January 23, 2006
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Ibolya Ignat, Staff Accountant
Division of Corporation Finance
Re: Chandler (U.S.A.), Inc.
Form 10-K for Fiscal Year Ended December 31, 2004
Filed March 22, 2005
Form 10-Q for Fiscal Quarter Ended March 31, 2005
Filed May 11, 2005
File No. 001-15135
Dear Ms. Ignat:
This letter is in response to the telephone conversation we had on
January 23, 2006 related to our Form 10-K for the fiscal year ended December
31, 2004. In accordance with our discussion, these are the proposed
disclosures that will be included in our 2005 Form 10-K:
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, 2004, NAICO's case reserves and IBNR for
each line of business are shown in the following table.
Gross reserves at December 31, 2004 Net Reserves at December 31, 2004
----------------------------------- ---------------------------------
Case Total Case Total
reserves IBNR reserves reserves IBNR reserves
---------- ---------- ---------- ---------- ---------- ----------
(In thousands) (In thousands)
Other liability ............. $ 14,419 $ 36,571 $ 50,990 $ 5,364 $ 15,330 $ 20,694
Automobile liability ........ 10,803 14,074 24,877 6,268 5,171 11,439
Workers compensation ........ 20,069 17,284 37,353 8,191 8,851 17,042
Automobile physical damage .. 201 3 204 142 3 145
Property .................... 1,148 37 1,185 231 38 269
Surety ...................... (6,454) 475 (5,979) (4,711) 254 (4,457)
Accident and health ......... (447) - (447) (451) - (451)
Inland marine ............... 49 1 50 13 1 14
---------- ---------- ---------- ---------- ---------- ----------
Total reserves ............. $ 39,788 $ 68,445 $ 108,233 $ 15,047 $ 29,648 $ 44,695
========== ========== ========== ========== ========== ==========
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 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,
2004.
Insurance program Low High Recorded
----------------------------------------- --------- ---------- ----------
(In thousands)
Gross Reserves:
---------------
Standard property and casualty... ....... $ 59,289 $ 136,527 $ 95,172
Political subdivisions .................. 10,413 10,413 10,413
Surety bonds ............................ (5,999) (5,999) (5,999)
Involuntary workers compensation pools .. 6,108 6,108 6,108
Other ................................... 2,539 2,539 2,539
--------- ---------- ----------
$ 72,350 $ 149,588 $ 108,233
========= ========== ==========
Net Reserves:
---------------
Standard property and casualty... ....... $ 31,272 $ 52,168 $ 37,019
Political subdivisions .................. 3,349 4,206 3,420
Surety bonds ............................ (4,420) (3,992) (4,477)
Involuntary workers compensation pools .. 6,108 6,108 6,108
Other ................................... 2,625 2,625 2,625
--------- ---------- ----------
$ 38,934 $ 61,115 $ 44,695
========= ========== ==========
For the workers compensation portion of the standard property and
casualty program, NAICO's actuaries selected the results of the incurred loss
development method for all but the 2003 accident year. The 2003 accident year
selection was an average of the incurred loss development method and the paid
loss development method. For the casualty portion of this program, the
actuaries used a weighted average of the incurred loss development method and
the paid loss development method for all accident years prior to 2004. The
2004 accident year selection was based on a judgmentally selected loss ratio.
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. Due to changes in case reserve adequacy and retrospective
sufficiency of paid loss projections, additional weight was given to paid loss
indications in the 2004 loss reserve analysis. The point estimates for the
political subdivisions 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 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.
A change in actuarial assumptions and methods was made in the 2004
loss reserve analysis. The 2003 loss reserve analysis assumed no development
beyond five years of maturity with respect to net reserves for NAICO's standard
property and casualty program. The impact of limiting the loss development
after five years of maturity was to reduce 2003 reserve levels and pre-tax
income by $2.7 million. In the 2004 loss reserve analysis, this assumption
appeared unjustified and development beyond this point was recognized.
Moreover, due to the changes in case reserve adequacy and retrospective
sufficiency of paid loss projections, additional weight was given to paid loss
indications in the 2004 loss reserve 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, 2004. 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, 2004, Chandler USA had a net operating loss
carryforward available for U.S. Federal income taxes of $11.8 million which
begins to expire in 2023. 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 tax 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, 2004, had net operating
loss carryforwards available for Oklahoma state income taxes totaling
approximately $53.2 million which expire in the years 2005 through 2024. At
December 31, 2004, Chandler USA also had a capital loss carryforward for U.S.
Federal income taxes of $1.1 million which expires in 2007. A valuation
allowance has been provided for the tax effect of the state net operating loss
and the net capital loss carryforwards since realization of such amounts is not
considered more likely than not.
OTHER
See Note 1 to Consolidated Financial Statements for information
related to other accounting and reporting policies.
As we discussed, we will not be filing the amended Form 10-K for 2004. If
you have any questions, please contact me at (405)258-4292.
Sincerely,
/s/ Mark C. Hart
- -----------------
Mark C. Hart
Vice President and
Chief Financial Officer
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