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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, 2004
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 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 an accelerated filer (as
defined in Rule 12b-2 of the Act). YES NO X
----- -----
Aggregate market value of the voting stock held by non-affiliates of the
registrant on June 30, 2004, 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, 2005 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 has a network of independent agents, totaling approximately
130 at December 31, 2004, 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. CIMI was established in
December 2002.
Prior to December 2003, Chandler USA was a wholly owned subsidiary of
Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") which, in turn, was
a wholly owned subsidiary of Chandler Insurance. In December 2003, Chandler
Barbados was dissolved following the transfer of its assets, liabilities and
business to Chandler Insurance. Chandler Insurance assumed the obligations of
Chandler Barbados including those under its reinsurance agreements with NAICO
pursuant to a Distribution Agreement and a General Conveyance. The
reorganization of Chandler Barbados and Chandler Insurance was approved by the
Cayman Islands Monetary Authority, the Supervisor of Insurance in Barbados and
the Oklahoma Insurance Department.
In December 2002, Chandler USA completed the sale of its wholly owned
subsidiary, LaGere & Walkingstick Insurance Agency, Inc. ("L&W"), to Brown &
Brown, Inc. L&W previously functioned as Chandler USA's agency segment and is
presented as discontinued operations. See Note 4 to Consolidated Financial
Statements for more information on the sale of L&W.
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 surety bonds.
PAGE 2
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, 2004 NAICO
insured 232 school districts primarily 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 2002 and 2003, NAICO significantly reduced its premium
writings in this portion of the program and did not write any premiums during
2004.
SURETY BOND PROGRAM
NAICO writes surety bonds, commonly referred to as contract performance
bonds, to secure the performance of contractors and suppliers on construction
projects. A substantial portion of this business is written in Texas and
Oklahoma. 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.
The following table shows gross premiums earned and net premiums earned by
insurance program for the years 2002, 2003 and 2004. 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 2002 2003 2004 2002 2003 2004
- ----------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Standard property and casualty .... $106,051 $ 93,193 $ 92,894 $ 49,570 $ 45,521 $ 54,278
Political subdivisions ............ 35,159 28,926 21,679 13,829 8,093 7,269
Surety bonds ...................... 5,104 3,908 2,788 3,310 2,724 1,993
Other (1) ......................... 249 252 507 248 245 502
-------- -------- -------- -------- -------- --------
TOTAL ............................. $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042
======== ======== ======== ======== ======== ========
- -------------------------------
(1) This category is comprised primarily of the run-off of discontinued programs and NAICO's
participation in various mandatory workers compensation pools and assigned risks.
PAGE 3
LINES OF INSURANCE
The lines of insurance written by NAICO through its programs are workers
compensation, automobile liability, other liability (including general
liability, products liability and umbrella liability), automobile physical
damage, property, 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,
----------------------------------------------------
2000 2001 2002 2003 2004
-------- -------- -------- -------- --------
Automobile liability .............. 20% 19% 25% 27% 28%
Other liability ................... 25% 25% 25% 23% 28%
Workers compensation .............. 25% 24% 22% 29% 27%
Automobile physical damage ........ 13% 17% 14% 10% 9%
Property .......................... 4% 7% 8% 5% 4%
Surety ............................ 8% 6% 5% 5% 3%
Inland marine ..................... 1% 2% 1% 1% 1%
Accident and health ............... 4% -% -% -% -%
-------- -------- -------- -------- --------
Total .......................... 100% 100% 100% 100% 100%
======== ======== ======== ======== ========
UNDERWRITING AND CLAIMS
Independent insurance agents submit applications for insurance coverage
for prospective customers to NAICO. NAICO reviews a prospective risk in
accordance with its specific underwriting guidelines. If the risk is
approved and coverage is accepted by the insured, NAICO issues an insurance
policy.
NAICO's claims department reviews and administers all claims. 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, 2005 reinsurance programs. At the present time, NAICO
expects to renew the reinsurance programs that renew on July 1, 2005.
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 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.
PAGE 4
Under the 2002 workers compensation reinsurance program, NAICO's net
retention was 50% of the first $200,000 of loss per occurrence. Effective
July 1, 2002, NAICO's net retention increased to 50% of the first $250,000 of
loss per occurrence. Effective January 1, 2003, NAICO's net retention
increased to 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 2002 casualty reinsurance program, NAICO's net retention was 80%
of the first $250,000 of loss per occurrence plus 40% of $250,000 excess of
$250,000 of loss per occurrence. Effective July 1, 2002, NAICO's net retention
decreased to 80% of the first $250,000 of loss per occurrence. Effective
January 1, 2003, NAICO's net retention decreased to 70% of the first $250,000
of loss for 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, 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.
Under the 2002 construction surety bond reinsurance program, NAICO's net
retention was 50% of the first $1,000,000 plus 10% of $4,000,000 excess of
$1,000,000 per principal (e.g., contractor). Effective January 1, 2003, NAICO
increased its retention for the first $1,000,000 of loss per principal from
50% to 70%. NAICO elected not to renew its construction surety bond excess of
loss reinsurance effective April 1, 2003 due to the decreased premium volume
in this program and to the current market for this reinsurance. Effective
April 1, 2003, NAICO retains 70% of the losses in this program.
Under the 2002 property reinsurance program, NAICO retained 33% of the
first $1,500,000 of risk for each loss per risk or location. Effective January
1, 2003, NAICO retains 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 2002
automobile physical damage reinsurance program, NAICO retained the first
$500,000 of each loss per occurrence, plus 5% of amounts exceeding $500,000 of
each loss per occurrence up to $1 million of each loss per occurrence.
Effective January 1, 2003, NAICO retains 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 $1,000,000 for 2002, $700,000 for 2003
and $1,400,000 effective January 1, 2004 for each loss occurrence.
On November 26, 2002, President Bush signed the Terrorism Risk Insurance
Act of 2002 (the "Act"), establishing a program for commercial property and
casualty losses, including workers compensation, resulting from foreign acts
of terrorism. The Act requires commercial insurers to offer terrorism coverage
on its commercial property and casualty lines of business. Each insurance
company will be responsible for a deductible based on a percentage of direct
earned premiums from the previous calendar year, which rises from 7% for losses
occurring in 2003 to 10% in 2004 and 15% in 2005. The Federal Government will
pay 90% of covered terrorism losses that exceed company deductibles. The
Federal Government will be required to recoup the portion of any federal
compensation paid to the extent that industry retentions are less than $10
billion for events in 2003, $12.5 billion for 2004 and $15 billion for 2005.
The recoupment will be accomplished through a surcharge on all policyholders,
not to exceed 3% of premiums in a given year. The Act is scheduled to expire
on December 31, 2005.
NAICO purchased quota share reinsurance for its deductible under the Act
limiting NAICO's retention to 10% for 2003 and 15% for 2004 and 2005 of such
deductible, subject to a reinsurance limit of $9,450,000 for 2003 and
$10,625,000 for 2004 and 2005 for each loss occurrence. The reinsurance
coverage is also limited to $9,450,000 for 2003 and $10,625,000 for 2004 and
2005 for all loss occurrences for any year. NAICO also purchased excess of
loss reinsurance covering acts of terrorism that provides coverage of $20
million excess of $10 million for 2003, $10 million excess of $12.5 million for
2004 and $15 million excess of $12.5 million for 2005 of loss per occurrence
based on NAICO's net retention.
PAGE 5
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, 2004.
CEDED REINSURANCE
NET PREMIUMS FOR A.M. BEST
REINSURANCE THE YEAR ENDED COMPANY
NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2004 RATING
- -------------------------------------------- --------------- ----------------- ------------
(Dollars in thousands)
Chandler Insurance ......................... $ 25,555 $ 30,055 -(2)
Employers Reinsurance Corporation .......... 23,955 9,731 A
Swiss Reinsurance America Corporation ...... 22,640 52 A+
Odyssey America Reinsurance Corporation .... 3,958 5,489 A
GE Reinsurance Corporation ................. 3,605 (27) A
--------------- -----------------
Top five reinsurers ..................... $ 79,713 $ 45,300
=============== =================
All reinsurers .......................... $ 87,945 $ 51,187
=============== =================
Percentage of total represented by top
five reinsurers .......................... 91% 88%
- --------------------------------------------
(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, 2004.
(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, 2004, Chandler Insurance had cash and investments
with a fair value of $28.6 million deposited in a trust account for the benefit of NAICO.
Transamerica Occidental Life Insurance Company ("Transamerica") reinsured
NAICO for certain workers compensation risks during 1989, 1990 and 1991.
Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed
under the reinsurance treaties. On March 15, 2004, an arbitration panel
ordered Transamerica to pay the losses and loss adjustment expenses owed to
NAICO in the amount of $1,607,704 plus interest at 6%, or approximately
$577,000, plus $25,000 in costs. NAICO has received payment for these amounts.
Reliance Insurance Company ("Reliance") reinsured NAICO for certain
workers compensation risks during 1998. At December 31, 2004, NAICO had
reinsurance recoverables from Reliance for paid and unpaid losses of
approximately $3.3 million. During October 2001, the Commonwealth of
Pennsylvania placed Reliance in liquidation. NAICO is unable to determine the
amount of its reinsurance recoverables from Reliance that will ultimately be
collected and has fully reserved the carrying value of such amounts as of
December 31, 2003 and 2004.
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 $1.7 million, $604,000 and $282,000 during 2002, 2003 and 2004,
respectively, in adjustments to ceded losses and loss adjustment expenses for
amounts deemed uncollectible.
PAGE 6
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,
--------------------------------------------
2000 2001 2002 2003 2004
-------- -------- -------- -------- --------
(Dollars in thousands)
Other liability:
Net premiums earned ........................ $ 20,992 $ 17,470 $ 16,458 $ 12,870 $ 18,044
Loss ratio ................................. 56% 57% 80% 94% 121%
Automobile liability:
Net premiums earned ........................ $ 17,517 $ 13,386 $ 16,526 $ 15,624 $ 17,742
Loss ratio ................................. 78% 70% 81% 49% 61%
Workers compensation:
Net premiums earned ........................ $ 21,161 $ 16,449 $ 14,808 $ 16,378 $ 17,371
Loss ratio ................................. 70% 105% 99% 72% 85%
Automobile physical damage:
Net premiums earned ........................ $ 11,434 $ 12,174 $ 9,552 $ 5,508 $ 5,933
Loss ratio ................................. 85% 52% 35% 36% 43%
Property:
Net premiums earned ........................ $ 3,377 $ 4,806 $ 5,543 $ 3,072 $ 2,611
Loss ratio ................................. 179% 93% 50% 74% 47%
Surety:
Net premiums earned ........................ $ 6,760 $ 4,125 $ 3,310 $ 2,723 $ 1,993
Loss ratio ................................. 33% 57% 59% 34% 134%
Inland marine:
Net premiums earned ........................ $ 1,088 $ 1,256 $ 760 $ 408 $ 348
Loss ratio ................................. 142% 143% 100% 54% 29%
Accident and health:
Net premiums earned ........................ $ 3,190 $ 319 $ - $ - $ -
Loss ratio ................................. 161% 281% -% -% -%
Total:
Net premiums earned ........................ $ 85,519 $ 69,985 $ 66,957 $ 56,583 $ 64,042
Loss ratio ................................. 76% 75% 76% 66% 84%
Underwriting expense ratio (1) ............. 30% 33% 34% 47% 34%
-------- -------- -------- -------- --------
Combined ratio (1) ......................... 106% 108% 110% 113% 118%
======== ======== ======== ======== ========
- ----------------------------------------------
(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, resulting in an increased
ratio for this period. See also "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS."
PAGE 7
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. 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 $5.7 million and $3.7 million at December 31, 2003 and 2004,
respectively. 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.
NAICO participates in various pools covering workers compensation risks
for insureds who were unable to purchase this coverage from an insurance
company on a voluntary basis. The consolidated financial statements reflect
the reserves for unpaid losses and loss adjustment expenses and net premiums
earned from its participation in the pools.
There may be significant reporting lags between the occurrence of the
insured loss and the time it is actually reported to the insurer. The inherent
uncertainties in estimating insurance reserves are generally greater for
casualty coverages, such as workers compensation, general and automobile
liability, than for property coverages primarily due to the longer period of
time that typically elapses before a definitive determination of ultimate loss
can be made, which is also affected by changing theories of legal liability and
changing political climates.
There are significant additional uncertainties in estimating the amount
of reserves required for environmental, asbestos-related and other latent
exposure claims, including a lack of historical data, long reporting delays
and complex unresolved legal issues regarding policy coverage and the extent
and timing of any such contractual liability. Courts have reached different
and frequently inconsistent conclusions as to when the loss occurred, what
claims are covered, under what circumstances the insurer has an obligation to
defend, how policy limits are determined and how policy exclusions are applied
and interpreted.
The loss settlement period on insurance claims for property damage is
relatively short. The more severe losses for bodily injury and workers
compensation claims have a much longer loss settlement period and may be paid
out over several years. It is often necessary to adjust estimates of liability
on a loss either upward or downward from the time a claim arises to the time of
payment. Workers compensation indemnity benefit reserves are determined based
on statutory benefits described by state law and are estimated based on the
same factors generally discussed above which may include, where state law
permits, inflation adjustments for rising benefits over time. Generally, the
more costly automobile liability claims involve one or more severe bodily
injuries or deaths. The ultimate cost of these types of claims is dependent on
various factors including the relative liability of the parties involved, the
number and severity of injuries and the legal jurisdiction where the incident
occurred.
PAGE 8
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,
-------------------------------------------------
2000 2001 2002 2003 2004
--------- --------- --------- --------- ---------
(In thousands)
Net balance at beginning of year .............. $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343
--------- --------- --------- --------- ---------
Net losses and loss adjustment expenses incurred
related to:
Current year .............................. 60,020 39,881 34,928 26,108 27,436
Prior years ............................... 4,979 12,669 15,784 11,092 26,345
--------- --------- --------- --------- ---------
Total ................................... 64,999 52,550 50,712 37,200 53,781
--------- --------- --------- --------- ---------
Net paid losses and loss adjustment expenses
related to:
Current year .............................. (33,661) (22,646) (13,283) (10,626) (10,222)
Prior years ............................... (36,009) (43,799) (37,050) (30,422) (28,207)
--------- --------- --------- --------- ---------
Total ................................... (69,670) (66,445) (50,333) (41,048) (38,429)
--------- --------- --------- --------- ---------
Net balance at end of year .................... $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695
========= ========= ========= ========= =========
NAICO has experienced a significant amount of incurred losses related to
prior accident years during the 2001, 2002, 2003 and 2004 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.
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%.
PAGE 9
The following table represents the development of net balance sheet
reserves for 1995 through 2004. The top line of the table shows the net
reserves at the balance sheet date for each of the indicated years. This
represents the estimated amounts of claims and claim expenses, net of
reinsurance deductions, arising in the current and all prior years that are
unpaid at the balance sheet date, including the net reserve for incurred but
not reported claims. The upper portion of the table shows the cumulative net
amounts paid as of successive years with respect to that reserve liability.
The estimate for unpaid losses and loss adjustment expenses changes as more
information becomes known about the frequency and severity of claims for
individual years. The next portion of the table shows the revised estimated
amount of the previously recorded net reserve based on experience as of the
end of each succeeding year. The heading "net cumulative (deficiency)
redundancy" represents the cumulative aggregate change in the estimates over
all prior years. The last portion of the table provides a reconciliation of
the net amounts to the gross amounts before any deductions for reinsurance.
The gross cumulative deficiency or redundancy results from the same factors as
those described above for the net amounts, and is also impacted by development
of large claims that exceed NAICO's net retention including umbrella and surety
per principal losses where NAICO has little or no net retention.
In evaluating the information in the following table, it should be noted
that each amount includes the effects of all changes in amounts for prior
periods. For example, the amount of the deficiency recorded in 1998 for claims
that occurred in 1995 will be included in the cumulative deficiency amount for
years 1995, 1996, 1997 and 1998. 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,
-----------------------------------------------------------------------------------------------------
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
--------- --------- --------- --------- --------- ---------- ---------- ---------- --------- --------
(In thousands)
Net reserve for unpaid losses
and loss adjustment
expenses .................... $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695
Net paid (cumulative) as of
One year later .............. 31,768 28,572 30,330 23,896 36,009 43,799 37,050 30,422 28,207
Two years later ............. 44,471 40,857 42,934 34,966 58,979 66,141 60,560 51,375
Three years later ........... 49,262 45,668 49,735 45,390 72,052 81,635 77,413
Four years later ............ 51,101 47,995 56,306 51,364 80,860 91,403
Five years later ............ 52,126 50,700 58,843 55,445 86,257
Six years later ............. 54,040 51,878 60,821 58,062
Seven years later ........... 54,574 52,964 62,720
Eight years later ........... 55,294 54,407
Nine years later ............ 56,364
Net liability re-estimated as of
One year later .............. 59,644 55,713 55,772 43,441 56,357 59,376 48,596 44,283 55,688
Two years later ............. 59,605 55,599 56,362 45,373 67,469 74,325 67,903 70,058
Three years later ........... 59,155 54,528 58,176 50,146 77,842 86,377 89,608
Four years later ............ 58,247 54,834 61,096 55,303 83,860 100,408
Five years later ............ 58,445 55,615 62,750 58,060 91,704
Six years later ............. 58,567 56,347 63,629 62,995
Seven years later ........... 59,013 56,879 67,608
Eight years later ........... 59,296 59,243
Nine years later ............ 61,152
Net cumulative (deficiency)
redundancy .................. $ (2,812) $ (5,398) $(13,573) $(23,074) $(40,326) $ (53,701) $ (56,796) $ (36,867) $(26,345) $ -
Supplemental gross data:
Gross liability ............. $116,149 $ 78,114 $ 73,721 $ 80,701 $ 98,460 $ 100,173 $ 84,756 $ 92,606 $ 87,768 $108,233
Reinsurance recoverable ..... 57,809 24,269 19,686 40,780 47,082 53,466 51,944 59,415 58,425 63,538
--------- --------- --------- --------- --------- ---------- ---------- ---------- --------- --------
Net liability - end of year.. $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695
========= ========= ========= ========= ========= ========== ========== ========== ========= ========
Gross re-estimated
liability - latest ....... $124,032 $ 98,346 $102,442 $131,420 $182,532 $ 244,570 $ 264,809 $ 203,881 $141,038
Re-estimated recoverable -
latest .................... 62,924 39,147 34,878 68,425 90,828 144,162 175,201 133,823 85,350
--------- --------- --------- --------- --------- ---------- ---------- ---------- ---------
Net re-estimated
liability - latest ........ $ 61,108 $ 59,199 $ 67,564 $ 62,995 $ 91,704 $ 100,408 $ 89,608 $ 70,058 $ 55,688
========= ========= ========= ========= ========= ========== ========== ========== =========
Gross cumulative (deficiency)
redundancy .................. $ (7,883) $(20,232) $(28,721) $(50,719) $(84,072) $(144,397) $(180,053) $(111,275) $(53,270)
========= ========= ========= ========= ========= ========== ========== ========== =========
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 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, 2004, 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, 2004, 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 6.17% at December 31,
2004. 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 6.17% at December 31, 2004. 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. Issuance costs in the amount of $711,000 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, and the December 31, 2003 balances
were restated accordingly. The adoption of FIN 46R had no effect on net
earnings.
EMPLOYEES AND ADMINISTRATION
At December 31, 2004, Chandler USA and its subsidiaries had approximately
260 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
much of the last decade, the industry has generally had excess underwriting
capacity resulting in depressed premium rates and expanded policy terms, which
generally occur when excess underwriting capacity exists. NAICO has been able
to increase its pricing for most coverages from 2000 through 2004, which has
generally been the trend industry wide. However, NAICO continues to experience
competition in all of its programs. NAICO's underwriting philosophy is to
forego underwriting risks from which it is unable to obtain what it believes
to be adequate premium rates.
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.
PAGE 13
RESTRICTIONS ON SHAREHOLDER DIVIDENDS
A significant portion of Chandler USA's consolidated assets represents
assets of NAICO that may not be immediately transferable to Chandler USA in the
form of shareholder dividends, loans, advances or other payments.
Statutes and regulations governing NAICO and other insurance companies
domiciled in Oklahoma regulate the payment of shareholder dividends and other
payments by NAICO to Chandler USA. Under applicable Oklahoma statutes and
regulations, NAICO is permitted to pay shareholder dividends only out of
statutory earned surplus. To the extent NAICO has statutory earned surplus,
NAICO may pay shareholder dividends only to the extent that such dividends are
not defined as extraordinary dividends or distributions. If the dividends are,
under applicable statutes and regulations, extraordinary dividends or
distributions, regulatory approval must be obtained. Under the applicable
Oklahoma statute, and subject to the availability of statutory earned surplus,
the maximum shareholder dividend that may be declared (or cash or property
distribution that may be made) by NAICO in any one calendar year without
regulatory approval is the greater of (i) NAICO's statutory net income,
excluding realized capital gains, for the preceding calendar year; or (ii) 10%
of NAICO's statutory policyholders' surplus as of the preceding calendar year
end, not to exceed NAICO's statutory earned surplus.
As of December 31, 2004, NAICO had statutory earned surplus of $3.8
million. Applying the Oklahoma statutory limits described above, the maximum
shareholder dividend NAICO may pay in 2005 without the approval of the Oklahoma
Department of Insurance is $3.8 million. NAICO paid shareholder dividends to
Chandler USA totaling $3.5 million in 2002 and $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
- ----------------------------------
(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.
PAGE 14
(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).
The ratios of total adjusted capital to authorized control level RBC for NAICO
were 6.7:1 and 4.8:1 at December 31, 2003 and 2004, 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 12
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
seven 2004 ratios that were outside of the "usual values," five of which
resulted primarily from adverse loss development as explained below.
NAICO's "change in net writings" for 2004 was 36% compared to a usual
value of greater than (33%) and less than 33%. The increase was due primarily
to the decrease in reinsurance purchased in 2004 which resulted in an increase
in net premiums written of $18.6 million.
NAICO's "two-year overall operating ratio" for 2004 was 107% compared to
a usual value of less than 100%. Factors that contributed to NAICO's ratio
include a lower ratio of investment income to net premiums earned due primarily
to lower interest rates experienced during 2004, and to adverse loss
development recorded during 2003 and 2004 for accident years prior to 2003.
Excluding this loss development, the two-year overall operating ratio would
have been 77% for 2004.
NAICO's "investment yield" as calculated using the IRIS formula was 3.6%
during 2004 compared to a usual value of greater than 4.5% and less than
10.0%. 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 "change in policyholders' surplus" for 2004 was (16%) compared to
a usual value of greater than (10%) and less than 50%. The decrease in surplus
was due to the adverse loss development experienced during 2004, and to the
payment of a shareholder dividend in the amount of $3.4 million to Chandler USA.
NAICO's "one-year reserve development to policyholders' surplus" and
"two-year reserve development to policyholders' surplus" for 2004 were 50% and
78%, respectively, compared to usual values of less than 20% for each ratio.
The primary reason for these unusual values was adverse loss development
experienced during 2003 and 2004 related to the 1997 - 2002 accident years.
This adverse loss development relates primarily to the workers compensation and
other liability lines of business in NAICO's standard property and casualty and
political subdivisions programs. Also contributing to the adverse loss
development were provisions for potentially uncollectible reinsurance
recoverables and deductibles of $1.3 million and $409,000 during 2003 and 2004,
respectively. Statutory accounting requires that these write-downs of
receivables and recoverables be reflected as prior year loss development.
PAGE 15
NAICO's "estimated current reserve deficiency to policyholders' surplus"
was 44% at December 31, 2004 compared to a usual value of less than 25%. The
adverse loss development experienced in 2003 and 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
$122 million in 2004. 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 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 11 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, 2004.
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, 2000, and the related consolidated statement of operations,
comprehensive income, shareholder's equity and cash flows for the year ended
December 31, 2000 were audited by Deloitte & Touche LLP, independent auditors,
whose independent auditors' report expressed an unqualified opinion and
included an explanatory paragraph relating to litigation. The consolidated
balance sheets of Chandler USA and its subsidiaries as of December 31, 2001,
2002, 2003 and 2004 and the related consolidated statements of operations,
comprehensive income, shareholder's equity and cash flows for the years ended
December 31, 2001, 2002, 2003 and 2004 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). All periods
have been restated to reflect the results of L&W as a discontinued operation.
PAGE 16
ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
YEAR ENDED DECEMBER 31,
------------------------------------------------------
2000 2001 2002 2003 2004
---------- ---------- ---------- ---------- ----------
OPERATING DATA (1) (Dollars in thousands)
Revenues
Direct premiums written and assumed .......... $ 197,196 $ 158,964 $ 140,162 $ 118,444 $ 121,651
========== ========== ========== ========== ==========
Net premiums earned .......................... $ 85,519 $ 69,985 $ 66,957 $ 56,583 $ 64,042
Investment income, net ....................... 4,281 3,632 2,540 2,148 3,186
Interest income, net from related parties .... - 371 380 412 491
Realized investment gains, net ............... 144 2,654 794 2,351 652
Other income (2) ............................. 301 101 261 5,077 640
---------- ---------- ---------- ---------- ----------
Total revenues .................................... 90,245 76,743 70,932 66,571 69,011
---------- ---------- ---------- ---------- ----------
Operating expenses
Losses and loss adjustment expenses .......... 64,999 52,550 50,712 37,200 53,781
Policy acquisition costs ..................... 16,882 10,869 10,239 11,278 11,039
General and administrative expenses .......... 10,557 11,549 12,473 13,486 12,380
Interest expense ............................. 2,255 2,240 2,234 2,441 2,397
---------- ---------- ---------- ---------- ----------
Total operating expenses .......................... 94,693 77,208 75,658 64,405 79,597
---------- ---------- ---------- ---------- ----------
Income (loss) from continuing operations before
income taxes ................................ (4,448) (465) (4,726) 2,166 (10,586)
Federal income tax benefit (provision) ............ 1,347 (16) 1,680 (192) 3,582
---------- ---------- ---------- ---------- ----------
Income (loss) from continuing operations .......... (3,101) (481) (3,046) 1,974 (7,004)
Income (loss) from discontinued operations ........ (894) (622) 284 - -
Gain on sale of subsidiary ........................ - - 671 - -
---------- ---------- ---------- ---------- ----------
Net income (loss) ................................. $ (3,995) $ (1,103) $ (2,091) $ 1,974 $ (7,004)
========== ========== ========== ========== ==========
Combined loss and underwriting expense ratio (3) .. 106% 108% 110% 113% 118%
BALANCE SHEET DATA
Cash and investments .............................. $ 104,760 $ 73,378 $ 68,276 $ 69,198 $ 86,913
Amounts due from related parties .................. - 7,880 10,582 9,642 10,891
Total assets ...................................... 273,498 234,809 229,855 218,213 237,297
Unpaid losses and loss adjustment expenses ........ 100,173 84,756 92,606 87,768 108,233
Amounts due to related parties .................... 717 - - - -
Debentures ........................................ 24,000 24,000 24,000 7,254 6,979
Junior subordinated debentures issued to affiliated
trusts ....................................... - - - 20,620 20,620
Total liabilities ................................. 228,647 191,067 186,855 174,374 201,105
Shareholder's equity .............................. 44,851 43,742 43,000 43,839 36,192
- -----------------------------------------------------
(1) All periods have been restated to reflect the results of L&W as a discontinued operation. See Note 4
to Consolidated Financial Statements for more information.
(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 17
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 surety bonds. The lines of insurance written by NAICO are commercial
coverages consisting of workers compensation, automobile liability, other
liability (including general liability, products liability and umbrella
liability), automobile physical damage, property, surety and inland marine.
NAICO markets these products through a network of independent insurance
agents. A portion of the insurance written by NAICO is reinsured by Chandler
USA's parent Chandler Insurance. CIMI maintains certain wholesale operations
related to NAICO's school districts and trucking insurance.
SUMMARY OF RESULTS
For the year ended December 31, 2004, Chandler USA had a net loss of $7.0
million compared to net income of $2.0 million for 2003 and a net loss of $2.1
million for 2002. For 2004 and 2003, the income (loss) from continuing
operations was the same as the net income (loss). Loss from continuing
operations was $3.0 million during 2002. Net income for 2003 included $3.1
million in gains on the purchase and cancellation of $16.7 million principal
amount of Debentures, and $1.7 million for the amortization of the deferred
gain on a sale and leaseback transaction. These transactions are discussed in
more detail under "Other Income" and "Liquidity and Capital Resources." The
net loss in 2004 is primarily due to the adverse loss development experienced
by Chandler USA. See "Losses and Loss Adjustment Expenses."
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.
DISCONTINUED OPERATIONS
In December 2002, Chandler USA completed the sale of its wholly owned
subsidiary L&W to Brown & Brown, Inc. 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. The gain on the sale may be increased depending on
certain adjustments to the purchase price as defined in the terms of the
transaction. Following the completion of the sale, L&W changed its name to
Brown & Brown of Central Oklahoma, Inc. ("B&B"). L&W previously functioned as
Chandler USA's agency segment and is presented as discontinued operations.
B&B continues to be a significant producer of business for NAICO. Retail
business produced by B&B and placed with NAICO constituted approximately 13% of
NAICO's direct premiums written and assumed in 2004. Chandler USA agreed to
indemnify Brown & Brown, Inc. for any breach of a representation, warranty or
covenant made in connection with the sale for a period of three years, and has
established a letter of credit in the amount of $500,000 for the benefit of
Brown & Brown, Inc. as security.
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.
PAGE 18
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.
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. See Notes to Consolidated Financial Statements.
The loss settlement period on insurance claims for property damage is
relatively short. The more severe losses for bodily injury and workers
compensation claims have a much longer loss settlement period and may be paid
out over several years. It is often necessary to adjust estimates of liability
on a loss either upward or downward between the time a claim arises and the
time of payment. Workers compensation indemnity benefit reserves are
determined based on statutory benefits prescribed by state law and are
estimated based on the same factors generally discussed above which may
include, where state law permits, inflation adjustments for rising benefits
over time. Generally, the more costly automobile liability claims involve one
or more severe bodily injuries or deaths. The ultimate cost of these types of
claims is dependent on various factors including the relative liability of
the parties involved, the number and severity of injuries and the legal
jurisdiction where the incident occurred.
NAICO does not ordinarily insure against environmental matters as that
term is commonly used. However, in some cases, regulatory filings made on
behalf of an insured can make NAICO directly liable to the regulatory authority
for property damage, which could include environmental pollution. In those
cases, NAICO ordinarily has recourse against the insured or the surety bond
principal for amounts paid. NAICO has insured certain trucking companies and
pest control operators who are required to provide proof of insurance which in
some cases assures payment for cleanup and restoration of damage resulting from
sudden and accidental release or discharge of contaminants or other substances
which may be classified as pollutants. NAICO also provides surety bonds for
construction contractors who use or have control of such substances and for
contractors who remove and dispose of asbestos as a part of their contractual
obligations.
NAICO also insures independent oil and gas producers who may purchase
coverage for the escape of oil, saltwater, or other substances which may be
harmful to persons or property, but may not generally be classified as
pollutants. NAICO maintains claims records which segregate this type of risk
for the purpose of evaluating environmental risk exposure. Based upon the
nature of such lines of business with NAICO's insureds, and current data
regarding the limited severity and infrequency of such matters, it appears that
potential environmental risks are not a significant portion of claim reserves
and therefore would not likely have a material adverse impact, if any, on the
financial condition of Chandler USA.
NAICO's statutory-based reserves (reserves calculated in accordance with
accounting practices prescribed or permitted by an insurer's domiciliary state
insurance regulatory authorities for purposes of financial reporting to
regulators) do not differ from its reserves reported on the basis of GAAP.
NAICO does not discount its reserves for unpaid losses and loss adjustment
expenses.
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.
PAGE 19
DEFERRED INCOME TAXES
Chandler USA uses an asset and liability approach for accounting for
income taxes. Deferred income taxes are recognized for the tax consequences
of temporary differences and carryforwards by applying enacted tax rates
applicable to future years to differences between the financial statement
amounts and the tax bases of existing assets and liabilities. A valuation
allowance is established if it is more likely than not that some portion of
the deferred tax asset will not be realized. The determination of whether a
valuation allowance is appropriate requires the exercise of management judgment.
At December 31, 2004, Chandler USA had a net operating loss carryforward
available for U.S. Federal income taxes of $11.8 million which begins to expire
in 2023. Chandler USA has concluded that the deferred tax asset including the
federal net operating loss carryforwards are more likely than not to be
realized. Chandler USA anticipates that its future U.S. consolidated income
tax will be sufficient to utilize the federal net operating losses within the
required time. Chandler USA will continue to evaluate income generated in
future periods in determining the reasonableness of its position. If Chandler
USA determines that future income is insufficient to cause the realization of
the federal net operating losses within the required time, a valuation
allowance will be established.
In addition, Chandler USA, at December 31, 2004, had net operating loss
carryforwards available for Oklahoma state income taxes totaling approximately
$53.2 million which expire in the years 2005 through 2024. At December 31,
2004, Chandler USA also had a capital loss carryforward for U.S. Federal income
taxes of $1.1 million which expires in 2007. A valuation allowance has been
provided for the tax effect of the state net operating loss and the net capital
loss carryforwards since realization of such amounts is not considered more
likely than not.
OTHER
See Note 1 to Consolidated Financial Statements for information related to
other accounting and reporting policies.
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 $108 million,
or 89%, of NAICO's direct written premiums in 2004 were in the states of
Oklahoma and Texas. An economic downturn in these states could have a
significant adverse impact on Chandler USA. A recession might also cause
defaults on fixed-income securities or a decrease in the value of the equity
mutual funds owned by NAICO. Management believes it has mitigated the impact
of a recession by employing conservative underwriting practices and strict
credit policies and maintaining a high-quality investment portfolio.
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.
A company's capacity to write insurance policies is dependent on a variety
of factors including its net worth or "surplus," the lines of business written,
the types of risk insured and its profitability. During much of the last
decade, the industry has generally had excess underwriting capacity resulting
in depressed premium rates and expanded policy terms, which generally occur
when excess underwriting capacity exists. NAICO has been able to increase its
pricing for most coverages from 2000 through 2004, which has generally been the
trend industry wide. However, NAICO continues to experience competition in all
of its programs. NAICO's underwriting philosophy is to forego underwriting
risks from which it is unable to obtain what it believes to be adequate premium
rates.
PAGE 20
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 21
ANALYSIS OF INSURANCE PROGRAM RESULTS OF OPERATIONS
The following tables summarize the net premiums earned and the financial
year (losses incurred and recognized by Chandler USA regardless of the year in
which the claim occurred) and accident year (losses incurred by Chandler USA
for a particular year regardless of the period in which Chandler USA recognizes
the costs) loss ratios (computed by dividing losses and loss adjustment
expenses by net premiums earned) in each of the years presented. 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,
----------------------------------
2002 2003 2004
---------- ---------- ----------
(Dollars in thousands)
INSURANCE PROGRAMS
- ----------------------------------------
STANDARD PROPERTY AND CASUALTY
Net premiums earned .................. $ 49,570 $ 45,521 $ 54,278
Financial year loss ratio ............ 81.1% 65.1% 79.0%
Accident year loss ratio ............. 50.5% 48.4% 43.6%
POLITICAL SUBDIVISIONS
Net premiums earned .................. $ 13,829 $ 8,093 $ 7,269
Financial year loss ratio ............ 55.9% 70.7% 98.0%
Accident year loss ratio ............. 34.7% 43.8% 37.9%
SURETY BONDS
Net premiums earned .................. $ 3,310 $ 2,724 $ 1,993
Financial year loss ratio ............ 59.4% 33.5% 134.4%
Accident year loss ratio ............. 24.0% 31.1% 37.2%
OTHER (1)
Net premiums earned .................. $ 248 $ 245 $ 502
Financial year loss ratio ............ 332.7% 374.0% 215.3%
Accident year loss ratio ............. 73.5% 110.1% 51.3%
TOTAL
Net premiums earned .................. $ 66,957 $ 56,583 $ 64,042
Financial year loss ratio ............ 75.7% 65.7% 84.0%
Accident year loss ratio ............. 46.0% 47.1% 42.8%
- --------------------------------
(1) This category is comprised primarily of the run-off of discontinued programs
and NAICO's participation in various mandatory workers compensation pools.
PAGE 22
YEAR ENDED DECEMBER 31,
----------------------------------
2002 2003 2004
---------- ---------- ----------
(Dollars in thousands)
LINES OF INSURANCE
- ---------------------------------------
OTHER LIABILITY
Net premiums earned ................. $ 16,458 $ 12,870 $ 18,044
Financial year loss ratio ........... 80.2% 94.0% 120.9%
Accident year loss ratio ............ 50.2% 44.5% 34.8%
AUTOMOBILE LIABILITY
Net premiums earned ................. $ 16,526 $ 15,624 $ 17,742
Financial year loss ratio ........... 81.2% 49.4% 61.2%
Accident year loss ratio ............ 49.3% 41.6% 55.1%
WORKERS COMPENSATION
Net premiums earned ................. $ 14,808 $ 16,378 $ 17,371
Financial year loss ratio ........... 99.4% 71.8% 85.5%
Accident year loss ratio ............ 53.5% 58.3% 41.8%
AUTOMOBILE PHYSICAL DAMAGE
Net premiums earned ................. $ 9,552 $ 5,508 $ 5,933
Financial year loss ratio ........... 35.3% 36.0% 42.9%
Accident year loss ratio ............ 35.8% 35.0% 39.6%
PROPERTY
Net premiums earned ................. $ 5,543 $ 3,072 $ 2,611
Financial year loss ratio ........... 49.9% 73.7% 46.8%
Accident year loss ratio ............ 33.9% 64.4% 36.3%
SURETY
Net premiums earned ................. $ 3,310 $ 2,723 $ 1,993
Financial year loss ratio ........... 59.4% 33.5% 134.4%
Accident year loss ratio ............ 24.1% 31.1% 37.2%
INLAND MARINE
Net premiums earned ................. $ 760 $ 408 $ 348
Financial year loss ratio ........... 99.7% 54.1% 29.5%
Accident year loss ratio ............ 46.2% 34.8% 21.6%
TOTAL
Net premiums earned ................. $ 66,957 $ 56,583 $ 64,042
Financial year loss ratio ........... 75.7% 65.7% 84.0%
Accident year loss ratio ............ 46.0% 47.1% 42.8%
PAGE 23
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 2002 2003 2004 2002 2003 2004
- ----------------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Standard property and casualty .......... $106,051 $ 93,193 $ 92,894 $ 49,570 $ 45,521 $ 54,278
Political subdivisions .................. 35,159 28,926 21,679 13,829 8,093 7,269
Surety bonds ............................ 5,104 3,908 2,788 3,310 2,724 1,993
Other ................................... 249 252 507 248 245 502
-------- -------- -------- -------- -------- --------
TOTAL ................................... $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042
======== ======== ======== ======== ======== ========
GROSS PREMIUMS EARNED NET PREMIUMS EARNED
-------------------------- --------------------------
LINES OF INSURANCE 2002 2003 2004 2002 2003 2004
- ----------------------------------------- -------- -------- -------- -------- -------- --------
(In thousands)
Other liability ......................... $ 36,078 $ 34,715 $ 35,438 $ 16,458 $ 12,870 $ 18,044
Automobile liability .................... 27,143 27,538 26,660 16,526 15,624 17,742
Workers compensation .................... 41,958 29,821 26,995 14,808 16,378 17,371
Automobile physical damage .............. 10,745 9,146 9,154 9,552 5,508 5,933
Property ................................ 22,722 19,359 15,130 5,543 3,072 2,611
Surety .................................. 5,104 3,908 2,788 3,310 2,723 1,993
Inland marine ........................... 2,813 1,792 1,703 760 408 348
-------- -------- -------- -------- -------- --------
TOTAL ................................... $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042
======== ======== ======== ======== ======== ========
Gross premiums earned decreased 14% and 7% in 2003 and 2004,
respectively. These decreases were primarily the result of NAICO's
continued efforts to improve underwriting profitability and increased
competition within the Oklahoma school districts portion of the political
subdivision program. Gross premiums earned in Texas decreased 18% and 3% in
2003 and 2004, respectively, and gross premiums earned in Oklahoma decreased
15% and 8% in 2003 and 2004. The workers compensation and property lines of
business accounted for a significant portion of the decreases. A majority of
NAICO's property premiums is written in the political subdivisions program.
Net premiums earned decreased 15% in 2003 and increased 13% in 2004. The
decrease in 2003 is primarily the result of the decrease in gross earned
premiums during this period. The increase in 2004 is due primarily to changes
in NAICO's reinsurance programs for certain excess of loss and quota share
reinsurance. Effective January 1, 2004, NAICO discontinued a quota share
reinsurance arrangement that covered casualty, workers compensation and
physical damage risks produced by certain agents. Effective April 1, 2004,
NAICO increased its net retention to include 56% of the layer covering $500,000
excess of $500,000 of loss per occurrence for its casualty and workers
compensation risks, and effective July 1, 2004, NAICO increased its net
retention to include 70% of this layer. These changes increased NAICO's net
retention for these lines of business and also increased net premiums earned.
Gross premiums earned in the standard property and casualty program
decreased 12% and less than 1% in 2003 and 2004, respectively. The decrease in
2003 was due primarily to discontinuing certain accounts where rates were not
believed to be adequate. Increases in premium rates partially offset the
decrease in premium production. Gross premiums earned in Texas decreased $9.9
million and $685,000 in 2003 and 2004, respectively, and gross premiums earned
in Oklahoma decreased $6.0 million in 2003 and increased $1.7 million in 2004.
Net premiums earned decreased 8% in 2003 and increased 19% in 2004. The
increase in 2004 is due primarily to reinsurance changes described above.
Gross premiums earned in the political subdivision program decreased 18%
and 25% in 2003 and 2004, respectively. The decrease in gross premiums earned
is due primarily to increased competition in the school districts portion of
the program in Oklahoma. Gross premiums earned for the municipality portion
of the program decreased $2.3 million and $529,000 in 2003 and 2004,
respectively, as NAICO discontinued writing most of these accounts in 2003 and
did not write any in 2004. Net premiums earned decreased 41% and 10% in 2003
and 2004, respectively. The decrease in 2003 was due to the decrease in gross
premiums earned, and to Chandler Insurance assuming a portion of the risk for
the property and automobile physical damage coverages. The decrease in 2004
was due to a decrease in gross premiums earned and was partially offset by the
reinsurance changes described above.
PAGE 24
Gross premiums earned in the surety bond program decreased 23% and 29% in
2003 and 2004, respectively. The decreases are primarily due to stricter
underwriting policies as NAICO continues to focus on improving underwriting
profitability in this program and to the bail bond portion of the program that
was discontinued in 2003. Gross premiums earned for the bail bond portion of
the program decreased $1.1 million and $1.0 million in 2003 and 2004,
respectively. Net premiums earned decreased 18% and 27% in 2003 and 2004,
respectively. NAICO elected not to renew its construction surety bond excess
of loss reinsurance effective April 1, 2003 due to the decreased premium volume
in this program and to the current market for this reinsurance.
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, 2004, 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 8% 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 from continuing operations, excluding interest
income from related parties, decreased 15% in 2003 and increased 48% in 2004.
The decrease in 2003 was due primarily to lower interest rates. 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. Interest income from related parties was $380,000, $412,000
and $491,000 during 2002, 2003 and 2004, respectively. See Liquidity and
Capital Resources.
Net realized investment gains were $794,000, $2,351,000 and $652,000 in
2002, 2003 and 2004, respectively. Realized investment gains in 2003 included
a gain of $1.7 million from the sale of 19,371 shares of common stock of
Insurance Services Office, Inc. ("ISO"). NAICO received these shares in 1997
as a result of ISO converting to a for-profit corporation.
The average net yield on the fixed maturity portfolio, including net
realized investment gains, was 4.8%, 6.7% and 4.0% in 2002, 2003 and 2004,
respectively. The average net yield on the fixed maturity portfolio, excluding
net realized investment gains, was 3.7%, 3.2% and 3.2% for 2002, 2003 and 2004,
respectively. Chandler USA excludes interest income from related parties when
calculating its average net yield on the portfolio. Chandler USA's average net
yield has been reduced by investment expenses to subsidize a premium finance
program for certain insureds of NAICO. While such expenses reduce Chandler
USA's average net yield, the premium finance program enhances cash flow by
providing cash which is available for investment earlier than conventional
deferred payment plans. Based on information provided by the premium finance
company, the outstanding balance of premiums financed at December 31, 2004 was
approximately $11.0 million. The average yield on the fixed maturity portfolio
before deducting investment expenses was 4.4%, 3.6% and 3.6% in 2002, 2003 and
2004, respectively, excluding capital gains.
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.
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 75.7%, 65.7% and 84.0% in 2002, 2003 and 2004,
respectively. Weather-related losses (net of applicable reinsurance) from wind
and hail were $1.5 million, $1.9 million and $761,000 in 2002, 2003 and 2004,
respectively, and increased the respective loss ratios by 2.2, 3.4 and 1.2
percentage points.
PAGE 25
NAICO has experienced a significant amount of incurred losses related to
prior accident years during the 2002, 2003 and 2004 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 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.
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%.
Reliance reinsured NAICO for certain workers compensation risks during
1998. At December 31, 2004, NAICO had reinsurance recoverables from Reliance
for paid and unpaid losses of approximately $3.3 million. During October 2001,
the Commonwealth of Pennsylvania placed Reliance in liquidation. NAICO is
unable to determine the amount of its reinsurance recoverables from Reliance
that will ultimately be collected and has fully reserved the carrying value of
such amounts as of December 31, 2003 and 2004. 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 2002, 2003 and 2004, NAICO incurred
charges of $1.7 million, $604,000 and $282,000, respectively, in adjustments
to ceded losses and loss adjustment expenses for amounts deemed uncollectible.
NAICO did not receive any claims related to the September 11, 2001
terrorist attacks on the World Trade Center and does not believe that it has
any significant exposure to these and related losses. While several of NAICO's
reinsurers did experience significant losses related to these attacks, it
currently does not appear that these losses will impair the reinsurers' ability
to pay claims.
POLICY ACQUISITION COSTS
Policy acquisition costs consist of costs associated with the acquisition
of new and renewal business and generally include direct costs such as premium
taxes, commissions to agents and ceding companies and premium-related
assessments and indirect costs such as salaries and expenses of personnel who
perform and support underwriting activities. NAICO also receives ceding
commissions from reinsurers who assume premiums from NAICO under certain
reinsurance contracts and the ceding commissions are accounted for as a
reduction of policy acquisition costs. Direct policy acquisition costs and
ceding commissions are deferred and amortized over the terms of the policies.
When the sum of the anticipated losses, loss adjustment expenses and
unamortized policy acquisition costs exceeds the related unearned premiums,
including anticipated investment income, a provision for the indicated
deficiency is recorded.
PAGE 26
The following table sets forth Chandler USA's policy acquisition costs
from continuing operations for each of the three years ended December 31, 2002,
2003 and 2004:
YEAR ENDED DECEMBER 31,
--------------------------------
2002 2003 2004
---------- ---------- ----------
(In thousands)
Commissions expense ........................ $ 20,151 $ 17,644 $ 16,078
Other premium related assessments .......... 1,397 1,159 1,137
Premium taxes .............................. 2,764 2,446 2,562
Excise taxes ............................... 240 260 301
Dividends to policyholders ................. 105 (52) -
Other expense .............................. 567 598 458
---------- ---------- ----------
Total direct expenses ...................... 25,224 22,055 20,536
Indirect underwriting expenses ............. 8,135 7,675 7,463
Commissions received from reinsurers ....... (22,309) (18,643) (17,068)
Adjustment for deferred acquisition costs .. (811) 191 108
---------- ---------- ----------
Net policy acquisition costs ............... $ 10,239 $ 11,278 $ 11,039
========== ========== ==========
Total gross direct and indirect expenses as a percentage of direct written
and assumed premiums were 23.8%, 25.1% and 23.0% in 2002, 2003 and 2004,
respectively. For these periods, commission expense as a percentage of gross
written and assumed premiums was 14.4%, 14.9% and 13.2%. The decrease in 2004
in commission expense was primarily due to a decrease in contingent commissions
to agents that resulted from higher loss ratios than had been projected for
these agents.
Indirect underwriting expenses were 5.8%, 6.5% and 6.1% of total direct
written and assumed premiums in 2002, 2003 and 2004, respectively. 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 30.8%, 28.0% and 33.3% in 2002, 2003 and 2004, respectively.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses from continuing operations were 8.5%,
10.7% and 10.5% of gross premiums earned in 2002, 2003 and 2004, respectively.
An increase in employee related expenses and fees paid to state insurance
departments contributed to the $1.0 million increase in expense in 2003.
General and administrative expenses decreased $1.1 million in 2004 due
primarily to a reduction in employee related expenses and to a recovery of
certain litigation expenses of $359,000. General and administrative expenses
have historically not varied in direct proportion to Chandler USA's revenues.
A portion of such expenses is allocated to policy acquisition costs (indirect
underwriting expenses) and loss and loss adjustment expenses based on various
factors, including employee counts, salaries, occupancy and specific
identification. Because certain types of expenses are fixed in nature, the
percentage of such expenses to revenues will vary depending on Chandler USA's
revenues.
INTEREST EXPENSE
Interest expense decreased less than 1% in 2002, increased 9% in 2003 and
decreased 2% in 2004. Substantially all of Chandler USA's interest expense is
related to its outstanding senior debentures and junior subordinated debentures.
FEDERAL INCOME TAXES
Chandler USA's federal income tax benefit (provision) as a percentage of
income (loss) from continuing operations before income taxes was 35.5%, 8.9%
and 33.8% for 2002, 2003 and 2004, respectively. The decrease in 2003 was
primarily due to offsetting taxable realized gains of $2.4 million against
Chandler USA's capital loss carryforward which is fully reserved due to its
realization not being considered more likely than not.
PAGE 27
At December 31, 2004, Chandler USA had a net deferred tax asset of $7.4
million including $4.0 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.
NAICO maintains a liquid operating position and follows investment
guidelines that are intended to provide for an acceptable return on investment
while preserving capital, maintaining sufficient liquidity to meet obligations
and keeping a sufficient margin of capital and surplus to ensure unimpaired
ability to write insurance. As of December 31, 2004, all of NAICO's
fixed-maturity investments were rated Aa3 or A+ or better by Moody's Investors
Service, Inc. or Standard & Poor's, respectively.
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, 2004, 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 $7.5 million and $6.0 million in cash from operations
during 2002 and 2003, respectively, and provided $20.2 million in cash from
operations in 2004. Cash flow from operations was negatively impacted during
2002 and 2003 due to the decline in written premiums during these years since
claim payments for any given year will include payments for claims on insurance
policies written in prior years. The cash used by operations was largely
funded from sales and maturities of investments and certain financing
activities described below. The cash provided by operations in 2004 is due
primarily to the decrease in reinsurance purchased in 2004 which resulted in
an increase in net premiums written of $18.6 million. Cash flow from
operations is positively impacted during times when net premiums written
increase since a substantial portion of the claim payments for any given year
will be made in future years. The cash provided by operations was used
primarily to fund purchases of investments and loans to related parties.
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 $794,000,
$2,351,000 and $652,000 during 2002, 2003 and 2004, respectively, from the
sale of investments. NAICO received proceeds of $31.5 million, $24.5 million
and $23.8 million during 2002, 2003 and 2004, respectively, from the sale of
available for sale securities prior to their maturity. The proceeds and
related net realized investment gains in 2002 and 2003 provided cash for
operating activities due to the decrease in written premiums. During 2003 and
2004, the market value of NAICO's available for sale fixed-income investments
decreased by $500,000 and $581,000, respectively, due primarily to changes in
interest rates experienced during this time. The average maturity of NAICO's
fixed maturity investments was 5.0 years and 4.9 years at December 31, 2003
and 2004, respectively. Cash flows from investing activities also included
proceeds from the sale of L&W in 2002 of $3.1 million net of cash disposed of
as part of the sale. See Note 4 to Consolidated Financial Statements for more
information.
PAGE 28
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 6 to Consolidated Financial Statements.
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, 2004, the total amount of cash and investments
restricted as a result of these arrangements was $8.4 million.
Chandler USA and Chandler Insurance are parties to an Intercompany Credit
Agreement (the "Credit Agreement") covering intercompany loans between the
parties. The Credit Agreement requires interest to be paid at the prime
interest rate published in The Wall Street Journal each month, and balances
owed by either party are payable at any time upon demand. At December 31,
2003 and 2004, Chandler USA had a receivable of $9.6 million and $10.9 million,
respectively, under the Credit Agreement, and Chandler USA earned $380,000,
$412,000 and $439,000 in interest income under the Credit Agreement during
2002, 2003 and 2004, respectively.
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
on the unpaid lease balance at a floating interest rate of 1% over JP Morgan
Chase Bank prime, which was 5.25% at December 31, 2004. 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 12 to Consolidated Financial Statements.
CONTRACTUAL OBLIGATIONS
The following table provides the future payments due by period under
contractual obligations as of December 31, 2004, aggregated by type of
obligation:
LESS THAN 1-3 3-5 MORE THAN
ONE YEAR YEARS YEARS 5 YEARS TOTAL
---------- --------- --------- --------- ----------
(In thousands)
Future minimum rental payments
under operating leases ....... $ 636 $ 543 $ - $ - $ 1,179
Capital leases .................. 52 50 - - 102
Debentures ...................... - - - 6,979 6,979
Junior subordinated debentures
issued to affiliated trusts .. - - - 20,620 20,620
---------- --------- --------- --------- ----------
Total ........................ $ 688 $ 593 $ - $ 27,599 $ 28,880
========== ========= ========= ========= ==========
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 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 expect to receive payment of the remaining settlement
funds of $497,000 and $192,000 during the first quarter of 2005.
PAGE 29
Transamerica Occidental Life Insurance Company ("Transamerica") reinsured
NAICO for certain workers compensation risks during 1989, 1990 and 1991.
Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed
under the reinsurance treaties. On March 15, 2004, an arbitration panel
ordered Transamerica to pay the losses and loss adjustment expenses owed to
NAICO in the amount of $1,607,704 plus interest at 6%, or approximately
$577,000, plus $25,000 in costs. NAICO has received payment for these amounts.
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, 2004, 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.
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) ----------------------
2003 2004 2003 2004
---------- ---------- ----------------- ---------- ----------
(Dollars in thousands) (Dollars in thousands)
Fixed-maturity investments... $ 61,980 $ 71,670 100 bp increase.. $ 59,226 $ 68,482
200 bp increase.. 56,663 65,501
100 bp decrease.. 64,946 75,083
200 bp decrease.. 68,146 78,744
The table above illustrates, for example, that an instantaneous 200 basis
point increase in market interest rates at December 31, 2004 would reduce the
estimated fair value of NAICO's fixed-maturity investments by approximately
$6.2 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.
PAGE 30
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. 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 ----------------------
2003 2004 2003 2004
---------- ---------- ----------------- ---------- ----------
(Dollars in thousands) (Dollars in thousands)
Equity securities ............ $ 92 $ 8,373 20% increase ... $ 110 $ 10,048
20% decrease ... 74 6,698
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, 2004, the fair value of Chandler
USA's Debentures was estimated to be $6.9 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, currently 6.17%. At
December 31, 2004, the fair value of Chandler USA's junior subordinated
debentures was estimated to be $20.6 million.
During March 2001, Chandler USA entered into a $3.8 million sale and
leaseback transaction for certain owned equipment for three years. The sale
and leaseback transaction resulted in a deferred gain of $2.0 million which
was amortized into income over the final year of the lease, resulting in other
income of $1.7 million in 2003 and $368,000 in 2004. During March 2004, the
lease was extended for 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 5.25% at December 31, 2004. 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 31
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 59 Chairman of the Board, Chief Executive Officer, Compensation
Committee Member and Director.
Mark T. Paden 48 President, Chief Operating Officer, Compensation Committee Member
and Director.
Brenda B. Watson 64 Executive Vice President of NAICO and CIMI.
Richard L. Evans 58 Senior Vice President and Director.
R. Patrick Gilmore 53 Senior Vice President, Secretary, General Counsel and Director.
Mark C. Hart 49 Vice President - Finance, Chief Financial Officer and Treasurer.
M. Steven Blain 47 Vice President - Administration.
Robert L. Rice 70 Audit Committee Chairman and Director.
W. Scott Martin 54 Audit Committee Member and Director.
William T. Keele 68 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 32
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
The Bank of Union in Union City, 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,
2004.
PAGE 33
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 2004 $ 501,726 $ 719,943 $ 390,399 $ 90,362
Chairman of the Board and CEO 2003 489,602 574,456 795,994 94,131
of Chandler USA, NAICO and CIMI 2002 458,723 484,120 348,172 49,332
Mark T. Paden 2004 313,793 490,718 70,273 25,930
President and COO of Chandler USA, 2003 304,654 395,427 73,934 7,133
NAICO and CIMI 2002 295,481 403,348 77,861 5,749
Brenda B. Watson 2004 256,457 - N/A 11,450
Executive Vice President 2003 254,072 - N/A 18,860
of NAICO and CIMI 2002 244,448 - N/A 11,526
Richard L. Evans 2004 260,530 - N/A 8,700
Senior Vice President - Claims of 2003 254,875 - N/A 9,866
Chandler USA and NAICO 2002 245,899 4,500 N/A 7,928
R. Patrick Gilmore 2004 234,515 - N/A 13,600
Senior Vice President, Secretary and 2003 224,154 - N/A 7,240
General Counsel of Chandler USA, 2002 216,790 - N/A 5,405
NAICO and CIMI
- ---------------------------------------
(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 $167,145, $366,902 and $206,583 for Mr. LaGere in
2002, 2003 and 2004, respectively, and $33,231, $32,996 and $39,865 for Mr. Paden in 2002,
2003 and 2004, respectively.
(4) The amounts shown under this column include contributions by Chandler USA's subsidiaries
to a 401(k) plan ($5,100 for Mr. LaGere, $4,350 for Mr. Paden, $4,350 for Ms. Watson,
$5,100 for Mr. Evans, and $4,100 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 ($33,600, $44,453 and $45,103 in 2002, 2003 and 2004,
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 34
OPTIONS EXERCISED AND HOLDINGS
No options were granted to or exercised by the Named Executives during
2004 and there were no unexercised options held by the Named Executives as of
December 31, 2004.
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 35
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, 2005, 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, 2004 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 18.9%
Mark T. Paden ............................................ Class A Common Shares 125,165 20.0%
Series A Preferred Shares 17,610 4.4%
Brenda B. Watson (4) ..................................... Series A Preferred Shares 18,024 4.5%
Series B Preferred Shares 35,542 9.0%
Richard L. Evans ......................................... Series A Preferred Shares 27,272 6.9%
Series B Preferred Shares 32,250 8.1%
R. Patrick Gilmore ....................................... Series B Preferred Shares 11,000 2.8%
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%
Steven R. Butler (6) ..................................... Series C Preferred Shares 3,200 *%
All directors and officers as a group (10 persons) (7) ... Class A Common Shares 625,826 100.0%
Series A Preferred Shares 141,586 35.6%
Series B Preferred Shares 78,792 19.9%
Series C Preferred Shares 144,617 22.5%
- ----------------------------------------------------------
* Less than 1%
(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, 397,822 Series A Preferred Shares of Chandler Insurance,
396,126 Series B Preferred Shares of Chandler Insurance and 642,069 Series C Preferred Shares of Chandler Insurance
outstanding on February 28, 2005.
(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) Mr. Butler is a director, Vice President - Administration and Secretary of Chandler Insurance, and also served as a
director and President of Chandler Barbados until December 2003.
(7) 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 36
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, 2005. 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 Laird, Matthew LaGere and Lance LaGere, Trustees
of the W. Brent LaGere Irrevocable Trust
1010 Manvel Avenue, Chandler, Oklahoma 74834 ......... 370,890 (3) 59.3%
- --------------------------------------------------------
(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, 2005.
(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 12 to Consolidated Financial Statements for additional information. The
bank that participated in the sale and leaseback transaction has 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 L&W. Chandler USA paid a fee of $5,000 during 2004 to the bank for
issuing the letter of credit. See Note 4 to Consolidated Financial Statements
for additional information. 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 2002, 2003 and 2004, Chandler USA incurred approximately
$255,000, $336,000 and $353,000, respectively, in expenses associated with its
use of this property, including $18,000, $12,000 and $14,000 for reimbursement
of certain expenses, such as utility and similar expenses, for the years 2002,
2003 and 2004, respectively.
PAGE 37
NAICO purchases and sells investment securities through various brokerage
firms including Raymond James & Associates, Inc., a subsidiary of Raymond James
Financial, Inc. K.R. Price was a director of NAICO and Chandler USA from May
2001 until November 2004. Mr. Price is employed by Raymond James Financial
Services, Inc. which is also a subsidiary of Raymond James Financial, Inc.
Mr. Price received no compensation from NAICO's investment transactions during
this time.
During the fourth quarter of 2002, Chandler USA's board of directors
approved the cancellation and release of certain judgments against three
directors of Chandler USA and one executive officer of NAICO that resulted from
the CenTra litigation. The amounts canceled included $233,122 for Mr. LaGere,
$136,467 for Ms. Watson, $99,338 for Mr. Evans and $72,142 for Mr. Paden. The
board's action followed a ruling during August 2002 by the U.S. District Court
for the Western District of Oklahoma denying CenTra's claim for post-judgment
interest from Chandler Insurance of approximately $2.5 million.
Chandler USA believes that all transactions with directors, officers, or
shareholders of Chandler USA and its subsidiaries are and will continue to be
on terms no less favorable to Chandler USA and its subsidiaries than could be
obtained from unaffiliated parties.
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 $146,700,
$149,600 and $155,000 for the years ended December 31, 2002, 2003 and 2004,
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 $20,500, $18,675 and $18,150 for the years ended
December 31, 2002, 2003 and 2004, 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 $40,430, $26,375 and $17,700 for the years ended December
31, 2002, 2003 and 2004, 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
$6,300 and $1,446 for the years ended December 31, 2002 and 2003, 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 31.4%,
23.7% and 18.8% for the years ended December 31, 2002, 2003 and 2004,
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, 2003 and 2004, 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, 2004, 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.
PAGE 38
2. FINANCIAL STATEMENT SCHEDULES. The financial statement schedules
listed in the accompanying index to consolidated financial
statements and schedules are filed as part of this Form 10-K. All
other schedules have been omitted since the required information is
not applicable or is not present in amounts sufficient to require
submission of the schedule or because the information is included
in the consolidated financial statements or the notes thereon.
3. EXHIBITS.
3.1 Certificate of Incorporation. (1)
3.2 Bylaws, as amended. (1)
4.1 Form of Indenture entered into by and between Chandler
(U.S.A.), Inc. as issuer and U.S. Trust of Texas, N.A. as
trustee. (1)
4.2 First Amendment to Indenture effective May 13, 2003
constituting the First Amendment to the Indenture dated as
of July 16, 1999, between Chandler (U.S.A.), Inc., and The
Bank of New York Trust Company of Florida, N.A. as successor
trustee to U.S. Trust Company of Texas, N.A., as Trustee
regarding the 8.75% senior debentures due 2014 issued by
Chandler (U.S.A.), Inc. (3)
4.3 Second Amendment to Indenture effective December 1, 2003
constituting the Second Amendment to the Indenture dated as
of July 16, 1999, between Chandler (U.S.A.), Inc., and The
Bank of New York Trust Company of Florida, N.A. as successor
trustee to U.S. Trust Company of Texas, N.A., as Trustee
regarding the 8.75% senior debentures due 2014 issued by
Chandler (U.S.A.), Inc. (5)
10.1 Employment Agreement, effective as of October 28, 1988, by
and between Chandler (U.S.A.), Inc. and Brent LaGere. (1)
10.2 Employment Agreement, effective as of October 28, 1988, by
and between Chandler (U.S.A.), Inc., and Brenda B. Watson
(formerly Brenda B. Pair). (1)
10.3 Amendment to Employment Agreement, effective as of January
1, 1999, by and between Chandler (U.S.A.), Inc. and Brenda
B. Watson. (1)
10.4 Intercompany Credit Agreement effective as of January 1,
2001, by and between Chandler (U.S.A.), Inc. and Chandler
Insurance (Barbados), Ltd. (2)
10.5 Stock Purchase Agreement effective as of December 1, 2002, by
and among Brown & Brown, Inc., Chandler (U.S.A.), Inc.,
Chandler Insurance Company, Ltd., National American Insurance
Company, W. Brent LaGere and Mark T. Paden. (3)
10.6 Amended and Restated Declaration of Trust of Chandler Capital
Trust I dated as of May 22, 2003 among Chandler (U.S.A.),
Inc., as sponsor, Wilmington Trust Company, as Delaware
trustee, Wilmington Trust Company, as institutional trustee,
and W. Brent LaGere, Mark T. Paden and Mark C. Hart, as
administrators. (4)
10.7 Indenture, dated as of May 22, 2003 among Chandler (U.S.A.),
Inc., as issuer, and Wilmington Trust Company, as
trustee. (4)
10.8 Guarantee Agreement, dated as of May 22, 2003 between
Chandler (U.S.A.), Inc., as guarantor, and Wilmington Trust
Company, as guarantee trustee. (4)
10.9 Capital Securities Subscription Agreement dated as of May
13, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital
Trust I, together as offerors, and InCapS Funding I, Ltd., as
purchaser. (4)
10.10 Placement Agreement dated May 13, 2003 among Chandler
(U.S.A.), Inc. and Chandler Capital Trust I, together as
offerors, and Sandler O'Neill & Partners, L.P., as placement
agent. (4)
10.11 Amended and Restated Declaration of Trust of Chandler Capital
Trust II dated as of December 16, 2003 among Chandler
(U.S.A.), Inc., as sponsor, Wilmington Trust Company, as
Delaware trustee, Wilmington Trust Company, as institutional
trustee, and W. Brent LaGere, Mark T. Paden and Mark C. Hart,
as administrators. (6)
PAGE 39
10.12 Indenture, dated as of December 16, 2003 among Chandler
(U.S.A.), Inc., as issuer, and Wilmington Trust Company, as
trustee. (6)
10.13 Guarantee Agreement, dated as of December 16, 2003 between
Chandler (U.S.A.), Inc., as guarantor, and Wilmington Trust
Company, as guarantee trustee. (6)
10.14 Capital Securities Subscription Agreement dated as of
December 4, 2003 among Chandler (U.S.A.), Inc. and Chandler
Capital Trust II, together as offerors, and InCapS Funding
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 40
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED
ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
CHANDLER (U.S.A.), INC.
Date: March 1, 2005 By:/s/ W. Brent LaGere
----------------------------------------------------
W. Brent LaGere
Chairman of the Board and Chief Executive Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS
REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE
REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.
Date: March 1, 2005 /s/ W. Brent LaGere
----------------------------------------------------
W. Brent LaGere, Chairman of the Board,
Chief Executive Officer and Director
(Principal Executive Officer)
Date: March 1, 2005 /s/ Mark T. Paden
----------------------------------------------------
Mark T. Paden, President, Chief Operating Officer
and Director
Date: March 1, 2005 /s/ Mark C. Hart
----------------------------------------------------
Mark C. Hart, Vice President - Finance,
Chief Financial Officer and Treasurer
(Principal Financial Officer)
Date: March 1, 2005 /s/ Richard L. Evans
----------------------------------------------------
Richard L. Evans, Senior Vice President and Director
Date: March 1, 2005 /s/ R. Patrick Gilmore
----------------------------------------------------
R. Patrick Gilmore, Senior Vice President,
Secretary, General Counsel and Director
Date: March 1, 2005 /s/ Robert L. Rice
----------------------------------------------------
Robert L. Rice, Director
Date: March 1, 2005 /s/ W. Scott Martin
----------------------------------------------------
W. Scott Martin, Director
Date: March 1, 2005 /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, 2003 and 2004 ................ F-2
Consolidated Statements of Operations for the years ended
December 31, 2002, 2003 and 2004 .......................................... F-3
Consolidated Statements of Comprehensive Income for the years ended
December 31, 2002, 2003 and 2004 .......................................... F-4
Consolidated Statements of Cash Flows for the years ended
December 31, 2002, 2003 and 2004 .......................................... F-5
Consolidated Statements of Shareholder's Equity for the years ended
December 31, 2002, 2003 and 2004 .......................................... 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,
----------------------------
2003 2004
------------ ------------
ASSETS
Investments
Fixed maturities available for sale, at fair value
Restricted (amortized cost $7,622 and $8,421 in 2003 and 2004, respectively) ...... $ 7,677 $ 8,279
Unrestricted (amortized cost $53,549 and $63,636 in 2003 and 2004, respectively)... 54,303 63,391
Equity securities at fair value (cost $8,058 in 2004) ............................... 92 8,373
------------ ------------
Total investments ................................................................. 62,072 80,043
Cash and cash equivalents ($601 and $141 restricted in 2003 and 2004, respectively).... 7,126 6,870
Premiums receivable, less allowance for non-collection
of $133 and $119 at 2003 and 2004, respectively ..................................... 20,304 22,809
Reinsurance recoverable on paid losses, less allowance for non-collection
of $2,934 and $3,035 at 2003 and 2004, respectively ................................. 9,036 2,172
Reinsurance recoverable on paid losses from related parties ........................... 271 83
Reinsurance recoverable on unpaid losses, less allowance for non-collection
of $380 and $237 at 2003 and 2004 ................................................... 48,688 50,381
Reinsurance recoverable on unpaid losses from related parties ......................... 9,737 13,157
Prepaid reinsurance premiums .......................................................... 15,269 9,837
Prepaid reinsurance premiums to related parties ....................................... 9,521 12,315
Deferred policy acquisition costs ..................................................... 165 57
Property and equipment, net ........................................................... 9,879 9,110
Amounts due from related parties ...................................................... 9,642 10,891
State insurance licenses, net ......................................................... 3,745 3,745
Other assets .......................................................................... 12,758 15,827
------------ ------------
Total assets .......................................................................... $ 218,213 $ 237,297
============ ============
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities
Unpaid losses and loss adjustment expenses .......................................... $ 87,768 $ 108,233
Unearned premiums ................................................................... 47,325 51,109
Policyholder deposits ............................................................... 4,807 4,912
Accrued taxes and other payables .................................................... 5,617 5,578
Premiums payable .................................................................... 983 3,674
Debentures .......................................................................... 7,254 6,979
Junior subordinated debentures issued to affiliated trusts .......................... 20,620 20,620
------------ ------------
Total liabilities ................................................................. 174,374 201,105
------------ ------------
Commitments and contingencies (Notes 11 and 12)
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 ................................................................ (17,342) (24,346)
Accumulated other comprehensive income (loss):
Unrealized gain (loss) on investments available for sale, net of
deferred income taxes .......................................................... 595 (48)
------------ ------------
Total shareholder's equity ....................................................... 43,839 36,192
------------ ------------
Total liabilities and shareholder's equity ........................................... $ 218,213 $ 237,297
============ ============
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,
--------------------------------------
2002 2003 2004
------------ ------------ ------------
Premiums and other revenues
Direct premiums written and assumed ................................ $ 140,162 $ 118,444 $ 121,651
Reinsurance premiums ceded ......................................... (48,380) (40,612) (21,132)
Reinsurance premiums ceded to related parties ...................... (24,115) (25,992) (30,055)
------------ ------------ ------------
Net premiums written and assumed ................................. 67,667 51,840 70,464
Decrease (increase) in unearned premiums ........................... (710) 4,743 (6,422)
------------ ------------ ------------
Net premiums earned .............................................. 66,957 56,583 64,042
Investment income, net ............................................... 2,540 2,148 3,186
Interest income, net from related parties ............................ 380 412 491
Realized investment gains, net ....................................... 794 2,351 652
Other income ......................................................... 261 5,077 640
------------ ------------ ------------
Total premiums and other revenues ................................ 70,932 66,571 69,011
------------ ------------ ------------
Operating costs and expenses
Losses and loss adjustment expenses, net of amounts ceded
to related parties of $16,936, $14,244 and $15,587
in 2002, 2003 and 2004, respectively ............................. 50,712 37,200 53,781
Policy acquisition costs, net of ceding commissions received
from related parties of $8,199, $8,770 and $11,550
in 2002, 2003 and 2004, respectively ............................. 10,239 11,278 11,039
General and administrative expenses ................................ 12,473 13,486 12,380
Interest expense ................................................... 2,234 2,441 2,397
------------ ------------ ------------
Total operating costs and expenses ............................... 75,658 64,405 79,597
------------ ------------ ------------
Income (loss) from continuing operations before income taxes ......... (4,726) 2,166 (10,586)
Federal income tax benefit (provision) ............................... 1,680 (192) 3,582
------------ ------------ ------------
Income (loss) from continuing operations ............................. (3,046) 1,974 (7,004)
Income from discontinued operations .................................. 284 - -
Gain on sale of subsidiary ........................................... 671 - -
------------ ------------ ------------
Net income (loss) .................................................. $ (2,091) $ 1,974 $ (7,004)
============ ============ ============
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,
--------------------------------------
2002 2003 2004
------------ ------------ ------------
Net income (loss) .............................................................. $ (2,091) $ 1,974 $ (7,004)
------------ ------------ ------------
Other comprehensive income (loss), before income tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period .................... 2,838 631 (322)
Less: Reclassification adjustment for gains included in net income (loss) .. (794) (2,351) (652)
------------ ------------ ------------
Other comprehensive income (loss), before income tax ........................... 2,044 (1,720) (974)
Income tax benefit (provision) related to items of other
comprehensive income (loss) .................................................. (695) 585 331
------------ ------------ ------------
Other comprehensive income (loss), net of income tax ........................... 1,349 (1,135) (643)
------------ ------------ ------------
Comprehensive income (loss) .................................................... $ (742) $ 839 $ (7,647)
============ ============ ============
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,
--------------------------------------
2002 2003 2004
------------ ------------ ------------
OPERATING ACTIVITIES
Net income (loss) .............................................................. $ (2,091) $ 1,974 $ (7,004)
Add (deduct):
Adjustments to reconcile net income (loss) to cash
provided by (applied to) operating activities:
Realized investment gains, net ............................................. (794) (2,351) (652)
Gain on sale of subsidiary ................................................. (671) - -
Gain on retirement of debentures ........................................... - (3,106) (36)
Net (gains) losses on sale of property and equipment ....................... 32 (1,661) (370)
Amortization and depreciation .............................................. 1,602 1,470 1,525
Provision for non-collection of premiums ................................... 444 272 42
Provision for non-collection of reinsurance recoverables ................... 1,726 604 282
Net change in non-cash balances relating to operating activities:
Premiums receivable ...................................................... (268) 3,433 (2,547)
Reinsurance recoverable on paid losses ................................... (712) 1,449 6,439
Reinsurance recoverable on paid losses from related parties .............. 212 (191) 188
Reinsurance recoverable on unpaid losses ................................. (8,288) 1,798 (1,551)
Reinsurance recoverable on unpaid losses from related parties ............ 361 (699) (3,420)
Prepaid reinsurance premiums ............................................. 7,688 3,933 5,432
Prepaid reinsurance premiums to related parties .......................... (577) (841) (2,794)
Deferred policy acquisition costs ........................................ (355) 190 108
Other assets ............................................................. (1,349) 2,427 (2,790)
Unpaid losses and loss adjustment expenses ............................... 7,850 (4,838) 20,465
Unearned premiums ........................................................ (6,402) (7,835) 3,784
Policyholder deposits .................................................... (356) 563 105
Accrued taxes and other payables ......................................... 307 (752) 329
Premiums payable ......................................................... (5,864) (1,822) 2,691
------------ ------------ ------------
Cash provided by (applied to) operating activities ......................... (7,505) (5,983) 20,226
------------ ------------ ------------
INVESTING ACTIVITIES
Unrestricted fixed maturities available for sale:
Purchases .................................................................... (23,163) (33,378) (38,927)
Sales ........................................................................ 31,460 22,806 23,772
Maturities ................................................................... 4,339 5,892 4,311
Equity securities available for sale:
Purchases .................................................................... - - (8,058)
Sales ........................................................................ - 1,720 36
Cost of property and equipment purchased ....................................... (373) (818) (208)
Proceeds from sale of property and equipment ................................... 98 104 85
Net proceeds from sale of subsidiary ........................................... 3,058 - -
------------ ------------ ------------
Cash provided by (applied to) investing activities ......................... 15,419 (3,674) (18,989)
------------ ------------ ------------
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 ........................................ 3,249 2,426 4,602
Payments and loans to related parties .......................................... (5,951) (1,486) (5,851)
------------ ------------ ------------
Cash provided by (applied to) financing activities ......................... (2,702) 7,447 (1,493)
------------ ------------ ------------
Increase (decrease) in cash and cash equivalents during the period ............. 5,212 (2,210) (256)
Cash and cash equivalents at beginning of period ............................... 4,124 9,336 7,126
------------ ------------ ------------
Cash and cash equivalents at end of period ..................................... $ 9,336 $ 7,126 $ 6,870
============ ============ ============
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, 2002 ................ $ 2 $ 60,584 $ (17,225) $ 381 $ 43,742
Net loss ................................ - - (2,091) - (2,091)
Change in unrealized gain on
investments available for
sale, net of income tax ............... - - - 1,349 1,349
----------- ----------- ----------- ------------- -------------
Balance, December 31, 2002 .............. 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
=========== =========== =========== ============= =============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
PAGE F-7
CHANDLER (U.S.A.), INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2002, 2003 AND 2004
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 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.
Chandler USA is wholly owned by Chandler Insurance Company, Ltd.
("Chandler Insurance"), a Cayman Islands company. Prior to December
2003, Chandler USA was a wholly owned subsidiary of Chandler Insurance
(Barbados), Ltd. ("Chandler Barbados") which, in turn, was a wholly
owned subsidiary of Chandler Insurance. In December 2003, Chandler
Barbados was dissolved following the transfer of its assets,
liabilities and business to Chandler Insurance. Chandler Insurance
assumed the obligations of Chandler Barbados including those under its
reinsurance agreements with NAICO pursuant to a Distribution Agreement
and a General Conveyance. The reorganization of Chandler Barbados and
Chandler Insurance was approved by the Cayman Islands Monetary
Authority, the Supervisor of Insurance in Barbados and the Oklahoma
Insurance Department.
In December 2002, Chandler USA completed the sale of its wholly
owned subsidiary LaGere and Walkingstick Insurance Agency, Inc.
("L&W"). L&W previously functioned as Chandler USA's agency segment.
All periods have been restated to reflect the results of L&W as a
discontinued operation. See Note 4 for more information on the sale
of L&W.
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.
PAGE F-8
(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.
(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. NAICO accrued expenses of $105,000 in 2002 and a credit of
$52,000 during 2003 and less than $1,000 in 2004 for dividends to
policyholders primarily on participating workers compensation
policies. Gross written premiums for participating policies were
$615,000, $50,000 and less than $1,000 in 2002, 2003 and 2004,
respectively.
(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:
2003 2004
---------- ----------
(In thousands)
Real estate and improvements .. $ 11,701 $ 11,714
Other property and equipment .. 9,206 9,010
---------- ----------
20,907 20,724
Accumulated depreciation ...... (11,028) (11,614)
---------- ----------
$ 9,879 $ 9,110
========== ==========
Depreciation expense from continuing operations was approximately
$916,000, $918,000 and $894,000 for 2002, 2003 and 2004, respectively.
PAGE F-9
(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 2003 and 2004 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:
2003 2004
---------- ----------
(In thousands)
State insurance licenses ...... $ 5,991 $ 5,991
Accumulated amortization ...... (2,246) (2,246)
---------- ----------
$ 3,745 $ 3,745
========== ==========
(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
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.
PAGE F-10
(n) SUPPLEMENTAL CASH FLOW INFORMATION
Cash payments for interest and income taxes, and noncash
investing activities were as follows:
YEAR ENDED DECEMBER 31,
--------------------------------
2002 2003 2004
---------- ---------- ----------
(In thousands)
Cash payments (refunds) during the year for:
Interest ...................................... $ 2,122 $ 2,809 $ 2,261
Income taxes .................................. (1,241) (300) -
Transfers from (to) restricted securities, net .. $ (1,341) $ (563) $ (801)
(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 12, reinsurance
contracts do not relieve NAICO from its obligation to policyholders.
In addition, failure of reinsurers to honor their obligations could
result in losses to Chandler USA.
(p) NEW ACCOUNTING STANDARDS
The Financial Accounting Standards Board ("FASB") periodically
issues new accounting standards in a continuing effort to improve
standards of financial accounting and reporting. Chandler USA has
reviewed the recently issued pronouncements and concluded that the
following new accounting standard is 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.
NOTE 2. INVESTMENTS AND INVESTMENT INCOME
Net investment income and realized investment gains from continuing
operations are summarized in the following table. These amounts are net of
investment expenses.
YEAR ENDED DECEMBER 31,
--------------------------------
2002 2003 2004
---------- ---------- ----------
(In thousands)
Interest on fixed-maturity investments ................. $ 2,755 $ 2,271 $ 2,746
Interest on cash equivalents ........................... 252 139 695
Dividend income on equity securities ................... - - 22
Interest on amounts due from related parties ........... 380 412 491
Investment expenses .................................... (467) (262) (277)
---------- ---------- ----------
Investment income, net ............................... 2,920 2,560 3,677
---------- ---------- ----------
Realized gains, net - fixed-maturity investments ....... 794 631 616
Realized gains, net - equity securities ................ - 1,720 36
---------- ---------- ----------
Realized investments gains, net ...................... 794 2,351 652
---------- ---------- ----------
$ 3,714 $ 4,911 $ 4,329
========== ========== ==========
Investment expenses include $244,000, $81,000 and $104,000 for the years
ended December 31, 2002, 2003 and 2004, respectively, in expense to subsidize a
premium finance program for certain insureds of NAICO with an unaffiliated
premium finance company.
PAGE F-11
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, 2003 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 ......................... $ 38,565 $ 587 $ (141) $ 39,011 $ 39,011
Corporate obligations .................. 11,645 313 (90) 11,868 11,868
Public utilities ....................... 6,816 220 (20) 7,016 7,016
Mortgage-backed securities ............. 4,145 - (60) 4,085 4,085
---------- ---------- ---------- ---------- ----------
$ 61,171 $ 1,120 $ (311) $ 61,980 $ 61,980
========== ========== ========== ========== ==========
EQUITY SECURITIES:
Corporate stock ........................ $ - $ 92 $ - $ 92 $ 92
========== ========== ========== ========== ==========
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
========== ========== ========== ========== ==========
The fair value of Chandler USA's investments with sustained gross
unrealized losses at December 31, 2004 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 ....... $ 8,280 $ 148 $ 6,485 $ 77 $ 14,765 $ 225
Corporate securities .............. 19,089 397 1,991 32 21,080 429
Public utilities .................. 4,157 74 1,618 21 5,775 95
Mortgage-backed securities ........ - - 2,745 69 2,745 69
----------- ---------- ----------- ---------- ----------- ----------
$ 31,526 $ 619 $ 12,839 $ 199 $ 44,365 $ 818
=========== ========== =========== ========== =========== ==========
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 has concluded that the declines
in the fair values of Chandler USA's investments at December 31, 2004 are
temporary.
PAGE F-12
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, 2004 are shown below:
AVAILABLE FOR SALE
------------------------
AMORTIZED
COST FAIR VALUE
------------ ----------
(In thousands)
Due in one year or less ...................... $ 1,024 $ 1,021
Due after one year through five years ........ 34,921 34,801
Due after five years through ten years ....... 30,477 30,266
Due after ten years .......................... 2,821 2,837
------------ ----------
69,243 68,925
Mortgage-backed securities ................... 2,814 2,745
------------ ----------
$ 72,057 $ 71,670
============ ==========
Realized gains and losses from sales of investments are shown below:
GROSS REALIZED GAINS GROSS REALIZED LOSSES
-------------------- ---------------------
(In thousands)
FIXED MATURITIES:
2002 ............ $ 904 $ 110
2003 ............ 631 -
2004 ............ 693 77
EQUITY SECURITIES:
2003 ............ 1,720 -
2004 ............ 36 -
NAICO is required by several states to deposit securities with state
regulators as a condition of doing business in those states. At December 31,
2003, Chandler USA had deposited cash of approximately $500,000 into a trust
account as security related to certain indemnification provisions related to
its sale of L&W. This deposit was replaced by a $500,000 letter of credit in
2004 (See Note 4). As of December 31, 2003 and 2004, the carrying value of
these deposits totaled approximately $8.3 million and $8.4 million,
respectively.
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 $5.7 million and $3.7 million at December 31, 2003
and 2004, respectively. 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.
PAGE F-13
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,
--------------------------------
2002 2003 2004
---------- ---------- ----------
(In thousands)
Net balance at beginning of year ........................... $ 32,812 $ 33,191 $ 29,343
---------- ---------- ----------
Net losses and loss adjustment expenses incurred related to:
Current year ............................................ 34,928 26,108 27,436
Prior years ............................................. 15,784 11,092 26,345
---------- ---------- ----------
Total ................................................ 50,712 37,200 53,781
---------- ---------- ----------
Net paid losses and loss adjustment expenses related to:
Current year ............................................ (13,283) (10,626) (10,222)
Prior years ............................................. (37,050) (30,422) (28,207)
---------- ---------- ----------
Total ................................................ (50,333) (41,048) (38,429)
---------- ---------- ----------
Net balance at end of year ................................. $ 33,191 $ 29,343 $ 44,695
========== ========== ==========
NAICO has experienced a significant amount of incurred losses related to
prior accident years during the 2002, 2003 and 2004 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 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.
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%.
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.
PAGE F-14
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. DISCONTINUED OPERATIONS
In December 2002, Chandler USA completed the sale of its wholly owned
subsidiary L&W to Brown & Brown, Inc. 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. The gain on the sale may be increased depending on
certain adjustments to the purchase price as defined in the terms of the
transaction. Following the completion of the sale, L&W changed its name to
Brown & Brown of Central Oklahoma, Inc. ("B&B"). L&W previously functioned as
Chandler USA's agency segment and is presented as discontinued operations.
B&B continues to be a significant producer of business for NAICO. Retail
business produced by B&B and placed with NAICO constituted approximately 13% of
NAICO's direct premiums written and assumed in 2004. Chandler USA agreed to
indemnify Brown & Brown, Inc. for any breach of a representation, warranty or
covenant made in connection with the sale for a period of three years, and has
established a letter of credit in the amount of $500,000 for the benefit of
Brown & Brown, Inc. as security.
NOTE 5. 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, 2004, Chandler USA has
capitalized $312,000 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, 2004, Chandler USA was in compliance with all
covenants.
NOTE 6. 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 F-15
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 6.17% at December 31, 2004.
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 6.17% at December 31, 2004. 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. Issuance costs in the amount of $711,000 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, and the December 31, 2003 balances
were restated accordingly. The adoption of FIN 46R had no effect on net
earnings.
PAGE F-16
NOTE 7. SHAREHOLDER'S EQUITY
CAPITAL STOCK
In addition to the regulatory oversight of NAICO by the Oklahoma
Department of Insurance, Chandler Insurance 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:
2002 2003 2004
-------- -------- --------
(In thousands)
Statutory net income (loss) ........ $ (405) $ 1,447 $(7,482)
Statutory capital and surplus ...... $44,073 $50,154 $41,458
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, 2003 and 2004.
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 2005 without the
approval of the Oklahoma Department of Insurance is approximately $3.8 million.
NAICO paid cash shareholder dividends to Chandler USA totaling $3.5 million in
2002 and $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 $3.8 million as
of December 31, 2004). NAICO paid approximately $120,000, $146,000 and $62,000
in policyholder dividends during 2002, 2003 and 2004, respectively.
PAGE F-17
NOTE 8. 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:
2002 2003 2004
---------- ---------- ----------
CONTINUING OPERATIONS: (In thousands)
Computed income tax provision (benefit) at 34% ...... $ (1,607) $ 736 $ (3,599)
Increase (decrease) in income taxes resulting from:
Utilization of capital loss ....................... (270) (800) (248)
Nondeductible expenses ............................ 197 256 265
---------- ---------- ----------
Federal income tax provision (benefit) .............. $ (1,680) $ 192 $ (3,582)
========== ========== ==========
DISCONTINUED OPERATIONS:
Computed income tax provision at 34% ................ $ 149 $ - $ -
Increase in income taxes resulting from:
Other, net ........................................ 6 - -
---------- ---------- ----------
Federal income tax provision ........................ $ 155 $ - $ -
========== ========== ==========
The sale of L&W resulted in a capital loss for tax purposes as Chandler
USA's tax basis in L&W exceeded the consideration received from the sale.
Accordingly, the gain on the sale of $671,000 that was recorded in the
consolidated statement of operations in 2002 was not reduced for income taxes.
U.S. Federal income tax provision (benefit) from continuing operations
consists of:
CURRENT DEFERRED TOTAL
--------------- ---------------- --------------
(In thousands)
2002 ........................................ $ (146) $ (1,534) $ (1,680)
2003 ........................................ (904) 1,096 192
2004 ........................................ - (3,582) (3,582)
Deferred income tax provision (benefit) from continuing operations
relating to temporary differences includes the following components:
2002 2003 2004
------------- ------------ ------------
(In thousands)
Loss reserve discounts ......................... $ 152 $ 276 $ (796)
Unearned premiums .............................. (6) 249 (372)
Deferred policy acquisition costs .............. 276 (65) (37)
Reserve for uncollectible premiums receivable .. (58) 38 5
Depreciation and lease expense ................. 126 627 5
Discount on fixed maturity investments ......... 11 (218) 11
Net operating loss carryforwards ............... (1,887) 214 (2,345)
Other .......................................... (148) (25) (53)
------------- ------------ ------------
$ (1,534) $ 1,096 $ (3,582)
============= ============ ============
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:
2003 2004
------------ ------------
(In thousands)
Deferred tax assets:
Loss reserve discounts ....................................... $ 1,774 $ 2,569
Unearned premiums ............................................ 1,617 1,989
Reserve for uncollectible premiums receivable ................ 45 40
Compensated absences ......................................... 231 242
Net operating loss carryforwards - federal ................... 1,673 4,019
Net operating loss carryforwards - state ..................... 3,037 3,194
Net capital loss carryforward ................................ 625 357
Other ........................................................ 110 119
Valuation allowance .......................................... (3,662) (3,551)
------------ ------------
Total deferred tax assets ...................................... 5,450 8,978
------------ ------------
Deferred tax liabilities:
Depreciation and lease expense ............................... 1,470 1,475
Amortization of discount on fixed maturity investments ....... 5 15
Unrealized gain (loss) on investments available for sale ..... 306 (25)
Deferred policy acquisition costs ............................ 56 20
Other ........................................................ 124 91
------------ ------------
Total deferred tax liabilities ................................. 1,961 1,576
------------ ------------
Net deferred tax assets ........................................ $ 3,489 $ 7,402
============ ============
At December 31, 2004, Chandler USA had a net operating loss carryforward
available for U.S. Federal income taxes of $11.8 million which begins to expire
in 2023. Chandler USA has concluded that the deferred tax asset including the
federal net operating loss carryforwards are more likely than not to be
realized. Chandler USA anticipates that its future U.S. consolidated income
tax will be sufficient to utilize the federal net operating losses within the
required time. Chandler USA will continue to evaluate income generated in
future periods in determining the reasonableness of its position. If Chandler
USA determines that future income is insufficient to cause the realization of
the federal net operating losses within the required time, a valuation
allowance will be established.
In addition, Chandler USA, at December 31, 2004, had net operating loss
carryforwards available for Oklahoma state income taxes totaling approximately
$53.2 million which expire in the years 2005 through 2024. At December 31,
2004, Chandler USA also had a capital loss carryforward for U.S. Federal income
taxes of $1.1 million which expires in 2007. A valuation allowance has been
provided for the tax effect of the state net operating loss and the net capital
loss carryforwards since realization of such amounts is not considered more
likely than not.
NOTE 9. 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 $5,100 per employee per year. In addition, Chandler USA may make additional
annual contributions to the 401(k) plan at its discretion. Chandler USA's
expense for 401(k) plan contributions from continuing operations was $282,000,
$286,000 and $321,000 for 2002, 2003 and 2004, respectively.
NOTE 10. 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, 2003 and 2004. The estimated fair values of Chandler USA's
fixed-maturity and equity security investments are disclosed at Note 2. At
December 31, 2004, the fair value of Chandler USA's Debentures was estimated to
be $6.9 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, currently 6.17%. At December 31, 2004, the fair value of
Chandler USA's junior subordinated debentures was estimated to be $20.6 million.
NOTE 11. 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 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 expect to receive 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 has received payment for these amounts.
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 12. 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 and construction surety bonds.
Chandler Insurance reinsures NAICO for a portion of the risk on NAICO's
reinsurance programs.
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, 2005 reinsurance programs. At the present time, NAICO
expects to renew the reinsurance programs that renew on July 1, 2005.
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.
Reliance Insurance Company ("Reliance") reinsured NAICO for certain
workers compensation risks during 1998. At December 31, 2004, NAICO had
reinsurance recoverables from Reliance for paid and unpaid losses of
approximately $3.3 million. During October 2004, the Commonwealth of
Pennsylvania placed Reliance in liquidation. NAICO is unable to determine the
amount of its reinsurance recoverables from Reliance that will ultimately be
collected and has fully reserved the carrying value of such amounts as of
December 31, 2003 and 2004.
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 2002,
2003 and 2004, NAICO incurred charges of $1.7 million, $604,000 and $282,000,
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:
2002 2003 2004
----------------------- ----------------------- -----------------------
WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED
----------- ---------- ----------- ---------- ----------- ----------
(In thousands)
Direct ............. $ 139,876 $ 146,307 $ 118,247 $ 126,067 $ 121,146 $ 117,383
Assumed ............ 286 256 197 212 505 484
Ceded .............. (72,495) (79,606) (66,604) (69,696) (51,187) (53,825)
----------- ---------- ----------- ---------- ----------- ----------
Net premiums ....... $ 67,667 $ 66,957 $ 51,840 $ 56,583 $ 70,464 $ 64,042
=========== ========== =========== ========== =========== ==========
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 $87.7 million,
$83.9 million and $52.1 million for 2002, 2003 and 2004, 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, 2003 and
2004 were $20.3 million and $22.8 million, respectively. Receivables for
deductibles, in most cases, are secured by cash deposits and letters of
credit. At December 31, 2004, NAICO maintained custody of such letters of
credit securing these and other transactions totaling approximately $21.7
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 2002 or 2003.
During 2004, one unaffiliated independent insurance agent produced
approximately 13% of NAICO's direct written and assumed premiums.
NAICO's bail bond underwriting manager was responsible for gross written
premiums of $2.3 million, $1.2 million and $130,000 during 2002, 2003 and 2004,
respectively.
PAGE F-21
Approximately $29.1 million, or 33% of NAICO's reinsurance recoverables
and prepaid reinsurance premiums at December 31, 2004 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.
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, 2004.
CEDED REINSURANCE
NET PREMIUMS FOR A.M. BEST
REINSURANCE THE YEAR ENDED COMPANY
NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2004 RATING
- --------------------------------------------------------- --------------- ------------------- ---------
(Dollars in thousands)
Chandler Insurance ...................................... $ 25,555 $ 30,055 -(2)
Employers Reinsurance Corporation ....................... 23,955 9,731 A
Swiss Reinsurance America Corporation ................... 22,640 52 A+
Odyssey America Reinsurance Corporation ................. 3,958 5,489 A
GE Reinsurance Corporation .............................. 3,605 (27) A
--------------- -------------------
Top five reinsurers .................................. $ 79,713 $ 45,300
=============== ===================
All reinsurers ....................................... $ 87,945 $ 51,187
=============== ===================
Percentage of total represented by top five reinsurers .. 91% 88%
- ---------------------------------------------------------
(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, 2004.
(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, 2004, Chandler Insurance had cash and
investments with a fair value of $28.6 million deposited in a trust
account for the benefit of NAICO.
OTHER
See Note 11 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 $853,000 and $1,037,000 at December 31, 2003 and 2004,
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 $2,451,000 and $2,812,000 at December 31, 2003 and 2004,
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 of such assessments.
PAGE F-22
At December 31, 2004, Chandler USA's subsidiaries were committed under
noncancellable operating leases for certain equipment and office space. Rental
payments under these leases for continuing operations were $1,086,000, $919,000
and $825,000 in 2002, 2003 and 2004, respectively. Future minimum lease
payments are as follows:
(In thousands)
2005 .......................... $ 688
2006 .......................... 500
2007 .......................... 82
2008 .......................... 11
--------------
$ 1,281
==============
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 5.25% at December 31, 2004. 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 13. 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 12 to Consolidated Financial Statements for additional information. The
bank that participated in the sale and leaseback transaction has 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 L&W. Chandler USA paid a fee of $5,000 during 2004 to the bank for
issuing the letter of credit. See Note 4 to Consolidated Financial Statements
for additional information. 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 $255,000, $336,000 and $353,000 in expenses associated with this
property during 2002, 2003 and 2004, respectively, including $18,000, $12,000
and $14,000 for reimbursement of certain expenses, such as utility and similar
expenses, for the years 2002, 2003 and 2004, 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,
2003 and 2004, Chandler USA had a receivable of $9.6 million and $10.9 million,
respectively, under the Credit Agreement, and Chandler USA earned $380,000,
$412,000 and $439,000 in interest income under the Credit Agreement during
2002, 2003 and 2004, respectively.
Chandler USA believes that all transactions with directors, officers or
shareholders of Chandler USA and its subsidiaries are and will continue to be
on terms no less favorable to Chandler USA and its subsidiaries than could be
obtained from unaffiliated parties.
PAGE F-23
NOTE 14. SEGMENT INFORMATION
Chandler USA has one reportable operating segment for property and
casualty insurance. In December 2002, Chandler USA sold L&W, which had
previously been reported as Chandler USA's agency segment. The agency segment
and certain items related to L&W have been restated and reported as
discontinued operations for all periods presented.
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 53%, 51%
and 51% of gross written premiums in 2002, 2003 and 2004, respectively, while
Texas accounted for approximately 37%, 36% and 37% 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 2002 2003 2004
- ---------------------------------------------------- ---------- ---------- ----------
(In thousands)
NET PREMIUMS EARNED
Standard property and casualty ..................... $ 49,570 $ 45,521 $ 54,278
Political subdivisions ............................. 13,829 8,093 7,269
Surety bonds ....................................... 3,310 2,724 1,993
Other (1) .......................................... 248 245 502
---------- ---------- ----------
$ 66,957 $ 56,583 $ 64,042
========== ========== ==========
LOSSES AND LOSS ADJUSTMENT EXPENSES
Standard property and casualty ..................... $ 40,194 $ 29,650 $ 42,901
Political subdivisions ............................. 7,726 5,722 7,122
Surety bonds ....................................... 1,967 911 2,677
Other (1) .......................................... 825 917 1,081
---------- ---------- ----------
$ 50,712 $ 37,200 $ 53,781
========== ========== ==========
- --------------------------------------
(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 15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
A summary of the unaudited quarterly operating results during 2003 and
2004 follows:
First Second Third Fourth Total
quarter quarter quarter quarter year
--------- --------- --------- --------- ---------
2003
- --------------------------------------------
Net premiums earned ........................ $ 14,537 $ 14,421 $ 14,145 $ 13,480 $ 56,583
Investment income, net ..................... 596 662 625 677 2,560
Realized investment gains, net ............. 151 1,787 413 - 2,351
Income (loss) before income taxes .......... (311) 3,389 470 (1,382) 2,166
Net income (loss) .......................... (223) 2,791 398 (992) 1,974
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)
During the second quarter of 2003, realized investment gains 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. Chandler USA
recorded other income of $2.2 million and $879,000 in the second quarter and
fourth quarter of 2003, respectively, related to the purchase and cancellation
of Debentures.
* * * * * * *
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, 2003 and
2004, 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, 2004. 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, 2003 and 2004, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 2004 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 11, 2005
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, 2004
(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 .......... $ 31,884 $ 31,824 $ 31,824
Corporate obligations ........................... 29,756 29,515 29,515
Public utilities ................................ 7,603 7,586 7,586
Mortgage-backed securities ...................... 2,814 2,745 2,745
------------ ------------ ---------------
72,057 71,670 71,670
EQUITY SECURITIES AVAILABLE FOR SALE:
Corporate stock ................................. 8,058 8,373 8,373
------------ ------------ ---------------
Total investments ............................. $ 80,115 $ 80,043 $ 80,043
============ ============ ===============
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,
---------------------
2003 2004
---------- ----------
ASSETS
Cash ............................................................ $ 495 $ 64
Premiums receivable ............................................. 9 7
Amounts due from subsidiaries ................................... 1,437 1,276
Property and equipment, net ..................................... 1,057 981
Amounts due from related parties ................................ 9,642 10,891
Other assets .................................................... 3,610 4,479
Investment in subsidiaries, net ................................. 57,536 48,381
---------- ----------
Total assets .................................................... $ 73,786 $ 66,079
========== ==========
LIABILITIES AND SHAREHOLDER'S EQUITY
Liabilities
Accrued taxes and other payables .............................. $ 2,073 $ 2,288
Debentures .................................................... 7,254 6,979
Junior subordinated debentures issued to affiliated trusts .... 20,620 20,620
---------- ----------
Total liabilities ............................................... 29,947 29,887
---------- ----------
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 ........................................... (17,342) (24,346)
Accumulated other comprehensive income (loss):
Unrealized gain (loss) on investments held by subsidiary
and available for sale, net of deferred income taxes ........ 595 (48)
---------- ----------
Total shareholder's equity ...................................... 43,839 36,192
---------- ----------
Total liabilities and shareholder's equity ...................... $ 73,786 $ 66,079
========== ==========
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,
--------------------------------
2002 2003 2004
---------- ---------- ----------
Revenues
Investment income, net ........................................... $ 7 $ 34 $ 2
Interest income, net from related parties ........................ 380 436 491
Other income ..................................................... 765 5,600 1,370
---------- ---------- ----------
Total revenues ................................................... 1,152 6,070 1,863
---------- ---------- ----------
Operating costs and expenses
General and administrative expenses .............................. 3,529 3,175 2,505
Interest expense ................................................. 2,213 2,447 2,385
---------- ---------- ----------
Total operating costs and expenses ............................. 5,742 5,622 4,890
---------- ---------- ----------
Income (loss) from continuing operations before income tax benefit .. (4,590) 448 (3,027)
Federal income tax benefit .......................................... 1,729 509 1,137
---------- ---------- ----------
Net income (loss) from continuing operations before equity
in net income (loss) of subsidiaries .............................. (2,861) 957 (1,890)
Equity in net income (loss) of subsidiaries ......................... 133 1,017 (5,114)
---------- ---------- ----------
Net income (loss) from continuing operations ........................ (2,728) 1,974 (7,004)
Loss from discontinued operations ................................... (34) - -
Gain on sale of subsidiary .......................................... 671 - -
---------- ---------- ----------
Net income (loss) ................................................... $ (2,091) $ 1,974 $ (7,004)
========== ========== ==========
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,
--------------------------------
2002 2003 2004
---------- ---------- ----------
Operating activities
Net income (loss) .............................................. $ (2,091) $ 1,974 $ (7,004)
Add (deduct):
Adjustments to reconcile net income (loss) to cash
applied to operating activities:
Net (income) loss of subsidiaries not distributed to parent .. (133) (1,017) 5,114
Net gains on sale of property and equipment .................. (12) (1,661) (371)
Gain on sale of subsidiary ................................... (671) - -
Gain on retirement of debentures ............................. - (3,106) (36)
Amortization and depreciation ................................ 222 221 205
Net change in non-cash balances relating to
operating activities:
Premiums receivable ........................................ 2,778 970 2
Amounts due from subsidiaries .............................. 314 325 161
Other assets ............................................... 1,428 1,020 (922)
Accrued taxes and other payables ........................... (692) (334) 581
Premiums payable ........................................... (3,200) (2,328) -
---------- ---------- ----------
Cash applied to operating activities ......................... (2,057) (3,936) (2,270)
---------- ---------- ----------
Investing activities
Cost of property and equipment purchased ....................... (103) (471) (154)
Proceeds from sale of property and equipment ................... 57 100 86
Proceeds from sale of subsidiary ............................... 3,247 - -
Investment in subsidiary ....................................... (2) (5,620) -
---------- ---------- ----------
Cash provided by (applied to) investing activities ........... 3,199 (5,991) (68)
---------- ---------- ----------
Financing activities
Shareholder dividend from subsidiaries ......................... 3,915 - 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 ........................ 3,249 2,426 4,602
Payments and loans to related parties .......................... (5,951) (1,486) (5,851)
---------- ---------- ----------
Cash provided by financing activities ........................ 1,213 8,067 1,907
---------- ---------- ----------
Increase (decrease) in cash and cash equivalents ................. 2,355 (1,860) (431)
Cash and cash equivalents at beginning of year ................... - 2,355 495
---------- ---------- ----------
Cash and cash equivalents at end of year ......................... $ 2,355 $ 495 $ 64
========== ========== ==========
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
----------- --------- -------- ---------- --------- --------- ---------- ----------- --------- --------
YEAR ENDED
DECEMBER 31, 2002
Property and casualty .. $ 355 $ 92,606 $ 55,160 $ 4,244 $ 66,957 $ 2,920 $ 50,712 $ 10,239 $ 14,707 $ 67,667
=========== ========= ======== ========== ========= ========= ========== =========== ========= ========
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
=========== ========= ======== ========== ========= ========= ========== =========== ========= ========
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, 2002
Property and casualty ........... $ 139,876 $ (72,495) $ 286 $ 67,667 0.42%
============ ============ ============ ============ ============
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%
============ ============ ============ ============ ============
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:
2002 ............................................ $ 298 $ 444 $ (496) $ 246
================ ================ ================ ===============
2003 ............................................ $ 246 $ 272 $ (385) $ 133
================ ================ ================ ===============
2004 ............................................ $ 133 $ 42 $ (56) $ 119
================ ================ ================ ===============
Allowance for non-collection of reinsurance
recoverables on paid and unpaid losses:
2002 ............................................ $ 1,096 $ 1,726 $ (55) $ 2,767
================ ================ ================ ===============
2003 ............................................ $ 2,767 $ 604 $ (57) $ 3,314
================ ================ ================ ===============
2004 ............................................ $ 3,314 $ 282 $ (324) $ 3,272
================ ================ ================ ===============
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, 2002
Property-casualty .......................... $ - $ 50,333
=============== ===============
Year ended December 31, 2003
Property-casualty .......................... $ - $ 41,048
=============== ===============
Year ended December 31, 2004
Property-casualty .......................... $ - $ 38,429
=============== ===============
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.