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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------------------------
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005
COMMISSION FILE NUMBER: 1-15135
CHANDLER (U.S.A.), INC.
(Exact name of registrant as specified in its charter)
OKLAHOMA 73-1325906
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1010 MANVEL AVENUE, CHANDLER, OKLAHOMA 74834
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (405) 258-0804
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
-------------------------------- ---------------------------------------------
8.75% SENIOR DEBENTURES DUE 2014 AMERICAN STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act: NONE
Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. YES NO X
----- -----
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. YES NO X
----- -----
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES X NO
----- -----
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. X
-----
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act).
Large accelerated filer Accelerated filer Non-accelerated filer X
---- ---- -----
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act). YES NO X
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Aggregate market value of the voting stock held by non-affiliates of the
registrant on June 30, 2005, the last business day of the registrant's most
recently completed second fiscal quarter: None.
The number of common shares, $1.00 par value, of the registrant
outstanding on February 28, 2006 was 2,484, which are owned by Chandler
Insurance Company, Ltd.
DOCUMENTS INCORPORATED BY REFERENCE
Registrant does not incorporate by reference in this report any annual
report, proxy statement, or Rule 424 prospectus.
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PAGE 1
PART I
FORWARD-LOOKING STATEMENTS
Some of the statements made in this Form 10-K report, as well as
statements made by Chandler (U.S.A.), Inc. ("Chandler USA") in periodic press
releases and oral statements made by Chandler USA's officials constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Such forward-looking statements involve known
and unknown risks, uncertainties and other factors that may cause the actual
results, performance or achievements of Chandler USA to be materially different
from any future results, performance or achievements expressed or implied by
the forward-looking statements. Such factors include, among other things,
(i) general economic and business conditions; (ii) interest rate changes;
(iii) competition and regulatory environment in which Chandler USA and its
subsidiaries operate, including the ability to implement price increases;
(iv) claims frequency; (v) claims severity; (vi) catastrophic events of
unanticipated frequency or severity; (vii) the number of new and renewal policy
applications submitted to National American Insurance Company ("NAICO") by its
agents; (viii) the ability of NAICO to obtain adequate reinsurance in amounts
and at rates that will not adversely affect its competitive position; (ix) the
ability of NAICO to collect reinsurance recoverables; (x) the ability of NAICO
to maintain favorable insurance company ratings; and (xi) various other factors.
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 coverage for businesses in various
industries. NAICO also provides homeowners insurance in Texas. NAICO has a
network of independent agents, totaling approximately 119 at December 31, 2005,
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 for certain wholesale operations related
to NAICO's school districts and trucking insurance.
INSURANCE PROGRAMS
NAICO writes various property and casualty insurance products through
three primary marketing programs. The programs are standard property and
casualty, political subdivisions and homeowners.
STANDARD PROPERTY AND CASUALTY PROGRAM
NAICO offers workers compensation, automobile liability and physical
damage, other liability (including general liability, products liability and
umbrella liability) and property coverages under its standard property and
casualty 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.
POLITICAL SUBDIVISIONS PROGRAM
Under the political subdivisions program, NAICO writes insurance policies
primarily for school districts in Oklahoma. As of December 31, 2005 NAICO
insured 183 school districts in Oklahoma. The coverages offered include
workers compensation, automobile liability, automobile physical damage, general
liability, property and school board legal liability. NAICO has also written
property and casualty insurance for municipalities, primarily in Oklahoma.
During 2003, NAICO significantly reduced its premium writings in this portion
of the program and did not write any premiums during 2004 or 2005.
PAGE 2
HOMEOWNERS PROGRAM
In the second quarter of 2005, NAICO began writing homeowners and
dwelling fire and allied lines policies in the state of Texas through a
managing general agent. NAICO is currently reviewing this program and may
modify or discontinue this program during 2006.
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 2003, 2004 and 2005. 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."
GROSS PREMIUMS EARNED NET PREMIUMS EARNED
-------------------------- --------------------------
INSURANCE PROGRAMS 2003 2004 2005 2003 2004 2005
- ----------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Standard property and casualty .... $ 93,193 $ 92,894 $ 92,224 $ 45,521 $ 54,278 $ 54,979
Political subdivisions ............ 28,926 21,679 18,630 8,093 7,269 6,690
Homeowners ........................ - - 4,229 - - 3,321
Surety bonds ...................... 3,908 2,788 930 2,724 1,993 669
Other (1).......................... 252 507 406 245 502 401
-------- -------- -------- -------- -------- --------
TOTAL ............................. $126,279 $117,868 $116,419 $ 56,583 $ 64,042 $ 66,060
======== ======== ======== ======== ======== ========
- ----------------------------
<FN>
(1) This category is comprised primarily of the run-off of discontinued programs and
NAICO's participation in various mandatory workers compensation pools.
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.
YEAR ENDED DECEMBER 31,
----------------------------------------------------
2001 2002 2003 2004 2005
-------- -------- -------- -------- --------
Automobile liability .............. 19% 25% 27% 28% 29%
Other liability ................... 25% 25% 23% 28% 27%
Workers compensation .............. 24% 22% 29% 27% 25%
Automobile physical damage ........ 17% 14% 10% 9% 9%
Property .......................... 7% 8% 5% 4% 8%
Surety ............................ 6% 5% 5% 3% 1%
Inland marine ..................... 2% 1% 1% 1% 1%
-------- -------- -------- -------- --------
Total ........................ 100% 100% 100% 100% 100%
======== ======== ======== ======== ========
PAGE 3
UNDERWRITING AND CLAIMS
Independent insurance agents submit applications for commercial insurance
policies for prospective customers to NAICO or to NAICO's managing general
agent for the homeowners program. NAICO and the managing general agent review
prospective risks in accordance with specific underwriting guidelines
established by NAICO. If the risk is approved and coverage is accepted by the
insured, a NAICO 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.
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 or
proportional 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 January 1, 2006 reinsurance programs. At the present time, NAICO
expects to renew the reinsurance programs that renew on July 1, 2006.
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.
Under the 2003 workers compensation reinsurance program, NAICO's net
retention was 70% of the first $250,000 of loss per occurrence, and effective
July 1, 2003, NAICO's net retention increased to 70% of the first $500,000 of
loss per occurrence. Effective April 1, 2004, NAICO added 56% of the $500,000
excess of $500,000 of loss per occurrence layer to its net retention, and
effective July 1, 2004, NAICO's net retention increased to 70% of the first
$1,000,000 of loss per occurrence.
Under the 2003 casualty reinsurance program, NAICO's net retention was
70% of the first $250,000 of loss per occurrence, and effective July 1, 2003,
NAICO's net retention increased to 70% of the first $500,000 of loss per
occurrence. Effective April 1, 2004, NAICO added 56% of the $500,000 excess
of $500,000 of loss per occurrence layer to its net retention, and 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 increased its net retention for umbrella liability losses
from 3.5% of the first $2,000,000 of loss per occurrence to 17.5% of the first
$4,000,000 of loss per occurrence.
NAICO elected not to renew its construction surety bond excess of loss
reinsurance program effective April 1, 2003 due to the decreased premium volume
in this program and to the market for this reinsurance. Effective April 1,
2003, NAICO retains 70% of the losses in this program.
PAGE 4
Under the 2003 property reinsurance program, NAICO retained 23.1% of the
first $1,500,000 of risk for each loss per risk or location. Effective January
1, 2004, NAICO retains 23.1% of the first $3,000,000 of risk for each loss per
risk or location. Under the 2003 automobile physical damage reinsurance
program NAICO retained 70% of the first $500,000 of each loss per occurrence,
plus 3.5% of amounts exceeding $500,000 of each loss per occurrence up to $1
million of each loss per occurrence. Effective January 1, 2004, NAICO retains
70% of each loss per occurrence on automobile physical damage risks. NAICO
purchases 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
$700,000 for 2003 and $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 $5,500,000
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.
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, 2005.
CEDED REINSURANCE
NET PREMIUMS FOR A.M. BEST
REINSURANCE THE YEAR ENDED COMPANY
NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2005 RATING
- -------------------------------------------------------- --------------- ----------------- ------------
(Dollars in thousands)
Employers Reinsurance Corporation ...................... $ 29,497 $ 8,186 A
Chandler Insurance ..................................... 26,532 27,158 -(2)
Swiss Reinsurance America Corporation .................. 16,691 46 A+
Odyssey America Reinsurance Corporation ................ 4,504 5,594 A
Berkley Insurance Company .............................. 3,542 994 A
--------------- -----------------
Top five reinsurers ................................. $ 80,766 $ 41,978
=============== =================
All reinsurers ...................................... $ 93,877 $ 50,218
=============== =================
Percentage of total represented by top five reinsurers.. 86% 84%
- --------------------------------------------------------
<FN>
(1) Includes losses and loss adjustment expenses paid and outstanding, unpaid losses and loss adjustment
expenses and prepaid reinsurance premiums recoverable from reinsurers as of December 31, 2005.
(2) Chandler Insurance owns 100% of the common stock of Chandler USA, which in turn owns 100% of the common
stock of NAICO. Although Chandler Insurance is not subject to the minimum capital, audit, reporting and
other requirements imposed by regulation upon United States reinsurance companies, as a foreign reinsurer,
it is required to secure its reinsurance obligations by depositing acceptable securities in trust for
NAICO's benefit. At December 31, 2005, Chandler Insurance had cash and investments, including accrued
interest, with a fair value of $28.9 million deposited in a trust account for the benefit of NAICO.
PAGE 5
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 $604,000, $282,000 and $108,000 during 2003, 2004 and 2005,
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."
YEAR ENDED DECEMBER 31,
--------------------------------------------
2001 2002 2003 2004 2005
-------- -------- -------- -------- --------
(Dollars in thousands)
Automobile liability:
Net premiums earned ........................ $ 13,386 $ 16,526 $ 15,624 $ 17,742 $ 19,126
Loss ratio ................................. 70% 81% 49% 61% 82%
Other liability:
Net premiums earned ........................ $ 17,470 $16,458 $ 12,870 $ 18,044 $ 18,052
Loss ratio ................................. 57% 80% 94% 121% 48%
Workers compensation:
Net premiums earned ........................ $ 16,449 $14,808 $ 16,378 $ 17,371 $ 16,475
Loss ratio ................................. 105% 99% 72% 85% 53%
Automobile physical damage:
Net premiums earned ........................ $ 12,174 $ 9,552 $ 5,508 $ 5,933 $ 5,807
Loss ratio ................................. 52% 35% 36% 43% 56%
Property:
Net premiums earned ........................ $ 4,806 $ 5,543 $ 3,072 $ 2,611 $ 5,594
Loss ratio ................................. 93% 50% 74% 47% 41%
Surety:
Net premiums earned ........................ $ 4,125 $ 3,310 $ 2,723 $ 1,993 $ 669
Loss ratio ................................. 57% 59% 34% 134% (255)%
Inland marine:
Net premiums earned ........................ $ 1,256 $ 760 $ 408 $ 348 $ 337
Loss ratio ................................. 143% 100% 54% 29% 162%
Accident and health:
Net premiums earned ........................ $ 319 $ - $ - $ - $ -
Loss ratio ................................. 281% -% -% -% -%
Total:
Net premiums earned ........................ $ 69,985 $66,957 $56,583 $ 64,042 $ 66,060
Loss ratio ................................. 75% 76% 66% 84% 57%
Underwriting expense ratio (1) ............. 33% 34% 47% 34% 35%
-------- -------- -------- -------- --------
Combined ratio (1) ......................... 108% 110% 113% 118% 92%
======== ======== ======== ======== ========
- ----------------------------------------------
<FN>
(1) Interest expense and certain litigation expenses are not considered underwriting expenses;
therefore, such costs have been excluded from these ratios. The underwriting expense ratio
for 2003 was impacted by a 23% decrease in net premiums written and assumed during 2003.
Certain types of expenses are fixed in nature, which resulted in an increased ratio for
this period. See also "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS."
PAGE 6
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 $3.7 million and $9.6 million at December 31, 2004 and 2005,
respectively. The increase in estimated recoveries in 2005 is due primarily to
NAICO recording net estimated recoveries totaling $4.1 million related to two
surety bond principals. During 2005, NAICO recorded additional net estimated
recoveries of $1.1 million as part of a settlement with a principal's
bankruptcy estate. The gross and net estimated recovery from the principal's
bankruptcy estate deducted from unpaid losses and loss adjustment expenses at
December 31, 2005 is $2.3 million and $1.9 million, respectively. NAICO is
currently pursuing the collection of this settlement. Also during 2005, NAICO
recorded additional net estimated recoveries of $3.0 million in regards to
on-going litigation with the obligee of two surety bonds written by NAICO. The
gross and net estimated recovery deducted from unpaid losses and loss
adjustment expenses related to this litigation at December 31, 2005 is $5.9
million and $3.4 million, respectively. Trial is scheduled for 2006. 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.
PAGE 7
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.
YEAR ENDED DECEMBER 31,
-------------------------------------------------
2001 2002 2003 2004 2005
--------- --------- --------- --------- ---------
(In thousands)
Net balance at beginning of year ............... $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695
--------- --------- --------- --------- ---------
Net losses and loss adjustment expenses incurred
related to:
Current year .............................. 39,881 34,928 26,108 27,436 30,985
Prior years ............................... 12,669 15,784 11,092 26,345 6,339
--------- --------- --------- --------- ---------
Total ................................... 52,550 50,712 37,200 53,781 37,324
--------- --------- --------- --------- ---------
Net paid losses and loss adjustment expenses
related to:
Current year .............................. (22,646) (13,283) (10,626) (10,222) (11,171)
Prior years ............................... (43,799) (37,050) (30,422) (28,207) (30,299)
--------- --------- --------- --------- ---------
Total ................................... (66,445) (50,333) (41,048) (38,429) (41,470)
--------- --------- --------- --------- ---------
Net balance at end of year ..................... $ 32,812 $ 33,191 $ 29,343 $ 44,695 $ 40,549
========= ========= ========= ========= =========
NAICO has experienced a significant amount of incurred losses related to
prior accident years during the 2001- 2005 calendar years. The loss
development occurred primarily in the 1997-2001 accident 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 2001, NAICO experienced adverse loss development totaling $12.7
million due primarily to increased loss severity in the standard property and
casualty and political subdivisions programs. A substantial part of this loss
development was for workers compensation losses in the 1999 accident year.
NAICO's net retention for workers compensation losses increased substantially
in 1999 due to the rescission of certain reinsurance treaties covering this
line of business. Also contributing to the adverse loss development were
provisions for potentially uncollectible reinsurance and deductibles of
approximately $1.2 million during 2001, an increase in losses in the surety
bond program and approximately $878,000 in losses for the runoff of a
discontinued group accident and health program.
During 2002, NAICO experienced adverse loss development totaling $15.8
million primarily in the standard property and casualty program including both
liability lines and workers compensation. This adverse development was
primarily due to an increase in loss severity within the 1997-2000 accident
years. The adverse development included approximately $2.0 million for
provisions for potentially uncollectible reinsurance and deductibles.
During 2003, NAICO experienced adverse loss development totaling $11.1
million primarily in the standard property and casualty 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.
PAGE 8
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.
The following table represents the development of net balance sheet
reserves for 1996 through 2005. 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.
PAGE 9
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 1999 for claims
that occurred in 1996 will be included in the cumulative deficiency amount for
years 1996, 1997, 1998 and 1999. 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.
DEVELOPMENT OF RESERVES
AS OF DECEMBER 31,
-----------------------------------------------------------------------------------------------------
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
--------- --------- --------- --------- ---------- ---------- ---------- ---------- --------- --------
(In thousands)
Net reserve for unpaid losses
and loss adjustment
expenses ................... $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695 $ 40,549
Net paid (cumulative) as of
One year later ............. 28,572 30,330 23,896 36,009 43,799 37,050 30,422 28,207 30,299
Two years later ............ 40,857 42,934 34,966 58,979 66,141 60,560 51,375 50,158
Three years later .......... 45,668 49,735 45,390 72,052 81,635 77,413 68,643
Four years later ........... 47,995 56,306 51,364 80,860 91,403 89,349
Five years later ........... 50,700 58,843 55,445 86,257 97,700
Six years later ............ 51,878 60,821 58,062 88,859
Seven years later .......... 52,964 62,720 59,135
Eight years later .......... 54,407 63,527
Nine years later ........... 54,535
Net liability re-estimated as of
One year later ............. 55,713 55,772 43,441 56,357 59,376 48,596 44,283 55,688 51,034
Two years later ............ 55,599 56,362 45,373 67,469 74,325 67,903 70,058 61,369
Three years later .......... 54,528 58,176 50,146 77,842 86,377 89,608 73,962
Four years later ........... 54,834 61,096 55,303 83,860 100,408 91,520
Five years later ........... 55,615 62,750 58,060 91,704 102,370
Six years later ............ 56,347 63,629 62,995 92,084
Seven years later .......... 56,879 67,608 62,712
Eight years later .......... 59,243 67,254
Nine years later ........... 58,329
Net cumulative (deficiency)
redundancy ................. $ (4,484) $(13,219) $(22,791) $(40,706) $ (55,663) $ (58,708) $ (40,771) $ (32,026) $ (6,339) $ -
Supplemental gross data:
Gross liability ............ $ 78,114 $ 73,721 $ 80,701 $ 98,460 $ 100,173 $ 84,756 $ 92,606 $ 87,768 $108,233 $109,541
Reinsurance recoverable .... 24,269 19,686 40,780 47,082 53,466 51,944 59,415 58,425 63,538 68,992
--------- --------- --------- --------- ---------- ---------- ---------- ---------- --------- --------
Net liability - end of year. $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695 $ 40,549
========= ========= ========= ========= ========== ========== ========== ========== ========= ========
Gross re-estimated
liability - latest ........ $ 98,418 $103,188 $132,434 $185,860 $ 254,850 $ 279,053 $ 223,732 $ 163,239 $138,811
Re-estimated recoverable -
latest ................... 40,089 35,934 69,722 93,776 152,480 187,533 149,770 101,870 87,777
--------- --------- --------- --------- ---------- ---------- ---------- ---------- ---------
Net re-estimated
liability - latest ....... $ 58,329 $ 67,254 $ 62,712 $ 92,084 $ 102,370 $ 91,520 $ 73,962 $ 61,369 $ 51,034
========= ========= ========= ========= ========== ========== ========== ========== =========
Gross cumulative (deficiency)
redundancy ................. $(20,304) $(29,467) $(51,733) $(87,400) $(154,677) $(194,297) $(131,126) $ (75,471) $(30,578)
========= ========= ========= ========= ========== ========== ========== ========== =========
PAGE 10
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, 2005, 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), mutual funds that invest
in equity securities, interest-bearing money market accounts, collateralized
repurchase agreements and common stock received in connection with an
unaffiliated entity's conversion to a for-profit corporation. 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. 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, 2005, 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.
PAGE 11
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 8.25% at December 31, 2005.
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 8.25% at December 31, 2005. 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. At December 31, 2005, issuance costs in the
amount of $670,000 have been capitalized and are being amortized over the
stated maturity periods of thirty years. Chandler USA used $13.3 million of
the proceeds to purchase $16.7 million principal amount of its outstanding
Debentures during 2003. The Debentures purchased by Chandler USA were
cancelled. The purchase and cancellation of the Debentures resulted in a
pre-tax gain of $3.1 million during 2003, net of an adjustment to unamortized
issuance costs, which is included in other income in the consolidated statement
of operations. Chandler USA also contributed $5.0 million of the proceeds to
NAICO to be used for general corporate purposes.
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, 2005, Chandler USA and its subsidiaries had approximately
247 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
experienced downward pressure, particularly for larger accounts. NAICO has
been able to increase its pricing for most coverages from 2001 through 2005.
However, NAICO continues to experience competition in all of its programs.
NAICO's underwriting philosophy is to forego underwriting risks from which it
is unable to obtain what it believes to be adequate premium rates.
PAGE 12
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.
PAGE 13
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, 2005, NAICO had statutory earned surplus of $9.6
million. Applying the Oklahoma statutory limits described above, the maximum
shareholder dividend NAICO may pay in 2006 without the approval of the Oklahoma
Department of Insurance is $5.7 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:
Ratio of Total Adjusted Capital to
Authorized Control Level RBC
(Less than or equal to)
----------------------------------
Regulatory Event (1)
--------------------
Company Action Level (2) ...... 2.0
Regulatory Action Level (3) ... 1.5
Authorized Control Level (4) .. 1.0
Mandatory Control Level (5) ... 0.7
- ----------------------------------
<FN>
(1) When an insurer's ratio exceeds 2.0, it is not subject to regulatory attention under
the RBC Model Act.
(2) "Company Action Level" requires an insurer to prepare and submit an RBC Plan to the
insurance commissioner of its state of domicile. After review, the insurance
commissioner will notify the insurer if the Plan is satisfactory.
(3) "Regulatory Action Level" requires the insurer to submit an RBC Plan, or if applicable,
a Revised RBC Plan to the insurance commissioner of its state of domicile. After
examination or analysis, the insurance commissioner will issue an order specifying
corrective actions to be taken.
(4) "Authorized Control Level" authorizes the insurance commissioner to take such regulatory
actions considered necessary to protect the best interest of the policyholders and
creditors of an insurer which may include the actions necessary to cause the insurer to be
placed under regulatory control (i.e., rehabilitation or liquidation).
(5) "Mandatory Control Level" authorizes the insurance commissioner to take actions necessary
to place the insurer under regulatory control (i.e., rehabilitation or liquidation).
PAGE 14
The ratios of total adjusted capital to authorized control level RBC for NAICO
were 4.8:1 and 5.2:1 at December 31, 2004 and 2005, 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
three 2005 ratios that were outside of the "usual values," two of which
resulted primarily from adverse loss development as explained below.
NAICO's "investment yield" as calculated using the IRIS formula was 2.9%
during 2005 compared to a usual value of greater than 3.0% and less than 6.5%.
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.
NAICO's "two-year reserve development to policyholders' surplus" for 2005
was 60% compared to a usual value of less than 20%. The primary reason was
adverse loss development experienced during 2004 related to the 1997 - 2002
accident years. This adverse loss development related primarily to the workers
compensation and other liability lines of business in NAICO's standard property
and casualty and political subdivisions programs.
NAICO's "estimated current reserve deficiency to policyholders' surplus"
was 43% at December 31, 2005 compared to a usual value of less than 25%. The
adverse loss development experienced in 2004 related to prior accident years
was primarily responsible for this ratio being outside of the normal range.
NAICO experienced significant growth from 1996 through 2000, with gross
premiums written increasing from $108 million in 1996 to $197 million in 2000.
Since 2000, NAICO has implemented substantial price increases on most lines of
business. NAICO also exited some classes of business and non-renewed accounts
with unfavorable frequency and/or severity characteristics. These actions
resulted in a reduction in gross premiums written from $197 million in 2000 to
$120 million in 2005. Management believes that while the insured exposure base
has been significantly reduced, the premium for that exposure has increased
significantly. The calculation of this ratio assumes that factors that led to
past under reserving will cause current under reserving without regard to
changes in premium volume, premium rates, product mix, the amount of risk
retained by NAICO and current reserving practices.
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. 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
2005 Annual Report on Form 10-K, should be considered carefully.
PAGE 15
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 experienced downward
pressure, particularly for larger accounts. 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.
PAGE 16
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 creditworthiness 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, 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 2005, approximately 83% 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.
PAGE 17
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.
PAGE 18
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. UNRESOLVED STAFF COMMENTS
Not applicable.
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. LEGAL PROCEEDINGS
See Note 10 to Consolidated Financial Statements for a discussion of
litigation matters.
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, 2005.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
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. 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 as
of December 31, 2001, 2002, 2003, 2004 and 2005 and the related consolidated
statements of operations, comprehensive income, shareholder's equity and cash
flows for the years ended December 31, 2001, 2002, 2003, 2004 and 2005 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 2001 and 2002 have been restated to
reflect the results of LaGere & Walkingstick Insurance Agency, Inc. ("L&W") as
a discontinued operation.
PAGE 19
ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
YEAR ENDED DECEMBER 31,
-------------------------------------------------
2001 2002 2003 2004 2005
--------- --------- --------- --------- ---------
(Dollars in thousands)
OPERATING DATA (1)
Revenues
Direct premiums written and assumed ............... $158,964 $140,162 $118,444 $121,651 $120,344
========= ========= ========= ========= =========
Net premiums earned ............................... $ 69,985 $ 66,957 $ 56,583 $ 64,042 $ 66,060
Investment income, net ............................ 3,632 2,540 2,148 3,186 2,798
Interest income, net from related parties ......... 371 380 412 491 670
Realized investment gains, net .................... 2,654 794 2,351 652 383
Other income (2) .................................. 101 261 5,077 640 251
--------- --------- --------- --------- ---------
Total revenues ..................................... 76,743 70,932 66,571 69,011 70,162
--------- --------- --------- --------- ---------
Operating expenses
Losses and loss adjustment expenses ............... 52,550 50,712 37,200 53,781 37,324
Policy acquisition costs .......................... 10,869 10,239 11,278 11,039 10,671
General and administrative expenses ............... 11,549 12,473 13,486 12,380 12,749
Interest expense .................................. 2,240 2,234 2,441 2,397 2,535
--------- --------- --------- --------- ---------
Total operating expenses ........................... 77,208 75,658 64,405 79,597 63,279
--------- --------- --------- --------- ---------
Income (loss) from continuing operations before
income taxes ..................................... (465) (4,726) 2,166 (10,586) 6,883
Federal income tax benefit (provision) ............. (16) 1,680 (192) 3,582 (2,450)
--------- --------- --------- --------- ---------
Income (loss) from continuing operations ........... (481) (3,046) 1,974 (7,004) 4,433
Income (loss) from discontinued operations ......... (622) 284 - - -
Gain on sale of subsidiary ......................... - 671 - - -
--------- --------- --------- --------- ---------
Net income (loss) .................................. $ (1,103) $ (2,091) $ 1,974 $ (7,004) $ 4,433
========= ========= ========= ========= =========
Combined loss and underwriting expense ratio (3) ... 108% 110% 113% 118% 92%
BALANCE SHEET DATA
Cash and investments ............................... $ 73,378 $ 68,276 $ 69,198 $ 86,913 $ 86,316
Amounts due from related parties ................... 7,880 10,582 9,642 10,891 9,360
Total assets ....................................... 234,809 229,855 218,213 237,297 245,059
Unpaid losses and loss adjustment expenses ......... 84,756 92,606 87,768 108,233 109,541
Debentures ......................................... 24,000 24,000 7,254 6,979 6,979
Junior subordinated debentures issued to affiliated
trusts ........................................... - - 20,620 20,620 20,620
Total liabilities .................................. 191,067 186,855 174,374 201,105 205,373
Shareholder's equity ............................... 43,742 43,000 43,839 36,192 39,686
- ----------------------------------------------------
<FN>
(1) In December 2002, Chandler USA completed the sale of a wholly owned
subsidiary for $3.6 million. Chandler USA recorded an after-tax gain of
$671,000 on the sale in 2002 based on the minimum purchase price for the
transaction. Amounts for 2001 and 2002 have been restated to reflect the
results of the subsidiary as a discontinued operation.
(2) Other income included a $3.1 million gain on the purchase and cancellation
of $16.7 million principal amount of Debentures in 2003, and $1.7 million
and $368,000 for the amortization of the deferred gain on a sale and
leaseback transaction in 2003 and 2004, respectively. For additional
information, see "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS."
(3) Interest expense and certain litigation expenses are not considered
underwriting expenses and have been excluded from this ratio.
PAGE 20
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 three separate
marketing programs: standard property and casualty, political subdivisions and
homeowners. 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. Beginning in
2005, NAICO also writes homeowner and dwelling fire and allied lines policies
in the state of Texas through a managing general agent. NAICO markets these
products through a network of independent insurance agents. A portion of the
insurance written by NAICO is reinsured by Chandler USA's parent Chandler
Insurance. CIMI maintains certain wholesale operations related to NAICO's
school districts and trucking insurance.
SUMMARY OF RESULTS
For the year ended December 31, 2005, Chandler USA had a net income of
$4.4 million compared to a net loss of $7.0 million for 2004 and net income of
$2.0 million for 2003. Net income for 2003 included $3.1 million in gains on
the purchase and cancellation of $16.7 million principal amount of Debentures,
and $1.7 million for the amortization of the deferred gain on a sale and
leaseback transaction. These transactions are discussed in more detail under
"Other Income" and "Liquidity and Capital Resources." The net loss in 2004 is
primarily due to the adverse loss development experienced by Chandler USA. See
"Losses and Loss Adjustment Expenses."
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.
PAGE 21
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, 2005, NAICO's case reserves and IBNR for
each line of business are shown in the following table.
Gross reserves at December 31, 2005 Net Reserves at December 31, 2005
----------------------------------- ---------------------------------
Case Total Case Total
reserves IBNR reserves reserves IBNR reserves
----------- ----------- ----------- ---------- ---------- -----------
(In thousands) (In thousands)
Other liability ........................ $ 15,354 $ 37,916 $ 53,270 $ 4,570 $ 10,637 $ 15,207
Automobile liability ................... 11,433 16,338 27,771 7,872 9,315 17,187
Workers compensation ................... 18,514 19,169 37,683 7,623 8,138 15,761
Automobile physical damage ............. 651 - 651 460 - 460
Property ............................... 2,134 176 2,310 642 128 770
Surety ................................. (12,281) 336 (11,945) (8,503) 48 (8,455)
Accident and health .................... (443) - (443) (443) - (443)
Inland marine .......................... 244 - 244 62 - 62
----------- ----------- ----------- ---------- ---------- -----------
Total reserves ........................ $ 35,606 $ 73,935 $ 109,541 $ 12,283 $ 28,266 $ 40,549
=========== =========== =========== ========== ========== ===========
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.
PAGE 22
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, 2005.
Insurance program Low High Recorded
- ---------------------------------------------- ---------- ---------- ----------
(In thousands)
Gross Reserves:
---------------
Standard property and casualty ........... $ 86,545 $ 130,134 $ 105,956
Political subdivisions ................... 6,086 6,086 6,086
Homeowners ............................... 683 683 683
Surety bonds ............................. (11,960) (11,960) (11,960)
Involuntary workers compensation pools .. 6,228 6,228 6,228
Other .................................... 2,548 2,548 2,548
---------- ---------- ----------
$ 90,130 $ 133,719 $ 109,541
========== ========== ==========
Net Reserves:
-------------
Standard property and casualty ........... $ 30,367 $ 53,307 $ 36,816
Political subdivisions ................... 2,513 3,399 2,837
Homeowners ............................... 512 512 512
Surety bonds ............................. (8,453) (5,954) (8,470)
Involuntary workers compensation pools .. 6,228 6,228 6,228
Other .................................... 2,626 2,626 2,626
---------- ---------- ----------
$ 33,793 $ 60,118 $ 40,549
========== ========== ==========
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 the 2002 and prior accident years. The 2003 and 2004
accident years were based on the loss ratios that resulted from using the
incurred loss development method before the application of certain quota share
reinsurance. The 2005 accident year selection was based on a judgmentally
selected loss ratio. For the casualty portion of this program, the actuaries
used an average of the incurred loss development method and the corresponding
selections from the prior quarter for all accident years prior to 2003. The
2003, 2004 and 2005 accident year selections were based on judgmentally
selected loss ratios. 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. Changes in actuarial methods were made in
the 2005 loss reserve analysis for the standard property and casualty program.
In the 2004 loss reserve analysis, additional weight was given to paid loss
indications for certain accident year selections for this program. The 2005
loss reserve analysis used only the incurred loss development method, adjusted
as described above, with judgmentally selected loss ratios for the more recent
accident years.
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.
PAGE 23
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, 2005. 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, 2005, Chandler USA had a net operating loss carryforward
available for U.S. Federal income taxes of $5.7 million which begins to expire
in 2023. 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, 2005, had net operating loss
carryforwards available for Oklahoma state income taxes totaling approximately
$54.2 million which expire in the years 2006 through 2025. At December 31,
2005, Chandler USA also had a capital loss carryforward for U.S. Federal income
taxes of $3.1 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.
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 $100.1 million, or 83%, of NAICO's direct written and assumed
premiums in 2005 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.
PAGE 24
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
experienced downward pressure, particularly for larger accounts. NAICO has
been able to increase its pricing for most coverages from 2001 through 2005.
However, NAICO continues to experience competition in all of its programs.
NAICO's underwriting philosophy is to forego underwriting risks from which it
is unable to obtain what it believes to be adequate premium rates.
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.
PAGE 25
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."
YEAR ENDED DECEMBER 31,
--------------------------------
2003 2004 2005
---------- ---------- ----------
(Dollars in thousands)
INSURANCE PROGRAMS
- --------------------------------------------
STANDARD PROPERTY AND CASUALTY
Net premiums earned ....................... $ 45,521 $ 54,278 $ 54,979
Loss ratio ................................ 65.1% 79.0% 61.0%
POLITICAL SUBDIVISIONS
Net premiums earned ....................... $ 8,093 $ 7,269 $ 6,690
Loss ratio ................................ 70.7% 98.0% 61.2%
HOMEOWNERS
Net premiums earned ....................... $ - $ - $ 3,321
Loss ratio ................................ -% -% 39.3%
SURETY BONDS
Net premiums earned ....................... $ 2,724 $ 1,993 $ 669
Loss ratio ................................ 33.5% 134.4% (254.7)%
OTHER (1)
Net premiums earned ....................... $ 245 $ 502 $ 401
Loss ratio ................................ 374.0% 215.3% 29.7%
TOTAL
Net premiums earned ....................... $ 56,583 $ 64,042 $ 66,060
Loss ratio ................................ 65.7% 84.0% 56.5%
- ----------------------------
<FN>
(1) This category is comprised primarily of the run-off of discontinued programs
and NAICO's participation in various mandatory workers compensation pools.
PAGE 26
YEAR ENDED DECEMBER 31,
--------------------------------
2003 2004 2005
---------- ---------- ----------
(Dollars in thousands)
LINES OF INSURANCE
- --------------------------------------------
AUTOMOBILE LIABILITY
Net premiums earned ....................... $ 15,624 $ 17,742 $ 19,126
Loss ratio ................................ 49.4% 61.2% 81.8%
OTHER LIABILITY
Net premiums earned ....................... $ 12,870 $ 18,044 $ 18,052
Loss ratio ................................ 94.0% 120.9% 47.6%
WORKERS COMPENSATION
Net premiums earned ....................... $ 16,378 $ 17,371 $ 16,475
Loss ratio ................................ 71.8% 85.5% 52.7%
AUTOMOBILE PHYSICAL DAMAGE
Net premiums earned ....................... $ 5,508 $ 5,933 $ 5,807
Loss ratio ................................ 36.0% 42.9% 56.3%
PROPERTY
Net premiums earned ....................... $ 3,072 $ 2,611 $ 5,594
Loss ratio ................................ 73.7% 46.8% 41.5%
SURETY
Net premiums earned ....................... $ 2,723 $ 1,993 $ 669
Loss ratio ................................ 33.5% 134.4% (254.7)%
INLAND MARINE
Net premiums earned ....................... $ 408 $ 348 $ 337
Loss ratio ................................ 54.1% 29.5% 162.0%
TOTAL
Net premiums earned ....................... $ 56,583 $ 64,042 $ 66,060
Loss ratio ................................ 65.7% 84.0% 56.5%
PAGE 27
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 NET PREMIUMS EARNED
-------------------------- --------------------------
INSURANCE PROGRAMS 2003 2004 2005 2003 2004 2005
- ----------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Standard property and casualty .... $ 93,193 $ 92,894 $ 92,224 $ 45,521 $ 54,278 $ 54,979
Political subdivisions ............ 28,926 21,679 18,630 8,093 7,269 6,690
Homeowners ........................ - - 4,229 - - 3,321
Surety bonds ...................... 3,908 2,788 930 2,724 1,993 669
Other ............................. 252 507 406 245 502 401
-------- -------- -------- -------- -------- --------
TOTAL ............................. $126,279 $117,868 $116,419 $ 56,583 $ 64,042 $ 66,060
======== ======== ======== ======== ======== ========
GROSS PREMIUMS EARNED NET PREMIUMS EARNED
-------------------------- --------------------------
LINES OF INSURANCE 2003 2004 2005 2003 2004 2005
- ----------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Other liability ................... $ 34,715 $ 35,438 $ 33,944 $ 12,870 $ 18,044 $ 18,052
Automobile liability .............. 27,538 26,660 28,031 15,624 17,742 19,126
Workers compensation .............. 29,821 26,995 25,769 16,378 17,371 16,475
Automobile physical damage ........ 9,146 9,154 8,914 5,508 5,933 5,807
Property .......................... 19,359 15,130 17,102 3,072 2,611 5,594
Surety ............................ 3,908 2,788 930 2,723 1,993 669
Inland marine ..................... 1,792 1,703 1,729 408 348 337
-------- -------- -------- -------- -------- --------
TOTAL ............................. $126,279 $117,868 $116,419 $ 56,583 $ 64,042 $ 66,060
======== ======== ======== ======== ======== ========
Gross premiums earned decreased 7% and 1% in 2004 and 2005, respectively.
These decreases were primarily the result of NAICO's continued efforts to
improve underwriting profitability and increased competition within the
Oklahoma school districts portion of the political subdivisions program. In
2005, the gross earned premium from the new homeowners program offset the
decreases in gross earned premiums in the political subdivision and surety bond
programs. Gross premiums earned in Texas decreased 3% and 4% in 2004 and 2005,
respectively, and gross premiums earned in Oklahoma decreased 8% and 4% in 2004
and 2005. Net premiums earned increased 13% and 3% in 2004 and 2005,
respectively. The increase in 2004 was due primarily to changes in NAICO's
reinsurance programs for certain excess of loss and quota share reinsurance.
Effective January 1, 2004, NAICO discontinued a quota share reinsurance
arrangement that covered casualty, workers compensation and physical damage
risks produced by certain agents. Effective, April 1, 2004, NAICO increased
its net retention to include 56% of the layer covering $500,000 excess of
$500,000 of loss per occurrence for its casualty and workers compensation
risks, and effective July 1, 2004, NAICO increased its net retention to include
70% of this layer. During 2005, the only significant change in NAICO's
reinsurance retention was that effective July 1, 2005, NAICO increased its net
retention for the casualty reinsurance program to include 70% of each loss
occurrence up to $2 million. These changes increased NAICO's net retention for
these lines of business and also increased net premiums earned. The new
homeowners program also contributed to the increase in net premiums earned in
2005.
Gross premiums earned in the standard property and casualty program
decreased less than 1% in 2004 and 2005. Gross premiums earned in Texas
decreased $685,000 and $4.9 million in 2004 and 2005, respectively, and gross
premiums earned in Oklahoma increased $1.7 million and $906,000 in 2004 and
2005. NAICO offset the decrease in Texas by expanding its standard property
and casualty program in several midwestern states, including New Mexico and
Colorado. NAICO has also increased premiums from trucking accounts in 2004 and
2005. Gross premiums earned from trucking accounts increased $4.9 million and
$6.4 million in 2004 and 2005, respectively, while net premiums earned
increased $2.8 million and $3.3 million in these periods. Net premiums earned
increased 19% and 1% in 2004 and 2005, respectively. The increases are
primarily due to reinsurance changes described above.
Gross premiums earned in the political subdivisions program decreased 25%
and 14% in 2004 and 2005, respectively. The decrease in gross premiums earned
is due primarily to increased competition related to Oklahoma school districts.
Net premiums earned decreased 10% and 8% in 2004 and 2005, respectively. The
decrease in 2004 and 2005 was due to a decrease in gross premiums earned and
was partially offset by the reinsurance changes described above.
PAGE 28
In the second quarter of 2005, NAICO began writing homeowner and dwelling
policies in the state of Texas through a managing general agent. Gross and net
earned premiums for 2005 were $4.2 million and $3.3 million, respectively.
NAICO is currently reviewing this program and may modify or discontinue this
program during 2006.
Gross premiums earned in the surety bond program decreased 29% and 67% in
2004 and 2005, respectively. Net premiums earned decreased 27% and 66% in 2004
and 2005, respectively. NAICO is no longer actively marketing surety business,
and expects premium volume to continue to decline.
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, 2005, Chandler USA's investment portfolio consisted
primarily of fixed income U.S. Treasury and government agency bonds,
high-quality corporate bonds and mutual funds that invest in equity securities,
with approximately 6% 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, excluding interest income from related parties,
increased 48% in 2004 and decreased 12% in 2005. The increase in 2004 was due
primarily to NAICO receiving $577,000 in interest from an arbitration award in
addition to an increase in fixed maturity investments during the year. The
interest received from the arbitration award in 2004 attributed to the decrease
in 2005. Excluding the arbitration interest, Chandler USA's net investment
income increased 7% in 2005. Interest income from related parties was
$412,000, $491,000 and $670,000 during 2003, 2004 and 2005, respectively. The
increase in 2004 was due primarily to an increase in the amount loaned to
Chandler Insurance. The 2005 increase was due primarily to higher interest
rates. See Liquidity and Capital Resources.
Net realized investment gains were $2,351,000, $652,000 and $383,000 in
2003, 2004 and 2005, respectively. Realized investment gains in 2003 included
a gain of $1.7 million from the sale of 19,371 shares of common stock of
Insurance Services Office, Inc. ("ISO"). NAICO received these shares in 1997
as a result of ISO converting to a for-profit corporation.
The average net yield on the fixed maturity portfolio, including net
realized investment gains, was 6.7%, 4.0% and 3.4% in 2003, 2004 and 2005,
respectively. The average net yield on the fixed maturity portfolio, excluding
net realized investment gains, was 3.2% for 2003 and 2004 and 3.4% for 2005.
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, 2005 was approximately
$10.5 million. The average yield on the fixed maturity portfolio before
deducting investment expenses was 3.6% in 2003 and 2004 and 3.8% in 2005,
excluding net realized capital gains.
OTHER INCOME
During 2003, Chandler USA's other income included a $3.1 million gain on
the purchase and cancellation of $16.7 million of its Debentures. In addition,
the amortization of a deferred gain related to a sale and leaseback transaction
increased other income by $1.7 million in 2003. During 2004, the remaining
$368,000 of deferred gain was amortized into income. The deferred gain was
amortized into income over the final year of the lease following the exercise
of the option for Chandler USA to repurchase the equipment at the end of the
lease.
PAGE 29
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 65.7%, 84.0% and 56.5% in 2003, 2004 and 2005,
respectively. Weather-related losses (net of applicable reinsurance) from wind
and hail were $1.9 million, $761,000 and $475,000 in 2003, 2004 and 2005,
respectively, and increased the respective loss ratios by 3.4, 1.2 and 0.7
percentage points. NAICO did not experience any losses related to Hurricane
Katrina, but did experience approximately $315,000 in net incurred losses from
Hurricane Rita.
NAICO has experienced a significant amount of incurred losses related to
prior accident years during the 2001- 2005 calendar years. The loss
development occurred primarily in the 1997-2001 accident 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.
Calendar years
--------------------------------
2003 2004 2005
---------- ---------- ----------
(In thousands)
Other liability ...................... $ 5,546 $ 15,537 $ 1,330
Automobile liability ................. (56) 1,082 4,562
Workers compensation ................. 4,183 7,580 1,387
Automobile physical damage ........... 180 194 255
Property ............................. 547 275 325
Surety ............................... 357 1,936 (1,844)
Accident and health .................. 240 (286) (26)
Inland marine ........................ 95 27 350
---------- ---------- ----------
$ 11,092 $ 26,345 $ 6,339
========== ========== ==========
In 2003 and 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, the majority of the
adverse loss development was in the automobile liability line of business, as
reserves were strengthened in the 1999-2004 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.
PAGE 30
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.
Accident years
--------------------------------------------------------------------------------------------------
Prior to
1997 1997 1998 1999 2000 2001 2002 2003 2004 Total
--------- --------- --------- --------- --------- --------- --------- --------- -------- ---------
(In thousands)
Reserves at beginning of 2003 .. $ 3,966 $ (720) $ 370 $ 1,947 $ 2,531 $ 3,413 $ 21,684 $ - $ - $ 33,191
Development during 2003 ........ 533 346 1,878 3,261 6,034 7,255 (8,215) - - 11,092
--------- --------- --------- --------- --------- --------- --------- --------- -------- ---------
Re-estimated reserves at
beginning of 2003 ............. $ 4,499 $ (374) $ 2,248 $ 5,208 $ 8,565 $ 10,668 $ 13,469 $ - $ - $ 44,283
========= ========= ========= ========= ========= ========= ========= ========= ======== =========
Reserves at beginning of 2004 .. $ 3,383 $ (1,266) $ 146 $ 481 $ 1,879 $ 2,651 $ 6,554 $ 15,515 $ - $ 29,343
Development during 2004 ........ 2,365 1,615 956 2,909 6,186 7,674 4,071 569 - 26,345
--------- --------- --------- --------- --------- --------- --------- --------- -------- ---------
Re-estimated reserves at
beginning of 2004 ............. $ 5,748 $ 349 $ 1,102 $ 3,390 $ 8,065 $ 10,325 $ 10,625 $ 16,084 $ - $ 55,688
========= ========= ========= ========= ========= ========= ========= ========= ======== =========
Reserves at beginning of 2005 .. $ 4,301 $ (107) $ 385 $ 610 $ 3,695 $ 3,242 $ 6,524 $ 8,833 $17,212 $ 44,695
Development during 2005 ........ (913) 559 71 664 1,582 (50) 1,992 1,777 657 6,339
--------- --------- --------- --------- --------- --------- --------- --------- -------- ---------
Re-estimated reserves at
beginning of 2005 ............. $ 3,388 $ 452 $ 456 $ 1,274 $ 5,277 $ 3,192 $ 8,516 $ 10,610 $ 17,869 $ 51,034
========= ========= ========= ========= ========= ========= ========= ========= ======== =========
During 2003, NAICO experienced adverse loss development totaling $11.1
million primarily in the standard property and casualty 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. Adverse loss development for workers compensation was $4.2 million and
adverse loss development for other liability was $5.5 million. A reduction in
losses for the 2002 accident year partially offset this adverse development.
This reduction was based on more favorable development patterns in the standard
property and casualty program including the workers compensation, other
liability and automobile liability lines of business. However, the patterns
experienced during 2003 worsened during 2004 and approximately half of this
reserve reduction had to be added back to the 2002 accident year. The adverse
loss development included approximately $1.3 million for provisions for
potentially uncollectible reinsurance and deductibles relating primarily to
the workers compensation line of business.
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 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. As discussed previously, the adverse
development in the 2002 accident year partially offset the reduction in losses
for this accident year that was recorded during 2003. 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 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.
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 2003,
2004 and 2005, NAICO incurred charges of $604,000, $282,000 and $108,000,
respectively, in adjustments to ceded losses and loss adjustment expenses for
amounts deemed uncollectible.
PAGE 31
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, 2003, 2004 and 2005:
YEAR ENDED DECEMBER 31,
--------------------------------
2003 2004 2005
---------- ---------- ----------
(In thousands)
Commissions expense ........................ $ 17,644 $ 16,078 $ 17,186
Other premium related assessments .......... 1,159 1,137 960
Premium taxes .............................. 2,446 2,562 2,205
Excise taxes ............................... 260 301 272
Dividends to policyholders ................. (52) - -
Other expense .............................. 598 458 723
---------- ---------- ----------
Total direct expenses ...................... 22,055 20,536 21,346
Indirect underwriting expenses ............. 7,675 7,463 6,384
Commissions received from reinsurers ....... (18,643) (17,068) (15,891)
Adjustment for deferred acquisition costs .. 191 108 (1,168)
---------- ---------- ----------
Net policy acquisition costs ............... $ 11,278 $ 11,039 $ 10,671
========== ========== ==========
Total gross direct and indirect expenses as a percentage of direct
written and assumed premiums were 25.1%, 23.0% and 23.0% in 2003, 2004 and
2005, respectively. For these periods, commission expense as a percentage of
gross written and assumed premiums was 14.9%, 13.2% and 14.3%. The decrease
in 2004 in commission expense was primarily due to a decrease in contingent
commissions to agents that resulted from higher loss ratios than had been
projected for these agents. The increase in 2005 in commission expense was
due primarily to the new homeowners program that began during 2005. This new
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 6.5%, 6.1% and 5.3% of total direct
written and assumed premiums in 2003, 2004 and 2005, respectively. The
decrease in 2005 was 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 28.0%, 33.3% and 31.6% in 2003, 2004 and 2005, respectively.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses were 10.7%, 10.5% and 11.0% of gross
premiums earned in 2003, 2004 and 2005, respectively. General and
administrative expenses decreased $1.1 million in 2004 due primarily to a
reduction in employee related expenses and to a recovery of certain litigation
expenses of $359,000. General and administrative expenses have historically
not varied in direct proportion to Chandler USA's revenues. A portion of such
expenses is allocated to policy acquisition costs (indirect underwriting
expenses) and loss and loss adjustment expenses based on various factors,
including employee counts, salaries, occupancy and specific identification.
Because certain types of expenses are fixed in nature, the percentage of such
expenses to revenues will vary depending on Chandler USA's revenues.
PAGE 32
INTEREST EXPENSE
Interest expense decreased 2% in 2004 and increased 6% in 2005.
Substantially all of Chandler USA's interest expense is related to its
outstanding senior debentures and junior subordinated debentures. The increase
in 2005 was due primarily to the increase in interest rates during 2005, 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 8.9%, 33.8% and 35.6% for 2003, 2004 and
2005, respectively. The low percentage in 2003 was primarily due to offsetting
taxable realized gains of $2.4 million against Chandler USA's capital loss
carryforward which is fully reserved due to its realization not being
considered more likely than not.
At December 31, 2005, Chandler USA had a net deferred tax asset of $5.6
million including $1.9 million related to federal net operating loss
carryforwards which begin to expire in 2023. 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, 2005, NAICO had statutory earned surplus of $9.6
million. Applying the Oklahoma statutory limits described above, the maximum
shareholder dividend NAICO may pay in 2006 without the approval of the Oklahoma
Department of Insurance is $5.7 million. NAICO paid shareholder dividends to
Chandler USA totaling $3.4 million in June of 2004.
PAGE 33
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. 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, 2005, 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, 2005 all of the investments of NAICO were in fixed-maturity
investments, mutual funds that invest in equity securities, interest-bearing
money market accounts, collateralized repurchase agreements and common stock
received in connection with an unaffiliated entity's conversion to a for-profit
corporation. 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 used $6.0 million in cash from operations during 2003,
provided $20.2 million in cash from operations in 2004 and used $131,000 in
cash from operations in 2005. Cash flow from operations was negatively
impacted during 2003 due to the decline in written premiums during this year
since claim payments for any given year will include payments for claims on
insurance policies written in prior years. The cash used by operations was
largely funded from sales and maturities of investments and certain financing
activities described below. The cash provided by operations in 2004 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.
Cash flows from investing activities during 2003 and 2004 were primarily
the result of normal purchases and sales of investment securities. During
2004, NAICO purchased $8.1 million of mutual funds that invest in equity
securities. Net realized investment gains before income taxes were $2,351,000,
$652,000 and $383,000 during 2003, 2004 and 2005, respectively, from the sale
of investments. NAICO received proceeds of $24.5 million, $23.8 million and
$2.5 million during 2003, 2004 and 2005, respectively, from the sale of
available for sale securities prior to their maturity. The proceeds and
related net realized investment gains in 2003 provided cash for operating
activities due to the decrease in written premiums. During 2003, 2004 and
2005, the market value of NAICO's available for sale fixed-income investments
decreased by $500,000, $581,000 and $1.6 million, respectively, due primarily
to changes in interest rates experienced during this time. The average
maturity of NAICO's fixed maturity investments was 4.9 years and 4.0 years at
December 31, 2004 and 2005, respectively.
Cash flows from financing activities during 2003 included $19.3 million
in proceeds from the issuance of junior subordinated debentures net of related
issuance costs and purchase of common securities of related trusts, less $12.8
million for payments to purchase $16.7 million principal amount of Chandler
USA's Debentures. See Note 5 to Consolidated Financial Statements.
PAGE 34
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, 2005, the total amount of cash and investments
restricted as a result of these arrangements was $7.8 million. In addition,
NAICO deposited $3.7 million into a trust account during 2005 as collateral for
a reinsurance agreement in which NAICO is the assuming reinsurer.
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, 2004
and 2005, Chandler USA had a receivable of $10.9 million and $9.4 million,
respectively, under the Credit Agreement, and Chandler USA earned $412,000,
$439,000 and $614,000 in interest income under the Credit Agreement during
2003, 2004 and 2005, respectively.
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 an additional three years with
monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest,
which was 8.25% at December 31, 2005, on the unpaid lease balance which is a
floating interest rate of 1% over JP Morgan Chase Bank prime. Chandler USA
has the option to repurchase the equipment at the end of the lease for
approximately $2.4 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 $1.9 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, 2005, aggregated by type of
obligation:
LESS THAN 1-3 3-5 MORE THAN
ONE YEAR YEARS YEARS 5 YEARS TOTAL
---------- --------- --------- --------- ----------
(In thousands)
Unpaid losses and loss adjustment
expenses (1) ...................... $ 49,522 $ 46,319 $ 10,310 $ 3,390 $ 109,541
Future minimum rental payments
under operating leases ............ 623 152 - - 775
Guaranteed residual value of
operating lease (2) ............... - 1,921 - - 1,921
Capital leases ..................... 61 88 46 - 195
Debentures ......................... - - - 6,979 6,979
Junior subordinated debentures
issued to affiliated trusts ....... - - - 20,620 20,620
---------- --------- --------- --------- ----------
Total ............................. $ 50,206 $ 48,480 $ 10,356 $ 30,989 $ 140,031
========== ========= ========= ========= ==========
- ---------------------------------
<FN>
(1) The amounts presented are estimates of the dollar amounts and time period in which NAICO
expects to pay out its gross unpaid losses and loss adjustment expenses. These amounts
are based on historical payment patterns and do not represent actual contractual
obligations. The actual payment amount and the related timing of those amounts could
differ significantly from these estimates.
(2) This amount represents the specified maximum deficiency that Chandler USA could be required
to make up under the sale and leaseback transaction discussed above.
PAGE 35
LITIGATION
Certain officers and directors of Chandler USA and Chandler Insurance
were named as defendants in certain litigation involving CenTra, Inc.
("CenTra"). This litigation was concluded in 2002. As a result of various
events in 1995, 1996 and 1997 related to the CenTra litigation, Chandler
Insurance (Barbados), Ltd. ("Chandler Barbados") and Chandler USA recorded
estimated recoveries of costs from its Director and Officer Liability Insurance
policy totaling $3,456,000 and $1,044,000, respectively, for reimbursable
amounts previously paid that relate to allowable defense and litigation costs.
Chandler Barbados and Chandler USA received payment for a 1995 claim during
1996 in the amount of $636,000 and $159,000, respectively. Chandler Insurance
assumed Chandler Barbados' remaining receivable in December 2003 under the
reorganization of these companies. During June 2004, Chandler Insurance and
Chandler USA received payment in the amount of $558,000 and $167,000,
respectively, in exchange for releasing certain insurers with respect to
policies covering periods from June 28, 1997 up to June 28, 2002. During the
third quarter of 2004, Chandler Insurance and its subsidiaries settled the
remaining litigation with the insurer for policy periods from June 28, 1992 to
June 28, 1997. Based on the terms of the settlement, Chandler Insurance and
Chandler USA recorded additional estimated recoveries of $1,204,000 and
$359,000, respectively, during the third quarter of 2004. Chandler Insurance
and Chandler USA received payment of $3,527,000 and $1,053,000, respectively,
during December 2004 and received payment of the remaining settlement funds of
$497,000 and $192,000 during the first quarter of 2005.
Transamerica Occidental Life Insurance Company ("Transamerica") reinsured
NAICO for certain workers compensation risks during 1989, 1990 and 1991.
Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed
under the reinsurance treaties. On March 15, 2004, an arbitration panel
ordered Transamerica to pay the losses and loss adjustment expenses owed to
NAICO in the amount of $1,607,704 plus interest at 6%, or approximately
$577,000, plus $25,000 in costs. NAICO received payment for these amounts
during 2004.
Chandler USA and its subsidiaries are not parties to any other material
litigation other than as is routinely encountered in their respective business
activities. While the outcome of these matters cannot be predicted with
certainty, Chandler USA does not expect these matters to have a material
adverse effect on its financial condition, results of operations or cash flows.
NEW ACCOUNTING STANDARDS
See Note 1 to Consolidated Financial Statements for a discussion of
recently issued accounting pronouncements.
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, 2005, 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), 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.
PAGE 36
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:
Estimated
fair value after
Hypothetical hypothetical
Fair value at change in change in
December 31, interest rate interest rate
---------------------- (bp=basis points) ----------------------
2004 2005 2004 2005
---------- ---------- ----------------- ---------- ----------
(Dollars in thousands) (Dollars in thousands)
Fixed-maturity investments... $ 71,670 $ 71,735 100 bp increase.. $ 68,482 $ 69,120
200 bp increase.. 65,501 66,657
100 bp decrease.. 75,083 74,516
200 bp decrease.. 78,744 77,477
The table above illustrates, for example, that an instantaneous 200 basis
point increase in market interest rates at December 31, 2005 would reduce the
estimated fair value of NAICO's fixed-maturity investments by approximately
$5.1 million at that date.
NAICO's portfolio of 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. These 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 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, 2004 and 2005. The selected hypothetical changes do not indicate
what could be the potential best or worst case scenarios.
Estimated
fair value after
Fair value at hypothetical
December 31, Hypothetical change in prices
---------------------- price change ----------------------
2004 2005 2004 2005
---------- ---------- ----------------- ---------- ----------
(Dollars in thousands) (Dollars in thousands)
Equity securities ............ $ 8,373 $ 9,071 20% increase ... $ 10,048 $ 10,885
20% decrease ... 6,698 7,257
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, 2005, the fair value of Chandler USA's
Debentures was estimated to be $6.1 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
8.25% at December 31, 2005. At December 31, 2005, the fair value of Chandler
USA's junior subordinated debentures was estimated to be $21.1 million.
PAGE 37
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 an additional three years with monthly rental
installments equal to the sum of (i) $17,512 plus (ii) interest, which was
8.25% at December 31, 2005, on the unpaid lease balance which is a floating
interest rate of 1% over JP Morgan Chase Bank prime. Chandler USA has the
option to repurchase the equipment at the end of the lease for approximately
$2.4 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 $1.9
million.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Item 15(a)1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
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. OTHER INFORMATION
None.
PAGE 38
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
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:
NAME AGE POSITION
- ---------------------- --- ---------------------------------------------------------------
W. Brent LaGere 60 Chairman of the Board, Chief Executive Officer, Compensation
Committee Member and Director.
Mark T. Paden 49 President, Chief Operating Officer, Compensation Committee Member
and Director.
Brenda B. Watson 65 Executive Vice President of NAICO and CIMI.
Richard L. Evans 59 Senior Vice President and Director.
R. Patrick Gilmore 54 Senior Vice President, Secretary, General Counsel and Director.
Mark C. Hart 50 Vice President - Finance, Chief Financial Officer and Treasurer.
M. Steven Blain 48 Vice President - Administration.
Robert L. Rice 71 Audit Committee Chairman and Director.
W. Scott Martin 55 Audit Committee Member and Director.
William T. Keele 69 Audit Committee Member and Director.
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 and was a director of Chandler Barbados until
December 2003.
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 since May 1998.
Mr. Paden has served as President and Chief Operating Officer of CIMI since
December 2002. 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.
BRENDA B. WATSON has been Executive Vice President of NAICO since August
1987 and of CIMI since December 2002. Since October 1988, she has served in
officer and director capacities for various subsidiaries of Chandler USA. Ms.
Watson has been a director of CIMI since December 2002. Ms. Watson also serves
as Executive Vice President of Chandler Insurance.
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.
PAGE 39
MARK C. HART has served as 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.
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 Board of Directors has determined that Robert L. Rice,
Chairman of the Audit Committee, 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,
2005.
PAGE 40
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth the compensation paid or to be paid by
Chandler USA or any of its subsidiaries as well as certain other compensation
paid or accrued, during the years indicated, to the Chairman and Chief
Executive Officer and the four other highest paid executive officers of
Chandler USA and its subsidiaries (the "Named Executives") for such period in
all capacities in which they served.
SUMMARY COMPENSATION TABLE
ANNUAL COMPENSATION (1)
-------------------------------------------------------
OTHER ANNUAL ALL OTHER
SALARY BONUS COMPENSATION COMPENSATION
NAME AND PRINCIPAL POSITION YEAR ($) ($)(2) ($)(3) ($)(4)
- --------------------------------------- -------- ---------- ---------- ------------ ------------
W. Brent LaGere 2005 $ 515,706 $ 442,552 $ 514,861 $ 124,521
Chairman of the Board and CEO 2004 501,726 719,943 390,399 90,362
of Chandler USA, NAICO and CIMI 2003 489,602 574,456 795,994 94,131
Mark T. Paden 2005 323,208 364,347 64,327 16,500
President and COO of Chandler USA, 2004 313,793 490,718 70,273 25,930
NAICO and CIMI 2003 304,654 395,427 73,934 7,133
Brenda B. Watson 2005 252,888 - N/A 5,600
Executive Vice President 2004 256,457 - N/A 11,450
of NAICO and CIMI 2003 254,072 - N/A 18,860
Richard L. Evans 2005 268,346 - N/A 10,600
Senior Vice President - Claims of 2004 260,530 - N/A 8,700
Chandler USA and NAICO 2003 254,875 - N/A 9,866
R. Patrick Gilmore 2005 237,537 10,000 N/A 6,357
Senior Vice President, Secretary and 2004 234,515 - N/A 13,600
General Counsel of Chandler USA, 2003 224,154 - N/A 7,240
NAICO and CIMI
- ----------------------------------------
<FN>
(1) Amounts shown include cash and non-cash compensation earned and received by the Named
Executives as well as amounts earned but deferred at their election.
(2) All Named Executives are eligible to receive bonuses based upon various factors.
(3) The amounts shown under this column represent various perquisites and other personal
benefits including any associated tax reimbursements to the Named Executives. Amounts
that did not exceed the lesser of $50,000 or 10% of the total annual salary and bonus for
any Named Executive have been excluded. Substantially all of the amounts shown in this
column represent payment of various personal expenses, none of which individually exceeded
25% of total perquisites for the Named Executive. Tax gross-ups for the personal expenses
included in the amounts shown above were $366,902, $206,583 and $248,411 for Mr. LaGere in
2003, 2004 and 2005, respectively, and $32,996, $39,865 and $33,598 for Mr. Paden in 2003,
2004 and 2005, respectively.
(4) The amounts shown under this column include contributions by Chandler USA's subsidiaries to
a 401(k) plan ($5,600 for Mr. LaGere, $4,600 for Mr. Paden, $5,600 for Ms. Watson, $5,600
for Mr. Evans, and $4,600 for Mr. Gilmore), and the premiums paid or to be paid by Chandler
USA's subsidiaries under life insurance arrangements with the Named Executives. A portion
of the premiums ($44,453, $45,103 and $39,453 in 2003, 2004 and 2005, respectively) were
paid under a split dollar life insurance plan. Under this plan, Chandler USA's
subsidiaries pay the premiums for life insurance issued to the Named Executive. Repayment
of the premiums is secured by the death benefit or the cash surrender value of the policy,
if any, if the Named Executive cancels and surrenders the policy.
PAGE 41
OPTIONS EXERCISED AND HOLDINGS
No options were granted to or exercised by the Named Executives during
2005 and there were no unexercised options held by the Named Executives as of
December 31, 2005.
DIRECTOR COMPENSATION
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. 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.
EMPLOYMENT AGREEMENTS
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.
PAGE 42
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
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, 2006, are beneficially owned by (i) each director of Chandler USA
and Chandler Insurance, (ii) Chandler USA's Chairman and Chief Executive
Officer and each of Chandler USA's four other most highly compensated executive
officers for services rendered for the fiscal year ended December 31, 2005 and
(iii) all current directors and executive officers as a group:
BENEFICIAL OWNERSHIP
-------------------------------------------------------
TYPE OF CAPITAL SHARES NUMBER OF
NAME OF DIRECTOR OR EXECUTIVE OFFICER OF CHANDLER INSURANCE CAPITAL SHARES (1) PERCENT (2)
- ---------------------------------------------------------- ------------------------ ------------------ -----------
W. Brent LaGere (3) ...................................... Class A Common Shares 500,661 80.0%
Series A Preferred Shares 75,152 19.6%
Mark T. Paden ............................................ Class A Common Shares 125,165 20.0%
Series A Preferred Shares 17,610 4.6%
Brenda B. Watson (4) ..................................... Series A Preferred Shares 18,024 4.7%
Series B Preferred Shares 26,451 7.3%
Richard L. Evans ......................................... Series A Preferred Shares 27,272 7.1%
Series B Preferred Shares 32,250 8.9%
R. Patrick Gilmore ....................................... Series B Preferred Shares 11,000 3.0%
Robert L. Rice ........................................... - - -%
W. Scott Martin .......................................... Series C Preferred Shares 19,000 3.0%
William T. Keele (5) ..................................... Series C Preferred Shares 122,417 19.1%
All directors and officers as a group (9 persons) (6) .... Class A Common Shares 625,826 100.0%
Series A Preferred Shares 141,586 37.0%
Series B Preferred Shares 69,701 19.1%
Series C Preferred Shares 141,417 22.0%
- ----------------------------------------------------------
<FN>
(1) The rules of the SEC provide that, for the purposes hereof, a person is
considered the "beneficial owner" of shares with respect to which the
person, directly or indirectly, has or shares the voting or investment
power, irrespective of his economic interest in the shares. Unless
otherwise noted, each person identified possesses sole voting and
investment power over the shares listed, subject to community property
laws. The Preferred Shares of Chandler Insurance have no voting rights.
The Series A Preferred Shares of Chandler Insurance are convertible to
Class A Common Shares of Chandler Insurance.
(2) Based on 625,826 Class A Common Shares of Chandler Insurance, 382,632
Series A Preferred Shares of Chandler Insurance, 364,308 Series B
Preferred Shares of Chandler Insurance and 642,069 Series C Preferred
Shares of Chandler Insurance outstanding on February 28, 2006.
(3) Includes (i) 348,390 Class A Common Shares of Chandler Insurance owned by
the W. Brent LaGere Irrevocable Trust (the "LaGere Trust") and (ii) 22,500
Class A Common Shares of Chandler Insurance owned by W&L Holding Corp.
("W&L Holding"), a corporation 100% of which is owned by the LaGere Trust.
Mr. LaGere holds an irrevocable proxy for the Class A Common Shares owned
by the LaGere Trust and W&L Holding. Mr. LaGere disclaims beneficial
ownership of the shares held by the LaGere Trust and W&L Holding. The
business address of Mr. LaGere is 1010 Manvel Avenue, Chandler, Oklahoma
74834.
(4) Includes 8,027 Series A Preferred Shares of Chandler Insurance held by Ms.
Watson's husband. Ms. Watson disclaims beneficial ownership of the shares
owned by her husband.
(5) Includes 63,787 Series C Preferred Shares of Chandler Insurance held by
the Keele Family Ltd. Partnership, 4,062 shares held by Mr. Keele's wife
and 23,911 shares held by Mr. Keele's children. Mr. Keele disclaims
beneficial ownership of the shares owned by his wife and children.
(6) Includes 3,528 Series A Preferred Shares of Chandler Insurance owned by
one executive officer of Chandler USA not listed in the table above.
PAGE 43
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, 2006. Except as otherwise indicated,
each of the persons named below has sole voting and investment power with
respect to the common shares beneficially owned.
BENEFICIAL OWNERSHIP
---------------------------------------
NAME OF SHAREHOLDER NUMBER OF SHARES (1) PERCENT (2)
- --------------------------------------------------------------- ---------------------- ---------------
Malinda K. LaGere Laird, Matthew C. LaGere and Lance A. LaGere,
Successor Co-Trustees of the W. Brent LaGere Irrevocable Trust
1010 Manvel Avenue, Chandler, Oklahoma 74834 ................. 370,890 (3) 59.3 %
- ---------------------------------------------------------------
<FN>
(1) The rules of the SEC provide that, for the purposes hereof, a person is considered the "beneficial
owner" of shares with respect to which the person, directly or indirectly, has or shares the voting
or investment power, irrespective of his economic interest in the shares. Unless otherwise noted,
each person identified possesses sole voting and investment power over the shares listed, subject to
community property laws.
(2) Based on 625,826 Class A Common Shares of Chandler Insurance outstanding on February 28, 2006.
(3) Includes 370,890 Class A Common Shares of Chandler Insurance held by the LaGere Trust, of which 22,500
Class A Common Shares are directly owned by W&L Holding, which is 100% owned by the LaGere Trust. Mr. LaGere
holds an irrevocable proxy for the Class A Common Shares owned by the LaGere Trust and W&L Holding.
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. CERTAIN RELATIONSHIPS AND RELATED 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 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.
Chandler USA leases a rural property from Davenport Farms, Inc.
("Davenport Farms"), a corporation owned by Messrs. LaGere, Evans and 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 2003, 2004 and 2005, Chandler USA incurred approximately
$336,000, $353,000 and $313,000, respectively, in expenses associated with its
use of this property, including $12,000, $14,000 and $10,000 for reimbursement
of certain expenses, such as utility and similar expenses, for the years 2003,
2004 and 2005, respectively.
PAGE 44
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 $149,600,
$155,000 and $167,100 for the years ended December 31, 2003, 2004 and 2005,
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 $18,675, $18,150 and $28,450 for the years ended
December 31, 2003, 2004 and 2005, 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 $26,375, $17,700 and $23,650 for the years ended December
31, 2003, 2004 and 2005, 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
$1,446 and $500 for the years ended December 31, 2003 and 2005, respectively.
There were no other fees billed by Tullius Taylor Sartain & Sartain LLP for
the year ended December 31, 2004.
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 23.7%,
18.8% and 23.9% for the years ended December 31, 2003, 2004 and 2005,
respectively.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) 1. FINANCIAL STATEMENTS. The consolidated balance sheets of
Chandler USA and its subsidiaries as of December 31, 2004 and
2005, 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, 2005,
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 F-1.
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.
PAGE 45
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)
PAGE 46
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 I, 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.
-----------------------------
(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.
PAGE 47
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: February 28, 2006 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: February 28, 2006 By:/s/ W. Brent LaGere
-------------------------------------------------
W. Brent LaGere, Chairman of the Board,
Chief Executive Officer and Director
(Principal Executive Officer)
Date: February 28, 2006 By:/s/ Mark T. Paden
-------------------------------------------------
Mark T. Paden, President, Chief Operating Officer
and Director
Date: February 28, 2006 By:/s/ Mark C. Hart
-------------------------------------------------
Mark C. Hart, Vice President - Finance,
Chief Financial Officer and Treasurer
(Principal Financial Officer)
Date: February 28, 2006 By:/s/ Richard L. Evans
-------------------------------------------------
Richard L. Evans, Senior Vice President
and Director
Date: February 28, 2006 By:/s/ R. Patrick Gilmore
-------------------------------------------------
R. Patrick Gilmore, Senior Vice President,
Secretary, General Counsel and Director
Date: February 28, 2006 By:/s/ Robert L. Rice
-------------------------------------------------
Robert L. Rice, Director
Date: February 28, 2006 By:/s/ W. Scott Martin
-------------------------------------------------
W. Scott Martin, Director
Date: February 28, 2006 By:/s/ William T. Keele
-------------------------------------------------
William T. Keele, Director
PAGE F-1
CHANDLER (U.S.A.), INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
PAGES
-----------------
FINANCIAL STATEMENTS
Consolidated Balance Sheets as of December 31, 2004 and 2005 ................ F-2
Consolidated Statements of Operations for the years ended
December 31, 2003, 2004 and 2005 ......................................... F-3
Consolidated Statements of Comprehensive Income for the years ended
December 31, 2003, 2004 and 2005 ........................................... F-4
Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2004 and 2005 ........................................... F-5
Consolidated Statements of Shareholder's Equity for the years ended
December 31, 2003, 2004 and 2005 ........................................... F-6
Notes to Consolidated Financial Statements .................................. F-7 through F-24
Report of Independent Registered Public Accounting
Firm on Consolidated Financial Statements
and Financial Statement Schedules .......................................... F-25
SCHEDULES
I Summary of Investments - Other Than Investments in Related Parties .... F-26
II Condensed Financial Information of Registrant ......................... F-27 through F-29
III Supplementary Insurance Information ................................... F-30
IV Reinsurance ........................................................... F-31
V Valuation and Qualifying Accounts ..................................... F-32
VI Supplemental Information (for property-casualty insurance
underwriters) ........................................................ F-33
PAGE F-2
CHANDLER (U.S.A.), INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands except share amounts)
DECEMBER 31,
------------------------
2004 2005
---------- ----------
ASSETS
Investments
Fixed maturities available for sale, at fair value
Restricted (amortized cost $8,421 and $11,789 in 2004 and 2005, respectively) ........... $ 8,279 $ 11,330
Unrestricted (amortized cost $63,636 and $61,954 in 2004 and 2005, respectively) ........ 63,391 60,405
Equity securities at fair value (cost $8,058 and $8,558 in 2004 and 2005, respectively) .. 8,373 9,071
---------- ----------
Total investments ....................................................................... 80,043 80,806
Cash and cash equivalents ($141 and $209 restricted in 2004 and 2005, respectively) ....... 6,870 5,510
Premiums receivable, less allowance for non-collection
of $119 and $223 at 2004 and 2005, respectively .......................................... 22,809 28,346
Reinsurance recoverable on paid losses, less allowance for non-collection
of $3,035 at 2004 ........................................................................ 2,172 2,875
Reinsurance recoverable on paid losses from related parties ............................... 83 -
Reinsurance recoverable on unpaid losses, less allowance for non-collection
of $237 and $174 at 2004 and 2005 ........................................................ 50,381 54,708
Reinsurance recoverable on unpaid losses from related parties ............................. 13,157 14,284
Prepaid reinsurance premiums .............................................................. 9,837 9,763
Prepaid reinsurance premiums to related parties ........................................... 12,315 12,247
Deferred policy acquisition costs ......................................................... 57 1,225
Property and equipment, net ............................................................... 9,110 8,640
Amounts due from related parties .......................................................... 10,891 9,360
State insurance licenses, net ............................................................. 3,745 3,745
Other assets .............................................................................. 15,827 13,550
---------- ----------
Total assets .............................................................................. $ 237,297 $ 245,059
========== ==========
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities
Unpaid losses and loss adjustment expenses ............................................... $ 108,233 $ 109,541
Unearned premiums ........................................................................ 51,109 55,034
Policyholder deposits .................................................................... 4,912 5,684
Accrued taxes and other payables ......................................................... 5,578 5,221
Premiums payable ......................................................................... 3,674 2,181
Premiums payable to related parties ...................................................... - 113
Debentures ............................................................................... 6,979 6,979
Junior subordinated debentures issued to affiliated trusts ............................... 20,620 20,620
---------- ----------
Total liabilities .................................................................... 201,105 205,373
---------- ----------
Commitments and contingencies (Notes 10 and 11)
Shareholder's equity
Common stock, $1.00 par value, 50,000 shares authorized;
2,484 shares issued and outstanding ..................................................... 2 2
Paid-in surplus .......................................................................... 60,584 60,584
Accumulated deficit ...................................................................... (24,346) (19,913)
Accumulated other comprehensive income (loss):
Unrealized loss on investments available for sale, net of deferred income taxes ......... (48) (987)
---------- ----------
Total shareholder's equity .............................................................. 36,192 39,686
---------- ----------
Total liabilities and shareholder's equity ................................................ $ 237,297 $ 245,059
========== ==========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
PAGE F-3
CHANDLER (U.S.A.), INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands)
YEAR ENDED DECEMBER 31,
--------------------------------------
2003 2004 2005
------------ ------------ ------------
Premiums and other revenues
Direct premiums written and assumed ............................... $ 118,444 $ 121,651 $ 120,344
Reinsurance premiums ceded ........................................ (40,612) (21,132) (23,060)
Reinsurance premiums ceded to related parties ..................... (25,992) (30,055) (27,158)
------------ ------------ ------------
Net premiums written and assumed ................................ 51,840 70,464 70,126
Decrease (increase) in unearned premiums .......................... 4,743 (6,422) (4,066)
------------ ------------ ------------
Net premiums earned ............................................. 56,583 64,042 66,060
Investment income, net .............................................. 2,148 3,186 2,798
Interest income, net from related parties ........................... 412 491 670
Realized investment gains, net ...................................... 2,351 652 383
Other income ........................................................ 5,077 640 251
------------ ------------ ------------
Total premiums and other revenues ............................... 66,571 69,011 70,162
------------ ------------ ------------
Operating costs and expenses
Losses and loss adjustment expenses, net of amounts ceded
to related parties of $14,244, $15,587 and $13,200
in 2003, 2004 and 2005, respectively ............................ 37,200 53,781 37,324
Policy acquisition costs, net of ceding commissions received
from related parties of $8,770, $11,550 and $10,498
in 2003, 2004 and 2005, respectively ............................ 11,278 11,039 10,671
General and administrative expenses ............................... 13,486 12,380 12,749
Interest expense .................................................. 2,441 2,397 2,535
------------ ------------ ------------
Total operating costs and expenses .............................. 64,405 79,597 63,279
------------ ------------ ------------
Income (loss) before income taxes ................................... 2,166 (10,586) 6,883
Federal income tax benefit (provision) .............................. (192) 3,582 (2,450)
------------ ------------ ------------
Income (loss) ....................................................... $ 1,974 $ (7,004) $ 4,433
============ ============ ============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
PAGE F-4
CHANDLER (U.S.A.), INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Amounts in thousands)
YEAR ENDED DECEMBER 31,
--------------------------------------
2003 2004 2005
------------ ------------ ------------
Net income (loss) ........................................................ $ 1,974 $ (7,004) $ 4,433
------------ ------------ ------------
Other comprehensive income (loss), before income tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period .............. 631 (322) (1,040)
Less: Reclassification adjustment for gains included in net
income (loss)....................................................... (2,351) (652) (383)
------------ ------------ ------------
Other comprehensive income (loss), before income tax ..................... (1,720) (974) (1,423)
Income tax benefit (provision) related to items of other
comprehensive income (loss) ............................................ 585 331 484
------------ ------------ ------------
Other comprehensive income (loss), net of income tax ..................... (1,135) (643) (939)
------------ ------------ ------------
Comprehensive income (loss) .............................................. $ 839 $ (7,647) $ 3,494
============ ============ ============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
PAGE F-5
CHANDLER (U.S.A.), INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
YEAR ENDED DECEMBER 31,
--------------------------------------
2003 2004 2005
------------ ------------ ------------
OPERATING ACTIVITIES
Net income (loss) .......................................................... $ 1,974 $ (7,004) $ 4,433
Add (deduct):
Adjustments to reconcile net income (loss) to cash
provided by (applied to) operating activities:
Realized investment gains, net ......................................... (2,351) (652) (383)
Gain on retirement of debentures ....................................... (3,106) (36) -
Net (gains) losses on sale of property and equipment ................... (1,661) (370) (2)
Amortization and depreciation .......................................... 1,470 1,525 1,486
Provision for non-collection of premiums ............................... 272 42 176
Provision for non-collection of reinsurance recoverables ............... 604 282 108
Net change in non-cash balances relating to operating activities:
Premiums receivable .................................................. 3,433 (2,547) (5,713)
Reinsurance recoverable on paid losses ............................... 1,449 6,439 (875)
Reinsurance recoverable on paid losses from related parties .......... (191) 188 83
Reinsurance recoverable on unpaid losses ............................. 1,798 (1,551) (4,263)
Reinsurance recoverable on unpaid losses from related parties ........ (699) (3,420) (1,127)
Prepaid reinsurance premiums ......................................... 3,933 5,432 74
Prepaid reinsurance premiums to related parties ...................... (841) (2,794) 68
Deferred policy acquisition costs .................................... 190 108 (1,168)
Other assets ......................................................... 2,427 (2,790) 2,704
Unpaid losses and loss adjustment expenses ........................... (4,838) 20,465 1,308
Unearned premiums .................................................... (7,835) 3,784 3,925
Policyholder deposits ................................................ 563 105 772
Accrued taxes and other payables ..................................... (752) 329 (357)
Premiums payable .................................................... (1,822) 2,691 (1,493)
Premiums payable to related parties .................................. - - 113
------------ ------------ ------------
Cash provided by (applied to) operating activities ..................... (5,983) 20,226 (131)
------------ ------------ ------------
INVESTING ACTIVITIES
Unrestricted fixed maturities available for sale:
Purchases ................................................................ (33,378) (38,927) (6,158)
Sales .................................................................... 22,806 23,772 2,091
Maturities ............................................................... 5,892 4,311 1,770
Equity securities available for sale:
Purchases ................................................................ - (8,058) (500)
Sales .................................................................... 1,720 36 380
Cost of property and equipment purchased ................................... (818) (208) (413)
Proceeds from sale of property and equipment ............................... 104 85 70
------------ ------------ ------------
Cash applied to investing activities ................................... (3,674) (18,989) (2,760)
------------ ------------ ------------
FINANCING ACTIVITIES
Proceeds from issuance of junior subordinated debentures, net .............. 20,000 - -
Payment on retirement of debentures ........................................ (12,782) (226) -
Debt issue costs ........................................................... (711) (18) -
Payments and loans from related parties .................................... 2,426 4,602 2,513
Payments and loans to related parties ...................................... (1,486) (5,851) (982)
------------ ------------ ------------
Cash provided by (applied to) financing activities ..................... 7,447 (1,493) 1,531
------------ ------------ ------------
Decrease in cash and cash equivalents during the period .................... (2,210) (256) (1,360)
Cash and cash equivalents at beginning of period ........................... 9,336 7,126 6,870
------------ ------------ ------------
Cash and cash equivalents at end of period ................................. $ 7,126 $ 6,870 $ 5,510
============ ============ ============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
PAGE F-6
CHANDLER (U.S.A.), INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY
(Amounts in thousands)
Accumulated
other Total
Common Paid-in Accumulated comprehensive shareholder's
stock surplus deficit income (loss) equity
----------- ----------- ----------- ------------- -------------
Balance, January 1, 2003 ................ $ 2 $ 60,584 $ (19,316) $ 1,730 $ 43,000
Net income .............................. - - 1,974 - 1,974
Change in unrealized gain on
investments available for
sale, net of income tax ............... - - - (1,135) (1,135)
----------- ----------- ----------- ------------- -------------
Balance, December 31, 2003 .............. 2 60,584 (17,342) 595 43,839
----------- ----------- ----------- ------------- -------------
Net loss ................................ - - (7,004) - (7,004)
Change in unrealized gain on
investments available for
sale, net of income tax ............... - - - (643) (643)
----------- ----------- ----------- ------------- -------------
Balance, December 31, 2004 .............. 2 60,584 (24,346) (48) 36,192
----------- ----------- ----------- ------------- -------------
Net income .............................. - - 4,433 - 4,433
Change in unrealized loss on
investments available for
sale, net of income tax ............... - - - (939) (939)
----------- ----------- ----------- ------------- -------------
Balance, December 31, 2005 .............. $ 2 $ 60,584 $ (19,913) $ (987) $ 39,686
=========== =========== =========== ============= =============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
PAGE F-7
CHANDLER (U.S.A.), INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2003, 2004 AND 2005
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 coverage 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 serves as an underwriting manager for certain wholesale operations
related to NAICO's school districts and trucking insurance.
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.
(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 and premiums are billed.
(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
PAGE F-8
(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:
2004 2005
---------- ----------
(In thousands)
Real estate and improvements .. $ 11,714 $ 11,756
Other property and equipment .. 9,010 8,468
---------- ----------
20,724 20,224
Accumulated depreciation ...... (11,614) (11,584)
---------- ----------
$ 9,110 $ 8,640
========== ==========
Depreciation expense was approximately $918,000, $894,000 and
$815,000 for 2003, 2004 and 2005, 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 2004 and 2005 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:
2004 2005
---------- ----------
(In thousands)
State insurance licenses ...... $ 5,991 $ 5,991
Accumulated amortization ...... (2,246) (2,246)
---------- ----------
$ 3,745 $ 3,745
========== ==========
PAGE F-9
(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.
(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:
YEAR ENDED DECEMBER 31,
--------------------------------
2003 2004 2005
---------- ---------- ----------
(In thousands)
Cash payments (refunds) during the year for:
Interest ...................................... $ 2,809 $ 2,261 $ 2,447
Income taxes .................................. (300) - 160
Transfers from (to) restricted securities, net .. $ (563) $ (801) $ (3,429)
(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.
PAGE F-10
(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.
In December 2004, the FASB issued Statement of Financial Accounting
Standards ("SFAS") No. 153, EXCHANGES OF NONMONETARY ASSETS - AN
AMENDMENT OF APB OPINION NO. 29. SFAS No. 153 amends APB Opinion No.
29 to eliminate the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for
exchanges of nonmonetary assets that do not have commercial substance.
SFAS No. 153 is to be applied prospectively for nonmonetary exchanges
occurring in fiscal periods beginning after June 15, 2005. The
adoption of SFAS No. 153 is not expected to have a material impact on
Chandler USA's financial position or results of operations.
In May 2005, the FASB issued SFAS No. 154, ACCOUNTING CHANGES AND
ERROR CORRECTIONS which replaces APB Opinion No. 20, ACCOUNTING CHANGES
and FASB Statement 3, REPORTING ACCOUNTING CHANGES IN INTERIM FINANCIAL
STATEMENTS. This statement changes the requirements for the accounting
for and reporting of a change in accounting principle. This statement
applies to all voluntary changes in accounting principles. It also
applies to changes required by an accounting pronouncement in the
unusual instance that the pronouncement does not include specific
transition provisions. This statement requires voluntary changes in
accounting principles be recognized retrospectively to prior periods'
financial statements, rather than recognition in the net income of the
current period. Retrospective application requires restatements of
prior period financial statements as if that accounting principle had
always been used. This statement carries forward without change the
guidance contained in Opinion 20 for reporting the correction of an
error in previously issued financial statements and a change in
accounting estimate. The provisions of SFAS No. 154 are effective for
accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005.
In September 2005, the Accounting Standards Executive Committee
issued Statement of Position ("SOP") No. 05-1, ACCOUNTING BY INSURANCE
ENTERPRISES FOR DEFERRED ACQUISITION COSTS IN CONNECTION WITH
MODIFICATIONS OR EXCHANGES OF INSURANCE CONTRACTS, which provides
guidance on the accounting by insurance companies for deferred
acquisition costs for internal replacements of insurance contracts
other than those accounted for under SFAS No. 97, ACCOUNTING AND
REPORTING BY INSURANCE ENTERPRISES FOR CERTAIN LONG-DURATION CONTRACTS
AND FOR REALIZED GAINS AND LOSSES FROM THE SALE OF INVESTMENTS. An
internal replacement occurs when an insurance contract's benefits,
features, rights or coverages are modified by exchanging an existing
contract for a new contract that is substantially changed from the
original contract, or by amendment, endorsement, or rider to a
contract, or by the election of a feature or coverage within a
contract. SOP 05-1 requires that internal replacements be accounted
for as an extinguishment of the replaced contract, and any unamortized
deferred acquisition costs related to the replaced contract should not
be deferred. This SOP is effective for internal replacements
occurring in fiscal years beginning after December 15, 2006, with
earlier adoption encouraged. The adoption of SOP No. 05-1 is not
expected to have a material impact on Chandler USA's financial
position or results of operations.
In November 2005, FASB released FASB Staff Position 115-1 "THE
MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO
CERTAIN INVESTMENTS." The proposed guidance addresses the
"determination as to when an investment is considered impaired,
whether that impairment is other-than-temporary, and the measurement
of an impairment loss." The effective date for the guidance is for
reporting periods beginning after December 15, 2005. The guidance is
not expected to have a material effect on Chandler USA's consolidated
financial statements.
PAGE F-11
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.
YEAR ENDED DECEMBER 31,
--------------------------------
2003 2004 2005
---------- ---------- ----------
(In thousands)
Interest on fixed-maturity investments ................. $ 2,271 $ 2,746 $ 2,791
Interest on cash equivalents ........................... 139 695 159
Dividend income on equity securities ................... - 22 135
Investment expenses .................................... (262) (277) (287)
---------- ---------- ----------
Investment income, net ................................ 2,148 3,186 2,798
---------- ---------- ----------
Realized gains, net - fixed-maturity investments ....... 631 616 3
Realized gains, net - equity securities ................ 1,720 36 380
---------- ---------- ----------
Realized investments gains, net ....................... 2,351 652 383
---------- ---------- ----------
$ 4,499 $ 3,838 $ 3,181
========== ========== ==========
Investment expenses include $81,000, $104,000 and $137,000 for the years
ended December 31, 2003, 2004 and 2005, 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:
GROSS GROSS
UNREALIZED UNREALIZED FAIR CARRYING
DECEMBER 31, 2004 COST GAINS LOSSES VALUE VALUE
- ---------------------------------------- ---------- ---------- ---------- ---------- ----------
FIXED MATURITIES AVAILABLE FOR SALE: (In thousands)
U.S. Treasury securities and obligations
of U.S. government corporations
and agencies ......................... $ 31,884 $ 165 $ (225) $ 31,824 $ 31,824
Corporate obligations .................. 29,756 188 (429) 29,515 29,515
Public utilities ....................... 7,603 78 (95) 7,586 7,586
Mortgage-backed securities ............. 2,814 - (69) 2,745 2,745
---------- ---------- ---------- ---------- ----------
$ 72,057 $ 431 $ (818) $ 71,670 $ 71,670
========== ========== ========== ========== ==========
EQUITY SECURITIES:
Corporate stock ........................ $ 8,058 $ 315 $ - $ 8,373 $ 8,373
========== ========== ========== ========== ==========
GROSS GROSS
UNREALIZED UNREALIZED FAIR CARRYING
DECEMBER 31, 2005 COST GAINS LOSSES VALUE VALUE
- ---------------------------------------- ---------- ---------- ---------- ---------- ----------
FIXED MATURITIES AVAILABLE FOR SALE: (In thousands)
U.S. Treasury securities and obligations
of U.S. government corporations
and agencies ......................... $ 37,933 $ - $ (904) $ 37,029 $ 37,029
Corporate obligations .................. 27,314 2 (861) 26,455 26,455
Public utilities ....................... 6,479 13 (159) 6,333 6,333
Mortgage-backed securities ............. 2,017 - (99) 1,918 1,918
---------- ---------- ---------- ---------- ----------
$ 73,743 $ 15 $ (2,023) $ 71,735 $ 71,735
========== ========== ========== ========== ==========
EQUITY SECURITIES:
Corporate stock ........................ $ 8,558 $ 513 $ - $ 9,071 $ 9,071
========== ========== ========== ========== ==========
At December 31, 2004, Chandler USA held fixed maturity investments from
General Electric Capital Corporation of $3.9 million which exceeded 10% of
Chandler USA's shareholder's equity. At December 31, 2005, Chandler USA did
not hold any fixed maturity investments that exceeded 10% of shareholder's
equity.
PAGE F-12
The fair value of Chandler USA's investments with sustained gross
unrealized losses at December 31, 2005 is presented below:
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
----------------------- ----------------------- -----------------------
UNREALIZED UNREALIZED UNREALIZED
FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES
----------- ---------- ----------- ---------- ----------- ----------
(In thousands)
U.S. Treasury securities and
obligations of U.S. government
corporations and agencies ....... $ 22,714 $ 349 $ 14,315 $ 555 $ 37,029 $ 904
Corporate securities .............. 4,035 49 20,396 813 24,431 862
Public utilities .................. - - 4,602 159 4,602 159
Mortgage-backed securities ........ - - 1,918 99 1,918 99
----------- ---------- ----------- ---------- ----------- ----------
$ 26,749 $ 398 $ 41,231 $ 1,626 $ 67,980 $ 2,024
=========== ========== =========== ========== =========== ==========
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, 2005.
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, 2005 are shown below:
AVAILABLE FOR SALE
------------------------
AMORTIZED
COST FAIR VALUE
------------ ----------
(In thousands)
Due in one year or less ...................... $ 5,419 $ 5,372
Due after one year through five years ........ 40,109 38,972
Due after five years through ten years ....... 23,398 22,717
Due after ten years .......................... 2,800 2,756
------------ ----------
71,726 69,817
Mortgage-backed securities ................... 2,017 1,918
------------ ----------
$ 73,743 $ 71,735
============ ==========
Realized gains and losses from sales of investments are shown below:
GROSS REALIZED GAINS GROSS REALIZED LOSSES
-------------------- ---------------------
(In thousands)
FIXED MATURITIES:
2003 ............ $ 631 $ -
2004 ............ 693 77
2005 ............ 20 17
EQUITY SECURITIES:
2003 ............ $ 1,720 $ -
2004 ............ 36 -
2005 ............ 380 -
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, 2004 and 2005, the carrying value of these deposits totaled approximately
$8.4 million and $7.8 million, respectively. In addition, NAICO deposited
$3.7 million into a trust account during 2005 as collateral for a reinsurance
agreement in which NAICO is the assuming reinsurer.
PAGE F-13
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 NAICO's
net liability for unpaid losses and loss adjustment expenses were approximately
$3.7 million and $9.6 million at December 31, 2004 and 2005, respectively. The
increase in estimated recoveries in 2005 is due primarily to NAICO recording
net estimated recoveries totaling $4.1 million related to two surety bond
principals. During 2005, NAICO recorded additional net estimated recoveries of
$1.1 million as part of a settlement with a principal's bankruptcy estate. The
gross and net estimated recovery from the principal's bankruptcy estate deducted
from unpaid losses and loss adjustment expenses at December 31, 2005 is $2.3
million and $1.9 million, respectively. NAICO is currently pursuing the
collection of this settlement. Also during 2005, NAICO recorded additional net
estimated recoveries of $3.0 million in regards to on-going litigation with the
obligee of two surety bonds written by NAICO for a principal. The gross and
net estimated recovery deducted from unpaid losses and loss adjustment expenses
related to this litigation at December 31, 2005 is $5.9 million and $3.4
million, respectively. Trial is scheduled for 2006. 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.
YEAR ENDED DECEMBER 31,
--------------------------------
2003 2004 2005
---------- ---------- ----------
(In thousands)
Net balance at beginning of year ........................... $ 33,191 $ 29,343 $ 44,695
---------- ---------- ----------
Net losses and loss adjustment expenses incurred related to:
Current year ............................................ 26,108 27,436 30,985
Prior years ............................................. 11,092 26,345 6,339
---------- ---------- ----------
Total ................................................ 37,200 53,781 37,324
---------- ---------- ----------
Net paid losses and loss adjustment expenses related to:
Current year ............................................ (10,626) (10,222) (11,171)
Prior years ............................................. (30,422) (28,207) (30,299)
---------- ---------- ----------
Total ................................................ (41,048) (38,429) (41,470)
---------- ---------- ----------
Net balance at end of year ................................. $ 29,343 $ 44,695 $ 40,549
========== ========== ==========
NAICO has experienced a significant amount of incurred losses related to
prior accident years during the 2003, 2004 and 2005 calendar years. The loss
development occurred primarily in the 1997-2001 accident 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 2003, NAICO experienced adverse loss development totaling $11.1
million primarily in the standard property and casualty 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.
PAGE F-14
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.
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, 2004, there were $6,979,000 principal amount
of the Debentures outstanding. As of December 31, 2005, Chandler USA has
capitalized $280,000 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, 2005, Chandler USA was in compliance with all
covenants.
PAGE F-15
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 8.25% at December 31, 2005.
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 8.25% at December 31, 2005. 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, 2005, issuance costs in the
amount of $670,000 have been capitalized and are being amortized over the stated
maturity periods of thirty years. Chandler USA used $13.3 million of the
proceeds to purchase $16.7 million principal amount of its outstanding
Debentures during 2003. The Debentures purchased by Chandler USA were
cancelled. The purchase and cancellation of the Debentures resulted in a
pre-tax gain of $3.1 million during 2003, net of an adjustment to unamortized
issuance costs, which is included in other income in the consolidated statement
of operations. Chandler USA also contributed $5.0 million of the proceeds to
NAICO to be used for general corporate purposes.
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.
PAGE F-16
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:
2003 2004 2005
-------- -------- --------
(In thousands)
Statutory net income (loss) ........ $ 1,447 $(7,482) $ 5,915
Statutory capital and surplus ...... $50,154 $41,458 $47,285
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 at December 31, 2005. 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, 2004 and 2005.
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 2006 without the
approval of the Oklahoma Department of Insurance is approximately $5.7 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 $9.6 million
as of December 31, 2005). NAICO paid approximately $146,000 and $62,000 in
policyholder dividends during 2003 and 2004, respectively. NAICO did not pay
any policyholder dividends during 2005.
PAGE F-17
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:
2003 2004 2005
---------- ---------- ----------
(In thousands)
Computed income tax provision (benefit) at 34% ...... $ 736 $ (3,599) $ 2,340
Increase (decrease) in income taxes resulting from:
Utilization of capital loss ....................... (800) (248) (104)
Nondeductible expenses ............................ 256 265 214
---------- ---------- ----------
Federal income tax provision (benefit) .............. $ 192 $ (3,582) $ 2,450
========== ========== ==========
U.S. Federal income tax provision (benefit) consists of:
CURRENT DEFERRED TOTAL
--------------- ---------------- --------------
(In thousands)
2003 ........................................ $ (904) $ 1,096 $ 192
2004 ........................................ - (3,582) (3,582)
2005 ........................................ 160 2,290 2,450
Deferred income tax provision (benefit) relating to temporary differences
includes the following components:
2003 2004 2005
------------- ------------ ------------
(In thousands)
Loss reserve discounts ......................... $ 276 $ (796) $ 454
Unearned premiums .............................. 249 (372) (256)
Deferred policy acquisition costs .............. (65) (37) 397
Investment in limited partnerships ............. - - (126)
Alternative minimum tax ........................ - - (160)
Reserve for uncollectible premiums receivable .. 38 5 (36)
Depreciation and lease expense ................. 627 5 (106)
Discount on fixed maturity investments ......... (218) 11 26
Net operating loss carryforwards ............... 214 (2,345) 2,076
Other .......................................... (25) (53) 21
------------- ------------ ------------
$ 1,096 $ (3,582) $ 2,290
============= ============ ============
PAGE F-18
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:
2004 2005
------------ ------------
(In thousands)
Deferred tax assets:
Loss reserve discounts ....................................... $ 2,569 $ 2,116
Unearned premiums ............................................ 1,989 2,246
Compensated absences ......................................... 242 227
Net operating loss carryforwards - federal ................... 4,019 1,942
Net operating loss carryforwards - state ..................... 3,194 3,254
Net capital loss carryforward ................................ 357 1,071
Investment in limited partnership ............................ - 126
Alternative minimum tax ...................................... - 160
Unrealized loss on investments available for sale ............ 25 508
Other ........................................................ 159 186
Valuation allowance .......................................... (3,551) (4,325)
------------ ------------
Total deferred tax assets ...................................... 9,003 7,511
------------ ------------
Deferred tax liabilities:
Depreciation and lease expense ............................... 1,475 1,370
Deferred policy acquisition costs ............................ 20 416
Other ........................................................ 106 129
------------ ------------
Total deferred tax liabilities ................................. 1,601 1,915
------------ ------------
Net deferred tax assets ........................................ $ 7,402 $ 5,596
============ ============
At December 31, 2005, Chandler USA had a net operating loss carryforward
available for U.S. Federal income taxes of $5.7 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
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, 2005, had net operating loss
carryforwards available for Oklahoma state income taxes totaling approximately
$54.2 million which expire in the years 2006 through 2025. At December 31,
2005, Chandler USA also had a capital loss carryforward for U.S. Federal income
taxes of $3.1 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 $5,600 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 $286,000, $321,000 and $315,000 for
2003, 2004 and 2005, 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.
PAGE F-19
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,
2004 and 2005. The estimated fair values of Chandler USA's fixed-maturity and
equity security investments are disclosed at Note 2. At December 31, 2005, the
fair value of Chandler USA's Debentures was estimated to be $6.1 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, 2005 was 8.25%. At December 31, 2005, the fair value of Chandler
USA's junior subordinated debentures was estimated to be $21.1 million.
NOTE 10. LITIGATION
Certain officers and directors of Chandler USA and Chandler Insurance
were named as defendants in certain litigation involving CenTra, Inc. This
litigation was concluded in 2002. As a result of various events in 1995, 1996
and 1997 related to the CenTra litigation, Chandler Insurance (Barbados), Ltd.
("Chandler Barbados") and Chandler USA recorded estimated recoveries of costs
from its Director and Officer Liability Insurance policy totaling $3,456,000
and $1,044,000, respectively, for reimbursable amounts previously paid that
relate to allowable defense and litigation costs. Chandler Barbados and
Chandler USA received payment for a 1995 claim during 1996 in the amount of
$636,000 and $159,000, respectively. Chandler Insurance assumed Chandler
Barbados' remaining receivable in December 2003 under the reorganization of
these companies. During June 2004, Chandler Insurance and Chandler USA
received payment in the amount of $558,000 and $167,000, respectively, in
exchange for releasing certain insurers with respect to policies covering
periods from June 28, 1997 up to June 28, 2002. During the third quarter of
2004, Chandler Insurance and its subsidiaries settled the remaining litigation
with the insurer for policy periods from June 28, 1992 to June 28, 1997. Based
on the terms of the settlement, Chandler Insurance and Chandler USA recorded
additional estimated recoveries of $1,204,000 and $359,000, respectively,
during the third quarter of 2004. Chandler Insurance and Chandler USA received
payment of $3,527,000 and $1,053,000, respectively, during December 2004 and
received payment of the remaining settlement funds of $497,000 and $192,000
during the first quarter of 2005.
Transamerica Occidental Life Insurance Company ("Transamerica") reinsured
NAICO for certain workers compensation risks during 1989, 1990 and 1991.
Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed
under the reinsurance treaties. On March 15, 2004, an arbitration panel
ordered Transamerica to pay the losses and loss adjustment expenses owed to
NAICO in the amount of $1,607,704 plus interest at 6%, or approximately
$577,000, plus $25,000 in costs. NAICO received payment for these amounts
during 2004.
Chandler USA and its subsidiaries are not parties to any other material
litigation other than as is routinely encountered in their respective business
activities. While the outcome of these matters cannot be predicted with
certainty, Chandler USA does not expect these matters to have a material
adverse effect on its financial condition, results of operations or cash flows.
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.
PAGE F-20
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 or
proportional 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 January 1, 2006 reinsurance programs. At the present time, NAICO
expects to renew the reinsurance programs that renew on July 1, 2006.
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 2003,
2004 and 2005, NAICO incurred charges of $604,000, $282,000 and $108,000,
respectively, in adjustments to ceded losses and loss adjustment expenses for
amounts deemed uncollectible.
The effect of reinsurance on premiums written and earned was as follows:
2003 2004 2005
----------------------- ----------------------- -----------------------
WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED
----------- ---------- ----------- ---------- ----------- ----------
(In thousands)
Direct ............. $ 118,247 $ 126,067 $ 121,146 $ 117,383 $ 119,051 $ 115,849
Assumed ............ 197 212 505 484 1,293 570
Ceded .............. (66,604) (69,696) (51,187) (53,825) (50,218) (50,359)
----------- ---------- ----------- ---------- ----------- ----------
Net premiums ....... $ 51,840 $ 56,583 $ 70,464 $ 64,042 $ 70,126 $ 66,060
=========== ========== =========== ========== =========== ==========
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 $83.9 million,
$52.1 million and $50.3 million for 2003, 2004 and 2005, 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, 2004 and 2005 were $22.8 million and $28.3 million,
respectively. Receivables for deductibles, in most cases, are secured by cash
deposits and letters of credit. At December 31, 2005, NAICO maintained custody
of such letters of credit securing these and other transactions totaling
approximately $20.4 million, which is a reasonable estimate of their fair value.
These letters of credit are not reflected in the accompanying consolidated
financial statements. There were no unaffiliated independent insurance agents
that produced 10% or more of NAICO's direct written and assumed premiums during
2003. During 2004 and 2005, one unaffiliated independent insurance agent
produced approximately 13% and 12%, respectively, of NAICO's direct written and
assumed premiums.
Approximately $26.7 million, or 28% of NAICO's reinsurance recoverables
and prepaid reinsurance premiums at December 31, 2005 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.
PAGE F-21
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, 2005.
CEDED REINSURANCE
NET PREMIUMS FOR A.M. BEST
REINSURANCE THE YEAR ENDED COMPANY
NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2005 RATING
- --------------------------------------------------------- --------------- ------------------- ---------
(Dollars in thousands)
Employers Reinsurance Corporation ....................... $ 29,497 $ 8,186 A
Chandler Insurance ...................................... 26,532 27,158 -(2)
Swiss Reinsurance America Corporation ................... 16,691 46 A+
Odyssey America Reinsurance Corporation ................. 4,504 5,594 A
Berkley Insurance Company ............................... 3,542 994 A
--------------- -------------------
Top five reinsurers ................................ $ 80,766 $ 41,978
=============== ===================
All reinsurers ..................................... $ 93,877 $ 50,218
=============== ===================
Percentage of total represented by top five reinsurers .. 86% 84%
- ---------------------------------------------------------
<FN>
(1) Includes losses and loss adjustment expenses paid and outstanding, unpaid losses and loss adjustment
expenses and prepaid reinsurance premiums recoverable from reinsurers as of December 31, 2005.
(2) Chandler Insurance owns 100% of the common stock of Chandler USA, which in turn owns 100% of the common
stock of NAICO. Although Chandler Insurance is not subject to the minimum capital, audit, reporting and
other requirements imposed by regulation upon United States reinsurance companies, as a foreign reinsurer,
it is required to secure its reinsurance obligations by depositing acceptable securities in trust for NAICO's
benefit. At December 31, 2005, Chandler Insurance had cash and investments, including accrued interest, with a
fair value of $28.9 million deposited in a trust account for the benefit of NAICO.
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 was
approximately $1,037,000 and $1,129,000 at December 31, 2004 and 2005,
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 in the amount that it expects to recover of
approximately $2,812,000 and $3,031,000 at December 31, 2004 and 2005,
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.
PAGE F-22
At December 31, 2005, Chandler USA's subsidiaries were committed under
noncancellable operating and capital leases for certain equipment and office
space. Rental payments under these leases were $919,000, $825,000 and $780,000
in 2003, 2004 and 2005, respectively. Future minimum lease payments are as
follows:
(In thousands)
2006 .......................... $ 684
2007 .......................... 182
2008 .......................... 58
2009 .......................... 33
2010 .......................... 13
--------------
$ 970
==============
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 an additional 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 8.25% at December 31, 2005. Chandler USA has the option to
repurchase the equipment at the end of the lease for approximately $2.4 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 $1.9 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 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.
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 $336,000, $353,000 and $313,000 in expenses associated with this
property during 2003, 2004 and 2005, respectively, including $12,000, $14,000
and $10,000 for reimbursement of certain expenses, such as utility and similar
expenses, for the years 2003, 2004 and 2005, respectively.
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, 2004
and 2005, Chandler USA had a receivable of $10.9 million and $9.4 million,
respectively, under the Credit Agreement, and Chandler USA earned $412,000,
$439,000 and $614,000 in interest income under the Credit Agreement during
2003, 2004 and 2005, respectively.
PAGE F-23
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%, 51% and 47% of gross written premiums in 2003, 2004 and 2005, respectively,
while Texas accounted for approximately 36%, 37% and 36% 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.
Chandler USA accounts for intercompany sales and transactions as if they
were to third parties and attempts to set fees consistent with those that would
apply in arm's length transactions with a non-affiliate. There can be no
assurance the rates charged reflect those that would have been agreed upon
following an arm's length negotiation.
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.
YEAR ENDED DECEMBER 31,
--------------------------------
INSURANCE PROGRAM 2003 2004 2005
- ---------------------------------------------------- ---------- ---------- ----------
(In thousands)
NET PREMIUMS EARNED
Standard property and casualty ..................... $ 45,521 $ 54,278 $ 54,979
Political subdivisions ............................. 8,093 7,269 6,690
Homeowners ......................................... - - 3,321
Surety bonds ....................................... 2,724 1,993 669
Other (1) .......................................... 245 502 401
---------- ---------- ----------
$ 56,583 $ 64,042 $ 66,060
========== ========== ==========
LOSSES AND LOSS ADJUSTMENT EXPENSES
Standard property and casualty ..................... $ 29,650 $ 42,901 $ 33,512
Political subdivisions ............................. 5,722 7,122 4,091
Homeowners ......................................... - - 1,306
Surety bonds ....................................... 911 2,677 (1,704)
Other (1) .......................................... 917 1,081 119
---------- ---------- ----------
$ 37,200 $ 53,781 $ 37,324
========== ========== ==========
- --------------------------------------
<FN>
(1) This category is comprised primarily of the run-off of discontinued programs and
NAICO's participation in various mandatory workers compensation pools.
PAGE F-24
NOTE 14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
A summary of the unaudited quarterly operating results during 2004 and
2005 follows:
First Second Third Fourth Total
quarter quarter quarter quarter year
--------- --------- --------- --------- ---------
2004
- --------------------------------------------
Net premiums earned ........................ $ 13,872 $ 16,732 $ 17,074 $ 16,364 $ 64,042
Investment income, net ..................... 1,238 749 853 837 3,677
Realized investment gains, net ............. 463 - 3 186 652
Loss before income taxes ................... (996) (4,921) (1,653) (3,016) (10,586)
Net loss ................................... (580) (3,297) (1,178) (1,949) (7,004)
2005
- --------------------------------------------
Net premiums earned ........................ $ 16,224 $ 16,294 $ 16,726 $ 16,816 $ 66,060
Investment income, net ..................... 821 845 880 922 3,468
Realized investment gains, net ............. - 3 - 380 383
Income before income taxes ................. 3,370 2,485 460 568 6,883
Net income ................................. 2,155 1,595 251 432 4,433
* * * * * * *
PAGE F-25
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholder of
Chandler (U.S.A.), Inc.:
We have audited the accompanying consolidated balance sheets of Chandler
(U.S.A.), Inc. and subsidiaries ("Chandler USA") as of December 31, 2004 and
2005, 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, 2005. Our audits also included the financial
statement schedules listed in the Index at Item 15. 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. 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 at
December 31, 2004 and 2005, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 2005 in
conformity with accounting principles generally accepted in the United States
of America. 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
February 10, 2006
PAGE F-26
SCHEDULE I
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
SUMMARY OF INVESTMENTS - OTHER
THAN INVESTMENTS IN RELATED PARTIES
AS OF DECEMBER 31, 2005
(In thousands)
AMOUNT AT WHICH
SHOWN IN THE
TYPE OF INVESTMENT COST FAIR VALUE BALANCE SHEET
- ------------------------------------------------- ------------ ------------ ---------------
FIXED MATURITIES AVAILABLE FOR SALE:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies .......... $ 37,933 $ 37,029 $ 37,029
Corporate obligations ........................... 27,314 26,455 26,455
Public utilities ................................ 6,479 6,333 6,333
Mortgage-backed securities ...................... 2,017 1,918 1,918
------------ ------------ ---------------
73,743 71,735 71,735
EQUITY SECURITIES AVAILABLE FOR SALE:
Corporate stock ................................. 8,558 9,071 9,071
------------ ------------ ---------------
Total investments ............................. $ 82,301 $ 80,806 $ 80,806
============ ============ ===============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE F-27
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)
DECEMBER 31,
---------------------
2004 2005
---------- ----------
ASSETS
Cash ............................................................ $ 64 $ 26
Premiums receivable ............................................. 7 -
Amounts due from subsidiaries ................................... 1,276 148
Property and equipment, net ..................................... 981 898
Amounts due from related parties ................................ 10,891 9,360
Other assets .................................................... 4,479 4,544
Investment in subsidiaries, net ................................. 48,381 54,363
---------- ----------
Total assets .................................................... $ 66,079 $ 69,339
========== ==========
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities
Accrued taxes and other payables ............................... $ 2,288 $ 2,054
Debentures ..................................................... 6,979 6,979
Junior subordinated debentures issued to affiliated trusts ..... 20,620 20,620
---------- ----------
Total liabilities ............................................... 29,887 29,653
---------- ----------
Shareholder's equity
Common stock, $1.00 par value, 50,000 shares authorized;
2,484 shares issued and outstanding ........................... 2 2
Paid-in surplus ................................................ 60,584 60,584
Accumulated deficit ............................................ (24,346) (19,913)
Accumulated other comprehensive income (loss):
Unrealized loss on investments held by subsidiary and available
for sale, net of deferred income taxes ........................ (48) (987)
---------- ----------
Total shareholder's equity ...................................... 36,192 39,686
---------- ----------
Total liabilities and shareholder's equity ...................... $ 66,079 $ 69,339
========== ==========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE F-28
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)
YEAR ENDED DECEMBER 31,
--------------------------------
2003 2004 2005
---------- ---------- ----------
Revenues
Investment income, net ........................................... $ 34 $ 2 $ 3
Interest income, net from related parties ........................ 436 491 670
Other income ..................................................... 5,600 1,370 908
---------- ---------- ----------
Total revenues ................................................. 6,070 1,863 1,581
---------- ---------- ----------
Operating costs and expenses
General and administrative expenses .............................. 3,175 2,505 2,749
Interest expense ................................................. 2,447 2,385 2,519
---------- ---------- ----------
Total operating costs and expenses ............................. 5,622 4,890 5,268
---------- ---------- ----------
Income (loss) before income tax benefit ............................. 448 (3,027) (3,687)
Federal income tax benefit .......................................... 509 1,137 1,198
---------- ---------- ----------
Net income (loss) before equity
in net income (loss) of subsidiaries ............................. 957 (1,890) (2,489)
Equity in net income (loss) of subsidiaries ......................... 1,017 (5,114) 6,922
---------- ---------- ----------
Net income (loss) ................................................... $ 1,974 $ (7,004) $ 4,433
========== ========== ==========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE F-29
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)
YEAR ENDED DECEMBER 31,
--------------------------------
2003 2004 2005
---------- ---------- ----------
Operating activities
Net income (loss) .............................................. $ 1,974 $ (7,004) $ 4,433
Add (deduct):
Adjustments to reconcile net income (loss) to cash
applied to operating activities:
Net (income) loss of subsidiaries not distributed to parent .. (1,017) 5,114 (6,922)
Net gains on sale of property and equipment .................. (1,661) (371) (7)
Gain on retirement of debentures ............................. (3,106) (36) -
Amortization and depreciation ................................ 221 205 210
Net change in non-cash balances relating to
operating activities:
Premiums receivable ........................................ 970 2 7
Amounts due from subsidiaries .............................. 325 161 1,128
Other assets ............................................... 1,020 (922) (121)
Accrued taxes and other payables ........................... (334) 581 (234)
Premiums payable ........................................... (2,328) - -
---------- ---------- ----------
Cash applied to operating activities ......................... (3,936) (2,270) (1,506)
---------- ---------- ----------
Investing activities
Cost of property and equipment purchased ....................... (471) (154) (130)
Proceeds from sale of property and equipment ................... 100 86 67
Investment in subsidiary ....................................... (5,620) - -
---------- ---------- ----------
Cash applied to investing activities ......................... (5,991) (68) (63)
---------- ---------- ----------
Financing activities
Shareholder dividend from subsidiaries ......................... - 3,400 -
Proceeds from issuance of debentures ........................... 20,620 - -
Payment on retirement of debentures ............................ (12,782) (226) -
Debt issue costs ............................................... (711) (18) -
Payments and loans from related parties ........................ 2,426 4,602 2,513
Payments and loans to related parties .......................... (1,486) (5,851) (982)
---------- ---------- ----------
Cash provided by financing activities ........................ 8,067 1,907 1,531
---------- ---------- ----------
Decrease in cash and cash equivalents ............................ (1,860) (431) (38)
Cash and cash equivalents at beginning of year ................... 2,355 495 64
---------- ---------- ----------
Cash and cash equivalents at end of year ......................... $ 495 $ 64 $ 26
========== ========== ==========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE F-30
SCHEDULE III
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
(In thousands)
FUTURE
POLICY AMORTI-
BENEFITS, OTHER CLAIMS, ZATION OF NET
DEFERRED LOSSES, POLICY LOSSES DEFERRED PREMIUMS
POLICY CLAIMS CLAIMS AND NET AND POLICY OTHER WRITTEN
ACQUISITION AND LOSS UNEARNED BENEFITS PREMIUM INTEREST SETTLEMENT ACQUISITION OPERATING AND
COSTS EXPENSES PREMIUMS PAYABLE REVENUE INCOME EXPENSES COSTS EXPENSES ASSUMED
----------- --------- -------- ---------- --------- --------- ---------- ----------- --------- --------
DECEMBER 31, 2003
Property and casualty .. $ 165 $ 87,768 $ 47,325 $ 4,807 $ 56,583 $ 2,560 $ 37,200 $ 11,278 $ 15,927 $ 51,840
=========== ========= ======== ========== ========= ========= ========== =========== ========= ========
DECEMBER 31, 2004
Property and casualty .. $ 57 $ 108,233 $ 51,109 $ 4,912 $ 64,042 $ 3,677 $ 53,781 $ 11,039 $ 14,777 $ 70,464
=========== ========= ======== ========== ========= ========= ========== =========== ========= ========
DECEMBER 31, 2005
Property and casualty .. $ 1,225 $ 109,541 $ 55,034 $ 5,684 $ 66,060 $ 3,468 $ 37,324 $ 10,671 $ 15,284 $ 70,126
=========== ========= ======== ========== ========= ========= ========== =========== ========= ========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE F-31
SCHEDULE IV
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
REINSURANCE
(Dollars in thousands)
ASSUMED PERCENTAGE
CEDED TO FROM OF AMOUNT
GROSS OTHER OTHER NET ASSUMED
AMOUNT COMPANIES COMPANIES AMOUNT TO NET
------------ ------------ ------------ ------------ ------------
Year ended December 31, 2003
Property and casualty ........... $ 118,247 $ (66,604) $ 197 $ 51,840 0.38%
============ ============ ============ ============ ============
Year ended December 31, 2004
Property and casualty ........... $ 121,146 $ (51,187) $ 505 $ 70,464 0.72%
============ ============ ============ ============ ============
Year ended December 31, 2005
Property and casualty ........... $ 119,051 $ (50,218) $ 1,293 $ 70,126 1.84%
============ ============ ============ ============ ============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE F-32
SCHEDULE V
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
(In thousands)
BALANCE AT PROVISION BALANCE
BEGINNING FOR AT END
OF PERIOD NON-COLLECTION WRITE-OFFS OF PERIOD
---------------- ---------------- ---------------- ---------------
Allowance for non-collection of
premiums receivable:
2003 ...................................... $ 246 $ 272 $ (385) $ 133
================ ================ ================ ===============
2004 ...................................... $ 133 $ 42 $ (56) $ 119
================ ================ ================ ===============
2005 ...................................... $ 119 $ 176 $ (72) $ 223
================ ================ ================ ===============
Allowance for non-collection of reinsurance
recoverables on paid and unpaid losses:
2003 ...................................... $ 2,767 $ 604 $ (57) $ 3,314
================ ================ ================ ===============
2004 ...................................... $ 3,314 $ 282 $ (324) $ 3,272
================ ================ ================ ===============
2005 ...................................... $ 3,272 $ 108 $ (3,206) $ 174
================ ================ ================ ===============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE F-33
SCHEDULE VI
CHANDLER (U.S.A.), INC. AND SUBSIDIARIES
SUPPLEMENTAL INFORMATION
(FOR PROPERTY-CASUALTY INSURANCE UNDERWRITERS)
(In thousands)
DISCOUNT PAID LOSSES AND
DEDUCTED LOSS ADJUSTMENT
FROM RESERVES EXPENSES
--------------- ---------------
Year ended December 31, 2003
Property-casualty .......................... $ - $ 41,048
=============== ===============
Year ended December 31, 2004
Property-casualty .......................... $ - $ 38,429
=============== ===============
Year ended December 31, 2005
Property-casualty .......................... $ - $ 41,470
=============== ===============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.
PAGE F-34
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.