distributions. If the dividends are, under applicable statutes and regulations, extraordinary dividends or distributions, regulatory approval must be obtained. Under the applicable Oklahoma statute, and subject to the availability of statutory earned surplus, the maximum shareholder dividend that may be declared (or cash or property distribution that may be made) by NAICO in any one calendar year without regulatory approval is the greater of (i) NAICO's statutory net income, excluding realized capital gains, for the preceding calendar year; or (ii) 10% of NAICO's statutory policyholders' surplus as of the preceding calendar year end, not to exceed NAICO's statutory earned surplus.
As of December 31, 2006, NAICO had statutory earned surplus of $14.0 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2007 without the approval of the Oklahoma Department of Insurance is $5.2 million. NAICO paid shareholder dividends to Chandler USA totaling $3.4 million in 2004.
In addition to the statutory limits described above, the amount of shareholder dividends and other payments to affiliates permitted can be further limited by contractual or regulatory restrictions or other agreements with regulatory authorities restricting dividends and other payments, including regulatory restrictions that are imposed as a matter of administrative policy. If insurance regulators determine that payment of a shareholder dividend or other payments to an affiliate (such as payments under a tax sharing agreement, payments for employee or other services, or payments pursuant to a surplus note) would be hazardous to such insurance company's policyholders or creditors, the regulators may block such payments that would otherwise be permitted without prior approval.
RISK-BASED CAPITAL
The National Association of Insurance Commissioners has adopted a methodology for assessing the adequacy of statutory surplus of domestic property and casualty insurers. This methodology is described in the Risk Based Capital Model Act (the "RBC Model Act"). The RBC Model Act includes a risk-based capital requirement that requires insurance companies to calculate and report information under a risk-based formula which attempts to measure statutory capital and surplus needs based on the risks in the insurance company's mix of products and investment portfolio. The formula is designed to allow state insurance regulators to identify potential under-capitalized companies. Under the formula, an insurer determines its "risk-based capital" ("RBC") by taking into account certain risks related to the insurer's assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer's liabilities (including underwriting risks related to the nature and experience of its insurance business). The RBC rules provide for different levels of regulatory attention depending on the ratio of a company's total adjusted capital to its "authorized control level" of RBC. Insurers below the specific ratios are classified within certain levels, each of which requires specific corrective action. The levels and ratios are as follows:
The ratios of total adjusted capital to authorized control level RBC for NAICO were 5.2:1 and 5.7:1 at December 31, 2005 and 2006, respectively. Therefore, NAICO's total adjusted capital exceeds the level that would trigger regulatory attention pursuant to the risk-based capital requirement.
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS-IRIS RATIOS
The National Association of Insurance Commissioners Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies 13 industry ratios and specifies "usual values" for each ratio. Departure from the "usual values," which fluctuate annually, on four or more ratios generally leads to inquiries from individual state insurance commissioners. NAICO had one 2006 ratio that was outside of the "usual values" as explained below.
NAICO's "investment yield" as calculated using the IRIS formula was 10.3% during 2006 compared to a usual value of greater than 3.0% and less than 6.5%. During 2006, NAICO recorded interest income of $6.6 million for its estimate of prejudgment interest for a favorable jury verdict in civil litigation regarding certain surety bond claims. Excluding this prejudgment interest, NAICO's investment yield as calculated using the IRIS formula was 3.1%. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" for more information. NAICO maintains a high-quality investment portfolio, with no non-investment grade bonds, derivative instruments or real estate investments (other than real estate occupied by the company). NAICO's investment yield is largely dependent upon prevailing levels of interest rates. The significant decline in interest rates in recent years had a significant impact on NAICO's investment yield. Moreover, in periods of relatively low interest rates, NAICO generally shortens maturities and accepts lower yields to reduce market risk for future rate increases.
EFFECT OF FEDERAL LEGISLATION
Although the Federal Government does not directly regulate the business of insurance, federal initiatives often affect the insurance business in a variety of ways. Current and proposed federal measures which may significantly affect the insurance business include Federal Government participation in asbestos and other product liability claims, claims related to acts of terrorism, pension and other employee benefit plan regulation (ERISA), examination of the taxation of insurers and reinsurers, minimum levels of liability insurance and automobile safety regulations. Federal regulation of the health care industry may directly and indirectly impact the business of insurance.
ITEM 1A.
ITEM 1A. RISK FACTORS.
Our business is subject to numerous risks and uncertainties, the outcome of which may adversely impact future results of operations and financial condition. The following risks, as well as other information included in this 2006 Annual Report on Form 10-K, should be considered carefully.
IF OUR ACTUAL LOSSES EXCEED OUR LOSS RESERVES, OUR FINANCIAL RESULTS WOULD BE ADVERSELY AFFECTED.
We maintain reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under our previously issued insurance policies and/or reinsurance contracts. These reserves do not represent an exact measurement of liability, but are estimates based upon historical data and anticipated future events. The process of estimating loss reserves is complex and imprecise. We periodically review the reserve estimates and the methods used to arrive at such reserve estimates, and we also retain independent professional actuaries who review such reserve estimates and methods. Any changes that result from these reviews are reflected in current operating results.
If our estimates are incorrect and our reserves are inadequate, we are required to increase our reserves. An increase in reserves results in an increase in losses and a reduction in our net income for the period in which the deficiency is identified. Accordingly, an increase in reserves could have a material adverse effect on our results of operations, liquidity and financial condition.
CATASTROPHIC EVENTS AND ACTS OF TERRORISM CAN HAVE A SIGNIFICANT IMPACT ON OUR RESULTS OF OPERATIONS, LIQUIDITY AND FINANCIAL CONDITION.
We are subject to claims arising out of catastrophes that may have a significant effect on our results of operations, liquidity and financial condition. Catastrophes can be caused by various events, including tornadoes, windstorms, hail, fires, severe winter weather, earthquakes, power outages and explosions, and may include man-made events such as terrorist attacks. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event.
We seek to reduce the impact of a catastrophe on our business through the purchase of catastrophe and terrorism reinsurance. Reinsurance does not relieve us of our direct liability to our policyholders. As long as the reinsurers meet their obligations, our net liability is limited to the amount of risk that we retain. Reinsurance, however, may prove inadequate if a major catastrophic loss exceeds the reinsurance limit or the reinsurers' financial capacity.
OUR RESULTS MAY FLUCTUATE BASED ON MANY FACTORS, INCLUDING CYCLICAL CHANGES IN THE INSURANCE INDUSTRY.
The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. The industry's profitability can be affected significantly by rising levels of claim costs that are not known by companies at the time they price their products. The property and casualty insurance industry historically is cyclical. The demand for property and casualty insurance can vary significantly, generally rising as the overall level of economic activity increases and falling as such activity decreases. The property and casualty insurance industry also has been very competitive. During the late 1990's and into 2000, property and casualty insurance companies generally under priced their products, which resulted in poor underwriting results that were partially offset by investment returns. Interest rates decreased in 2000 and underwriting results continued to deteriorate for business written in the late 1990's and into 2000. These factors coupled with additional potential losses due to terrorism and lower investment returns caused the industry to increase pricing beginning in the latter half of 2001. Rate increases continued through 2003 and to a lesser extent in 2004, and the industry's underwriting results have improved. The pricing environment during 2005 and 2006 experienced downward pressure, particularly for larger accounts. The recent industry trend has been for insurers to maintain or reduce rate levels, and NAICO has reduced its pricing in certain situations and for certain coverages including workers compensation during 2006. The hurricane activity during the third quarter of 2005 may result in higher rates for certain property business. Reinsurance costs may increase substantially. Competition for profitable business in the past has resulted in pressure on pricing and less restrictive terms and conditions, contributing to the cyclical pricing and underwriting results.
Our underwriting philosophy is to forego underwriting risks from which we are unable to obtain what we believe to be adequate premium rates. However, the fluctuations in demand and competition and the impact on us of other factors described above could have a material adverse effect on our business, results of operations and/or financial condition.
OUR ABILITY TO REDUCE OUR EXPOSURE TO RISKS DEPENDS ON THE AVAILABILITY AND COST OF REINSURANCE.
We transfer a portion of our risks insured under our policies and reinsurance contracts to other companies through reinsurance arrangements. These reinsurance arrangements reduce the potential impact of unusually severe or frequent losses. The amount and cost of reinsurance are subject, in large part, to prevailing market conditions that are beyond our control. Our ability to provide insurance at competitive premium rates and coverage limits on a continuing basis depends to a great extent upon our ability to obtain adequate reinsurance in amounts and at rates that will not adversely affect our competitive position. If we are unable to maintain such arrangements, then we would be forced to either bear the associated increase in net exposures or reduce the amount of risk that we underwrite. Either of these circumstances could have a material adverse effect on our results of operations, liquidity and/or financial condition.
IF WE ARE UNABLE TO COLLECT FROM OUR REINSURERS ON A TIMELY BASIS, OUR FINANCIAL RESULTS WOULD BE ADVERSELY AFFECTED.
We face a credit risk when we obtain reinsurance because we are still liable for the transferred risks if the reinsurer cannot meet the transferred obligations. Losses may not be recovered from our reinsurers until claims are paid and, in the case of certain long-term workers compensation and liability claims, the credit worthiness of our reinsurers may change before we can recover amounts to which we are entitled. The failure of any of our reinsurers to pay reinsurance claims on a timely basis could have a material adverse effect on our results of operations, liquidity and financial condition.
THE FAIR VALUE OF OUR INVESTMENT PORTFOLIO AND OUR INVESTMENT INCOME COULD SUFFER AS A RESULT OF FLUCTUATIONS IN INTEREST RATES AND MARKET CONDITIONS.
Our market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of our investment portfolio as a result of fluctuations in prices and interest rates. A portion of our interest expense fluctuates with changes in interest rates as well.
Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of those instruments. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative investments, liquidity of the instrument and other general market conditions. Any significant decline in our investment income as a result of falling interest rates, decreased dividend payment rates or general market conditions would have an adverse effect on our results. Any significant decline in the market value of our investments would reduce our shareholder's equity and our policyholders' surplus, which could impact our ability to write additional business.
WE MAY BE ADVERSELY IMPACTED BY A CHANGE IN OUR FINANCIAL STRENGTH RATING.
Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors they believe are important to policyholders. Ratings are not recommendations to buy our securities.
NAICO's ability to write business is most influenced by our rating from A.M. Best Company. A.M Best ratings are designed to assess an insurer's financial strength and ability to meet continuing obligations to policyholders. Currently, our rating from A.M. Best is "B+" (Very Good), with a negative outlook. A negative outlook is placed on a company's rating if it is experiencing unfavorable financial or market trends, and if continued, the company has a good possibility of having its rating downgraded. NAICO's rating and outlook were downgraded to the current rating from "B++" effective June 21, 2005. The downgrade was primarily due to the significant net loss and decline in statutory surplus in 2004 which were driven by adverse loss reserve development on prior accident years. We believe that as a result of our improved surplus and operating performance in 2005 and 2006, our rating will remain at least at its current level. However, there can be no assurance that A.M. Best will not change its rating in the future. A rating downgrade from A.M. Best could adversely affect the business we write and our results of operations.
WE DEPEND ON OUR INDEPENDENT INSURANCE AGENTS.
We market and sell our insurance products through independent, non-exclusive insurance agencies. These agencies are not obligated to sell our insurance products, and generally they also sell our competitors' insurance products. As a result, our business depends in part on the marketing and sales efforts of these agencies. If we diversify and expand our business geographically, then we may need to expand our network of agencies to successfully market our products. If these agencies fail to market our products successfully, our business may be adversely impacted. Also, independent agents may decide to sell their businesses to banks, other insurance agencies or other businesses. Changes in ownership of agencies, or expansion of agencies through acquisition, could adversely affect an agency's ability to control growth and profitability, thereby adversely affecting our business.
MUCH OF OUR BUSINESS IS CONCENTRATED IN THE SOUTHWEST AND MIDWEST AREAS OF THE UNITED STATES, WHICH TIES OUR PERFORMANCE TO THE ENVIRONMENTAL, BUSINESS, ECONOMIC AND REGULATORY CONDITIONS OF THESE REGIONS.
During 2006, approximately 76% of our written premiums were in the states of Oklahoma and Texas. Unusually severe storms or other natural or man-made disasters that destroy property in these states could adversely affect our operations. Our revenues and profitability are also subject to prevailing economic and regulatory conditions in these states. An economic downturn in these states could have a significant adverse impact on our business. The loss of a significant amount of premiums written in either of these states, whether due to regulatory changes, competitive changes, economic downturns in these states or other reasons, would reduce our revenues and could have a material adverse effect on our results of operations, liquidity and/or financial condition.
WE OPERATE IN A HIGHLY COMPETITIVE INDUSTRY.
We compete with local, regional and national insurance companies in our selected lines of business. Many of these companies are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than we do. In addition, we face competition within each insurance agency that sells our insurance because we sell through independent agencies that represent more than one insurance company.
The property and casualty insurance industry is highly competitive on the basis of product, price and service. If our competitors offer products with more coverage, or price their products more aggressively, our ability to grow or renew our business may be adversely impacted. The inability to compete effectively could materially reduce our customer base and revenues, and could adversely affect our results of operations, liquidity and financial condition.
WE ARE AN INSURANCE HOLDING COMPANY WITH NO DIRECT OPERATIONS, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO MEET OUR DEBT OBLIGATIONS.
As a holding company with no business operations of its own, we receive cash principally through borrowings, subsidiary dividends and other payments from our subsidiaries and parent company to pay interest on and repay the principal of our debt. Statutes and regulations governing NAICO and other insurance companies domiciled in Oklahoma regulate the payment of shareholder dividends and other payments from NAICO to Chandler USA. To the extent that these restrictions limit NAICO's ability to pay dividends or other payments to us, our ability to satisfy our obligations may also be limited.
Historically, NAICO has played a significant role in the servicing of debt and other obligations of Chandler USA through the payment of shareholder dividends. Management's expectation is that Chandler Insurance or other subsidiaries will be able to meet these obligations in the future. It is possible that dividends from NAICO may be necessary to service Chandler USA's debt obligations. To the extent that the restrictions discussed previously limit NAICO's ability to pay shareholder dividends or other payments to Chandler USA, Chandler USA's ability to satisfy the debt obligations may also be limited.
WE ARE HEAVILY REGULATED IN THE STATES IN WHICH WE OPERATE.
NAICO is subject to regulation by government agencies in the jurisdictions in which it does 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, unpaid 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 financial and market conduct examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders or creditors.
NAICO is also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include redefinitions of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through re-pricing, if permitted by applicable regulations, of coverages or limitations or cessation of the affected business.
This extensive regulation of our business may affect the cost or demand for our products and may limit our ability to obtain rate increases or to take other actions that we might desire to increase our profitability. In addition, we may be unable to maintain all required approvals or comply fully with the wide variety of applicable laws and regulations, or the relevant authority's interpretation of such laws and regulations.
LITIGATION AND LEGAL PROCEEDINGS AGAINST US COULD HAVE AN ADVERSE EFFECT ON OUR BUSINESS, RESULTS OF OPERATIONS AND/OR FINANCIAL CONDITION.
Like other insurance companies, we are involved in lawsuits and legal proceedings in the normal course of our business, some of which involve claims for substantial amounts and the outcomes of which are unpredictable. This litigation is based on a variety of issues including insurance and claim settlement practices.
ASSESSMENTS FOR GUARANTY FUNDS AND OTHER MANDATORY POOLING ARRANGEMENTS MAY REDUCE OUR PROFITABILITY.
Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insureds as the result of impaired or insolvent insurance companies. These obligations are funded by assessments that are expected to continue in the future as a result of insolvencies. In addition, as a condition to the ability to conduct business in some states, insurance companies are required to participate in mandatory workers compensation shared market mechanisms or pooling arrangements, which provide workers compensation insurance coverage from private insurers. The effect of these assessments and mandatory shared market mechanism or changes in them could reduce our profitability in any given period or limit our ability to grow our business.
WE DEPEND ON KEY PERSONNEL.
We believe that our future success will depend to a significant extent on our ability to attract and retain key employees, in particular our senior officers, and key management, information systems, underwriting, claims and corporate personnel.
MANAGING TECHNOLOGY INITIATIVES AND MEETING NEW DATA SECURITY REQUIREMENTS PRESENT SIGNIFICANT CHALLENGES.
While technological developments can streamline many business processes and ultimately reduce the cost of operations, technology initiatives can present short term cost and implementation risks. Data security is subject to increasing regulation. We face rising costs and competing time constraints in meeting compliance requirements of new and proposed regulations. The expanding volume and sophistication of computer viruses, hackers and other external hazards may increase the vulnerability of our data systems to security breaches. These increased risks and expanding regulatory requirements expose us to potential data loss and damages and significant increases in compliance costs.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
Not applicable.
ITEM 2.
ITEM 2. PROPERTIES.
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 believes such space is sufficient for its operations for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
See Note 10 to Consolidated Financial Statements for a discussion of litigation matters.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the quarter ended December 31, 2006.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
All of the common stock of Chandler USA, its sole class of common equity on the date hereof, is owned by Chandler Insurance. Chandler USA has never paid cash dividends on its common shares.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
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, 2006 have been audited by Tullius Taylor Sartain & Sartain LLP, independent auditors, whose independent auditors' report expresses an unqualified opinion. 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). Amounts for 2002 have been restated to reflect the results of LaGere & Walkingstick Insurance Agency, Inc. ("L&W") as a discontinued operation.
ITEM 6. SELECTED FINANCIAL DATA (CONTINUED).
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
GENERAL
References to Chandler USA which follow within this Item 7 refer to Chandler USA and its subsidiaries on a consolidated basis unless otherwise indicated.
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 a new arrangement between Praetorian and CIMI. 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.
SUMMARY OF RESULTS
For the year ended December 31, 2006, Chandler USA had net income of $3.4 million compared to net income of $4.4 million for 2005 and a net loss of $7.0 million for 2004. The net loss in 2004 is primarily due to the adverse loss development experienced by NAICO. See "Losses and Loss Adjustment Expenses."
Many factors determine the profitability of an insurance company including regulation and rate competition; the frequency and severity of claims; the cost, availability and collectibility of reinsurance; interest rates; inflation; general business conditions; and jury awards, court decisions and legislation expanding the extent of coverage and the amount of compensation due for injuries and losses.
CRITICAL ACCOUNTING POLICIES
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.
RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Insurance companies provide in their financial statements reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under their previously issued insurance policies and reinsurance contracts. In estimating reserves, insurance companies use various standardized methods based on historical experience and payment and reporting patterns for the type of risk involved. The application of these methods necessarily involves subjective determinations by the personnel of the insurance company. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount of and uncertainty in the estimates is affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances, and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs, such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that expand insurance coverage after the insurance policy was priced and sold. In recent years, certain of these factors have contributed to incurred amounts that were significantly higher than original estimates. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims.
Estimating the ultimate loss and loss adjustment expense liability is a complex and judgmental process inasmuch as the amounts are based on management's informed estimates, assumptions and judgments using data currently available. The assumptions used in establishing reserves are regularly reviewed and updated by management as new data becomes available. Changes to estimates of previously established reserves are included in earnings in the period in which the estimate is changed. Such changes in estimates may be material. If the ultimate losses prove to differ substantially from the amounts previously recorded, the related adjustments could have a material adverse effect on Chandler USA's financial condition, results of operations and liquidity.
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, 2006, NAICO's case reserves and IBNR for each line of business are shown in the following table.
NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Methods used include the paid loss development method, incurred loss development method, Bornhuetter-Ferguson method and loss ratio method. Most methods assume that past patterns in the historical data will be repeated in the future, as long as there are no significant changes in pertinent variables. The methods chosen are those that are believed to produce the most reliable indication at that particular evaluation date. While each of the methods produce point estimates for each period analyzed, management's best estimate is usually comprised of a combination of methods due to differences in conditions during each period. The selected estimate may be one method, or a weighted average of several methods, or a judgmental selection if management determines it is appropriate. The ultimate point estimate selected by management represents the amount that management believes is the most likely amount that will ultimately be paid to settle the net reserves recorded at a particular point in time.
Reserves for losses and loss adjustment expenses are developed using multiple estimation methods that result in various point estimates for each insurance program. 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 process of selecting the point estimate from the set of possible outcomes produced by the various actuarial methods discussed above is based upon the judgment of management. In making its selection, management considers recent trends in claims frequency and severity and other factors including, but not limited to, large loss activity, large case reserve additions, historical loss information, per claim information, NAICO's loss retention, legislative enactments, judicial decisions, and trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. Significant changes in claims development patterns from historical claims development patterns may cause a significant variation between current reserve estimates and the actual future paid amounts. Assumptions used in establishing loss reserves are regularly reviewed and updated by management as new data becomes available. The changes in these estimates, resulting from the review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of operations for the period in which such estimates are changed. Such changes in estimates may be material. See Notes to Consolidated Financial Statements.
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, 2006.
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For the standard lines program, NAICO's actuaries selected the results of the incurred loss development method for the 2004 and prior accident years. The 2005 and 2006 accident years were based on judgmentally selected loss ratios in order to adjust for the effect of case reserve strengthening that was recorded during these years. The estimation methods chosen are those that are believed to produce the most reliable indication at that particular evaluation date for the losses being evaluated. The point estimates for the political subdivisions, homeowners and surety bond programs are less volatile as portions of these programs are in a run-off mode and can be estimated with more certainty. Surety bond reserves are actually a net receivable due to anticipated subrogation recoveries. Certain involuntary pools provided their own estimates and NAICO records these estimates plus an accrual to account for the lag time in reporting to NAICO. The actuarial methods used in the 2006 loss reserve analysis were similar to those used in the 2005 analysis.
The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury, workers compensation and other liability 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. Other liability claims include coverages protecting the insured against legal liability resulting from negligence, carelessness, or a failure to act causing property damage or personal injury to others. The estimation of loss reserves for other liability claims is affected by the timing of claims reporting, the applicable statute of limitations, the litigious climate and magnitude of jury awards, the unpredictability of judicial decisions regarding coverage issues and outside counsel costs. 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 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 cleanup 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.
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. 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 claim reserves and therefore would not likely have a material adverse impact, if any, on the financial condition of Chandler USA.
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 GAAP. NAICO does not discount its reserves for unpaid losses and loss adjustment expenses.
Management believes that its unpaid losses and related reinsurance recoverables are fairly stated as of December 31, 2006. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management's informed estimates, assumptions and judgments using data currently available.
REINSURANCE RECOVERABLES
Reinsurance recoverables on unpaid losses and loss adjustment expenses are 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.
DEFERRED INCOME TAXES
Chandler USA uses an asset and liability approach for accounting for income taxes. Deferred income taxes are recognized for the tax consequences of temporary differences and carryforwards by applying enacted tax rates applicable to future years to differences between the financial statement amounts and the tax bases of existing assets and liabilities. A valuation allowance is established if it is more likely than not that some portion of the deferred tax asset will not be realized. The determination of whether a valuation allowance is appropriate requires the exercise of management judgment.
At December 31, 2006, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $4.6 million which begins to expire in 2024. Chandler USA has concluded that the deferred tax asset including the federal net operating loss carryforwards is more likely than not to be realized. Chandler USA anticipates that its future U.S. consolidated income will be sufficient to utilize the federal net operating losses within the required time. Chandler USA will continue to evaluate income generated in future periods in determining the reasonableness of its position. If Chandler USA determines that future income is insufficient to cause the realization of the federal net operating losses within the required time, a valuation allowance will be established.
In addition, Chandler USA, at December 31, 2006, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $53.8 million which expire in the years 2007 through 2026. At December 31, 2006, Chandler USA also had a capital loss carryforward for U.S. Federal income taxes of $2.4 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.
OTHER
See Note 1 to Consolidated Financial Statements for information related to other accounting and reporting policies.
ECONOMIC CONDITIONS
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 $86.4 million, or 76%, of NAICO's direct written and assumed premiums in 2006 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.
Periods of inflation have varying effects on Chandler USA and its 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.
COMPETITION
NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO.
An insurance 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 the late 1990's and into 2000, property and casualty insurance companies generally under priced their products, which resulted in poor underwriting results that were partially offset by investment returns. Interest rates decreased in 2000 and underwriting results continued to deteriorate for business written in the late 1990's and into 2000. These factors coupled with additional potential losses due to terrorism and lower investment returns caused the industry to increase pricing beginning in the latter half of 2001. Rate increases continued through 2003 and to a lesser extent in 2004, and the industry's underwriting results have improved. The pricing environment during 2005 and 2006 experienced downward pressure, particularly for larger accounts. NAICO was able to increase its pricing for most coverages from 2001 through 2005. However, the recent industry trend has been for insurers to maintain or reduce rate levels, and NAICO has reduced its pricing in certain situations and for certain coverages including workers compensation during 2006. 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.
REGULATION
NAICO is subject to regulation by government agencies in the jurisdictions in which it does business. The nature and extent of such regulations 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, unpaid 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 shareholders or creditors.
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.
In addition to the regulatory oversight of NAICO, Chandler Insurance is also subject to regulation under the laws of the Cayman Islands and Chandler USA and all of its affiliates are also subject to regulation under the Oklahoma Insurance Code. The Oklahoma Insurance Code contains certain reporting requirements including those requiring Chandler Insurance, 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 Oklahoma Insurance Code contains special reporting and prior approval requirements with respect to transactions among affiliates. The Oklahoma Insurance Code also imposes certain requirements upon any person controlling or seeking to control an insurance company domiciled in Oklahoma. Control is generally presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing 10% or more of the voting securities of the insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Persons owning any securities of Chandler USA or Chandler Insurance must comply with the Oklahoma Insurance Code. See "BUSINESS - Regulation."
Insurance companies are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include the redefinition of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through coverage re-pricing, if permitted by applicable regulations, or limitations or cessation of the affected business.
ANALYSIS OF INSURANCE PROGRAM RESULTS OF OPERATIONS
The following tables summarize the net premiums earned and loss ratios (computed by dividing losses and loss adjustment expenses by net premiums earned) in each of the years presented. The "loss ratio" is based on losses recorded during the calendar year presented regardless of the accident year in which the claim occurred. 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. See "Premiums Earned" and "Losses and Loss Adjustment Expenses."
PREMIUMS EARNED
The following tables set forth premiums earned on a gross basis (before reductions for premiums ceded to reinsurers) and on a net basis (after such reductions) for each insurance program as well as each line of insurance for each year presented:
Gross premiums earned decreased 1% in both 2005 and 2006. These decreases were primarily the result of NAICO's continued efforts to improve underwriting profitability, increased competition within the Oklahoma school districts portion of the political subdivisions program, and a decrease in surety bond premiums as NAICO no longer actively markets this program. The decreases in gross premiums earned were partially offset by premiums earned in the homeowners program which began during 2005. Gross premiums earned in Texas decreased 4% and 12% in 2005 and 2006, respectively, and gross premiums earned in Oklahoma decreased 4% and less than 1% in 2005 and 2006.
Net premiums earned increased 3% and decreased 1% in 2005 and 2006, respectively. Net premiums earned in the homeowners program offset the decreases in net premiums earned in the political subdivisions and surety bond programs in 2005 and 2006.
Gross premiums earned in the standard lines program decreased less than 1% in 2005 and 1% in 2006. Gross premiums earned in Texas decreased $4.9 million and $9.2 million in 2005 and 2006, respectively, and gross premiums earned in Oklahoma increased $906,000 and $4.6 million in 2005 and 2006. The decrease in Texas premiums was due primarily to a reduction in the number of agents producing this business for NAICO, as NAICO has been focusing on increasing premium production in Oklahoma and several other states. NAICO has also increased premiums from trucking accounts in 2005 and 2006. Gross premiums earned from trucking accounts increased $6.4 million and $8.9 million in 2005 and 2006, respectively, while net premiums earned increased $3.3 million and $5.3 million in these periods. Net premiums earned in the standard lines program increased 1% and decreased 1% in 2005 and 2006, respectively.
Gross premiums earned in the political subdivisions program decreased 14% and 23% in 2005 and 2006, respectively. The decrease in gross premiums earned is due primarily to increased competition related to Oklahoma school districts. Net premiums earned decreased 8% and 21% in 2005 and 2006, respectively. The decrease in net premiums earned was significantly less than the decrease in gross premiums earned because this program has a larger portion of property risks than other programs, and property risks have more reinsurance than other lines of business.
In 2005, NAICO began writing homeowner and dwelling policies in the state of Texas through a managing general agent. Gross and net premiums earned in the homeowners program increased 102% and 61% in 2006. The increase in net premiums earned was significantly less than the increase in gross premiums earned due to an increase in the amount and cost of reinsurance covering catastrophic exposures. NAICO discontinued this program during the second quarter of 2006 due primarily to increased catastrophic exposures.
Gross premiums earned in the surety bond program decreased 67% and 70% in 2005 and 2006, respectively. Net premiums earned decreased 66% and 71% in 2005 and 2006, respectively. NAICO is no longer actively marketing its surety bond program, and does not expect premium volume in this program to increase in the future.
Other programs in the preceding table include premiums from the runoff of various programs which are no longer offered by NAICO and NAICO's participation in various mandatory pools covering workers compensation for insureds that were unable to purchase this coverage from an insurance company on a voluntary basis.
NET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS
At December 31, 2006, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate bonds, equity securities and mutual funds that invest in equity securities, with approximately 24% invested in cash and money market instruments. Income generated from this portfolio is largely dependent upon prevailing levels of interest rates. Chandler USA's portfolio contains no non-investment grade bonds or real estate investments. Chandler USA also receives interest income from related parties on intercompany loans. Net investment income included $577,000 in interest from an arbitration award in 2004, and $6.6 million for the accrual of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims in 2006. See Litigation and Note 10 of Notes to Consolidated Financial Statements.
Net investment income, excluding interest income from related parties and interest from the arbitration award in 2004 and the prejudgment interest accrual in 2006, increased 7% in 2005 and 13% in 2006. Interest income from related parties was $491,000, $670,000 and $792,000 during 2004, 2005 and 2006, respectively. The increases were due primarily to higher interest rates. See Liquidity and Capital Resources.
Net realized investment gains were $652,000, $383,000 and $745,000 in 2004, 2005 and 2006, respectively.
The average net yield on the fixed maturity portfolio, including net realized investment gains, was 4.0%, 3.4% and 3.6% in 2004, 2005 and 2006, respectively. The average net yield on the fixed maturity portfolio, excluding net realized investment gains, was 3.2% for 2004, 3.4% for 2005 and 3.6% for 2006. 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, 2006 was approximately $11.3 million. The average yield on the fixed maturity portfolio before deducting investment expenses was 3.6% in 2004, 3.8% in 2005 and 4.0% in 2006, excluding net realized capital gains.
OTHER INCOME
During 2004, the remaining $368,000 of deferred gain related to a sale and leaseback transaction for certain equipment was amortized into income.
LOSSES AND LOSS ADJUSTMENT EXPENSES
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 84.0%, 56.5% and 69.2% in 2004, 2005 and 2006, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $761,000, $475,000 and $727,000 in 2004, 2005 and 2006, respectively, and increased the respective loss ratios by 1.2, 0.7 and 1.1 percentage points.
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2004-2006 calendar years. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. The development was primarily a function of more adverse frequency and severity patterns than previously anticipated. Since such development patterns were not present in the loss history available at the time the earlier estimates were prepared, they could therefore not be anticipated. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results.
The following table sets forth the loss development by line of business during each of the calendar years shown.
In 2004, the majority of the adverse loss development was in the other liability and workers compensation lines of business. Other liability claims may not be reported for several years after the occurrence of a loss and may not be settled for several years once reported. Workers compensation claims may be paid out over several years. In 2005 and 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. 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.
The following table sets forth the net reserves at the beginning of each accident year, the loss development incurred during each calendar year, and the re-estimated net reserves as of the beginning of each calendar year.
During 2004, NAICO experienced adverse loss development totaling $26.3 million primarily in the standard lines and political subdivisions programs. This adverse development was due primarily to continued increases in losses in the workers compensation and other liability lines of business in the 1997-2002 accident years. Adverse loss development for other liability was $15.5 million. Adverse loss development for workers compensation, surety bonds and automobile liability were $7.6 million, $1.9 million and $1.1 million, respectively. Involuntary workers compensation pools experienced $803,000 in adverse loss development, with $703,000 of this in 1996 and prior accident years. NAICO records losses based on information obtained from the pools plus an accrual for the lag time in reporting. 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%.
During 2005, NAICO experienced adverse loss development totaling $6.3 million primarily in the standard lines and political subdivisions programs. A portion of the adverse development was offset by favorable development of $1.8 million in the surety bond program, primarily in accident years 1994 and 2001 that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the workers compensation, other liability and automobile liability lines of business in the 2000, 2002 and 2003 accident years. The adverse loss development included approximately $108,000 for provisions for potentially uncollectible reinsurance.
During 2006, NAICO experienced adverse loss development totaling $3.8 million primarily in the standard lines program. A portion of the adverse development was offset by favorable development of $1.0 million in the surety bond program, primarily in the 2001 accident year, that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the automobile liability line of business in the 2005 accident year and in the workers compensation line of business in the 1997 and 1999 accident years. The adverse loss development included approximately $97,000 for provisions for potentially uncollectible reinsurance.
In the last five 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 2004, 2005 and 2006, NAICO incurred charges of $282,000, $108,000 and $97,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
NAICO did not receive any claims related to the September 11, 2001 terrorist attacks on the World Trade Center and does not believe that it has any significant exposure to these and related losses. While several of NAICO's reinsurers did experience significant losses related to these attacks, it currently does not appear that these losses will impair the reinsurers' ability to pay claims.
POLICY ACQUISITION COSTS
Policy acquisition costs consist of costs associated with the acquisition of new and renewal business and generally include direct costs such as premium taxes, commissions to agents and ceding companies and premium-related assessments and indirect costs such as salaries and expenses of personnel who perform and support underwriting activities. NAICO also receives ceding commissions from reinsurers who assume premiums from NAICO under certain reinsurance contracts and the ceding commissions are accounted for as a reduction of policy acquisition costs. Direct policy acquisition costs and ceding commissions are deferred and amortized over the terms of the policies. When the sum of the anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded.
The following table sets forth Chandler USA's policy acquisition costs for each of the three years ended December 31, 2004, 2005 and 2006:
YEAR ENDED DECEMBER 31, -------------------------------- 2004 2005 2006 ---------- ---------- ---------- (In thousands)
Commissions expense ............................. $ 16,078 $ 17,186 $ 15,933 Other premium related assessments ............... 1,137 960 1,061 Premium taxes ................................... 2,562 2,205 2,020 Excise taxes .................................... 301 272 272 Other expense ................................... 458 723 730 ---------- ---------- ---------- Total direct expenses ........................... 20,536 21,346 20,016 Indirect underwriting expenses .................. 7,463 6,384 6,296 Commissions received from reinsurers ............ (17,068) (15,891) (15,026) Adjustment for deferred acquisition costs ....... 108 (1,168) 380 ---------- ---------- ---------- Net policy acquisition costs .................... $ 11,039 $ 10,671 $ 11,666 ========== ========== ==========
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.0% in both 2004 and 2005, and 23.3% in 2006. For these periods, commission expense as a percentage of gross written and assumed premiums was 13.2%, 14.3% and 14.1%. The increase in 2005 in commission expense was due primarily to the homeowners program that began during 2005. This program has a higher average commission rate than most of the other programs due to the use of a managing general agent who performs certain underwriting, claims and administrative functions.
Indirect underwriting expenses were 6.1%, 5.3% and 5.6% of total direct written and assumed premiums in 2004, 2005 and 2006, respectively. The decreases in 2005 and 2006 were due primarily to a reduction in employee related expenses. 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. Commissions received from reinsurers as a percentage of ceded reinsurance premiums were 33.3%, 31.6% and 31.1% in 2004, 2005 and 2006, respectively.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses were 10.5%, 11.0% and 10.9% of gross premiums earned in 2004, 2005 and 2006, respectively. General and administrative expenses in 2004 included 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
Interest expense increased 6% in both 2005 and 2006. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. The increases in 2005 and 2006 were due primarily to the increase in interest rates during these periods, as a portion of Chandler USA's junior subordinated debentures were issued with a floating interest rate.
FEDERAL INCOME TAXES
Chandler USA's federal income tax benefit (provision) as a percentage of income (loss) before income taxes was 33.8%, 35.6% and 32.9% for 2004, 2005 and 2006, respectively.
At December 31, 2006, Chandler USA had a net deferred tax asset of $4.0 million including $1.6 million related to federal net operating loss carryforwards which begin to expire in 2024. Chandler USA believes it is more likely than not that the deferred income tax asset including the federal net operating loss carryforwards 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 federal net operating loss carryforwards and the other remaining deferred tax assets.
LIQUIDITY AND CAPITAL RESOURCES
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.
A significant portion of Chandler USA's consolidated assets represents assets of NAICO that may not be immediately transferable to Chandler USA in the form of shareholder dividends, loans, advances or other payments.
Statutes and regulations governing NAICO and other insurance companies domiciled in Oklahoma regulate the payment of shareholder dividends and other payments by NAICO to Chandler USA. Under applicable Oklahoma statutes and regulations, NAICO is permitted to pay shareholder dividends only out of statutory earned surplus. To the extent NAICO has statutory earned surplus, NAICO may pay shareholder dividends only to the extent that such dividends are not defined as extraordinary dividends or distributions. If the dividends are, under applicable statutes and regulations, extraordinary dividends or distributions, regulatory approval must be obtained. Under the applicable Oklahoma statute, and subject to the availability of statutory earned surplus, the maximum shareholder dividend that may be declared (or cash or property distribution that may be made) by NAICO in any one calendar year without regulatory approval is the greater of (i) NAICO's statutory net income, excluding realized capital gains, for the preceding calendar year; or (ii) 10% of NAICO's statutory policyholders' surplus as of the preceding calendar year end, not to exceed NAICO's statutory earned surplus.
As of December 31, 2006, NAICO had statutory earned surplus of $14.0 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2007 without the approval of the Oklahoma Department of Insurance is $5.2 million. NAICO paid shareholder dividends to Chandler USA totaling $3.4 million in June of 2004.
In addition to the statutory limits described above, the amount of shareholder dividends and other payments to affiliates can be further limited by contractual or regulatory restrictions or other agreements with regulatory authorities restricting dividends and other payments, including regulatory restrictions that are imposed as a matter of administrative policy. If insurance regulators determine that payment of a shareholder dividend or other payments to an affiliate (such as payments under a tax sharing agreement, payments for employee or other services, or payments pursuant to a surplus note) would be hazardous to such insurance company's policyholders or creditors, the regulators may block such payments that would otherwise be permitted without prior approval.
Historically, NAICO has played a significant role in the servicing of debt and other obligations of Chandler USA through the payment of shareholder dividends. These obligations include $7.0 million of 8.75% senior debentures due in 2014, $13.4 million of 9.75% junior subordinated debentures due in 2033, $7.2 million of floating rate junior subordinated debentures due in 2034 and the obligations under the sale and leaseback transaction discussed below. Management's expectation is that Chandler Insurance or other subsidiaries will be able to meet these obligations in the future. It is possible that dividends from NAICO may be necessary to service Chandler USA's debt obligations. To the extent that the restrictions discussed previously limit NAICO's ability to pay shareholder dividends or other payments to Chandler USA, Chandler USA's ability to satisfy the debt obligations may also be limited.
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, 2006, 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.
NAICO purchases investments to support its investment strategies which are developed based on many factors including rate of return, maturity, credit risk, tax considerations, regulatory requirements and its mix of business. As of December 31, 2006 all of the investments of NAICO were in fixed-maturity investments, equity securities, mutual funds that invest in equity securities, interest-bearing money market accounts and collateralized repurchase agreements. At the time of purchase, investments in debt securities that NAICO has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. NAICO has not classified any investments as trading account assets. Debt securities not classified as held to maturity or trading and equity securities are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of deferred income tax as a separate component of other comprehensive income until realized.
Chandler USA provided $20.2 million in cash from operations in 2004, used $131,000 in cash from operations in 2005 and provided $4.4 million in cash from operations in 2006. The cash provided by operations in 2004 was 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. During 2005, net premiums written decreased slightly which attributed to Chandler USA using only $131,000 in cash from operations. In 2005, the increase in premium receivables and reinsurance recoverables on unpaid losses were offset by Chandler USA's net income and an increase in unearned premium. 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. See "Litigation."
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 $652,000, $383,000 and $745,000 during 2004, 2005 and 2006, respectively, from the sale of investments. NAICO received proceeds of $23.8 million, $2.5 million and $21.3 million during 2004, 2005 and 2006, respectively, from the sale of available for sale securities prior to their maturity. During 2004, 2005 and 2006, the market value of NAICO's available for sale fixed-income investments decreased by $581,000, $1.6 million and $1,000, respectively, due primarily to changes in interest rates experienced during this time. The average maturity of NAICO's fixed maturity investments was 4.0 years and 3.4 years at December 31, 2005 and 2006, 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, 2005 and 2006, Chandler USA had a receivable of $9.4 million and $9.6 million, respectively, under the Credit Agreement, and Chandler USA earned $439,000, $614,000 and $733,000 in interest income under the Credit Agreement during 2004, 2005 and 2006, respectively.
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, 2006, the total amount of cash and investments restricted as a result of these arrangements was $7.7 million. In addition, NAICO has deposited $11.9 million of cash and investments into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer.
During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for a three year term. During March 2004, the lease was extended for three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest, which was 9.25% at December 31, 2006, on the unpaid lease balance which is a floating interest rate of 1% over JP Morgan Chase Bank prime. During March 2007, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $13,834 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.9 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.5 million. See Note 11 to Consolidated Financial Statements.
CONTRACTUAL OBLIGATIONS
The following table provides the future payments due by period under contractual obligations as of December 31, 2006, aggregated by type of obligation:
LITIGATION
On August 1, 2006, a jury trial concluded in Harris County, Texas, related to the construction of two gas processing plants in Louisiana. NAICO had provided surety bonds in connection with the construction of these plants. The amounts the jury found owing to NAICO include approximately $20.2 million in actual damages and $70.0 million in punitive damages. See Note 10 of Notes to Consolidated Financial Statements for a discussion of this jury verdict.
On October 30, 2006, NAICO filed its Motion for Entry of Judgment requesting that the Trial Court enter judgment for a total of $100.6 million plus court costs and anticipated attorney fees for appeals. This amount includes $70.0 million in punitive damages, $8.3 million in prejudgment interest through November 1, 2006, and attorney fees of $4.6 million through entry of judgment. The Trial Court denied the request for attorney fees on January 5, 2007. NAICO expects the Trial Court to enter judgment based upon its request during 2007. When entering judgment, the Court may enter judgment based upon NAICO's request or may enter a different judgment. After judgment is entered, all parties may file post-judgment motions. Following the Court's rulings on post-judgment motions, all parties may appeal all or any of those rulings or judgments.
During the third quarter of 2006, NAICO increased the estimated recovery on the surety bond claims related to the construction of the two gas processing plants which resulted in a decrease in losses and loss adjustment expenses incurred of $4.7 million. In addition, unpaid losses and loss adjustment expenses decreased $22.7 million, reinsurance recoverable on unpaid losses and loss adjustment expenses decreased $16.8 million, and reinsurance recoverable on paid losses and loss adjustment expenses decreased $1.2 million. NAICO also recorded $6.6 million of interest income for its estimate of prejudgment interest through December 31, 2006, including a recovery for a pre-verdict settlement with certain other parties. Prejudgment interest will continue to accrue at 8.25%.
NEW ACCOUNTING STANDARDS
See Note 1 to Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Chandler USA's consolidated balance sheets include a certain amount of assets and liabilities whose fair values are subject to market risk. Due to Chandler USA's significant investment in fixed-maturity investments, interest rate risk represents the largest market risk factor affecting Chandler USA's consolidated financial position. Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of those instruments. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative investments, liquidity of the instrument and other general market conditions.
As of December 31, 2006, substantially all of the investments of NAICO were in fixed-maturity investments (rated Aa3 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), equity securities, mutual funds that invest in equity securities, interest-bearing money market accounts and collateralized repurchase agreements. NAICO does not hold any investments classified as trading account assets or derivative financial instruments.
The table below summarizes the estimated effects of hypothetical increases and decreases in interest rates on NAICO's fixed-maturity investment portfolio. It is assumed that the changes occur immediately and uniformly, with no effect given to any steps that management might take to counteract that change. The hypothetical changes in market interest rates reflect what could be deemed best and worst case scenarios. The fair values shown in the following table are based on contractual maturities. Significant variations in market interest rates could produce changes in the timing of repayments due to prepayment options available. The fair value of such instruments could be affected and, therefore, actual results might differ from those reflected in the following table:
The table above illustrates, for example, that an instantaneous 200 basis point increase in market interest rates at December 31, 2006 would reduce the estimated fair value of NAICO's fixed-maturity investments by approximately $3.9 million at that date.
NAICO's portfolio of equities and equity mutual funds has exposure to equity price risk. Equity price risk is defined as the potential loss in fair value resulting from an adverse change in prices. The mutual funds primarily invest in equity securities of large U.S. entities across a variety of industries. These funds are managed by the individual fund managers, and NAICO's Investment Committee monitors the performance of these mutual funds. The equities and equity mutual funds are carried on the balance sheet at fair value. The changes in estimated fair value of the equity portfolio are presented as a component of shareholder's equity in accumulated other comprehensive income, net of taxes.
The table below summarizes NAICO's equity price risk and shows the effect of a hypothetical 20% increase and a 20% decrease in market prices as of December 31, 2005 and 2006. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios.
Chandler USA is obligated for $7.0 million principal amount of Debentures that have a maturity date of July 16, 2014. The Debentures have a fixed interest rate of 8.75%. At December 31, 2006, the fair value of Chandler USA's Debentures was estimated to be $5.8 million based on the latest reported trade. Chandler USA's Debentures have not historically traded regularly, and settlement at the reported fair value may not be possible. The Debentures are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium, but may be purchased and cancelled by Chandler USA at a price of less than the sum of the principal amount and accrued interest at any time. Chandler USA is obligated for $13.4 million principal amount of junior subordinated debentures that mature in 2033 with a fixed interest rate of 9.75%, and $7.2 million principal amount of junior subordinated debentures that mature in 2034 with a floating rate of 4.10% over LIBOR. The interest rate was 9.47% at December 31, 2006. At December 31, 2006, the fair value of Chandler USA's junior subordinated debentures was estimated to be $21.7 million.
During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for three years. The sale and leaseback transaction resulted in a deferred gain of $2.0 million which was amortized into income over the final year of the lease, resulting in other income of $1.7 million in 2003 and $368,000 in 2004. During March 2004, the lease was extended for three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest, which was 9.25% at December 31, 2006, on the unpaid lease balance which is a floating interest rate of 1% over JP Morgan Chase Bank prime. During March 2007, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $13,834 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.9 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.5 million.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
See Item 15(a)1.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
As of the end of the period covered by this report and pursuant to Rule 13a-15 of the Securities Exchange Act of 1934 (the "Exchange Act"), Chandler USA's management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness and design of Chandler USA's disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act). Based upon that evaluation, Chandler USA's Chief Executive Officer and Chief Financial Officer concluded, as of the end of the period covered by this report, that Chandler USA's disclosure controls and procedures were effective in recording, processing, summarizing and reporting information required to be disclosed by Chandler USA, within the time periods specified in the Securities and Exchange Commission's rules and forms.
CHANGES IN INTERNAL CONTROLS
As of the end of the period covered by this report, there have been no changes in internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the quarter to which this report relates that have materially affected or are reasonably likely to materially affect, Chandler USA's internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
DIRECTORS AND EXECUTIVE OFFICERS
A brief description of each director and executive officer of Chandler USA is provided below. Directors hold office until the next annual meeting of shareholders or until their respective successors are duly elected and qualified. Executive officers are elected by the Board of Directors at its annual meeting and hold office until its next annual meeting or until their respective successors are duly elected and qualified. The current directors and executive officers of Chandler USA are as follows:
W. BRENT LAGERE has been a director, Chairman of the Board and Chief Executive Officer of Chandler USA since 1988 and of CIMI since December 2002. Since 1988, Mr. LaGere has served in officer and director capacities for various subsidiaries of Chandler USA pursuant to an employment contract with Chandler USA. Mr. LaGere serves as Chairman of the Board and Chief Executive Officer of Chandler Insurance.
MARK T. PADEN has served as President of Chandler USA and NAICO since May 2001 and as Chief Operating Officer of Chandler USA and NAICO from May 1998 to February 2006. Mr. Paden has served as President of CIMI since December 2002 and Chief Operating Officer of CIMI from December 2002 to February 2006. From May 1998 to May 2001, Mr. Paden also served as Executive Vice President of Chandler USA and NAICO. Mr. Paden has served as Chief Financial Officer of NAICO from January 1988 through May 2001 and also served as Vice President-Finance of NAICO from January 1988 through May 1998. Mr. Paden has been a director of Chandler USA since July 1988, NAICO since November 1992 and CIMI since December 2002. Mr. Paden also serves as a director and President of Chandler Insurance.
LANCE A. LAGERE has served as Executive Vice President of NAICO since January 2006, and of Chandler USA and CIMI since February 2006. Mr. LaGere has also served as Chief Operating Officer of these companies since February 2006. From December 2002 to December 2005, Mr. LaGere was a retail insurance agent for Brown & Brown of Central Oklahoma, Inc. From June 2002 to December 2002, Mr. LaGere was a retail insurance agent for LaGere & Walkingstick Insurance Agency, Inc., which was a wholly owned subsidiary of Chandler USA until its sale to Brown & Brown, Inc. in December 2002. Mr. LaGere was also appointed as Executive Vice President of Chandler Insurance during 2006, pending approval by the Cayman Islands Monetary Authority. Mr. LaGere is the son of W. Brent LaGere, Chairman of the Board and Chief Executive Officer of Chandler USA.
RICHARD L. EVANS has been a director of Chandler USA since May 1990. He has been Senior Vice President of Chandler USA and NAICO since March 1999, and served as Vice President of NAICO since 1987, and of Chandler USA since 1989. Mr. Evans also serves as Senior Vice President of Chandler Insurance.
R. PATRICK GILMORE has served as General Counsel for Chandler USA and its subsidiaries since 1988 and currently serves as corporate Secretary and Senior Vice President. Mr. Gilmore has been a director of Chandler USA since May 1990 and NAICO since September 2000.
MARK C. HART has served as Senior Vice President-Finance and Treasurer of Chandler USA and NAICO since May 1998, and has served as Chief Financial Officer of Chandler USA and NAICO since May 2001. Mr. Hart has also served as Vice President of Chandler USA since March 1994. Mr. Hart has served as Treasurer of CIMI since December 2002. Mr. Hart also serves as Vice President-Accounting, Chief Financial Officer and Treasurer of Chandler Insurance.
M. STEVEN BLAIN has served as Vice President-Administration of Chandler USA and NAICO since August 2003. From November 1999 to August 2003, Mr. Blain was employed by NAICO in various capacities. Prior to his employment by NAICO in November 1999, Mr. Blain was Vice President-Operations and Chief Financial Officer for J.B. Pratt Foods, Inc.
ROBERT L. RICE has been a director of Chandler USA since June 1993 and a director of NAICO since March 2000. He has for more than 20 years engaged in private practice as a Certified Public Accountant.
W. SCOTT MARTIN has been a director of Chandler USA and NAICO since March 2000. Mr. Martin has been President of the Tulsa Loan Production Office with First Bank & Trust Company in Wagoner, Oklahoma since 1994. Mr. Martin also serves as a director of First Bank & Trust in Wagoner, Oklahoma, First Bank of Chandler in Chandler, Oklahoma, First National Bank in Burkburnett, Texas and First Bank in Ketchum, Oklahoma. Mr. Martin is also the Manager for Basin Management, LLC.
WILLIAM T. KEELE has been a director of Chandler USA and NAICO since May 2001. Mr. Keele has been President of Hallman & Keele, Inc., a construction and steel fabrication firm, since 1974.
AUDIT COMMITTEE FINANCIAL EXPERT
Chandler USA's Audit Committee is composed of Messrs. Rice, Martin and Keele, with Mr. Rice serving as Chairman. Chandler USA's Board of Directors has determined that Mr. Rice is an "audit committee financial expert", as defined by Securities and Exchange Commission rules. Mr. Rice is an independent director, as that term is used in Item 7(d)(3)(IV) of Schedule 14A under the Securities Exchange Act of 1934.
CODE OF ETHICS
Chandler USA has adopted a Code of Ethics for Principal Executive and Senior Financial Officers, a copy of which was filed as Exhibit 14.1 to Chandler USA's Form 10-K for the fiscal year ended December 31, 2003.
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934
Based solely upon a review of Forms 3, 4 and 5, any amendments thereto furnished to Chandler USA pursuant to the rules of the Securities and Exchange Commission, or written representations from certain reporting persons presented to Chandler USA, all such reports required to be filed by reporting persons have been filed in a timely fashion during the fiscal year ended December 31, 2006.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
COMPENSATION DISCUSSION AND ANALYSIS
This section provides information regarding the compensation of our Chief Executive Officer, Chief Financial Officer and, in addition, our three most highly compensated executive officers. Collectively, we refer to these executives as the named executive officers. Our executive compensation program is developed and monitored by our Compensation Committee which consists of our Chief Executive Officer and our President.
COMPENSATION PROGRAM OBJECTIVES Our overall goal in compensating executive officers is to attract, retain and motivate key executives who are critical to our future success. We want to reinforce our goal to grow our business profitably and to reward each executive's contributions toward this goal. Our decisions with respect to executive officer salaries and incentives are influenced by the executive's level of responsibility and function within Chandler USA as well as the overall performance and profitability of Chandler USA.
EXECUTIVE COMPENSATION ELEMENTS Our Compensation Committee reviews the performance results of each named executive officer and establishes individual compensation levels. Our executive compensation program consists of base salaries, cash bonuses and perquisites.
BASE SALARIES The purpose of the base salary is to reflect each executive's job responsibilities and to reward each executive's job performance. During 2006, the following base salaries were approved for our named executive officers:
Base annual salaries are evaluated at least annually on the officer's anniversary date for each of the named executive officers. This evaluation includes recommendations from the Chief Operating Officer for certain of the executive officers. At that time, the Compensation Committee determines the base salary adjustment for each executive officer. The factors that influence the determination include the executive's experience, performance, changes in responsibilities and budgetary considerations.
Chandler USA has an employment agreement with W. Brent LaGere, Chairman of the Board and Chief Executive Officer of Chandler USA and its subsidiaries. Under this agreement, Mr. LaGere's base compensation is established at not less than $250,000 per year. In the event that Mr. LaGere is terminated without cause, as defined in the agreement, he is entitled to receive his base compensation for the remainder of the term of the agreement, but in no event for more than 60 months. The agreement will terminate upon Mr. LaGere attaining age 70, unless earlier terminated by Chandler USA for cause.
CASH BONUSES While the company does not have a formal incentive bonus program, all of the named executive officers are eligible to receive cash bonuses. The amount of cash bonuses to be paid are determined at the discretion of the Compensation Committee. During 2006, the Compensation Committee awarded cash bonuses to Mr. LaGere and Mr. Paden as shown in the Summary Compensation Table that follows. These cash bonuses were paid during 2006.
PERQUISITES Each of the named executive officers participate in employee benefit plans generally available to our employees, including medical, life insurance, disability plans and our defined contribution 401(k) retirement plan. Other perquisites such as company provided automobiles, additional disability and life insurance are also provided to certain named executive officers. In addition, various personal expenses are paid for on behalf of our Chief Executive Officer and President, and these expenses and related income tax gross-ups are reported as "All Other Compensation" in the Summary Compensation Table that follows. The amount and nature of the personal expenses to be paid are determined at the discretion of the Compensation Committee.
ROLE OF EXECUTIVE OFFICERS IN DETERMINING COMPENSATION Our Compensation Committee consists of our Chief Executive Officer and President. These two individuals also own 100% of the outstanding common stock of our ultimate parent company. As such, they determine the levels of their own compensation including cash bonuses and perquisites. They also determine the levels of compensation, with input from the Chief Operating Officer, for each of the other named executive officers.
The following table sets forth the compensation paid or to be paid by Chandler USA or any of its subsidiaries as well as all other compensation paid or accrued to the Chief Executive Officer, Chief Financial Officer, and the three other most highly compensated executive officers of Chandler USA and its subsidiaries during the years indicated.
COMPENSATION OF DIRECTORS Directors who are employees of Chandler USA do not receive additional compensation for serving as directors. Each non-employee director of Chandler USA is paid $1,000 per day for any meeting or committee meeting attended. However, if a non-employee director is attending meetings for two or more affiliates of Chandler USA on the same day, his compensation is $750 per day for any meeting or committee meeting of Chandler USA attended. Each non-employee director is also paid $1,500 per day for any NAICO board meeting attended. If a non-employee director attends the meeting by telephonic conference, his compensation is $500 per day for any meeting or committee meetings so attended. As Chairman of the Audit Committee, Mr. Rice's compensation for audit committee meetings is 150% of the applicable meeting fee.
The following table sets forth the compensation earned by our non-employee directors for 2006.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Chandler USA's Compensation Committee consists of W. Brent LaGere and Mark T. Paden. Mr. LaGere is the Chief Executive Officer of Chandler USA and its subsidiaries, and is also a director of Chandler USA's sole shareholder Chandler Insurance. Mr. Paden is President of Chandler USA and its subsidiaries, and is also a director of Chandler Insurance. Chandler Insurance has no employees and does not have a compensation committee.
COMPENSATION COMMITTEE REPORT The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis section with management and, based on such review and discussion, recommended to our Board of Directors that it be included in this Annual Report on Form 10-K.
March 6, 2007 Compensation Committee: W. Brent LaGere Mark T. Paden
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
All of the common stock of Chandler USA, its sole class of common equity, is owned by Chandler Insurance.
The following table sets forth the number and percentage of outstanding shares of each class of the capital stock of Chandler Insurance that, as of February 28, 2007, are beneficially owned by (i) each director of Chandler USA and Chandler Insurance, (ii) each of the named executive officers and (iii) all current directors and executive officers as a group:
SHAREHOLDERS HOLDING OVER FIVE PERCENT
Listed below are persons, other than those listed previously, who are known by Chandler USA to own beneficially more than 5% of Chandler Insurance's Class A Common Shares as of February 28, 2007. Except as otherwise indicated, each of the persons named below has sole voting and investment power with respect to the common shares beneficially owned.
OTHER MATTERS REGARDING BENEFICIAL OWNERSHIP
For purposes of this report, unless otherwise indicated, Chandler USA has assumed that the following persons are affiliates: an entity's executive officers and directors or its managing partners, persons holding more than 10% of an entity, and those persons who are controlling, controlled by, or under common control with such officers, directors, managing partners, or shareholders.
Statements of percentages of ownership are made based upon pertinent reporting requirements and guidelines specifically applicable to this report on Form 10-K. Determination of voting power under Chandler USA's Articles of Incorporation or applicable insurance holding company laws may be at variance with the above stated percentages.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
Transactions with related persons are reviewed and approved by the Board of Directors of Chandler USA or, in certain situations, by the Board of Directors of one of its subsidiary companies.
During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for a three year term. During March 2004, the lease was extended for three years, and during March 2007 the lease was extended for an additional three years. See Note 11 to Consolidated Financial Statements for additional information. The bank that participated in the sale and leaseback transaction established a letter of credit in the amount of $500,000 on behalf of Chandler USA for the benefit of Brown & Brown, Inc. as security in connection with the sale of a subsidiary. Chandler USA paid a fee of $5,000 during 2004 to the bank for issuing the letter of credit. This letter of credit expired on December 31, 2005. W. Scott Martin, a director of NAICO and Chandler USA, is an officer and director of the bank that participated in these transactions, and is also a significant shareholder of the bank's holding company. Mr. Martin is also a director of the bank that Chandler USA and its subsidiaries use as their principal disbursement bank, and is a significant shareholder of the bank's holding company. The balance maintained by Chandler USA and each subsidiary is fully insured by the Federal Deposit Insurance Corporation, and Chandler USA and its subsidiaries pay customary service charges to the bank for the services provided.
During the second quarter of 2006, CIMI purchased two limited partnership units in Basin Drilling #2 LP for $2,000, and purchased 8% cumulative subordinated debentures in the amount of $500,000. The timing of payment of interest and principal on the debentures is subject to various restrictions contained in the cumulative subordinated debenture note. The purpose of the partnership is to own and operate an oil and gas drilling rig. CIMI financed the purchase with a $500,000 variable rate bank loan. Principal and interest payments are due on the bank loan in five quarterly installments beginning September 1, 2006. Interest is payable at 1% over New York Prime, which was 9.25% at December 31, 2006. The partnership is managed by Basin Management, LLC ("BMLLC") who is the General Partner. W. Scott Martin, a director of NAICO and Chandler USA, is the Manager for BMLLC, and is also a director of the bank and a significant shareholder of the bank holding company that provided the bank loan described above.
Chandler USA leases a rural property from Davenport Farms, Inc. ("Davenport Farms"), a corporation owned by W. Brent LaGere, Richard L. Evans and Mark T. Paden. Chandler USA has placed three mobile homes on the property, drilled a water well connected to the mobile homes and made other smaller improvements to the property. Its personnel maintain these improvements. These mobile homes and the property provide hunting, fishing, lodging, dining and other outdoor recreational activities for the entertainment of customers and business associates of Chandler USA and/or its subsidiaries. Chandler USA pays no rent to Davenport Farms but reimburses it for one-half of the utilities and for hunting supplies. Chandler USA has also agreed to indemnify Davenport Farms for claims arising out of its use of the property. Chandler USA retains the right to remove all structures located upon the property when the lease terminates. In 2004, 2005 and 2006, Chandler USA incurred approximately $353,000, $313,000 and $308,000, respectively, in expenses associated with its use of this property, including $14,000, $10,000 and $11,000 for reimbursement of certain expenses, such as utility and similar expenses, for the years 2004, 2005 and 2006, respectively.
DIRECTOR INDEPENDENCE
Chandler USA is a privately held corporation with only debt securities listed on the American Stock Exchange ("AMEX"). The AMEX requires that a majority of the directors be "independent directors" as defined in the AMEX Company Guide. Chandler USA has relied upon an exception to this requirement which is provided for companies listing only debt securities. The Board of Directors has determined that Messrs. Rice, Martin and Keele are independent directors.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
AUDIT FEES
The aggregate audit fees billed or to be billed by Tullius Taylor Sartain & Sartain LLP for the audit of Chandler USA's annual financial statements and review of financial statements included in Chandler USA's Form 10-Q and services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements were approximately $155,000, $167,100 and $178,900 for the years ended December 31, 2004, 2005 and 2006, respectively.
AUDIT-RELATED FEES
The aggregate fees billed for professional services rendered by Tullius Taylor Sartain & Sartain LLP for audit related services rendered in connection with the audits of employee benefit plans and consultation on accounting standards or transactions were $18,150, $28,450 and $21,000 for the years ended December 31, 2004, 2005 and 2006, respectively.
TAX FEES
The aggregate fees billed or to be billed for professional services rendered by Tullius Taylor Sartain & Sartain LLP for tax compliance, tax advice and tax planning were $17,700, $23,650 and $20,750 for the years ended December 31, 2004, 2005 and 2006, respectively.
ALL OTHER FEES
The aggregate fees billed by Tullius Taylor Sartain & Sartain LLP for professional services other than those reported in the categories above were $500 for the year ended December 31, 2005. There were no other fees billed by Tullius Taylor Sartain & Sartain LLP for the years ended December 31, 2004 and 2006.
POLICY ON PRE-APPROVAL OR RETENTION OF INDEPENDENT AUDITORS
All audit and permitted non-audit services for which Chandler USA engages Tullius Taylor Sartain & Sartain LLP require pre-approval by Chandler USA's Audit Committee. The percentage of Audit-Related Fees, Tax Fees and All Other Fees out of all fees paid to Tullius Taylor Sartain & Sartain LLP was 18.8%, 23.9% and 18.9% for the years ended December 31, 2004, 2005 and 2006, respectively.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a) 1. FINANCIAL STATEMENTS. The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 2005 and 2006, and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for each of the three years in the period ended December 31, 2006, together with the related notes thereto and the report of Tullius Taylor Sartain & Sartain LLP, independent auditors on such financial statements, are filed as a part of this Form 10-K. See accompanying Index on page.
2. FINANCIAL STATEMENT SCHEDULES. The financial statement schedules listed in the accompanying index to consolidated financial statements and schedules are filed as part of this Form 10-K. All other schedules have been omitted since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule or because the information is included in the consolidated financial statements or the notes thereon.
3. EXHIBITS.
3.1 Certificate of Incorporation. (1)
3.2 Bylaws, as amended. (1)
4.1 Form of Indenture entered into by and between Chandler (U.S.A.), Inc. as issuer and U.S. Trust of Texas, N.A. as trustee. (1)
4.2 First Amendment to Indenture effective May 13, 2003 constituting the First Amendment to the Indenture dated as of July 16, 1999, between Chandler (U.S.A.), Inc., and The Bank of New York Trust Company of Florida, N.A. as successor trustee to U.S. Trust Company of Texas, N.A., as Trustee regarding the 8.75% senior debentures due 2014 issued by Chandler (U.S.A.), Inc. (3)
4.3 Second Amendment to Indenture effective December 1, 2003 constituting the Second Amendment to the Indenture dated as of July 16, 1999, between Chandler (U.S.A.), Inc., and The Bank of New York Trust Company of Florida, N.A. as successor trustee to U.S. Trust Company of Texas, N.A., as Trustee regarding the 8.75% senior debentures due 2014 issued by Chandler (U.S.A.), Inc. (5)
10.1 Employment Agreement, effective as of October 28, 1988, by and between Chandler (U.S.A.), Inc. and Brent LaGere. (1)
10.2 Employment Agreement, effective as of October 28, 1988, by and between Chandler (U.S.A.), Inc., and Brenda B. Watson (formerly Brenda B. Pair). (1)
10.3 Amendment to Employment Agreement, effective as of January 1, 1999, by and between Chandler (U.S.A.), Inc. and Brenda B. Watson. (1)
10.4 Intercompany Credit Agreement effective as of January 1, 2001, by and between Chandler (U.S.A.), Inc. and Chandler Insurance (Barbados), Ltd. (2)
10.5 Stock Purchase Agreement effective as of December 1, 2002, by and among Brown & Brown, Inc., Chandler (U.S.A.), Inc., Chandler Insurance Company, Ltd., National American Insurance Company, W. Brent LaGere and Mark T. Paden. (3)
10.6 Amended and Restated Declaration of Trust of Chandler Capital Trust I dated as of May 22, 2003 among Chandler (U.S.A.), Inc., as sponsor, Wilmington Trust Company, as Delaware trustee, Wilmington Trust Company, as institutional trustee, and W. Brent LaGere, Mark T. Paden and Mark C. Hart, as administrators. (4)
10.7 Indenture, dated as of May 22, 2003 among Chandler (U.S.A.), Inc., as issuer, and Wilmington Trust Company, as trustee. (4)
10.8 Guarantee Agreement, dated as of May 22, 2003 between Chandler (U.S.A.), Inc., as guarantor, and Wilmington Trust Company, as guarantee trustee. (4)
10.9 Capital Securities Subscription Agreement dated as of May 13, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust I, together as offerors, and InCapS Funding I, Ltd., as purchaser. (4)
10.10 Placement Agreement dated May 13, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust I, together as offerors, and Sandler O'Neill & Partners, L.P., as placement agent. (4)
10.11 Amended and Restated Declaration of Trust of Chandler Capital Trust II dated as of December 16, 2003 among Chandler (U.S.A.), Inc., as sponsor, Wilmington Trust Company, as Delaware trustee, Wilmington Trust Company, as institutional trustee, and W. Brent LaGere, Mark T. Paden and Mark C. Hart, as administrators. (6)
10.12 Indenture, dated as of December 16, 2003 among Chandler (U.S.A.), Inc., as issuer, and Wilmington Trust Company, as trustee. (6)
10.13 Guarantee Agreement, dated as of December 16, 2003 between Chandler (U.S.A.), Inc., as guarantor, and Wilmington Trust Company, as guarantee trustee. (6)
10.14 Capital Securities Subscription Agreement dated as of December 4, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust II, together as offerors, and InCapS Funding II, Ltd., as purchaser. (6)
10.15 Placement Agreement dated December 4, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust II, together as offerors, and Sandler O'Neill & Partners, L.P., as placement agent. (6)
14.1 Code of Ethics. (6)
21.1 Subsidiaries of the registrant.
31.1 Rule 13a-14(a)/15d-14(a) Certifications.
32.1 Section 1350 Certifications
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(1) Previously filed as an exhibit to Registration No. 333-76393 on Form S-1 and incorporated herein by reference.
(2) Previously filed as an exhibit to Chandler USA's Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference.
(3) Previously filed as an exhibit to Chandler USA's Annual Report on Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.
(4) Previously filed as an exhibit to Chandler USA's Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 and incorporated herein by reference.
(5) Previously filed as an exhibit to Chandler USA's current report on Form 8-K dated December 1, 2003 and incorporated herein by reference.
(6) Previously filed as an exhibit to Chandler USA's Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference.
Copies of the foregoing exhibits filed with this Form 10-K or incorporated by reference are available from Chandler USA upon written request and payment of a reasonable copying fee.
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
CHANDLER (U.S.A.), INC.
Date: March 6, 2007 By: /s/ W. Brent LaGere ---------------------------------------------------- W. Brent LaGere Chairman of the Board and Chief Executive Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.
Date: March 6, 2007 /s/ W. Brent LaGere ---------------------------------------------------- W. Brent LaGere, Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer)
Date: March 6, 2007 /s/ Mark T. Paden ---------------------------------------------------- Mark T. Paden, President and Director
Date: March 6, 2007 /s/ Mark C. Hart ---------------------------------------------------- Mark C. Hart, Sr. Vice President - Finance, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)
Date: March 6, 2007 /s/ Richard L. Evans ---------------------------------------------------- Richard L. Evans, Senior Vice President and Director
Date: March 6, 2007 /s/ R. Patrick Gilmore ---------------------------------------------------- R. Patrick Gilmore, Senior Vice President, Secretary, General Counsel and Director
Date: March 6, 2007 /s/ Robert L. Rice ---------------------------------------------------- Robert L. Rice, Director
Date: March 6, 2007 /s/ W. Scott Martin ---------------------------------------------------- W. Scott Martin, Director
Date: March 6, 2007 /s/ William T. Keele ---------------------------------------------------- William T. Keele, Director
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CHANDLER (U.S.A.), INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
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CHANDLER (U.S.A.), INC. CONSOLIDATED BALANCE SHEETS (Amounts in thousands except share amounts)
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
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CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands)
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
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CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in thousands)
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
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CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands)
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
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CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY (Amounts in thousands)
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
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CHANDLER (U.S.A.), INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(a) BASIS OF PRESENTATION
Chandler (U.S.A.), Inc. ("Chandler USA") is a holding company organized and domiciled in Oklahoma. Chandler USA's wholly owned subsidiaries are engaged in various property and casualty insurance operations. The insurance products offered by Chandler USA through its subsidiary, National American Insurance Company ("NAICO"), include property and casualty insurance products primarily for businesses in various industries, political subdivisions, homeowners insurance in Texas and surety bonds for small contractors in the United States of America ("U.S."). The business is conducted through individual independent insurance agencies and underwriting managers, primarily in the Southwest and Midwest areas of the U.S. Chandler Insurance Managers, Inc. ("CIMI") is a wholly owned subsidiary of Chandler USA and is an underwriting manager and wholesaler that offers multiple insurance products for businesses in various industries and political subdivisions.
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of the financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates. Certain reclassifications of prior years have been made to conform to the 2006 presentation.
(b) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Chandler USA and all wholly owned subsidiaries that meet consolidation requirements including NAICO and CIMI. All significant intercompany accounts and transactions have been eliminated in consolidation.
(c) IMPAIRMENT OF LONG-LIVED ASSETS
Chandler USA periodically evaluates the carrying value of long-lived assets to be held and used when changes in events and circumstances warrant such a review. The carrying value of a long-lived asset is considered impaired when the separately identifiable anticipated undiscounted cash flow from such asset is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the long-lived asset. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that fair values are reduced for disposal costs.
(d) REVENUE RECOGNITION
Premiums are generally recognized as earned on a pro rata basis over the policy period, which is in proportion to the insurance protection provided. The portion of premiums that will be earned in the future are deferred and reported as unearned premiums. Amounts recorded for ceded reinsurance premiums are reported as prepaid reinsurance premiums and amortized over the remaining contract period in proportion to the amount of the insurance protection provided. Commission revenues are generally recognized when coverage is effective or premiums are billed, whichever is later. Commission revenues are reported net of commissions paid to producing agents.
(e) PREMIUMS RECEIVABLE
Premiums receivable are presented net of valuation allowances for estimated uncollectible amounts. Chandler USA determines the allowance for non-collection by regularly evaluating individual agent accounts and balances due from insureds, considering their financial condition and other appropriate factors. Such accounts are considered past due based on contractual terms for the agent or insured. Premiums receivable are written off when deemed uncollectible. Recoveries of accounts previously written off are recorded when received.
PAGE (f) UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
Losses and loss adjustment expenses are charged to income as incurred. The reserve for unpaid losses and loss adjustment expenses represents the accumulation of estimates for reported losses and includes provisions for losses incurred but not reported based on data available at this time. The methods of determining such estimates and establishing resulting reserves are periodically reviewed and updated, and adjustments therefrom are necessary to maintain an adequate reserve for unpaid losses and loss adjustment expenses. As more fully explained in Note 3, such estimates are management's best estimates of the expected values. The actual results may vary from these values because the evaluation of losses is inherently subjective and susceptible to significant changing factors.
(g) DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs that vary with and are primarily related to the acquisition of new and renewal business (such as premium taxes, agent commissions, commissions received from reinsurers and a portion of other underwriting expenses) are deferred and amortized over the terms of the policies. When the sum of the anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded. Certain policy acquisition costs, such as policyholder dividends, are expensed directly.
(h) PROPERTY AND EQUIPMENT
Real estate and improvements and other property and equipment are stated at cost and depreciated using the straight-line method over their useful lives which range from 3 to 31 years. Property and equipment consisted of the following at December 31:
Depreciation expense was approximately $894,000, $815,000 and $780,000 for 2004, 2005 and 2006, respectively.
(i) INTANGIBLE ASSETS
Intangible assets are stated at cost less accumulated amortization. Prior to 2002, the cost of state insurance licenses acquired was amortized over 40 years using the straight-line method. Effective January 1, 2002, the state insurance licenses are no longer amortized since they were determined to have indefinite lives but are reviewed at least annually for impairment. Chandler USA completed the required impairment tests during 2005 and 2006 and concluded that there has not been an impairment loss since the fair values exceeded their carrying values. The fair values were determined based on the present value of projected future net cash flows. Intangible assets included the following at December 31:
(j) POLICYHOLDER DEPOSITS
NAICO requires certain policyholders to pay a deposit at inception of coverage to secure payment of future premiums and deductibles on claims incurred. It is expressly agreed between NAICO and the policyholder that the funds will be used by NAICO only in the event the policyholder fails to pay any premiums, deductibles or other charges when due. NAICO has established a liability for these deposits in an amount equal to that due the policyholders based on insurance premiums reported as of the balance sheet date.
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(k) INVESTMENTS
At the time of purchase, investments in debt securities that Chandler USA has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments in debt and equity securities classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. Chandler USA has not classified any investments as trading account assets. Debt securities not classified as held to maturity or trading and equity securities are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of deferred income tax as other comprehensive income until realized. Realized gains and losses on sales of securities are based on the specific identification method. Declines in the fair value of securities below their carrying value that are other than temporary are recognized in earnings.
Chandler USA regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Some factors considered in evaluating whether or not a decline in fair value is other than temporary include Chandler USA's ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value; the duration and extent to which the fair value has been less than cost; and the financial condition and prospects of the issuer.
(l) INCOME TAXES
Chandler USA uses an asset and liability approach for accounting for income taxes. Deferred income taxes are recognized for the tax consequences of temporary differences and carryforwards by applying enacted tax rates applicable to future years to differences between the financial statement amounts and the tax bases of existing assets and liabilities. A valuation allowance is established if it is more likely than not that some portion of the deferred tax asset will not be realized.
(m) CASH AND CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, Chandler USA considers all highly liquid investments with original maturities of 14 days or less to be cash equivalents. For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.
(n) SUPPLEMENTAL CASH FLOW INFORMATION
Cash payments for interest and income taxes, and noncash investing activities were as follows:
(o) REINSURANCE
Management believes all of NAICO's reinsurance contracts with reinsurers meet the criteria for risk transfer and the revenue and cost recognition provisions in order to be accounted for as reinsurance. As more fully explained in Note 11, reinsurance contracts do not relieve NAICO from its obligation to policyholders. In addition, failure of reinsurers to honor their obligations could result in losses to Chandler USA.
(p) NEW ACCOUNTING STANDARDS
The Financial Accounting Standards Board ("FASB") periodically issues new accounting standards in a continuing effort to improve standards of financial accounting and reporting. Chandler USA has reviewed the recently issued pronouncements and concluded that the following new accounting standards are applicable to Chandler USA.
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In February 2006, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140." SFAS 155 amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This Statement also resolves issues addressed in Statement No. 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133. SFAS 140 is amended to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued during fiscal years beginning after September 15, 2006. Chandler USA does not expect this statement to have a material impact on its consolidated financial statements.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140." SFAS No. 156 amends SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS 156 requires an entity to separately recognize financial assets as servicing assets or servicing liabilities each time it undertakes an obligation to service a financial asset by entering into certain kinds of servicing contracts. The entity must also initially measure all separately recognized servicing assets and servicing liabilities at fair value, if practicable. Servicing assets and servicing liabilities subsequently measured at fair value must be separately presented in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. SFAS 156 is effective for Chandler USA's fiscal year beginning January 1, 2007. Chandler USA does not expect this statement to have a material impact on its consolidated financial statements.
In July 2006, the FASB issued FASB Interpretation ("FIN") No. 48, "Accounting for Uncertainty in Income Taxes," which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109, "Accounting for Income Taxes." FIN 48 provides guidance regarding the recognition, measurement, presentation and disclosure of a tax position taken or expected to be taken in a tax return as well as the derecognition of a tax position previously recognized in the financial statements. Chandler USA will be required to adopt FIN 48 as of January 1, 2007. Chandler USA does not expect this statement to have a material impact on its consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The statement does not require new fair value measurements, but is applied to the extent that other accounting pronouncements require or permit fair value measurements. The statement emphasizes that fair value is a market-based measurement that should be determined based on the assumptions that market participants would use in pricing an asset or liability. Companies will be required to disclose the extent to which fair value is used to measure assets and liabilities, the inputs used to develop the measurements, and the effect of certain of the measurements on earnings (or changes in net assets) for the period. Chandler USA will be required to adopt SFAS No. 157 as of January 1, 2008. Chandler USA does not expect this statement to have a material impact on its consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R)." This statement requires the company to recognize the funded status of its defined benefit postretirement plans as an asset or liability in its financial statements. In addition, the statement eliminates the use of a measurement date that is different than the date of the company's year-end financial statements. Chandler USA will be required to adopt SFAS No. 158 as of December 31, 2006. Chandler USA does not expect this statement to have a material impact on its consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115." SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value at specified election dates. Upon adoption, an entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Most of the provisions apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," applies to all entities with available for sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Chandler USA is currently evaluating the impact that SFAS No. 159 will have, if any, on its consolidated financial statements.
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NOTE 2. INVESTMENTS AND INVESTMENT INCOME
Net investment income and realized investment gains are summarized in the following table. These amounts are net of investment expenses.
During 2006, NAICO recorded $6.6 million of interest income for its estimate of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims. See Note 10.
Investment expenses include $104,000, $137,000 and $164,000 for the years ended December 31, 2004, 2005 and 2006, respectively, in expense to subsidize a premium finance program for certain insureds of NAICO with an unaffiliated premium finance company.
The amortized cost of fixed maturities or cost of equity securities, gross unrealized gains or losses, fair value and carrying value of investments are as follows:
At December 31, 2005 and 2006, Chandler USA did not hold any fixed maturity investments that exceeded 10% of shareholder's equity.
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The fair value of Chandler USA's investments with sustained gross unrealized losses at December 31, 2006 is presented below:
The unrealized losses of Chandler USA's fixed maturity investments were caused by interest rate increases. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Chandler USA regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Based on an evaluation of the issues, including, but not limited to, Chandler USA's intentions to sell or ability to hold the investments; the length of time and amount of the unrealized loss; and the credit ratings of the issuers of the investments, Chandler USA does not consider these investments to be other-than-temporarily impaired at December 31, 2006.
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The maturities of investments in fixed maturities at December 31, 2006 are shown below:
Realized gains and losses from sales of investments are shown below:
NAICO is required by several states to deposit securities with state regulators as a condition of doing business in those states. As of December 31, 2005 and 2006, the carrying value of these deposits totaled approximately $7.8 million and $7.7 million, respectively. In addition, NAICO has deposited $11.9 million of cash and investments into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer.
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NOTE 3. UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
NAICO provides a reserve for estimated losses (reported and unreported) and loss adjustment expenses based on historical experience and payment reporting patterns for the type of risk involved. These estimates are based on data available at the time of the estimate and such estimates are periodically reviewed by independent professional actuaries. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount and uncertainty in the estimates are affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances, and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that define and expand insurance coverage subsequent to the time that the insurance policy was priced and sold.
Salvage and subrogation recoverables are accrued using the "case basis" method for large recoverables and statistical estimates based on historical experience for smaller recoverables. Recoverable amounts deducted from Chandler USA's net liability for losses and loss adjustment expenses were approximately $9.6 million and $13.2 million at December 31, 2005 and 2006, respectively. The increase in estimated recoveries in 2006 is due primarily to NAICO recording net estimated recoveries totaling $5.6 million related to a favorable jury verdict in civil litigation regarding certain surety bond claims during 2006. See Note 10 for more information related to this litigation. The gross and net estimated recovery deducted from unpaid losses and loss adjustment expenses related to this litigation at December 31, 2006 is $31.5 million and $10.8 million, respectively. NAICO may or may not recover the above estimated recoveries and could incur significant costs in collecting these recoverables.
Although such estimates are management's best estimates of the expected values, the ultimate liability for unpaid claims may vary from these values. NAICO does not discount the liability for unpaid losses and loss adjustment expenses.
The following table sets forth a reconciliation of the beginning and ending unpaid losses and loss adjustment expenses which are net of reinsurance deductions.
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2004, 2005 and 2006 calendar years. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results.
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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%.
During 2005, NAICO experienced adverse loss development totaling $6.3 million primarily in the standard property and casualty and political subdivisions programs. A portion of the adverse development was offset by favorable development of $1.8 million in the surety bond program, primarily in accident years 1994 and 2001 that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the workers compensation, other liability and automobile liability lines of business in the 2000, 2002 and 2003 accident years. The adverse loss development included approximately $108,000 for provisions for potentially uncollectible reinsurance.
During 2006, NAICO experienced adverse loss development totaling $3.8 million primarily in the standard lines program. A portion of the adverse development was offset by favorable development of $1.0 million in the surety bond program, primarily in the 2001 accident year, that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the automobile liability line of business in the 2005 accident year and in the workers compensation line of business in the 1997 and 1999 accident years.
NAICO does not ordinarily insure against environmental matters as that term is commonly used. However, in some cases, regulatory filings made by NAICO 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 that are required to provide proof of insurance which in some cases assures payment for clean-up and remediation 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 that use or have control of such substances and for contractors that remove and dispose of asbestos as a part of their contractual obligations. NAICO also insures independent oil and gas producers that 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. 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 insureds of NAICO, 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 impact, if any, on the consolidated financial condition, results of operations or cash flows of Chandler USA.
At this time, NAICO has not received any claims related to the September 11, 2001 terrorist attacks on the World Trade Center and does not believe that it has any significant exposure to these and related losses. While several of NAICO's reinsurers did experience significant losses related to these attacks, it currently does not appear that these losses will impair the reinsurers' ability to pay claims.
NOTE 4. DEBENTURES
On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior debentures (the "Debentures") with a maturity date of July 16, 2014. The Debentures were priced at $1,000 each with an interest rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium. The indenture governing the Debentures was amended during 2003 to clarify that purchases of Debentures by Chandler USA through private treaty or on the open market for an agreed price of less than the sum of the principal amount and accrued interest are not considered to be a redemption of the Debentures, and that any such Debentures purchased by Chandler USA will be cancelled. Chandler USA purchased and cancelled $16.7 million and $275,000 principal amount of the Debentures during 2003 and 2004, respectively, and at December 31, 2006, there were $6,979,000 principal amount of the Debentures outstanding. As of December 31, 2006, Chandler USA has capitalized $247,000 related to debt issuance costs for the Debentures. These costs are being amortized as interest expense over the term of the Debentures. When Debentures are purchased and cancelled by Chandler USA, debt issuance costs are reduced accordingly and reflected in the gain on retirement of debt which is included in other income in the consolidated statements of operations. Chandler USA's subsidiaries and affiliates are not obligated by the Debentures. Accordingly, the Debentures are effectively subordinated to all existing and future liabilities and obligations of Chandler USA's existing and future subsidiaries. The indenture governing the Debentures contains certain restrictive covenants, including covenants that limit subsidiary debt, issuance or sale of subsidiary stock, incurring of liens, sale-leaseback transactions for a period of more than three years, mergers, consolidations and sales of assets. At December 31, 2006, Chandler USA was in compliance with all covenants.
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NOTE 5. TRUST PREFERRED SECURITIES
In May 2003, Chandler USA established Chandler Capital Trust I ("Trust I") by purchasing all of its common securities for $403,000. Trust I is a Delaware statutory business trust and is a wholly owned non-consolidated subsidiary of Chandler USA. On May 22, 2003, Trust I issued $13.0 million of capital securities (the "Trust I Preferred Securities") to InCapS Funding I, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust I used the proceeds from the issuance to purchase $13,403,000 of 9.75% junior subordinated debentures (the "Junior Debentures I") of Chandler USA. Distributions on the Junior Debentures I are payable quarterly at a fixed annual rate of 9.75%. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures I, with such deferred payments accruing interest compounded quarterly. The Junior Debentures I are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year.
The Junior Debentures I are the sole assets of Trust I and Trust I will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust I Preferred Securities are payable quarterly at a fixed annual rate of 9.75%. Trust I may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust I Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust I Preferred Securities are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year. All payments by Trust I regarding the Trust I Preferred Securities are guaranteed by Chandler USA.
In December 2003, Chandler USA established Chandler Capital Trust II ("Trust II") by purchasing all of its common securities for $217,000. Trust II is a Delaware statutory business trust and is a wholly owned non-consolidated subsidiary of Chandler USA. On December 16, 2003, Trust II issued $7.0 million of capital securities (the "Trust II Preferred Securities") to InCapS Funding II, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust II used the proceeds from the issuance to purchase $7,217,000 of floating rate junior subordinated debentures (the "Junior Debentures II") of Chandler USA. Distributions on the Junior Debentures II are payable quarterly at a floating rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed 12.5% prior to January 8, 2009). The interest rate was 9.47% at December 31, 2006. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures II, with such deferred payments accruing interest compounded quarterly. The Junior Debentures II are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium.
The Junior Debentures II are the sole assets of Trust II and Trust II will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust II Preferred Securities are payable quarterly at a floating rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed 12.5% prior to January 8, 2009). The interest rate was 9.47% at December 31, 2006. Trust II may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust II Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust II Preferred Securities are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium. All payments by Trust II regarding the Trust II Preferred Securities are guaranteed by Chandler USA.
The sale of the Trust I Preferred Securities and the Trust II Preferred Securities during 2003 resulted in net proceeds of $19.3 million to Chandler USA, net of placement costs. As of December 31, 2006, issuance costs in the amount of $646,000 have been capitalized and are being amortized over the stated maturity periods of thirty years.
In December 2003, the Financial Accounting Standards Board issued Revised Interpretation No. 46 ("FIN 46R"), CONSOLIDATION OF VARIABLE INTEREST ENTITIES. FIN 46R provides guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights. FIN 46R is used to determine whether consolidation is required or, alternatively, whether the variable-interest model under FIN 46R should be used to account for existing and new entities. Chandler USA adopted FIN 46R effective January 1, 2004. The result of adoption was the deconsolidation of the two capital trusts that were created during 2003 in connection with the issuance of trust preferred securities. Chandler USA reports the $20.6 million of junior subordinated debentures that were issued to the capital trusts on its consolidated balance sheet. The adoption of FIN 46R had no effect on net earnings.
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NOTE 6. SHAREHOLDER'S EQUITY
CAPITAL STOCK
In addition to the regulatory oversight of NAICO by the Oklahoma Department of Insurance, Chandler Insurance Company Ltd. ("Chandler Insurance"), Chandler USA's parent company, and Chandler USA are also subject to regulation under the insurance laws of Oklahoma (the "Oklahoma Insurance Code"). In addition to various reporting requirements imposed on Chandler Insurance and Chandler USA, the Oklahoma Insurance Code requires any person who seeks to acquire or exercise control over NAICO (which is presumed to exist if any person owns 10% or more of Chandler Insurance's or Chandler USA's outstanding voting stock) to file and obtain approval of certain applications with the Oklahoma Department of Insurance regarding their proposed ownership of such shares.
STATUTORY FINANCIAL INFORMATION AND MINIMUM CAPITAL REQUIREMENTS
NAICO is required to file financial statements with state regulatory authorities prepared on a statutory basis which differs from GAAP. Statutory net income (loss) and statutory capital and surplus of NAICO are as follows:
During 2005, the Oklahoma Insurance Code was amended to allow domestic insurers to admit office equipment, furniture and other such property constituting less than 3% of its otherwise admitted assets. This prescribed accounting practice increased NAICO's statutory capital and surplus by $510,000 and $404,000 at December 31, 2005 and 2006, respectively. There is no difference between NAICO's statutory net income under the National Association of Insurance Commissioners' ("NAIC") ACCOUNTING PRACTICES AND PROCEDURES manual and practices prescribed by the Oklahoma Insurance Code.
The Oklahoma Insurance Commissioner has the right to permit other specific practices that deviate from prescribed practices. NAICO does not have any such permitted practices.
The NAIC has adopted risk-based capital ("RBC") standards for domestic property and casualty insurance companies. The RBC standards are designed to assist insurance regulators in analytically determining a level of capital and surplus that would be sufficient to withstand reasonably foreseeable adverse events associated with underwriting risk, investment risk, credit risk and loss reserve risk. NAICO is subject to the RBC standards. Based on available information, management believes NAICO complied with the RBC standards at December 31, 2005 and 2006.
At periodic intervals, various insurance regulatory authorities routinely examine the required statutory financial statements of NAICO as part of their legally prescribed oversight of the insurance industry. Based on these examinations, the regulators can direct such financial statements to be adjusted in accordance with their findings.
DIVIDEND RESTRICTIONS
The amount of cash shareholder dividends that NAICO can pay to Chandler USA within any one year without the approval of the Oklahoma Department of Insurance is generally limited to the greater of (i) statutory net income excluding realized capital gains for the preceding year, or (ii) 10% of statutory surplus as regards policyholders as of the preceding December 31 with such amount not to exceed NAICO's statutory earned surplus. Based on this criteria the maximum shareholder dividend NAICO may pay in 2007 without the approval of the Oklahoma Department of Insurance is approximately $5.2 million. NAICO paid cash shareholder dividends to Chandler USA totaling $3.4 million in 2004.
The future payment of shareholder dividends also depends upon the earnings, financial position and cash requirements of Chandler USA, as well as regulatory limitations and such other factors as the board of directors may deem relevant.
NAICO is subject to regulations which restrict its ability to pay dividends to policyholders. The maximum amount of available policyholder dividends is limited to statutory earned surplus (approximately $14.0 million as of December 31, 2006). NAICO paid approximately $62,000 and $4,000 in policyholder dividends during 2004 and 2006, respectively. NAICO did not pay any policyholder dividends during 2005.
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NOTE 7. INCOME TAXES
Chandler USA and its wholly owned subsidiaries file a consolidated U.S. Federal income tax return. The income taxes reflected in the accompanying consolidated statements of operations differ from those expected using U.S. Federal enacted income tax rates as noted by the following:
U.S. Federal income tax provision (benefit) consists of:
Deferred income tax provision (benefit) relating to temporary differences includes the following components:
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The tax effect of temporary differences between the consolidated financial statement carrying amounts and tax bases of assets and liabilities that give rise to significant portions of the net deferred tax assets, which are included in other assets, at December 31, relate to the following:
At December 31, 2006, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $4.6 million which begins to expire in 2024. Chandler USA has concluded that the deferred tax asset including the federal net operating loss carryforwards are more likely than not to be realized. Chandler USA anticipates that its future U.S. consolidated income will be sufficient to utilize the federal net operating losses within the required time. Chandler USA will continue to evaluate income generated in future periods in determining the reasonableness of its position. If Chandler USA determines that future income is insufficient to cause the realization of the federal net operating losses within the required time, a valuation allowance will be established.
In addition, Chandler USA, at December 31, 2006, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $53.8 million which expire in the years 2007 through 2026. At December 31, 2006, Chandler USA also had a capital loss carryforward for U.S. Federal income taxes of $2.4 million which expires in 2007. Chandler USA's capital loss carryforward increased in 2005 due to Chandler USA finalizing the sales price of a subsidiary sold in 2002. 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.
NOTE 8. EMPLOYEE BENEFITS
Chandler USA and its subsidiaries participate in a defined contribution retirement plan established under Section 401(k) of the Internal Revenue Code. All full time employees who have completed one year of service and attained age 21 may elect to participate in the 401(k) plan. Participants may contribute up to 25% of compensation, subject to certain limitations. Chandler USA matches 50% of the first $2,000, 40% of the next $3,000, 30% of the next $3,000 and 25% of the remaining employee contributions up to a maximum employer contribution of $6,100 per employee per year. In addition, Chandler USA may make additional annual contributions to the 401(k) plan at its discretion. Chandler USA's expense for 401(k) plan contributions was $321,000, $315,000 and $307,000 for 2004, 2005 and 2006, respectively.
NOTE 9. FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS. The estimated fair value amounts have been determined by Chandler USA using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates of fair values presented herein are not necessarily indicative of the amounts that Chandler USA could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
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A number of Chandler USA's significant assets (including deferred policy acquisition costs, property and equipment, reinsurance recoverables, prepaid reinsurance premiums and state insurance licenses) and liabilities (including unpaid losses and loss adjustment expenses and unearned premiums) are not considered financial instruments. Based on the short term nature or other relevant characteristics, Chandler USA has concluded that the carrying value of other assets and liabilities considered financial instruments, such as cash equivalents, premiums receivable, policyholder deposits, accrued taxes and other payables, and premiums payable, approximates their fair value as of December 31, 2005 and 2006. The estimated fair values of Chandler USA's fixed-maturity and equity security investments are disclosed at Note 2. At December 31, 2006, the fair value of Chandler USA's Debentures was estimated to be $5.8 million based on the latest reported trade. Chandler USA's Debentures have not historically traded regularly, and settlement at the reported fair value may not be possible. The Debentures are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium, but may be purchased and cancelled by Chandler USA at a price of less than the sum of the principal amount and accrued interest at any time. Chandler USA is obligated for $13.4 million principal amount of junior subordinated debentures that mature in 2033 with a fixed interest rate of 9.75%, and $7.2 million principal amount of junior subordinated debentures that mature in 2034 with a floating rate of 4.10% over LIBOR. The interest rate at December 31, 2006 was 9.47%. At December 31, 2006, the fair value of Chandler USA's junior subordinated debentures was estimated to be $21.7 million.
NOTE 10. LITIGATION
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.
The trial in the Harris County cases began in late April 2006, and concluded August 1, 2006. The jury found in favor of NAICO, Gulsby, Bay Limited and the joint venture between Gulsby and Bay Limited ("Gulsby-Bay Plant Partners") on all counts and fixed damages against Gulf Liquids and Williams totaling $402,568,089.53. The damages determined by the jury included a total of $325 million in punitive damages. Among other findings, the jury found:
1. Williams tortiously interfered with NAICO's contractual relationship with Gulsby and Gulf Liquids; and 2. Williams fraudulently induced NAICO to issue the surety bonds; and 3. Williams defrauded NAICO after the bonds were issued; and 4. Williams' actions were malicious; and 5. Gulf Liquids fraudulently induced NAICO to issue the surety bonds; and 6. Gulf Liquids breached its obligations to NAICO under the bonds; and 7. Williams is responsible for the claims against Gulf Liquids because Gulf Liquids is the alter ego of Williams; and 8. There were material alterations (cardinal changes) to the contracts NAICO bonded.
The amounts the jury found owing to NAICO include $20,182,499 in actual damages, against both Gulf Liquids and Williams, $20 million in punitive damages against Gulf Liquids, and $50 million in punitive damages against Williams. The verdicts in favor of Gulsby included $20,941,436 in actual damages against both Gulf Liquids and Williams, $25 million in punitive damages against Gulf Liquids and $60 million in punitive damages against Williams.
NAICO is subrogated to any recovery by Gulsby to the extent of NAICO's losses on the bonds including loss adjustment expenses with interest from the date the losses and loss expenses were paid.
A significant amount of NAICO's losses on the surety bonds were ceded to various reinsurers and NAICO will be required to reimburse these reinsurers in accordance with the agreements between NAICO and the reinsurers.
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On October 30, 2006, NAICO filed its Motion for Entry of Judgment requesting that the Trial Court enter judgment on the jury verdicts for a total of $100,577,559 plus court costs and anticipated attorney fees for appeals. This request for judgment will be reviewed by the Trial Court and a judgment entered after the Trial Court has considered objections by Williams and Gulf Liquids. Of the total requested judgment, $70,000,000 is punitive damages and $8,328,824 is prejudgment interest through November 1, 2006. Prejudgment interest accrues at the rate of $4,561 per day based upon an 8.25% interest rate. NAICO has requested attorney fees of $4,566,236 through entry of judgment. The Trial Court denied that request on January 5, 2007. Gulsby has filed a separate motion for judgment that includes a request for fees. The request for judgment takes into account mandatory credits for a pre-verdict settlement with parties other than Williams and Gulf Liquids. NAICO expects the Trial Court to enter judgment based upon its request during 2007. When entering judgment, the Court may enter judgment based upon NAICO's request or may enter a different judgment. After judgment is entered, all parties may file post-judgment motions. Following the Court's rulings on post-judgment motions, all parties may appeal all or any of those rulings or judgments.
During the third quarter of 2006, NAICO increased the estimated recovery on the surety bond claims related to the construction of the two gas processing plants which resulted in a decrease in losses and loss adjustment expenses incurred of $4.7 million. Unpaid losses and loss adjustment expenses decreased $22.7 million, reinsurance recoverable on unpaid losses and loss adjustment expenses decreased $16.8 million, and reinsurance recoverable on paid losses and loss adjustment expenses decreased $1.2 million as of December 31, 2006 as a result of increasing the estimated recovery. NAICO has also recorded $6.6 million of interest income for its estimate of prejudgment interest through December 31, 2006, including a recovery for a pre-verdict settlement with certain other parties. Prejudgment interest will continue to accrue at 8.25%.
NOTE 11. COMMITMENTS AND CONTINGENCIES
REINSURANCE
In the ordinary course of business, NAICO cedes insurance to other insurers and reinsurers under various reinsurance treaties that cover individual risks (facultative reinsurance) or entire classes of business (treaty reinsurance). Reinsurance provides greater diversification of business written and also reduces NAICO's exposure arising from high limits of liability or from hazards of an unusual nature. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In formulating its reinsurance programs, NAICO considers numerous factors, including the financial stability of the reinsurer, ability to provide sufficient collateral (if required), reinsurance coverage offered and price.
NAICO has structured separate reinsurance programs for property (including inland marine), workers compensation, casualty (including automobile liability, general and products liability, umbrella liability and related professional liability), automobile physical damage, homeowners and construction surety bonds. Chandler Insurance reinsures NAICO for a portion of the risk on NAICO's reinsurance programs except for the homeowners program.
In addition, NAICO purchases catastrophe protection to limit its retention for single loss occurrences involving multiple policies and/or policyholders, such as floods, winds and severe storms. NAICO also purchases facultative reinsurance when it writes a risk with limits of liability exceeding the maximum limits of its treaties or when it otherwise considers such action appropriate.
Treaty reinsurance may be ceded under treaties on both a pro rata basis (where the reinsurer shares proportionately in premiums and losses) and an excess of loss basis (where only losses above a specific amount are reinsured). The availability, costs and limits of reinsurance purchased can vary from year to year based upon prevailing market conditions, reinsurers' underwriting results and NAICO's desired risk retention levels. A majority of NAICO's reinsurance programs renew on January 1 or July 1 of each year. NAICO renewed all applicable January 1, 2007 reinsurance programs. NAICO discontinued its property reinsurance program effective January 1, 2007 due to the transfer of its commercial property business to another insurance company. See Note 15 for more information. At the present time, NAICO expects to renew the reinsurance programs that renew on July 1, 2007.
NAICO periodically reviews certain prospective single year reinsurance treaties, subject to commutation provisions therein, to determine if it is advantageous to assume the estimated loss exposure on expired insurance policies covered by such treaties in exchange for return premiums. Commutation of such reinsurance treaties will be determined in future periods based on timely review of all available data. NAICO reviews the historical results for reinsurance contracts with similar commutation provisions and accrues for such commutations where a commutation election is considered probable.
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 2004, 2005 and 2006, NAICO incurred charges of $282,000, $108,000 and $97,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
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The effect of reinsurance on premiums written and earned was as follows:
Losses and loss adjustment expenses are reported net of the effect of reinsurance recoveries and recoverables in the consolidated statements of operations. Ceded losses and loss adjustment expenses were $52.1 million, $50.3 million and $10.2 million for 2004, 2005 and 2006, respectively.
SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK
NAICO conducts its business through individual independent insurance agencies and underwriting managers. Certain of these underwriting managers have provided collateral to NAICO to secure a portion of the premiums receivable. Substantially all of the principal shareholders of the independent agencies and underwriting managers have provided personal guarantees for payment of premiums to NAICO. NAICO also requires certain policyholders to pay a deposit at the time of inception of coverage to secure payment of future premiums or other policy related obligations. Receivables under installment plans do not exceed the corresponding liability for unearned premiums. Total consolidated premiums receivable at December 31, 2005 and 2006 were $28.3 million and $31.0 million, respectively. Receivables for deductibles, in most cases, are secured by cash deposits and letters of credit. At December 31, 2006, NAICO maintained custody of such letters of credit securing these and other transactions totaling approximately $24.9 million, which is a reasonable estimate of their fair value. These letters of credit are not reflected in the accompanying consolidated financial statements. During 2004, 2005 and 2006, one unaffiliated independent insurance agent produced approximately 13%, 12% and 12%, respectively, of NAICO's direct written and assumed premiums.
Approximately $11.8 million, or 18% of NAICO's reinsurance recoverables and prepaid reinsurance premiums at December 31, 2006 are collateralized by premiums payable to the reinsurers, securities pledged in trust or letters of credit for the benefit of NAICO. Chandler USA believes the above value of such collateral is a reasonable estimate of their fair value. NAICO's reinsurance contracts include provisions for offsets against premiums owed to the reinsurers.
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The following table sets forth certain information related to NAICO's five largest reinsurers determined on the basis of net reinsurance recoverables as of December 31, 2006.
OTHER
See Note 10 regarding contingencies relating to litigation matters.
Chandler USA has an employment agreement with W. Brent LaGere, Chairman of the Board and Chief Executive Officer of Chandler USA and its subsidiaries. Under this agreement, Mr. LaGere's base compensation is established at not less than $250,000 per year. In the event that Mr. LaGere is terminated without cause, as defined in the agreement, he is entitled to receive his base compensation for the remainder of the term of the agreement, but in no event for more than 60 months. The agreement will terminate upon Mr. LaGere attaining age 70, unless earlier terminated by Chandler USA for cause. In addition to his base compensation, Mr. LaGere is eligible to receive certain benefits and bonuses from Chandler USA and its subsidiaries.
In addition, certain executives are eligible to receive bonuses based upon various factors.
NAICO is subject to a variety of assessments related to insurance activities, including those by state guaranty funds and workers compensation second-injury funds. The amounts and timing of such assessments are beyond the control of NAICO. NAICO provides for these charges on a current basis by applying historical factors to premiums earned. Actual results may vary from these values and adjustments therefrom are necessary to maintain an adequate reserve for these assessments. The reserve for unpaid assessments which is included in accrued taxes and other payables was approximately $1,129,000 and $914,000 at December 31, 2005 and 2006, respectively. In certain cases, NAICO is permitted to recover a portion of its assessments generally as a reduction to premium taxes paid to certain states. NAICO has recorded receivables which are included in other assets in the amount that it expects to recover of approximately $3,031,000 and $2,870,000 at December 31, 2005 and 2006, respectively. NAICO may receive additional guaranty fund assessments in the future related to insolvent insurance companies. At this time, NAICO is unable to estimate the amount and timing of such assessments.
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At December 31, 2006, Chandler USA's subsidiaries were committed under noncancellable operating and capital leases for certain equipment and office space. Rental payments under these leases were $825,000, $780,000 and $777,000 in 2004, 2005 and 2006, respectively. Future minimum lease payments are as follows:
During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for three years. The sale and leaseback transaction resulted in a deferred gain of $2.0 million which was amortized into income over the final year of the lease, resulting in other income of $1.7 million in 2003 and $368,000 in 2004. During March 2004, the lease was extended for three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest on the unpaid lease balance at a floating interest rate of 1% over JP Morgan Chase Bank prime, which was 9.25% at December 31, 2006. During March 2007, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $13,834 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.9 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.5 million.
Chandler USA has guaranteed the obligations of Trust I and Trust II. It guarantees payment of distributions and the redemption price of the trust preferred securities until the securities are redeemed in full. The total redemption price of the trust preferred securities is $20.0 million.
NOTE 12. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for a three year term. During March 2004, the lease was extended for three years, and during March 2007 the lease was extended for an additional three years. See Note 11 to Consolidated Financial Statements for additional information. The bank that participated in the sale and leaseback transaction also established a letter of credit in the amount of $500,000 on behalf of Chandler USA for the benefit of Brown & Brown, Inc. as security in connection with the sale of a subsidiary. Chandler USA paid a fee of $5,000 during 2004 to the bank for issuing the letter of credit. The letter of credit expired on December 31, 2005. A director of NAICO and Chandler USA is an officer and director of the bank that participated in these transactions, and is also a significant shareholder of the bank's holding company. This director is also a director of the bank that Chandler USA and its subsidiaries use as their principal disbursement bank, and is a significant shareholder of the bank's holding company. The balance maintained by Chandler USA and each subsidiary is fully insured by the Federal Deposit Insurance Corporation, and Chandler USA and its subsidiaries pay customary service charges to the bank for the services provided.
During the second quarter of 2006, CIMI purchased two limited partnership units in Basin Drilling #2 LP for $2,000, and purchased 8% cumulative subordinated debentures in the amount of $500,000. The timing of payment of interest and principal on the debentures is subject to various restrictions contained in the cumulative subordinated debenture note. The purpose of the partnership is to own and operate an oil and gas drilling rig. CIMI financed the purchase with a $500,000 variable rate bank loan. Principal and interest payments are due on the bank loan in five quarterly installments beginning September 1, 2006. Interest is payable at 1% over New York Prime, which was 9.25% at December 31, 2006. The partnership is managed by Basin Management, LLC ("BMLLC") who is the General Partner. A director of NAICO and Chandler USA is the Manager for BMLLC, and is also a director of the bank and a significant shareholder of the bank holding company that provided the bank loan described above.
Chandler USA leases and has made certain improvements to a rural property in which certain directors and officers of Chandler USA own interests. Under the lease, no cash rental is paid. Chandler USA drilled a water well on the property and maintains certain structures it regularly uses. This property provides recreational activities for the entertainment of customers and business associates of Chandler USA's subsidiaries. Chandler USA incurred approximately $353,000, $313,000 and $308,000 in expenses associated with this property during 2004, 2005 and 2006, respectively, including $14,000, $10,000 and $11,000 for reimbursement of certain expenses, such as utility and similar expenses, for the years 2004, 2005 and 2006, respectively.
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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, 2005 and 2006, Chandler USA had a receivable of $9.4 million and $9.6 million, respectively, under the Credit Agreement, and Chandler USA earned $439,000, $614,000 and $733,000 in interest income under the Credit Agreement during 2004, 2005 and 2006, respectively.
NOTE 13. SEGMENT INFORMATION
Chandler USA has one reportable operating segment for property and casualty insurance. The insurance products reported in the property and casualty segment are underwritten by NAICO and are marketed through independent insurance agencies. NAICO underwrites various lines of property and casualty insurance, including surety bonds and workers compensation insurance. NAICO's main areas of concentration include the construction, manufacturing, oil and gas, trucking, wholesale, service and retail industries along with political subdivisions. The property and casualty segment operates primarily in Oklahoma and Texas, and other surrounding states. Oklahoma accounted for approximately 51%, 47% and 51% of gross written premiums in 2004, 2005 and 2006, respectively, while Texas accounted for approximately 37%, 36% and 26% of gross written premiums during the same years. Management evaluates the property and casualty segment's performance on the basis of growth in gross written premiums and income before income taxes.
Net premiums earned and losses and loss adjustment expenses within the property and casualty segment can be identified to Chandler USA designated insurance programs. Chandler USA's chief operating decision makers review net premiums earned and losses and loss adjustment expenses in assessing the performance of an insurance program. In addition, Chandler USA's chief operating decision makers consider many other factors such as the lines of business offered within an insurance program and the states in which the insurance programs are offered. Certain discrete financial information is not readily available by insurance program, including assets, interest income, and investment gains or losses. Chandler USA does not consider its insurance programs to be reportable segments, however, the following supplemental information pertaining to each insurance program's net premiums earned and losses and loss adjustment expenses is presented for the property and casualty segment.
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NOTE 14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
A summary of the unaudited quarterly operating results during 2005 and 2006 follows:
	Net investment income included $6.3 million and $324,000 in the third and fourth quarters of 2006, respectively, for the accrual of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims. See Note 10.
NOTE 15. SUBSEQUENT EVENT
Effective January 1, 2007, the commercial property and inland marine lines of insurance that were previously written by NAICO will be written by Praetorian Insurance Company ("Praetorian") through an arrangement between Praetorian and CIMI. NAICO also transferred its existing commercial property and inland marine business to Praetorian under this new arrangement effective January 1, 2007. Under this arrangement, CIMI receives commission income for the business it produces for Praetorian. CIMI is responsible for the payment of commissions to the producing agents, and is also responsible for providing underwriting and loss control services for this business. NAICO handles all claims for this business under a separate claims handling agreement with Praetorian.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholder of Chandler (U.S.A.), Inc.:
We have audited the consolidated balance sheets of Chandler (U.S.A.), Inc. and subsidiaries ("Chandler USA") as of December 31, 2005 and 2006, and the related consolidated statements of operations, comprehensive income, cash flows and shareholder's equity for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules of Chandler USA listed in Item 15(a). These financial statements and financial statement schedules are the responsibility of Chandler USA's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. Chandler USA is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of Chandler USA's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Chandler USA as of December 31, 2005 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
/s/ Tullius Taylor Sartain & Sartain LLP TULLIUS TAYLOR SARTAIN & SARTAIN LLP Tulsa, Oklahoma March 27, 2007
PAGE SCHEDULE I
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES AS OF DECEMBER 31, 2006
(In thousands)
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE SCHEDULE II
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER (U.S.A.), INC. (PARENT COMPANY ONLY)
BALANCE SHEETS
(In thousands except share amounts)
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE SCHEDULE II
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER (U.S.A.), INC. (PARENT COMPANY ONLY)
STATEMENTS OF OPERATIONS
(In thousands)
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE SCHEDULE II
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER (U.S.A.), INC. (PARENT COMPANY ONLY)
STATEMENTS OF CASH FLOWS
(In thousands)
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE SCHEDULE III
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
(IN THOUSANDS)
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE SCHEDULE IV
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
REINSURANCE
(Dollars in thousands)
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE SCHEDULE V
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE SCHEDULE VI
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
SUPPLEMENTAL INFORMATION
(FOR PROPERTY-CASUALTY INSURANCE UNDERWRITERS)
(IN THOUSANDS)
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE
INDEX TO EXHIBITS -----------------
Exhibit No. - -----------
21.1 Subsidiaries of the registrant. 31.1 Rule 13a-14(a)/15d-14(a) Certifications. 32.1 Section 1350 Certifications.