-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, NObown7INDLqmfj/R16NU6d3h24ViT1+d8ugy7zK57qn4Qz0v14wh3gxAzuTV6fO 27YEaW1/DMR2WX45H7ONIw== 0001083750-03-000010.txt : 20030318 0001083750-03-000010.hdr.sgml : 20030318 20030318165519 ACCESSION NUMBER: 0001083750-03-000010 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20021231 FILED AS OF DATE: 20030318 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CHANDLER USA INC CENTRAL INDEX KEY: 0001083750 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 731325906 STATE OF INCORPORATION: OK FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-15135 FILM NUMBER: 03608042 BUSINESS ADDRESS: STREET 1: 1010 MANVEL AVE CITY: CHANDLER STATE: OK ZIP: 74834 BUSINESS PHONE: 4052580804 MAIL ADDRESS: STREET 1: 1010 MANVEL AVE CITY: CHANDLER STATE: OK ZIP: 74834 10-K 1 edg10k03fnl.txt CUSA 10-K 12/31/2002 =============================================================================== 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, 2002 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 ----------------------------------- ----------------------------------------- $24,000,000 8.75% SENIOR DEBENTURES 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, 2002 and February 28, 2003: None. The number of common shares, $1.00 par value, of the registrant outstanding on February 28, 2003 was 2,484, which are owned by Chandler Insurance (Barbados), Ltd., a wholly owned subsidiary of 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. =============================================================================== 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 maintain favorable insurance company ratings; and (x) 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 (Barbados), Ltd. ("Chandler Barbados"), which, in turn, 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 175 at December 31, 2002, 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. On December 20, 2002, Chandler USA completed the sale of its wholly owned subsidiary, LaGere & Walkingstick Insurance Agency, Inc. ("L&W"), to Brown & Brown, Inc. for $3,247,000 in cash and a $361,000 note receivable. Chandler USA recorded an after-tax gain of $671,000 on the sale based on the minimum purchase price for the transaction. This amount may be increased over the next three years depending on certain adjustments as defined in the terms of the transaction. The transaction was effective December 1, 2002. L&W is expected to continue to be a significant producer of business for NAICO. Retail business produced by L&W and placed with NAICO constituted approximately 8% of NAICO's direct premiums written and assumed in 2002. Chandler USA will maintain certain wholesale operations related to NAICO's school districts and trucking programs through CIMI, an underwriting manager that was established in December 2002. 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. Chandler Barbados is a Barbados company and a wholly owned subsidiary of Chandler Insurance that reinsures risks underwritten by NAICO. NAICO retains a portion of each risk, then transfers the balance to reinsurance companies including Chandler Barbados. Chandler Insurance reinsures Chandler Barbados for a portion of the risk that it assumes from NAICO. PAGE 2 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. STANDARD PROPERTY AND CASUALTY PROGRAM NAICO offers workers compensation, automobile liability and physical damage, general 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, 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, 2002, NAICO insured 444 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, NAICO significantly reduced its premium writings in this portion of the program. 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. Individual bonds generally do not exceed $3.5 million, and an individual contractor generally does not have "work in progress" for both bonded and unbonded jobs in excess of $7 million. A substantial portion of this business is written in Texas and Oklahoma. NAICO also writes bail bonds, which guarantee that the principal will discharge obligations set by the court, as well as other types of miscellaneous bonds. NAICO has reduced the underwriting authority for the bail bond program for 2003, and expects to discontinue the bail bond program by the end of 2003. The following table shows gross premiums earned and net premiums earned by insurance program for the years 2000, 2001 and 2002. 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 2000 2001 2002 2000 2001 2002 - ------------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Standard property and casualty ...... $139,051 $128,554 $106,051 $ 62,823 $ 53,130 $ 49,570 Political subdivisions .............. 34,353 34,178 35,159 12,826 12,534 13,829 Surety bonds ........................ 13,691 8,796 5,104 6,467 4,125 3,310 Other (1) ........................... 3,672 71 249 3,403 196 248 -------- -------- -------- -------- -------- -------- TOTAL ............................... $190,767 $171,599 $146,563 $ 85,519 $ 69,985 $ 66,957 ======== ======== ======== ======== ======== ======== - ------------------------------ (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, surety, accident and health, automobile physical damage, property, inland marine and other liability lines, which include general and professional liability lines. 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, -------------------------------------------- 1998 1999 2000 2001 2002 -------- -------- -------- -------- -------- Automobile liability .................. 22% 17% 20% 19% 25% Other liability ....................... 22% 19% 25% 25% 25% Workers compensation .................. 19% 34% 25% 24% 22% Automobile physical damage ............ 9% 8% 13% 17% 14% Property .............................. 4% 3% 4% 7% 8% Surety ................................ 14% 9% 8% 6% 5% Inland marine ......................... 1% 1% 1% 2% 1% Accident and health ................... 9% 9% 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 has maintained a continuous contractual relationship with an underwriting manager for its bail bond program. During 2000, 2001 and 2002, the gross written premiums in this program were $2.5 million, $2.3 million and $2.3 million, respectively. This underwriting manager operates through a network of bail bond agents who submit applications to the underwriting manager. If the application meets the specific guidelines set by the underwriting manager, a bail bond is issued. This underwriting manager is an independent contractor and is responsible for collection of all premiums and payment of all commissions to bail bond agents. Additionally, it is responsible for all claims and recoveries and is required to maintain collateral security for each bond. NAICO's claim 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 claim 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, April 1 or July 1 of each year. NAICO renewed all January 1, 2003 reinsurance programs. At the present time, NAICO expects to renew the reinsurance programs that renew on April 1 or July 1, 2003, as applicable. PAGE 4 NAICO has structured separate reinsurance programs for construction surety bonds, property (including inland marine), workers compensation, casualty (including automobile liability, general liability, umbrella liability and related professional liability), and automobile physical damage. Chandler Barbados reinsures NAICO for a portion of the risk on NAICO's construction surety bonds, workers compensation and casualty reinsurance programs. A portion of the risk that Chandler Barbados assumes from NAICO is reinsured by Chandler Insurance. Under the 2000 workers compensation reinsurance program, NAICO's net retention was 42.5% of the first $10,000 of loss per occurrence plus 37.5% of $90,000 excess of $10,000 of loss per occurrence. Effective October 1, 2000, NAICO purchased quota share reinsurance which reduced NAICO's net retention to 34% of the first $10,000 of loss per occurrence plus 30% of $90,000 excess of $10,000 of loss per occurrence. Effective July 1, 2001, NAICO added 28% of the $100,000 excess of $100,000 of loss per occurrence layer to its net retention. Effective January 1, 2002, NAICO's net retention increased to 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. Under the 2000 casualty reinsurance program, NAICO retained 80% of the first $100,000 of loss per occurrence. Effective October 1, 2000, NAICO purchased quota share reinsurance which reduced NAICO's net retention to 64% of the first $100,000 of loss per occurrence. Effective July 1, 2001, NAICO's net retention increased to 64% of the first $100,000 of loss per occurrence plus 60% of $150,000 excess of $100,000 of loss per occurrence plus 40% of $250,000 excess of $250,000 of loss per occurrence. Effective January 1, 2002, NAICO's net retention increased to 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 increased to 80% of the first $250,000 of loss per occurrence. Under the construction surety bond reinsurance program, NAICO's net retention was 50% of the first $250,000 plus 5% of $6,000,000 excess of $4,000,000 per principal (e.g., contractor) during 2000. Effective April 1, 2001, NAICO's net retention increased to 50% of the first $350,000 plus 5% of $6,000,000 excess of $4,000,000 per principal. Effective April 1, 2002, NAICO's net retention increased to 50% of the first $1,000,000 plus 10% of $4,000,000 excess of $1,000,000 per principal. Under the 2000 property reinsurance program, NAICO retained 30% of the first $500,000 of risk for each loss per risk or location. Effective January 1, 2001, NAICO retains 33% of the first $1,500,000 of risk for each loss per risk or location. 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 is purchased primarily from Lloyd's of London. Under its 2000 automobile physical damage reinsurance program, NAICO retained the first $250,000 of loss per occurrence, plus 5% of amounts exceeding $250,000 of loss per occurrence up to $1 million of loss per occurrence. Effective January 1, 2001, NAICO retains the first $500,000 of loss per occurrence, plus 5% of amounts exceeding $500,000 of loss per occurrence up to $1 million of loss per occurrence. NAICO has also purchased reinsurance which limits its net retained loss for both automobile physical damage and property losses to $1,000,000 for each loss occurrence. 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. 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 immediately 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 1% for losses occurring in 2002, to 7% in 2003, 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 2002 and 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. Effective January 1, 2003, NAICO purchased quota share reinsurance for its deductible under the Act limiting NAICO's retention to 10% of such deductible subject to a reinsurance limit of $9,450,000 for each loss occurrence. The reinsurance coverage is also limited to $9,450,000 for all 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 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, 2002.
CEDED REINSURANCE NET PREMIUMS FOR A.M. BEST REINSURANCE THE YEAR ENDED COMPANY NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2002 RATING - ----------------------------------------------------------- --------------- ----------------- --------- (Dollars in thousands) Swiss Reinsurance America Corporation ..................... $ 34,661 $ 10,264 A++ Chandler Barbados ......................................... 17,798 24,115 -(2) GE Reinsurance Corporation ................................ 11,090 1,958 A+ Employers Reinsurance Corporation ......................... 6,869 10,151 A+ Red River Reinsurance, Ltd. ............................... 5,798 5,674 -(3) --------------- ----------------- Top five reinsurers .................................. $ 76,216 $ 52,162 =============== ================= All reinsurers ....................................... $ 98,575 $ 72,495 =============== ================= Percentage of total represented by top five reinsurers .... 77% 72% - ------------------------------------------------------------- (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, 2002. (2) Chandler Barbados owns 100% of the common stock of Chandler USA, which in turn owns 100% of the common stock of NAICO. Although Chandler Barbados 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, 2002, Chandler Barbados had cash and investments with a fair value of $18.7 million deposited in a trust account for the benefit of NAICO. (3) Red River Reinsurance, Ltd. ("Red River") is required to secure its reinsurance obligations by depositing acceptable securities in trust for NAICO's benefit. At December 31, 2002, Red River's reinsurance recoverables were collateralized by cash and investments with a fair value of $5.9 million deposited in a trust account for the benefit of NAICO and by premiums payable to Red River of approximately $766,000.
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. Transamerica owed NAICO approximately $1.5 million for reinsurance recoverables on paid losses and loss adjustment expenses as of December 31, 2002. NAICO is currently engaged in arbitration in order to enforce the terms of the reinsurance treaties. Reliance Insurance Company ("Reliance") reinsured NAICO for certain workers compensation risks during 1998. At December 31, 2002, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses of approximately $2.8 million. During October 2001, the Commonwealth of Pennsylvania placed Reliance in liquidation. At this time, 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, 2002. 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 did not incur any charges for uncollectible reinsurance recoverables from unaffiliated reinsurers in 2000. During 2001 and 2002, NAICO incurred charges of $454,000 and $1.7 million, 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, -------------------------------------------- 1998 1999 2000 2001 2002 -------- -------- -------- -------- -------- (Dollars in thousands) Automobile liability: Net premiums earned ................ $ 11,419 $ 15,027 $ 17,517 $ 13,386 $ 16,526 Loss ratio ......................... 75% 78% 78% 70% 81% Other liability: Net premiums earned ................ $ 11,357 $ 15,785 $ 20,992 $ 17,470 $ 16,458 Loss ratio ......................... 66% 70% 56% 57% 80% Workers compensation (1): Net premiums earned ................ $ 9,937 $ 29,244 $ 21,161 $ 16,449 $ 14,808 Loss ratio ......................... 66% 77% 70% 105% 99% Automobile physical damage: Net premiums earned ................ $ 4,702 $ 7,039 $ 11,434 $ 12,174 $ 9,552 Loss ratio ......................... 86% 104% 85% 52% 35% Property: Net premiums earned ................ $ 2,332 $ 2,972 $ 3,377 $ 4,806 $ 5,543 Loss ratio ......................... 136% 203% 179% 93% 50% Surety: Net premiums earned ................ $ 7,619 $ 8,061 $ 6,760 $ 4,125 $ 3,310 Loss ratio ......................... 18% 6% 33% 57% 59% Inland marine: Net premiums earned ................ $ 448 $ 775 $ 1,088 $ 1,256 $ 760 Loss ratio ......................... 126% 138% 142% 143% 100% Accident and health: Net premiums earned ................ $ 4,610 $ 8,195 $ 3,190 $ 319 $ - Loss ratio ......................... 91% 104% 161% 281% -% Total (1): Net premiums earned ................ $ 52,424 $ 87,098 $ 85,519 $ 69,985 $ 66,957 Loss ratio ......................... 69% 79% 76% 75% 76% Underwriting expense ratio (2) ..... 33% 32% 30% 33% 34% -------- -------- -------- -------- -------- Combined ratio (2) ................. 102% 111% 106% 108% 110% ======== ======== ======== ======== ======== - ----------------------------------------- (1) The rescission of two reinsurance treaties during 1999 increased net premiums earned for workers compensation by $19.6 million and increased the workers compensation loss ratio by 20 percentage points. The rescission of the reinsurance treaties also increased the total 1999 loss ratio by 2 percentage points and the 1999 combined ratio by 4 percentage points. (2) Interest expense and litigation expenses are not considered underwriting expenses; therefore, such costs have been excluded from these ratios.
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. 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. 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 $5.0 million and $5.6 million at December 31, 2001 and 2002, 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. In addition, NAICO receives direct assignments to write workers compensation for such insureds in lieu of participating in the pools. The consolidated financial statements reflect the reserves for unpaid losses and loss adjustment expenses and net premiums earned from its participation in the pools and from these direct assignments. 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, ------------------------------------------------- 1998 1999 2000 2001 2002 --------- --------- --------- --------- --------- (In thousands) Net balance before provision for uncollectible reinsurance at beginning of year ............ $ 53,345 $ 39,570 $ 51,123 $ 46,588 $ 32,743 --------- --------- --------- --------- --------- Net losses and loss adjustment expenses incurred related to: Current year .............................. 34,313 65,139 60,020 39,881 34,928 Prior years ............................... 1,737 3,520 4,979 12,669 15,784 --------- --------- --------- --------- --------- Total ................................... 36,050 68,659 64,999 52,550 50,712 --------- --------- --------- --------- --------- Net paid losses and loss adjustment expenses related to: Current year .............................. (19,495) (33,210) (33,525) (22,596) (13,246) Prior years ............................... (30,330) (23,896) (36,009) (43,799) (37,050) --------- --------- --------- --------- --------- Total .................................. (49,825) (57,106) (69,534) (66,395) (50,296) --------- --------- --------- --------- --------- Net balance before provision for uncollectible reinsurance at end of year .................. 39,570 51,123 46,588 32,743 33,159 Adjustments to reinsurance recoverables on unpaid losses for uncollectible reinsurance.. 351 255 119 69 32 --------- --------- --------- --------- --------- Net balance at end of year ................... $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 ========= ========= ========= ========= =========
During 2001, NAICO experienced adverse loss development related to prior accident years 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 the discontinued group accident and health program. During 2002, NAICO experienced adverse loss development related to prior accident years totaling $15.8 million primarily in the standard property and casualty program including both liability lines and workers compensation. This adverse development is generally the result of ongoing analysis of recent loss development trends that reflect an increase in loss severity within the 1997-2000 accident years. The adverse loss development included approximately $2.0 million for provisions for potentially uncollectible reinsurance and deductibles. The following table represents the development of net balance sheet reserves for 1993 through 2002. The top line of the table shows the net reserves at the balance sheet date for each of the indicated years. This represents the estimated amounts of claims and claim expenses, net of reinsurance deductions, arising in the current and all prior years that are unpaid at the balance sheet date, including the net reserve for incurred but not reported claims. The upper portion of the table shows the cumulative net amounts paid as of successive years with respect to that reserve liability. The estimate for unpaid losses and loss adjustment expenses changes as more information becomes known about the frequency and severity of claims for individual years. The next portion of the table shows the revised estimated amount of the previously recorded net reserve based on experience as of the end of each succeeding year. The heading "net cumulative (deficiency) redundancy" represents the cumulative aggregate change in the estimates over all prior years. The last portion of the table provides a reconciliation of the net amounts to the gross amounts before any deductions for reinsurance. The gross cumulative deficiency or redundancy results from the same factors as those described above for the net amounts, and is also impacted by development of large claims that exceed NAICO's net retention including umbrella and surety per principal losses where NAICO has little or no net retention. PAGE 9 In evaluating the information in the following table, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For example, the amount of the deficiency recorded in 1996 for claims that occurred in 1993 will be included in the cumulative deficiency amount for years 1993, 1994, 1995 and 1996. 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, --------------------------------------------------------------------------------------------------- 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- (In thousands) Net reserve for unpaid losses and loss adjustment expenses (1) .. $ 51,648 $ 64,308 $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 Net paid (cumulative) as of One year later ................ 26,469 30,771 31,768 28,572 30,330 23,896 36,009 43,799 37,050 Two years later ............... 38,655 45,321 44,471 40,857 42,934 34,966 58,979 66,141 Three years later ............. 45,357 51,985 49,262 45,668 49,735 45,390 72,052 Four years later .............. 48,385 54,825 51,101 47,995 56,306 51,364 Five years later .............. 49,116 55,691 52,126 50,700 58,843 Six years later ............... 49,399 56,278 54,040 51,878 Seven years later ............. 49,681 57,826 54,574 Eight years later ............. 50,291 58,378 Nine years later .............. 50,403 Net liability re-estimated as of (1) One year later ................ 52,058 62,757 59,644 55,713 55,772 43,441 56,357 59,376 48,596 Two years later ............... 50,135 61,924 59,605 55,599 56,362 45,373 67,469 74,325 Three years later ............. 50,492 62,737 59,155 54,528 58,176 50,146 77,842 Four years later .............. 51,022 62,636 58,247 54,834 61,096 55,303 Five years later .............. 50,981 62,195 58,445 55,615 62,750 Six years later ............... 50,954 62,295 58,567 56,347 Seven years later ............. 50,832 62,630 59,013 Eight years later ............. 50,932 63,026 Nine years later .............. 50,987 Net cumulative (deficiency) redundancy .................... $ 661 $ 1,282 $ (673) $ (2,502) $ (8,715) $(15,382) $(26,464) $(27,618) $(15,784) $ - Supplemental gross data: Gross liability after reclassification of pools - end of year ................. $167,187 $143,437 $116,149 $ 78,114 $ 73,721 $ 80,701 $ 98,460 $100,173 $ 84,756 $ 92,606 Reclassification of pool liabilities ................. (15,694) - - - - - - - - - --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Gross liability before reclassification of pools - end of year (1) ............. $151,493 $143,437 $116,149 $ 78,114 $ 73,721 $ 80,701 $ 98,460 $100,173 $ 84,756 $ 92,606 Reinsurance recoverable ....... 99,845 79,129 57,809 24,269 19,686 40,780 47,082 53,466 51,944 59,415 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Net liability - end of year (1) .................... $ 51,648 $ 64,308 $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 ========= ========= ========= ========= ========= ========= ========= ========= ========= ========= Gross re-estimated liability - latest .......... $149,556 $144,029 $121,140 $ 94,216 $ 96,020 $117,529 $159,378 $179,078 $145,968 Re-estimated recoverable - latest ...................... 98,569 81,003 62,127 37,869 33,270 62,226 81,536 104,753 97,372 --------- --------- --------- --------- --------- --------- --------- --------- --------- Net re-estimated liability - latest (1) .................. $ 50,987 $ 63,026 $ 59,013 $ 56,347 $ 62,750 $ 55,303 $ 77,842 $ 74,325 $ 48,596 ========= ========= ========= ========= ========= ========= ========= ========= ========= Gross cumulative (deficiency) redundancy .................. $ 1,937 $ (592) $ (4,991) $(16,102) $(22,299) $(36,828) $(60,918) $(78,905) $(61,212) ========= ========= ========= ========= ========= ========= ========= ========= ========= - -------------------------------------------------- (1) The December 31, 1993 amounts do not include the reclassification of pool liabilities.
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. Fixed-maturity 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 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. Securities not classified as held to maturity or trading 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 investment securities below their carrying value that are other than temporary are recognized in earnings. As of December 31, 2002, all of the investments of NAICO were in fixed-maturity investments (rated Aa3 or AA or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), interest-bearing money market accounts, a collateralized repurchase agreement and common stock received in connection with two unaffiliated entities' conversion to for-profit corporations. 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 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. 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. EMPLOYEES AND ADMINISTRATION At December 31, 2002, Chandler USA and its subsidiaries had approximately 336 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. 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. Since the late 1980's, the industry has generally had excess underwriting capacity. This condition resulted in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO continues to experience competition, however, NAICO was able to increase its pricing for most coverages during 2001 and 2002, which has generally been the trend industry wide. 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 11 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, Chandler Barbados 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 12 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, 2002, NAICO had statutory earned surplus of $11.4 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2003 without the approval of the Oklahoma Department of Insurance is $4.4 million. NAICO paid shareholder dividends totaling $7.0 million and $3.5 million to Chandler USA in 2001 and 2002, respectively. The Oklahoma Department of Insurance approved the payment of the extraordinary dividend by NAICO to Chandler USA in 2001. 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 13 (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 6.6:1 and 5.8:1 at December 31, 2001 and 2002, 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 five 2002 ratios that were outside of the "usual values," four of which resulted primarily from adverse loss development as explained below. NAICO's "two-year overall operating ratio" for 2002 was 102% compared to a usual value of less than 100%. Factors that contributed to NAICO's ratio include a decrease in the ratio of investment income to net premiums earned due primarily to lower interest rates experienced during 2002, and to adverse loss development recorded during 2001 and 2002 for accident years prior to 2001. Excluding this loss development, the two-year overall operating ratio would have been 81% for 2002. NAICO's "investment yield" as calculated using the IRIS formula was 2.1% during 2002 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), and NAICO holds only a small investment in equity securities. NAICO's investment yield is largely dependent upon prevailing levels of interest rates. The significant decline in interest rates during 2001 and 2002 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. Included in NAICO's investments, under statutory accounting principles, is real estate occupied by the company of $7,708,000 at December 31, 2002. In accordance with statutory accounting principles, NAICO records investment income for its occupancy of the company owned real estate, and corresponding charges for rental expense and other real estate related expenses are recorded as a reduction of investment income. NAICO also incurred $244,000 in investment expenses to subsidize a premium finance program for certain insureds of NAICO during 2002. While these expenses reduced NAICO's investment yield, the premium finance program enhances cash flow by providing cash that is available for investment earlier than conventional deferred payment plans. NAICO's investment yield excluding the investment income and expenses related to the real estate and investment expenses to subsidize the premium finance program was 4.0% during 2002. NAICO's "one-year reserve development to policyholders' surplus" and "two-year reserve development to policyholders' surplus" for 2002 were 30% and 53%, respectively, compared to usual values of less than 20% for both ratios. The primary reason for these unusual values was adverse loss development experienced during 2001 and 2002 related to the 1997 - 2000 accident years. This adverse loss development was due primarily to increased loss severity in NAICO's 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 recoverables and deductibles of $888,000 and $1,926,000 during 2001 and 2002, respectively. Statutory accounting requires that these write-downs of receivables and recoverables be reflected as prior year loss development. Adverse loss development in NAICO's discontinued group accident and health program was $900,000 and $522,000 during 2001 and 2002, respectively. This program was discontinued during 2000 due to poor underwriting results. PAGE 14 NAICO's "estimated current reserve deficiency to policyholders' surplus" was 40% at December 31, 2002 compared to a usual value of less than 25%. The adverse loss development experienced in 2001 and 2002 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. Despite the growth in written premiums, pricing competition and expansion of coverages was prevalent throughout the industry, resulting in a much lower premium for the exposures insured. At the same time, claim costs, especially medical, increased at a much faster pace. Now that the results have shown how underpriced the business was during this time, NAICO has re-priced and re-underwritten this business. During 2001 and 2002, NAICO implemented substantial price increases on every line of business that it writes, and reduced the overall written premiums to $159 million and $140 million in 2001 and 2002, respectively. Further, NAICO exited some classes of business and non-renewed accounts with severity and/or frequency exposure. 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's subsidiaries also lease approximately 1,500 square feet in the aggregate for its branch offices. Chandler USA believes such space is sufficient for its operations for the foreseeable future. ITEM 3. LEGAL PROCEEDINGS Chandler Insurance and certain of its subsidiaries and affiliates, including Chandler USA, are involved in litigation with their director and officer liability insurer. See Note 10 to Consolidated Financial Statements for a discussion of this and other 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, 2002. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK 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 Barbados, which is a wholly owned subsidiary of 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 14(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 years 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 and 2002 and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for the years ended December 31, 2001 and 2002 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 14(a). All periods have been restated to reflect the results of L&W as a discontinued operation. PAGE 15 ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
YEAR ENDED DECEMBER 31, ------------------------------------------------------ 1998 1999 2000 2001 2002 ---------- ---------- ---------- ---------- ---------- OPERATING DATA (1) (Dollars in thousands) Revenues Direct premiums written and assumed ............. $ 134,293 $ 169,569 $ 197,196 $ 158,964 $ 140,162 ========== ========== ========== ========== ========== Net premiums earned ............................. $ 52,424 $ 87,098 $ 85,519 $ 69,985 $ 66,957 Interest income, net ............................ 4,849 3,927 4,281 3,632 2,540 Interest income, net from related parties ....... - - - 371 380 Realized investment gains, net .................. 1,036 57 144 2,654 794 Fee for rescinded reinsurance treaties .......... - 10,000 - - - Other income .................................... 278 164 301 101 261 ---------- ---------- ---------- ---------- ---------- Total revenues .................................... 58,587 101,246 90,245 76,743 70,932 ---------- ---------- ---------- ---------- ---------- Operating expenses Losses and loss adjustment expenses ............. 36,050 68,659 64,999 52,550 50,712 Policy acquisition costs ........................ 10,673 21,195 16,882 10,869 10,239 General and administrative expenses ............. 9,474 9,126 10,557 11,549 12,473 Interest expense ................................ 885 1,494 2,255 2,240 2,234 ---------- ---------- ---------- ---------- ---------- Total operating expenses .......................... 57,082 100,474 94,693 77,208 75,658 ---------- ---------- ---------- ---------- ---------- Income (loss) from continuing operations before income taxes .................................... 1,505 772 (4,448) (465) (4,726) Federal income tax benefit (provision) ............ (278) (326) 1,347 (16) 1,680 ---------- ---------- ---------- ---------- ---------- Income (loss) from continuing operations .......... 1,227 446 (3,101) (481) (3,046) Income (loss) from discontinued operations ........ (794) (533) (894) (622) 284 Gain on sale of subsidiary ........................ - - - - 671 ---------- ---------- ---------- ---------- ---------- Net income (loss) ................................. $ 433 $ (87) $ (3,995) $ (1,103) $ (2,091) ========== ========== ========== ========== ========== Combined loss and underwriting expense ratio (2) .. 102% 111% 106% 108% 110% BALANCE SHEET DATA Cash and investments .............................. $ 94,947 $ 93,666 $ 104,760 $ 73,378 $ 68,276 Amounts due from related parties .................. - - - 7,880 10,582 Total assets ...................................... 223,351 256,836 273,498 234,809 229,855 Unpaid losses and loss adjustment expenses ........ 80,701 98,460 100,173 84,756 92,606 Notes payable ..................................... 9,410 - - - - Amounts due to related parties .................... 12,219 533 717 - - Debentures ........................................ - 24,000 24,000 24,000 24,000 Total liabilities ................................. 174,090 210,097 228,647 191,067 186,855 Shareholder's equity .............................. 49,261 46,739 44,851 43,742 43,000 - ----------------------------------------------------- (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) Interest expense is not considered an underwriting expense and has been excluded from this ratio. The rescission of two reinsurance treaties during 1999 increased the 1999 combined loss and underwriting expense ratio by four percentage points. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
PAGE 16 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 (including both bail bonds and construction bonds). The lines of insurance written by NAICO are commercial coverages consisting of automobile liability, workers compensation, surety, automobile physical damage, property, inland marine and other liability lines, which include general and professional liability lines. CIMI maintains certain wholesale operations related to NAICO's school districts and trucking programs. Many factors determine the profitability of an insurance company including regulation and rate competition; the frequency and severity of claims; the cost, availability and collectibility of reinsurance; interest rates; inflation; general business conditions; and jury awards, court decisions and legislation expanding the extent of coverage and the amount of compensation due for injuries and losses. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with GAAP requires the application of accounting policies that often involve a significant degree of judgment. Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods. If management determines, as a result of its consideration of facts and circumstances, that changes in estimates and assumptions are appropriate, results of operations and financial position as reported in the consolidated financial statements may change significantly. Management has identified the following accounting policies as critical in understanding Chandler USA's reported financial results: RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES Insurance companies provide in their financial statements reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under their previously issued insurance policies and reinsurance contracts. In estimating reserves, insurance companies use various standardized methods based on historical experience and payment and reporting patterns for the type of risk involved. The application of these methods necessarily involves subjective determinations by the personnel of the insurance company. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount of and uncertainty in the estimates is affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances, and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs, such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that expand insurance coverage after the insurance policy was priced and sold. 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. 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. PAGE 17 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. 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 $127 million, or 90%, of NAICO's direct written premiums in 2002 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 owned by NAICO. During 2002, the market value of NAICO's available for sale investments increased by $2.8 million due primarily to lower interest rates experienced during this time. 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. 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 18 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 repricing, if permitted by applicable regulations, or limitations or cessation of the affected business. 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. Since the late 1980's, the industry has generally had excess underwriting capacity. This condition resulted in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO continues to experience competition, however, NAICO was able to increase its pricing for most coverages during 2001 and 2002, which has generally been the trend industry wide. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates. DISCONTINUED OPERATIONS On December 20, 2002, Chandler USA completed the sale of its wholly owned subsidiary L&W to Brown & Brown, Inc. for $3,247,000 in cash and a $361,000 note receivable that is due on or before December 31, 2003. Chandler USA recorded an after-tax gain of $671,000 on the sale based on the minimum purchase price for the transaction, after deducting Chandler USA's goodwill related to L&W of $2,350,000, equity in L&W of $224,000 and approximately $400,000 of expenses in connection with the sale. The gain on the sale may be increased over the next three years depending on certain adjustments to the purchase price as defined in the terms of the transaction, with a maximum purchase price of $6.0 million. The transaction was effective December 1, 2002. PAGE 19 L&W is expected to continue to be a significant producer of business for NAICO. Retail business produced by L&W and placed with NAICO constituted approximately 8% of NAICO's direct premiums written and assumed in 2002. Chandler USA will maintain certain wholesale operations related to NAICO's school districts and trucking programs through CIMI, an underwriting manager that was established in December 2002. L&W previously functioned as Chandler USA's agency segment and is presented as discontinued operations. 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 deposited cash in the amount of $500,000 into a trust account for the benefit of Brown & Brown, Inc. as security. Prior to completing the sale, L&W transferred its real estate to NAICO, and transferred substantially all of its remaining assets and liabilities, primarily premiums receivable and premiums payable, to Chandler USA through a shareholder dividend. 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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- (Dollars in thousands) INSURANCE PROGRAMS - --------------------------------------------------- STANDARD PROPERTY AND CASUALTY Net premiums earned ............................. $ 62,823 $ 53,130 $ 49,570 Financial year loss ratio ....................... 76.6% 71.0% 81.1% Accident year loss ratio ........................ 77.4% 54.7% 58.9% POLITICAL SUBDIVISIONS Net premiums earned ............................. $ 12,826 $ 12,534 $ 13,829 Financial year loss ratio ....................... 80.6% 91.1% 55.9% Accident year loss ratio ........................ 98.2% 67.3% 35.5% SURETY BONDS Net premiums earned ............................. $ 6,467 $ 4,125 $ 3,310 Financial year loss ratio ....................... 35.1% 56.7% 59.4% Accident year loss ratio ........................ 14.3% 72.9% 19.2% OTHER (1) Net premiums earned ............................. $ 3,403 $ 196 $ 248 Financial year loss ratio ....................... 124.9% 555.4% 332.7% Accident year loss ratio ........................ 118.4% 107.3% 79.9% TOTAL Net premiums earned ............................. $ 85,519 $ 69,985 $ 66,957 Financial year loss ratio ....................... 76.0% 75.1% 75.7% Accident year loss ratio ........................ 77.4% 58.2% 52.2% - -------------------------------------- (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.
YEAR ENDED DECEMBER 31, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- (Dollars in thousands) LINES OF INSURANCE - --------------------------------------------------- AUTOMOBILE LIABILITY Net premiums earned ............................. $ 17,517 $ 13,386 $ 16,526 Financial year loss ratio ....................... 78.1% 70.0% 81.2% Accident year loss ratio ........................ 75.9% 60.4% 70.6% OTHER LIABILITY Net premiums earned ............................. $ 20,992 $ 17,470 $ 16,458 Financial year loss ratio ....................... 55.6% 57.4% 80.2% Accident year loss ratio ........................ 51.7% 36.3% 62.3% WORKERS COMPENSATION Net premiums earned ............................. $ 21,161 $ 16,449 $ 14,808 Financial year loss ratio ....................... 70.4% 105.4% 99.4% Accident year loss ratio ........................ 85.1% 67.7% 50.7% AUTOMOBILE PHYSICAL DAMAGE Net premiums earned ............................. $ 11,434 $ 12,174 $ 9,552 Financial year loss ratio ....................... 85.5% 52.0% 35.3% Accident year loss ratio ........................ 91.8% 48.6% 33.1% PROPERTY Net premiums earned ............................. $ 3,377 $ 4,806 $ 5,543 Financial year loss ratio ....................... 179.5% 92.8% 49.9% Accident year loss ratio ........................ 179.0% 97.4% 25.4% SURETY Net premiums earned ............................. $ 6,760 $ 4,125 $ 3,310 Financial year loss ratio ....................... 33.4% 56.7% 59.4% Accident year loss ratio ........................ 14.3% 72.9% 19.2% INLAND MARINE Net premiums earned ............................. $ 1,088 $ 1,256 $ 760 Financial year loss ratio ....................... 141.9% 143.0% 99.7% Accident year loss ratio ........................ 197.4% 122.8% 40.6% ACCIDENT AND HEALTH Net premiums earned ............................. $ 3,190 $ 319 $ - Financial year loss ratio ....................... 160.9% 281.2% -% Accident year loss ratio ........................ 121.4% -% -% TOTAL Net premiums earned ............................. $ 85,519 $ 69,985 $ 66,957 Financial year loss ratio ....................... 76.0% 75.1% 75.7% Accident year loss ratio ........................ 77.4% 58.2% 52.2%
PAGE 21 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 2000 2001 2002 2000 2001 2002 - ----------------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Standard property and casualty .......... $139,051 $128,554 $106,051 $ 62,823 $ 53,130 $ 49,570 Political subdivisions .................. 34,353 34,178 35,159 12,826 12,534 13,829 Surety bonds ............................ 13,691 8,796 5,104 6,467 4,125 3,310 Other ................................... 3,672 71 249 3,403 196 248 -------- -------- -------- -------- -------- -------- TOTAL ................................... $190,767 $171,599 $146,563 $ 85,519 $ 69,985 $ 66,957 ======== ======== ======== ======== ======== ========
GROSS PREMIUMS EARNED NET PREMIUMS EARNED -------------------------- -------------------------- LINES OF INSURANCE 2000 2001 2002 2000 2001 2002 - ----------------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Other liability ......................... $ 37,543 $ 36,166 $ 36,078 $ 20,992 $ 17,470 $ 16,458 Workers compensation .................... 61,888 57,585 41,958 21,161 16,449 14,808 Automobile liability .................... 31,427 27,237 27,143 17,517 13,386 16,526 Automobile physical damage .............. 13,224 13,516 10,745 11,434 12,174 9,552 Property ................................ 22,682 22,377 22,722 3,377 4,806 5,543 Surety .................................. 13,983 8,796 5,104 6,760 4,125 3,310 Inland marine ........................... 6,626 5,580 2,813 1,088 1,256 760 Accident and health ..................... 3,394 342 - 3,190 319 - -------- -------- -------- -------- -------- -------- TOTAL ................................... $190,767 $171,599 $146,563 $ 85,519 $ 69,985 $ 66,957 ======== ======== ======== ======== ======== ========
Gross premiums earned decreased 10% and 15% in 2001 and 2002, respectively, as NAICO focused on improving underwriting profitability in its core programs by re-underwriting and re-pricing the business and discontinuing certain classes of business. Increases in premium rates partially offset the decrease in premium production. Net premiums earned decreased 18% and 4% in 2001 and 2002, respectively. Effective October 1, 2000, NAICO purchased quota share reinsurance which reduced NAICO's net retention for its casualty and workers compensation lines of business and also reduced net premiums earned. This quota share reinsurance expired effective January 1, 2002 and NAICO elected not to renew it. The quota share reinsurance reduced net premiums earned by $3.2 million, $11.3 million and $4.6 million in 2000, 2001 and 2002, respectively. Gross premiums earned in the standard property and casualty program decreased 8% and 18% in 2001 and 2002, respectively. The decreases in 2001 and 2002 were due primarily to discontinuing certain accounts and classes of business 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 $4.2 million and $13.7 million in 2001 and 2002, respectively, and gross premiums earned in Oklahoma decreased $6.9 million and $7.2 million in 2001 and 2002, respectively. Net premiums earned decreased 15% and 7% in 2001 and 2002, respectively. The quota share reinsurance reduced net premiums earned by $2.7 million, $9.5 million and $3.8 million in this program in 2000, 2001 and 2002, respectively. Gross premiums earned in the political subdivisions program decreased 1% in 2001 and increased 3% in 2002. Gross premiums earned in the school districts portion of the program increased $1.2 million and $4.5 million in 2001 and 2002, respectively, due primarily to increased premium rates in Oklahoma. This was largely offset by a decrease in gross premiums earned for the municipalities portion of the program. Net premiums earned decreased 2% in 2001 and increased 10% in 2002. The quota share reinsurance reduced net premiums earned by $504,000, $1.8 million and $835,000 in this program in 2000, 2001 and 2002, respectively. PAGE 22 Gross premiums earned in the surety bond program decreased 36% and 42% in 2001 and 2002, respectively. The decreases are primarily due to stricter underwriting policies and a reduction in the number of appointed agents that produce this business as NAICO focuses on improving underwriting profitability in this program. Net premiums earned in the surety bond program decreased 36% and 20% in 2001 and 2002, respectively. Other programs in the preceding table include premiums from the runoff of various programs which are no longer offered by NAICO, 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, and direct assignments to write workers compensation for such insureds in certain states in lieu of participating in related pools. NET INTEREST INCOME AND NET REALIZED INVESTMENT GAINS At December 31, 2002, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Government and high-quality corporate bonds, with approximately 14% 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 Chandler Barbados on intercompany loans. Net interest income from continuing operations, excluding interest income from Chandler Barbados, decreased 15% and 30% in 2001 and 2002, respectively. The decreases in 2001 and 2002 were due primarily to lower interest rates and a reduction in invested assets. Cash and invested assets decreased from $104.8 million at December 31, 2000 to $73.4 million and $68.3 million at December 31, 2001 and 2002, respectively. This decrease resulted primarily from the reduction in premiums written during 2001 and 2002, the payment of claims for prior years and an increase in intercompany loans to Chandler Barbados. The increase in intercompany loans during 2001 was primarily to provide financing for a going private transaction for Chandler Insurance. Interest income from Chandler Barbados was $371,000 and $380,000 during 2001 and 2002, respectively. Chandler USA did not have any interest income from Chandler Barbados during 2000. See Liquidity and Capital Resources. Net realized investment gains were $144,000, $2,654,000 and $794,000 in 2000, 2001 and 2002, respectively. The net realized investment gains in 2001 and 2002 resulted primarily from sales of fixed maturity investments available for sale to provide cash for operating activities due to the decrease in written premiums. The average net yield on the portfolio, including net realized investment gains, was 4.5%, 7.7% and 4.8% in 2000, 2001 and 2002, respectively. The average net yield on the portfolio, excluding net realized investment gains, was 4.3%, 4.4% and 3.7% for 2000, 2001 and 2002, 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, 2002 was approximately $11 million. The average yield on the portfolio before deducting investment expenses was 6.1%, 5.9% and 4.4% in 2000, 2001 and 2002, respectively, excluding capital gains. 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 76.0%, 75.1% and 75.7% in 2000, 2001 and 2002, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $2.9 million, $2.0 million and $1.5 million in 2000, 2001 and 2002, respectively, and increased the respective loss ratios by 3.4, 2.9 and 2.2 percentage points. During 2001, the decline in weather-related losses and increases in premium rates resulted in improved loss ratios for the standard property and casualty and political subdivisions programs for the 2001 accident year. However, these improvements were offset by adverse loss development experienced during 2001 related to prior accident years totaling $12.7 million. This adverse loss development was 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 the discontinued group accident and health program. PAGE 23 During 2002, NAICO experienced adverse loss development related to prior accident years totaling $15.8 million primarily in the standard property and casualty program including both liability lines and workers compensation. This adverse development is generally the result of ongoing analysis of recent loss development trends that reflect an increase in loss severity within the 1997-2000 accident years. The adverse loss development included approximately $2.0 million for provisions for potentially uncollectible reinsurance and deductibles. 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. POLICY ACQUISITION COSTS Policy acquisition costs consist of costs associated with the acquisition of new and renewal business and generally include direct costs such as premium taxes, commissions to agents and ceding companies and premium-related assessments and indirect costs such as salaries and expenses of personnel who perform and support underwriting activities. NAICO also receives ceding commissions from reinsurers who assume premiums from NAICO under certain reinsurance contracts and the ceding commissions are accounted for as a reduction of policy acquisition costs. Direct policy acquisition costs and ceding commissions are deferred and amortized over the terms of the policies. When the sum of the anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded. The following table sets forth Chandler USA's policy acquisition costs from continuing operations for each of the three years ended December 31, 2000, 2001 and 2002:
YEAR ENDED DECEMBER 31, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- (In thousands) Commissions expense ........................ $ 30,851 $ 23,241 $ 20,151 Other premium related assessments .......... 989 463 1,397 Premium taxes .............................. 4,487 4,276 2,764 Excise taxes ............................... 351 234 240 Dividends to policyholders ................. 190 143 105 Other expense .............................. 176 295 567 ---------- ---------- ---------- Total direct expenses ...................... 37,044 28,652 25,224 Indirect underwriting expenses ............. 9,139 9,099 8,135 Commissions received from reinsurers ....... (32,447) (27,325) (22,309) Adjustment for deferred acquisition costs .. 3,146 443 (811) ---------- ---------- ---------- Net policy acquisition costs ............... $ 16,882 $ 10,869 $ 10,239 ========== ========== ==========
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.4%, 23.7% and 23.8% in 2000, 2001 and 2002, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 15.6%, 14.6% and 14.4%. Indirect underwriting expenses were 4.6%, 5.7% and 5.8% of total direct written and assumed premiums in 2000, 2001 and 2002, 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. Premium taxes decreased $1.5 million in 2002 due to the decrease in written premiums, a decrease in expenses associated with guaranty fund assessments and the elimination of a 2% tax on workers compensation premiums written in Oklahoma. However, an increase in premium related assessments in Oklahoma offset part of this savings. Expenses associated with guaranty fund assessments, net of applicable premium tax credits, were approximately $252,000, $489,000 and $31,000 in 2000, 2001 and 2002, respectively. NAICO may receive additional guaranty fund assessments in the future related to Reliance or other insolvent insurance companies. At this time, NAICO is unable to estimate the amount of such assessments. Commissions received from reinsurers included $3.4 million, $4.6 million and $744,000 in 2000, 2001 and 2002, respectively, for the quota share reinsurance purchased in the fourth quarter of 2000. Net policy acquisition costs decreased $1.5 million, $4.9 million and $2.3 million in 2000, 2001 and 2002, respectively, due to the purchase of the quota share reinsurance, net of the adjustment for deferred acquisition costs. PAGE 24 GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses from continuing operations were 5.5%, 6.7% and 8.5% of gross premiums earned in 2000, 2001 and 2002, respectively. General and administrative expenses included $297,000 for settlement of certain litigation, and $736,000 for a reserve for receivables related to certain derivative claims. Amortization of Chandler USA's state insurance licenses and goodwill was discontinued effective January 1, 2002 due to the implementation of Statement of Financial Accounting Standard No. 142. Amortization expense from continuing operations was $529,000 and $150,000 in 2000 and 2001, respectively, for these items. 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 2001 and 2002. Substantially all of Chandler USA's interest expense is related to the $24 million of outstanding debentures. See "Liquidity and Capital Resources." NET LOSS As a result of the factors described above, Chandler USA reported a loss from continuing operations of $3.1 million, $481,000 and $3.0 million in 2000, 2001 and 2002, respectively, and a net loss of $4.0 million, $1.1 million and $2.1 million in 2000, 2001 and 2002, respectively. 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. NAICO purchases fixed-maturity 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. 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. Securities not classified as held to maturity or trading 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. During 2000, Chandler USA provided $10.7 million in cash from operations. During 2001, Chandler USA used $27.8 million in cash from operations due primarily to decreases in unpaid losses and loss adjustment expenses, unearned premiums and premiums payable that resulted from the decrease in written premiums in 2001, and from the payment of claims for prior years. During 2002, Chandler USA used $7.5 million in cash from operations due primarily to a decrease in premiums payable that resulted from the reduction in reinsurance premiums ceded. PAGE 25 Cash flows from investing activities were primarily the result of normal purchases and sales of investment securities. Net realized investment gains before income taxes were $144,000, $2,654,000 and $794,000 during 2000, 2001 and 2002, respectively, from the sale of investments. NAICO received proceeds of $14.2 million, $73.1 million and $31.5 million during 2000, 2001 and 2002, respectively, from the sale of available for sale fixed-income securities prior to their maturity. The proceeds and related net realized investment gains in 2001 and 2002 provided cash for operating activities due to the decrease in written premiums. The average maturity of NAICO's investments was 3.3 years and 3.1 years at December 31, 2001 and 2002, respectively. Cash flows from investing activities also included $3.8 million from a sale and leaseback transaction for certain equipment owned by Chandler USA during 2001. The sale and leaseback transaction resulted in a reduction of property and equipment of $1.8 million and a deferred gain of $2.0 million which is included in accrued taxes and other payables. Chandler USA has exercised its option to repurchase the equipment at the end of the lease for approximately $3.0 million and will amortize the deferred gain into income over the last year of the lease. See Note 11 to Consolidated Financial Statements. 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. 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. Chandler USA has deposited cash into a trust account as security related to certain indemnification provisions related to its sale of L&W. At December 31, 2002, the total amount of cash and investments restricted as a result of these arrangements was $8.0 million. On March 5, 2001, shareholders of Chandler USA's indirect parent, Chandler Insurance, approved a going private transaction. Chandler Insurance financed the going private transaction through (i) a $2.4 million sale of Chandler Insurance Class A Common Shares to Messrs. LaGere and Paden, (ii) a $10.7 million intercompany loan from Chandler Barbados, and (iii) proceeds of approximately $735,000 from the exercise of outstanding Chandler Insurance options. Chandler USA loaned approximately $10.7 million to Chandler Barbados. Chandler USA's intercompany loan to Chandler Barbados was financed by a $3.8 million sale and leaseback transaction for certain equipment owned by Chandler USA and a $7.0 million dividend declared and paid by NAICO. During 2001, Chandler USA and Chandler Barbados entered into 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, 2001 and 2002, Chandler Barbados owed approximately $7.9 million and $10.6 million, respectively, to Chandler USA, and Chandler USA earned $371,000 and $380,000 in interest income from Chandler Barbados during 2001 and 2002, respectively. Reliance reinsured NAICO for certain workers compensation risks during 1998. At December 31, 2002, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses of approximately $2.8 million. During October 2001, the Commonwealth of Pennsylvania placed Reliance in liquidation. At this time, 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, 2002. 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 did not incur any charges for uncollectible reinsurance recoverables from reinsurers in 2000. During 2001 and 2002, NAICO incurred charges of $454,000 and $1.7 million, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible. PAGE 26 LITIGATION Chandler Insurance and certain of its subsidiaries and affiliates, including Chandler USA, were previously involved in various matters of litigation with CenTra, Inc. ("CenTra"). In the CenTra litigation, certain officers and directors of Chandler USA and Chandler Insurance were named as defendants. In accordance with its Articles of Association, Chandler Insurance and its subsidiaries have advanced the litigation expenses of these persons in exchange for undertakings to repay such expenses if those persons are later determined to have breached the standard of conduct provided in the Articles of Association. These expenses together with certain other expenses may be recovered from Chandler Insurance's director and officer liability insurance policy (the "D&O Insurer"). As a result of various events in 1995, 1996 and 1997, Chandler Barbados and Chandler USA recorded estimated recoveries of costs from its D&O Insurer totaling $3,456,000 and $1,044,000, respectively, for reimbursable amounts previously paid that relate to allowable defense and litigation costs for such parties. Chandler Barbados and Chandler USA received payment for a 1995 claim during 1996 in the amount of $636,000 and $159,000, respectively. The balance of $2,820,000 and $885,000 is included in other assets in Chandler Barbados' and Chandler USA's respective balance sheets. Chandler Insurance and its subsidiaries contend they are entitled to a total of $5 million under the applicable insurance policy to the extent they have advanced reimbursable expenses. The D&O Insurer contends that certain policy provisions exclude coverage for these claims. On August 22, 2001, Chandler Insurance and its subsidiaries, including Chandler USA, filed an action in the State District Court in Oklahoma City, Oklahoma ("Oklahoma State Court") alleging that the director and officer liability insurance policies should be rescinded and seeking repayment of more than $5 million in premiums they previously paid. Chandler Insurance and its subsidiaries are currently involved in litigation with the insurer for payment of the policy balance or rescission and repayment of premiums previously paid. The litigation is pending in the Oklahoma State Court. The case is still in the early pleading stages and Chandler USA cannot predict the date of resolution or the outcome of this case. Chandler Insurance and its subsidiaries may or may not recover the remaining policy limits or the previously paid premiums and could incur significant costs in resolving this matter. 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. Transamerica owed NAICO approximately $1.5 million for reinsurance recoverables on paid losses and loss adjustment expenses as of December 31, 2002. NAICO is currently engaged in arbitration in order to enforce the terms of the reinsurance treaties. 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, 2002, substantially all of the investments of NAICO were in fixed-maturity investments (rated Aa3 or AA or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), interest-bearing money market accounts and a collateralized repurchase agreement. NAICO does not hold any investments classified as trading account assets or derivative financial instruments. PAGE 27 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) ---------------------- 2001 2002 2001 2002 ---------- ---------- ----------------- ---------- ---------- (Dollars in thousands) (Dollars in thousands) Fixed-maturity investments .... $ 68,894 $ 58,327 100 bp increase.. $ 66,949 $ 56,630 200 bp increase.. 65,085 55,022 100 bp decrease.. 70,928 60,126 200 bp decrease.. 73,053 62,034
The table above illustrates, for example, that an instantaneous 200 basis point increase in market interest rates at December 31, 2002 would reduce the estimated fair value of NAICO's fixed-maturity investments by approximately $3.3 million at that date. Chandler USA is obligated for senior debentures that have a maturity date of July 16, 2014. The debentures have a fixed interest rate of 8.75%. At December 31, 2002, the fair value of Chandler USA's debentures was estimated to be $23 million based on quoted market prices for similar securities. 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. During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment. Chandler USA agreed to lease the equipment for three years with monthly rental installments equal to the sum of (i) $22,167 plus (ii) interest on the unpaid lease balance at a floating interest rate of 1% over Chase Manhattan Bank Prime, which was 4.25% at December 31, 2002. The sale and leaseback transaction resulted in a reduction of property and equipment of $1.9 million and a deferred gain of $2.0 million which is included in accrued taxes and other payables. Chandler USA has exercised its option to repurchase the equipment at the end of the lease for approximately $3.0 million and will amortize the deferred gain into income over the final year of the lease. 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 On June 11, 2001, the Audit Committee of the Board of Directors determined not to re-engage its independent auditors, Deloitte & Touche LLP, and appointed Tullius Taylor Sartain & Sartain LLP as Chandler USA's independent auditors for the fiscal year ending December 31, 2001. See the Current Report on Form 8-K filed by Chandler USA on June 14, 2001. PAGE 28 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 57 Chairman of the Board, Chief Executive Officer, Compensation Committee Member and Director. Mark T. Paden 46 President, Chief Operating Officer, Compensation Committee Member and Director. Brenda B. Watson 62 Executive Vice President of NAICO. Richard L. Evans 56 Senior Vice President and Director. R. Patrick Gilmore 51 Senior Vice President, Secretary, General Counsel and Director. Mark C. Hart 47 Vice President - Finance, Chief Financial Officer and Treasurer. Larry B. McMillon 58 Vice President - Administration. Robert L. Rice 68 Audit Committee Chairman and Director. W. Scott Martin 52 Audit Committee Member and Director. K.R. Price 65 Audit Committee Member and Director. William T. Keele 66 Director.
W. BRENT LAGERE has been a director, Chairman of the Board and Chief Executive Officer of Chandler USA since 1988. 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 is a director of Chandler Barbados. Mr. LaGere served as an officer and a director of L&W prior to December 1, 2002. 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. 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 and NAICO since November 1992. Mr. Paden also serves as a director and President of Chandler Insurance. Mr. Paden served as an officer and a director of L&W prior to December 1, 2002. BRENDA B. WATSON has been Executive Vice President of NAICO since August 1987. Since October 1988, she has served in officer and director capacities for various subsidiaries of Chandler USA pursuant to an employment contract with Chandler USA. Ms. Watson also serves as Executive Vice President of Chandler Insurance. Ms. Watson served as an officer of L&W prior to December 1, 2002. 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. Mr. Evans served as an officer of L&W prior to December 1, 2002. PAGE 29 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. Mr. Gilmore served as an officer and a director of L&W prior to December 1, 2002. 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 also serves as Vice President-Accounting, Chief Financial Officer and Treasurer of Chandler Insurance. Mr. Hart served as an officer of L&W prior to December 1, 2002. LARRY B. MCMILLON has served as Vice President-Administration of Chandler USA and NAICO since 1989. He was an Executive Vice President and Controller for W. H. Braum, Inc. before joining Chandler USA. 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. K. R. PRICE has been a director of Chandler USA and NAICO since May 2001. Mr. Price has been a stockbroker for Raymond James Financial Services, Inc. since April 1997, and was Executive Vice President and a director for Southwest Securities, Inc. from 1974 until April 1997. 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. 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, 2002. PAGE 30 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 2002 $ 507,410 $ 484,120 $ 299,485 $ 49,332 Chairman of the Board and CEO 2001 464,376 305,000 109,743 46,381 of Chandler USA and NAICO 2000 414,922 150,000 N/A 39,525 Mark T. Paden 2002 295,481 403,348 77,861 5,749 President and COO of Chandler USA 2001 293,295 225,000 N/A 5,502 and NAICO 2000 238,865 150,000 N/A 5,225 Brenda B. Watson 2002 244,448 - N/A 11,526 Executive Vice President 2001 238,904 - N/A 10,372 of NAICO 2000 230,987 84,936 N/A 9,725 Richard L. Evans 2002 245,899 4,500 N/A 7,928 Senior Vice President - Claims of 2001 238,713 - N/A 7,261 Chandler USA and NAICO 2000 232,219 - N/A 6,525 R. Patrick Gilmore 2002 216,790 - N/A 5,405 Senior Vice President, Secretary and 2001 210,460 - N/A 3,837 General Counsel of Chandler USA 2000 204,119 - N/A 3,808 and NAICO - --------------------------------------- (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 in 2002 were $118,459 for Mr. LaGere and $33,231 for Mr. Paden. (4) The amounts shown under this column include contributions by Chandler USA's subsidiaries to a 401(k) plan ($4,100 each for Mr. LaGere and Ms. Watson, $3,850 each for Mr. Paden and Mr. Evans, and $2,980 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 ($28,700, $31,300 and $33,600 in 2000, 2001 and 2002, respectively) were paid under split dollar life insurance plans. Under these plans, 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 31 OPTIONS EXERCISED AND HOLDINGS No options were granted to or exercised by the Named Executives during 2002 and there were no unexercised options held by the Named Executives as of December 31, 2002. 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. Chandler USA has an employment agreement with Brenda B. Watson, an executive officer of NAICO. Under this agreement, Ms. Watson's base compensation is established at not less than $125,000 per year. The agreement terminates on December 31, 2003, unless earlier terminated by Chandler USA for cause, as defined in the agreement. In the event that Ms. Watson is terminated without cause, she is entitled to receive her base compensation through the termination date. In addition to her base compensation, Ms. Watson is eligible to receive certain benefits and to participate in an incentive bonus plan offered by Chandler USA and its subsidiaries. PAGE 32 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 Barbados, which is a wholly owned subsidiary of 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, 2003, 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, 2002 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 18.8% 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 8.0% Richard L. Evans ......................................... Series A Preferred Shares 27,272 6.8% Series B Preferred Shares 32,250 7.3% R. Patrick Gilmore ....................................... Series B Preferred Shares 11,000 2.5% Robert L. Rice ........................................... - - -% W. Scott Martin .......................................... Series C Preferred Shares 31,500 4.4% K.R. Price (5) ........................................... Series C Preferred Shares 146,200 20.5% William T. Keele (6) ..................................... Series C Preferred Shares 142,417 19.9% Steven R. Butler (7) ..................................... Series C Preferred Shares 3,200 *% All directors and officers as a group (12 persons) (8) ... Class A Common Shares 625,826 100.0% Series A Preferred Shares 162,776 40.8% Series B Preferred Shares 78,792 17.8% Series C Preferred Shares 323,317 45.2% - ---------------------------------------------------------- * 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, 399,110 Series A Preferred Shares of Chandler Insurance, 441,580 Series B Preferred Shares of Chandler Insurance and 714,569 Series C Preferred Shares of Chandler Insurance outstanding on February 28, 2003. (3) Includes (i) 348,390 Class A Common Shares of Chandler Insurance owned by the W. Brent LaGere Irrevocable Trust (the "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 Trust. Mr. LaGere holds an irrevocable proxy for the Class A Common Shares owned by the Trust and W&L Holding. Mr. LaGere disclaims beneficial ownership of the shares held by the 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 11,500 Series C Preferred Shares of Chandler Insurance held by Mr. Price's wife. Mr. Price disclaims beneficial ownership of these shares. (6) 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. (7) Mr. Butler is a director, Vice President - Administration and Secretary of Chandler Insurance, and also serves as a director and President of Chandler Barbados. (8) Includes 24,718 Series A Preferred Shares of Chandler Insurance owned by two executive officers of Chandler USA not listed in the table above.
PAGE 33 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, 2003. 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, 2003. (3) Includes 370,890 Class A Common Shares of Chandler Insurance held by the Trust, of which 22,500 Class A Common Shares are directly owned by W&L Holding, which is 100% owned by the Trust. Mr. LaGere holds an irrevocable proxy for the Class A Common Shares owned by the 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. PAGE 34 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 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 maintains 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 2000, 2001 and 2002, Chandler USA incurred approximately $265,000, $263,000 and $255,000, respectively, in expenses associated with its use of this property, including $9,000, $25,000 and $18,000 paid to Davenport Farms for reimbursement of certain expenses, such as utility and similar expenses, for the years 2000, 2001 and 2002, respectively. Prior to May 1, 1997, Benjamin T. Walkingstick was an employee of Chandler USA pursuant to an employment agreement dated October 28, 1988 (the "Employment Agreement") and served as an executive officer and director of Chandler USA and certain of it subsidiaries. Effective May 1, 1997, Mr. Walkingstick resigned these positions and ceased to be an employee of Chandler USA. He continued to be a consultant to Chandler USA and its subsidiaries pursuant to the Employment Agreement and continued to receive compensation under the Employment Agreement through October 2000. In March 2001, Chandler USA entered into a consulting agreement (the "Consulting Agreement") with Mr. Walkingstick. The Consulting Agreement has a term of five years with monthly payments of $12,500. Mr. Walkingstick received $125,000 and $150,000 in compensation under the Consulting Agreement during 2001 and 2002, respectively. 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 is employed by Raymond James Financial Services, Inc. which is also a subsidiary of Raymond James Financial, Inc. Since May 2001, Mr. Price has been a director of NAICO and Chandler USA. Mr. Price receives no compensation from NAICO's investment transactions since joining the boards in May 2001. 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, including loans, 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. CONTROLS AND PROCEDURES Chandler USA's Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of Chandler USA's disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of a date within 90 days prior to the filing date of this annual report. Based on such evaluation, such officers have concluded that Chandler USA's disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Chandler USA (including its consolidated subsidiaries) required to be included in Chandler USA's periodic filings under the Exchange Act. There have not been any significant changes in Chandler USA's internal controls or in other factors that could significantly affect such controls subsequent to the date of this evaluation. PAGE 35 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS. The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 2001 and 2002, 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, 2002, together with the related notes thereto and the report of Tullius Taylor Sartain & Sartain LLP, independent auditors on such financial statements as of December 31, 2001 and 2002 and for the two years ended December 31, 2002, and the report of Deloitte & Touche LLP, independent auditors on such financial statements for the year ended December 31, 2000, are filed as a part of this Form 10-K. See accompanying Index on page F-1. 2. FINANCIAL STATEMENT SCHEDULES. The financial statement schedules listed in the accompanying index to consolidated financial statements and schedules are filed as part of this Form 10-K. All other schedules have been omitted since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule or because the information is included in the consolidated financial statements or the notes thereon. 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 USA as issuer and U.S. Trust of Texas, N.A. as trustee. (1) 10.1 Employment Agreement, effective as of October 28, 1988, by and between Chandler USA and Brent LaGere. (1) 10.2 Employment Agreement, effective as of October 28, 1988, by and between Chandler USA, 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 USA and Brenda B. Watson. (1) 10.4 Intercompany Credit Agreement effective as of January 1, 2001, by and between Chandler USA and Chandler Barbados. (2) 10.5 Stock Purchase Agreement effective as of December 1, 2002, by and among Brown & Brown, Inc., Chandler USA, Chandler Insurance, NAICO, W. Brent LaGere and Mark T. Paden. 21.1 Subsidiaries of the registrant. 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes - Oxley Act of 2002. - ------------------------------- (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. 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. (b) Reports on Form 8-K. Chandler USA filed one current report on Form 8-K dated December 20, 2002 responding to Item 5 of Form 8-K. PAGE 36 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 4, 2003 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 4, 2003 /s/ W. Brent LaGere ------------------------------------------------- W. Brent LaGere, Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer) Date: March 4, 2003 /s/ Mark T. Paden ------------------------------------------------- Mark T. Paden, President, Chief Operating Officer and Director Date: March 4, 2003 /s/ Mark C. Hart ------------------------------------------------- Mark C. Hart, Vice President - Finance, Chief Financial Officer and Treasurer (Principal Financial Officer) Date: March 4, 2003 /s/Richard L. Evans ------------------------------------------------- Richard L. Evans, Senior Vice President and Director Date: March 4, 2003 /s/ R. Patrick Gilmore ------------------------------------------------- R. Patrick Gilmore, Senior Vice President, Secretary, General Counsel and Director Date: March 4, 2003 /s/ Robert L. Rice ------------------------------------------------- Robert L. Rice, Director PAGE 37 Date: March 4, 2003 /s/ W. Scott Martin ------------------------------------------------- W. Scott Martin, Director Date: March 4, 2003 /s/ K.R. Price ------------------------------------------------- K.R. Price, Director Date: March 4, 2003 /s/ William T. Keele ------------------------------------------------- William T. Keele, Director PAGE 38 CERTIFICATIONS - -------------- I, W. Brent LaGere, certify that: 1. I have reviewed this annual report on Form 10-K of Chandler (U.S.A.), Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 4, 2003 /s/ W. Brent LaGere --------------------------------------- W. Brent LaGere Chairman of the Board and Chief Executive Officer PAGE 39 I, Mark C. Hart, certify that: 1. I have reviewed this annual report on Form 10-K of Chandler (U.S.A.), Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 4, 2003 /s/ Mark C. Hart --------------------------------------- Mark C. Hart Vice President - Finance, Chief Financial Officer and Treasurer 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, 2001 and 2002 .......................... F-2 Consolidated Statements of Operations for the years ended December 31, 2000, 2001 and 2002 .................................................... F-3 Consolidated Statements of Comprehensive Income for the years ended December 31, 2000, 2001 and 2002 .................................................... F-4 Consolidated Statements of Cash Flows for the years ended December 31, 2000, 2001 and 2002 .................................................... F-5 Consolidated Statements of Shareholder's Equity for the years ended December 31, 2000, 2001 and 2002 .................................................... F-6 Notes to Consolidated Financial Statements ............................................ F-7 through F-23 Independent Auditors' Report on Consolidated Financial Statements and Financial Statement Schedules - Deloitte & Touche LLP ........................... F-24 Independent Auditors' Report on Consolidated Financial Statements and Financial Statement Schedules - Tullius Taylor Sartain & Sartain LLP ............ 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, ---------------------- 2001 2002 ---------- ---------- ASSETS Investments Fixed maturities available for sale, at fair value Restricted (amortized cost $5,419 and $6,737 in 2001 and 2002, respectively) ........ $ 5,501 $ 6,943 Unrestricted (amortized cost $62,124 and $48,362 in 2001 and 2002, respectively) .... 62,154 50,096 Fixed maturities held to maturity, at amortized cost Restricted (fair value $385 and $394 in 2001 and 2002, respectively) ................ 353 374 Unrestricted (fair value $854 and $895 in 2001 and 2002, respectively) .............. 782 846 Equity securities available for sale, at fair value ................................... 464 681 ---------- ---------- Total investments ................................................................... 69,254 58,940 Cash and cash equivalents ($210 and $711 restricted in 2001 and 2002, respectively) ..... 4,124 9,336 Premiums receivable, less allowance for non-collection of $298 and $246 at 2001 and 2002, respectively ....................................... 24,185 24,009 Reinsurance recoverable on paid losses, less allowance for non-collection of $1,096 and $2,275 at 2001 and 2002, respectively .................... 11,756 11,198 Reinsurance recoverable on paid losses from related parties ............................. 292 80 Reinsurance recoverable on unpaid losses, less allowance for non-collection of $492 at 2002 ........................................................ 42,545 50,377 Reinsurance recoverable on unpaid losses from related parties ........................... 9,399 9,038 Prepaid reinsurance premiums ............................................................ 26,890 19,202 Prepaid reinsurance premiums to related parties ......................................... 8,103 8,680 Deferred policy acquisition costs ....................................................... - 355 Property and equipment, net ............................................................. 10,822 10,093 Amounts due from related parties ........................................................ 7,880 10,582 State insurance licenses, net ........................................................... 3,745 3,745 Goodwill ................................................................................ 2,350 - Other assets ............................................................................ 13,464 14,220 ---------- ---------- Total assets ............................................................................ $ 234,809 $ 229,855 ========== ========== LIABILITIES AND SHAREHOLDER'S EQUITY Liabilities Unpaid losses and loss adjustment expenses ............................................ $ 84,756 $ 92,606 Unearned premiums ..................................................................... 61,562 55,160 Policyholder deposits ................................................................. 4,600 4,244 Accrued taxes and other payables ...................................................... 7,480 8,040 Premiums payable ...................................................................... 8,669 2,805 Debentures ............................................................................ 24,000 24,000 ---------- ---------- Total liabilities ................................................................... 191,067 186,855 ---------- ---------- Commitments and contingencies (Notes 10 and 11) Shareholder's equity Common stock, $1.00 par value, 50,000 shares authorized; 2,484 shares issued and outstanding ................................................. 2 2 Paid-in surplus ....................................................................... 60,584 60,584 Accumulated deficit ................................................................... (17,225) (19,316) Accumulated other comprehensive income: Unrealized gain on investments available for sale, net of deferred income taxes ............................................................ 381 1,730 ---------- ---------- Total shareholder's equity .......................................................... 43,742 43,000 ---------- ---------- Total liabilities and shareholder's equity .............................................. $ 234,809 $ 229,855 ========== ==========
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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- Premiums and other revenues Direct premiums written and assumed ........................ $ 197,196 $ 158,964 $ 140,162 Reinsurance premiums ceded ................................. (83,674) (70,086) (48,380) Reinsurance premiums ceded to related parties .............. (35,077) (23,455) (24,115) ---------- ---------- ---------- Net premiums written and assumed ......................... 78,445 65,423 67,667 Decrease (increase) in unearned premiums ................... 7,074 4,562 (710) ---------- ---------- ---------- Net premiums earned ...................................... 85,519 69,985 66,957 Interest income, net ......................................... 4,281 3,632 2,540 Interest income, net from related parties .................... - 371 380 Realized investment gains, net ............................... 144 2,654 794 Other income ................................................. 301 101 261 ---------- ---------- ---------- Total premiums and other revenues ........................ 90,245 76,743 70,932 ---------- ---------- ---------- Operating costs and expenses Losses and loss adjustment expenses, net of amounts ceded to related parties of $19,212, $15,712 and $16,936 in 2000, 2001 and 2002, respectively ..................... 64,999 52,550 50,712 Policy acquisition costs, net of ceding commissions received from related parties of $12,390, $8,029 and $8,199 in 2000, 2001 and 2002, respectively ..................... 16,882 10,869 10,239 General and administrative expenses ........................ 10,557 11,549 12,473 Interest expense ........................................... 2,255 2,240 2,234 ---------- ---------- ---------- Total operating costs and expenses ....................... 94,693 77,208 75,658 ---------- ---------- ---------- Loss from continuing operations before income taxes .......... (4,448) (465) (4,726) Federal income tax benefit (provision) ....................... 1,347 (16) 1,680 ---------- ---------- ---------- Loss from continuing operations .............................. (3,101) (481) (3,046) Income (loss) from discontinued operations ................... (894) (622) 284 Gain on sale of subsidiary ................................... - - 671 ---------- ---------- ---------- Net loss ................................................... $ (3,995) $ (1,103) $ (2,091) ========== ========== ==========
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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- Net loss ............................................................... $ (3,995) $ (1,103) $ (2,091) ---------- ---------- ---------- Other comprehensive income (loss), before income tax: Unrealized gains on securities: Unrealized holding gains arising during period ..................... 3,337 2,644 2,838 Less: Reclassification adjustment for gains included in net loss ... (144) (2,654) (794) ---------- ---------- ---------- Other comprehensive income (loss), before income tax ................... 3,193 (10) 2,044 Income tax benefit (provision) related to items of other comprehensive income (loss) .......................................... (1,086) 4 (695) ---------- ---------- ---------- Other comprehensive income (loss), net of income tax ................... 2,107 (6) 1,349 ---------- ---------- ---------- Comprehensive loss ..................................................... $ (1,888) $ (1,109) $ (742) ========== ========== ==========
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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- OPERATING ACTIVITIES Net loss ............................................................. $ (3,995) $ (1,103) $ (2,091) Add (deduct): Adjustments to reconcile net loss to cash provided by (applied to) operating activities: Realized investment gains, net ................................... (144) (2,654) (794) Gain on sale of subsidiary ....................................... - - (671) Net losses on sale of property and equipment ..................... 10 23 32 Amortization and depreciation .................................... 2,592 2,169 1,602 Provision for non-collection of premiums ......................... 179 305 444 Provision for non-collection of reinsurance recoverables ......... - 454 1,726 Net change in non-cash balances relating to operating activities: Premiums receivable ............................................ 14,019 9,029 (268) Reinsurance recoverable on paid losses ......................... (50) (9,396) (712) Reinsurance recoverable on paid losses from related parties .... (614) 322 212 Reinsurance recoverable on unpaid losses ....................... (1,799) (2,689) (8,288) Reinsurance recoverable on unpaid losses from related parties .. (4,537) 4,680 361 Prepaid reinsurance premiums ................................... (12,739) 5,809 7,688 Prepaid reinsurance premiums to related parties ................ (764) 2,265 (577) Deferred policy acquisition costs .............................. 3,134 - (355) Other assets ................................................... (3,006) 1,906 (1,349) Unpaid losses and loss adjustment expenses ..................... 1,713 (15,417) 7,850 Unearned premiums .............................................. 6,429 (12,636) (6,402) Policyholder deposits .......................................... (73) (462) (356) Accrued taxes and other payables ............................... 146 (1,248) 307 Premiums payable ............................................... 10,494 (9,138) (5,864) Premiums payable to related parties ............................ (343) - - ---------- ---------- ---------- Cash provided by (applied to) operating activities ............... 10,652 (27,781) (7,505) ---------- ---------- ---------- INVESTING ACTIVITIES Unrestricted fixed maturities available for sale: Purchases .......................................................... (39,653) (61,448) (23,163) Sales .............................................................. 14,167 73,107 31,460 Maturities ......................................................... 24,391 14,297 4,339 Cost of property and equipment purchased ............................. (2,949) (1,356) (373) Proceeds from sale of property and equipment ......................... 46 3,924 98 Net proceeds from sale of subsidiary ................................. - - 3,058 ---------- ---------- ---------- Cash provided by (applied to) investing activities ............... (3,998) 28,524 15,419 ---------- ---------- ---------- FINANCING ACTIVITIES Payments and loans from related parties .............................. 1,200 4,032 3,249 Payments and loans to related parties ................................ (1,016) (12,629) (5,951) ---------- ---------- ---------- Cash provided by (applied to) financing activities ............... 184 (8,597) (2,702) ---------- ---------- ---------- Increase (decrease) in cash and cash equivalents during the period ... 6,838 (7,854) 5,212 Cash and cash equivalents at beginning of period ..................... 5,140 11,978 4,124 ---------- ---------- ---------- Cash and cash equivalents at end of period ........................... $ 11,978 $ 4,124 $ 9,336 ========== ========== ==========
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, 2000 ................ $ 2 $ 60,584 $ (12,127) $ (1,720) $ 46,739 Net loss ................................ - - (3,995) - (3,995) Change in unrealized loss on investments available for sale, net of income tax ............... - - - 2,107 2,107 ----------- ----------- ----------- ------------- ------------- Balance, December 31, 2000 .............. 2 60,584 (16,122) 387 44,851 ----------- ----------- ----------- ------------- ------------- Net loss ................................ - - (1,103) - (1,103) Change in unrealized gain on investments available for sale, net of income tax ............... - - - (6) (6) ----------- ----------- ----------- ------------- ------------- Balance, December 31, 2001 .............. 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 =========== =========== =========== ============= =============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-7 CHANDLER (U.S.A.), INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2000, 2001 AND 2002 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. Effective December 1, 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. Chandler USA is wholly owned by Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") which, in turn, is wholly owned by Chandler Insurance Company, Ltd. ("Chandler Insurance"), a Cayman Islands company. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of the financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates. Certain reclassifications of prior years have been made to conform to the 2002 presentation. (b) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Chandler USA and all wholly owned subsidiaries including NAICO. 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. Due to Chandler USA's purchase of additional quota share reinsurance during 2000, Chandler USA's deferred ceding commissions exceeded the deferred policy acquisition costs related to direct and assumed business by approximately $456,000 at December 31, 2001 and are recorded in accrued taxes and other payables. Certain policy acquisition costs, such as policyholder dividends, are expensed directly. NAICO expensed $190,000, $143,000 and $105,000 during 2000, 2001 and 2002, respectively, for dividends to policyholders primarily on participating workers compensation policies. Gross written premiums for participating policies were $1.6 million, $1.2 million and $615,000 in 2000, 2001 and 2002, 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:
2001 2002 ---------- ---------- (In thousands) Real estate and improvements .. $ 10,382 $ 10,411 Other property and equipment .. 10,039 8,870 ---------- ---------- 20,421 19,281 Accumulated depreciation ...... (9,599) (9,188) ---------- ---------- $ 10,822 $ 10,093 ========== ==========
Depreciation expense from continuing operations was approximately $1,094,000, $1,016,000 and $916,000 for 2000, 2001 and 2002, 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. Goodwill was amortized using the straight-line method over 15-17 years. Effective January 1, 2002, goodwill and the state insurance licenses are no longer amortized but reviewed at least annually for impairment. Chandler USA completed the required impairment tests during 2002 and concluded that there has not been an impairment loss since the fair values of the licenses and goodwill exceeded their respective carrying values. The fair values were determined based on the present value of projected future net cash flows. All of Chandler USA's goodwill pertains to the agency operating segment and was written off in 2002 following the sale of L&W. Intangible assets included the following at December 31:
2001 2002 ---------- ---------- (In thousands) State insurance licenses ...... $ 5,991 $ 5,991 Accumulated amortization ...... (2,246) (2,246) ---------- ---------- $ 3,745 $ 3,745 ========== ========== Goodwill ...................... $ 10,726 $ - Accumulated amortization ...... (8,376) - ---------- ---------- $ 2,350 $ - ========== ==========
(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 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. Securities not classified as held to maturity or trading 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 investment securities below their carrying value that are other than temporary are recognized in earnings. (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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- (In thousands) Cash payments (refunds) during the year for: Interest ...................................... $ 2,255 $ 2,128 $ 2,122 Income taxes .................................. 587 (1,025) (1,241) Transfers from (to) restricted securities, net .. $ 1,441 $ (146) $ (1,341)
(o) REINSURANCE Management believes all of NAICO's reinsurance contracts with reinsurers meet the criteria for risk transfer and the revenue and cost recognition provisions in order to be accounted for as reinsurance. As more fully explained in Note 11, reinsurance contracts do not relieve NAICO from its obligation to policyholders. In addition, failure of reinsurers to honor their obligations could result in losses to Chandler USA. (p) NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board ("FASB") periodically issues new accounting standards in a continuing effort to improve standards of financial accounting and reporting. Chandler USA has reviewed the recently issued pronouncements and concluded that the following new accounting standards are applicable to Chandler USA. In June 2001, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS. SFAS No. 142 supercedes Accounting Principles Board ("APB") Opinion No. 17, INTANGIBLE ASSETS, and primarily addresses accounting for goodwill and intangible assets subsequent to acquisition. Under SFAS No. 142, goodwill and separately identified intangible assets with indefinite lives will no longer be amortized but reviewed annually (or more frequently if impairment indicators arise) for impairment. Separately identified intangible assets not deemed to have indefinite lives will continue to be amortized over their useful lives. Chandler USA adopted SFAS No. 142 effective January 1, 2002. Chandler USA completed the required impairment tests of its state insurance licenses and goodwill during 2002 and concluded that there has not been an impairment. The fair values were determined based on the present value of projected future net cash flows. All of Chandler USA's goodwill pertains to the agency operating segment and was written off in the fourth quarter of 2002 following the sale of L&W. A reconciliation of the reported loss from continuing operations to the adjusted loss from continuing operations had SFAS No. 142 been applied as of January 1, 2000 follows:
YEAR ENDED DECEMBER 31, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- (In thousands) Reported loss from continuing operations ..... $ (3,101) $ (481) $ (3,046) Add back amortization: Goodwill ................................... 379 - - State insurance licenses ................... 150 150 - ---------- ---------- ---------- Adjusted loss from continuing operations ..... $ (2,572) $ (331) $ (3,046) ========== ========== ==========
PAGE F-11 In August 2001, the FASB issued SFAS No. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS. SFAS No. 144 supercedes SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, and APB Opinion No. 30, REPORTING THE RESULTS OF OPERATIONS - REPORTING THE EFFECTS OF DISPOSAL OF A SEGMENT OF A BUSINESS, AND EXTRAORDINARY, UNUSUAL AND INFREQUENTLY OCCURRING EVENTS AND TRANSACTIONS. SFAS No. 144 establishes an accounting model based on SFAS No. 121 for long-lived assets to be disposed of by sale, previously accounted for under APB Opinion No. 30. Chandler USA adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS No. 144 did not have a material impact on Chandler USA's consolidated financial condition, results of operations or cash flows. In June 2002, the FASB issued SFAS No. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES. This standard requires entities to recognize a liability, at its fair value, associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Chandler USA adopted SFAS No. 146 effective January 1, 2002. The adoption of SFAS No. 146 did not have a material impact on Chandler USA's consolidated financial statements, results of operations or cash flows. NOTE 2. INVESTMENTS AND INTEREST INCOME Net interest 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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- (In thousands) Interest on fixed-maturity investments ................. $ 5,330 $ 4,406 $ 2,755 Interest on cash equivalents ........................... 673 555 252 Interest on amounts due from related parties ........... - 371 380 Investment expenses .................................... (1,722) (1,329) (467) ---------- ---------- ---------- Interest income, net ................................. 4,281 4,003 2,920 Realized gains, net - fixed-maturity investments ....... 144 2,654 794 ---------- ---------- ---------- $ 4,425 $ 6,657 $ 3,714 ========== ========== ==========
Investment expenses include $1,365,000, $997,000 and $244,000 for the years ended December 31, 2000, 2001 and 2002, respectively, in expense to subsidize a premium finance program for certain insureds of NAICO with an unaffiliated premium finance company. The amortized cost of fixed maturities or cost of equity securities, gross unrealized gains or losses, fair value and carrying value of investments are as follows:
GROSS GROSS UNREALIZED UNREALIZED FAIR CARRYING DECEMBER 31, 2001 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 ......................... $ 43,443 $ 262 $ (391) $ 43,314 $ 43,314 Corporate obligations .................. 10,351 255 (80) 10,526 10,526 Public utilities ....................... 8,930 204 (51) 9,083 9,083 Mortgage-backed securities ............. 4,819 - (87) 4,732 4,732 ---------- ---------- ---------- ---------- ---------- $ 67,543 $ 721 $ (609) $ 67,655 $ 67,655 ========== ========== ========== ========== ========== FIXED MATURITIES HELD TO MATURITY: U.S. Treasury securities and obligations of U.S. government corporations and agencies ......................... $ 1,135 $ 104 $ - $ 1,239 $ 1,135 ========== ========== ========== ========== ========== EQUITY SECURITIES AVAILABLE FOR SALE: Corporate stock ........................ $ - $ 464 $ - $ 464 $ 464 ========== ========== ========== ========== ==========
PAGE F-12
GROSS GROSS UNREALIZED UNREALIZED FAIR CARRYING DECEMBER 31, 2002 COST GAINS LOSSES VALUE VALUE - ---------------------------------------- ---------- ---------- ---------- ---------- ---------- FIXED MATURITIES AVAILABLE FOR SALE: (In thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies ......................... $ 37,135 $ 1,348 $ - $ 38,483 $ 38,483 Corporate obligations .................. 11,173 357 (5) 11,525 11,525 Public utilities ....................... 6,791 258 (18) 7,031 7,031 ---------- ---------- ---------- ---------- ---------- $ 55,099 $ 1,963 $ (23) $ 57,039 $ 57,039 ========== ========== ========== ========== ========== FIXED MATURITIES HELD TO MATURITY: U.S. Treasury securities and obligations of U.S. government corporations and agencies ......................... $ 1,220 $ 69 $ - $ 1,289 $ 1,220 ========== ========== ========== ========== ========== EQUITY SECURITIES AVAILABLE FOR SALE: Corporate stock ........................ $ - $ 681 $ - $ 681 $ 681 ========== ========== ========== ========== ==========
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, 2002 are shown below:
AVAILABLE FOR SALE HELD TO MATURITY ----------------------- ----------------------- AMORTIZED AMORTIZED COST FAIR VALUE COST FAIR VALUE ----------- ----------- ----------- ----------- (In thousands) Due in one year or less ...................... $ 7,181 $ 7,300 $ 1,220 $ 1,289 Due after one year through five years ........ 38,377 39,987 - - Due after five years through ten years ....... 9,541 9,752 - - Due after ten years .......................... - - - - ----------- ----------- ----------- ----------- $ 55,099 $ 57,039 $ 1,220 $ 1,289 =========== =========== =========== ===========
Realized gains and losses from sales of fixed maturities are shown below:
GROSS REALIZED GAINS GROSS REALIZED LOSSES -------------------- --------------------- (In thousands) 2000 .......... $ 204 $ 60 2001 .......... 2,654 - 2002 .......... 904 110
NAICO is required by several states to deposit securities with state regulators as a condition of doing business in those states. Chandler USA has deposited cash into a trust account as security related to certain indemnification provisions related to its sale of L&W. As of December 31, 2001 and 2002, the carrying value of these deposits totaled approximately $6.0 million and $8.0 million, respectively. PAGE F-13 NOTE 3. UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES NAICO provides a reserve for estimated losses (reported and unreported) and loss adjustment expenses based on historical experience and payment reporting patterns for the type of risk involved. These estimates are based on data available at the time of the estimate and such estimates are periodically reviewed by independent professional actuaries. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount and uncertainty in the estimates are affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances, and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that define and expand insurance coverage subsequent to the time that the insurance policy was priced and sold. Salvage and subrogation recoverables are accrued using the "case basis" method for large recoverables and statistical estimates based on historical experience for smaller recoverables. Recoverable amounts deducted from NAICO's net liability for unpaid losses and loss adjustment expenses were approximately $5.0 million and $5.6 million at December 31, 2001 and 2002, 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. 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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- (In thousands) Net balance before provision for uncollectible reinsurance at beginning of year ................................................. $ 51,123 $ 46,588 $ 32,743 ---------- ---------- ---------- Net losses and loss adjustment expenses incurred related to: Current year ......................................................... 60,020 39,881 34,928 Prior years .......................................................... 4,979 12,669 15,784 ---------- ---------- ---------- Total .............................................................. 64,999 52,550 50,712 ---------- ---------- ---------- Net paid losses and loss adjustment expenses related to: Current year ......................................................... (33,525) (22,596) (13,246) Prior years .......................................................... (36,009) (43,799) (37,050) ---------- ---------- ---------- Total .............................................................. (69,534) (66,395) (50,296) ---------- ---------- ---------- Balance before provision for uncollectible reinsurance at end of year .. 46,588 32,743 33,159 Adjustments to reinsurance recoverables on unpaid losses for uncollectible reinsurance .......................... 119 69 32 ---------- ---------- ---------- Net balance at end of year ............................................. $ 46,707 $ 32,812 $ 33,191 ========== ========== ==========
During 2001, NAICO experienced adverse loss development related to prior accident years 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 the discontinued group accident and health program. During 2002, NAICO experienced adverse loss development related to prior accident years totaling $15.8 million primarily in the standard property and casualty program including both liability lines and workers compensation. This adverse development is generally the result of ongoing analysis of recent loss development trends that reflect an increase in loss severity within the 1997-2000 accident years. The adverse loss development included approximately $2.0 million for provisions for potentially uncollectible reinsurance and deductibles. PAGE F-14 NAICO does not ordinarily insure against environmental matters as that term is commonly used. However, in some cases, regulatory filings made by NAICO on behalf of an insured can make NAICO directly liable to the regulatory authority for property damage which could include environmental pollution. In those cases, NAICO ordinarily has recourse against the insured or the surety bond principal for amounts paid. NAICO has insured certain trucking companies and pest control operators that are required to provide proof of insurance which in some cases assures payment for clean-up and remediation of damage resulting from sudden and accidental release or discharge of contaminants or other substances which may be classified as pollutants. NAICO also provides surety bonds for construction contractors that use or have control of such substances and for contractors that remove and dispose of asbestos as a part of their contractual obligations. NAICO also insures independent oil and gas producers that may purchase coverage for the escape of oil, saltwater, or other substances which may be harmful to persons or property, but may not generally be classified as pollutants. NAICO maintains claims records which segregate this type of risk for the purpose of evaluating environmental risk exposure. Based upon the nature of such lines of business with insureds of NAICO, and current data regarding the limited severity and infrequency of such matters, it appears that potential environmental risks are not a significant portion of claims reserves and therefore would not likely have a material impact, if any, on the consolidated financial condition, results of operations or cash flows of Chandler USA. At this time, NAICO has not received any claims related to the September 11, 2001 terrorist attacks on the World Trade Center and does not believe that it has any significant exposure to these and related losses. While several of NAICO's reinsurers did experience significant losses related to these attacks, it currently does not appear that these losses will impair the reinsurers' ability to pay claims. NOTE 4. DISCONTINUED OPERATIONS On December 20, 2002, Chandler USA completed the sale of its wholly owned subsidiary L&W to Brown & Brown, Inc. for $3,247,000 in cash and a $361,000 note receivable that is due on or before December 31, 2003. Chandler USA recorded an after-tax gain of $671,000 on the sale based on the minimum purchase price for the transaction, after deducting Chandler USA's goodwill related to L&W of $2,350,000, equity in L&W of $224,000 and approximately $400,000 of expenses in connection with the sale. The gain on the sale may be increased over the next three years depending on certain adjustments to the purchase price as defined in the terms of the transaction, with a maximum purchase price of $6.0 million. The transaction was effective December 1, 2002. L&W is expected to continue to be a significant producer of business for NAICO. Retail business produced by L&W and placed with NAICO constituted approximately 8% of NAICO's direct premiums written and assumed in 2002. Chandler USA will maintain certain wholesale operations related to NAICO's school districts and trucking programs through its wholly owned subsidiary, Chandler Insurance Managers, Inc. ("CIMI"), an underwriting manager that was established in December 2002. L&W previously functioned as Chandler USA's agency segment and is presented as discontinued operations. 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 deposited cash in the amount of $500,000 into a trust account for the benefit of Brown & Brown, Inc. as security. Prior to completing the sale, L&W transferred its real estate to NAICO, and transferred substantially all of its remaining assets and liabilities, primarily premiums receivable and premiums payable, to Chandler USA through a shareholder dividend. NOTE 5. DEBENTURES On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior 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. As of December 31, 2002, Chandler USA has capitalized $1.3 million related to debt issuance costs for the debentures. These costs are being amortized as interest expense over the term of the debentures. 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, 2002, Chandler USA was in compliance with all covenants. PAGE F-15 NOTE 6. 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:
2000 2001 2002 ---------- ---------- ---------- (In thousands) Statutory net income (loss) ............... $ 2,915 $ 3,472 $ (405) Statutory capital and surplus ............. $ 48,550 $ 49,060 $ 44,073
In 1998, the National Association of Insurance Commissioners ("NAIC") adopted codified statutory accounting principles ("Codification"). Codification changed, to some extent, prescribed statutory accounting practices and resulted in changes to the accounting practices that NAICO uses to prepare its statutory financial statements. The State of Oklahoma adopted Codification to be effective January 1, 2001. The adoption of Codification increased NAICO's statutory policyholders' surplus by $3.5 million as of January 1, 2001 which resulted primarily from the recognition of a net deferred tax asset. Under Codification, office equipment, furniture and other such property are not admitted assets. Prior to 2002, the Oklahoma Insurance Code considered office equipment, furniture and other such property constituting less than 3% of otherwise admitted assets to be admissible. This prescribed accounting practice increased NAICO's statutory capital and surplus by $1.1 million at December 31, 2001. During 2002, the Oklahoma Insurance Code was modified to exclude office equipment, furniture and other such property from admitted assets and these have been deducted from NAICO's statutory capital and surplus as of December 31, 2002. There is no difference between NAICO's statutory net income under Codification and practices prescribed by the Oklahoma Insurance Code. The Oklahoma Insurance Commissioner has the right to permit other specific practices that deviate from prescribed practices. NAICO does not have any such permitted practices. The NAIC has adopted risk-based capital ("RBC") standards for domestic property and casualty insurance companies. The RBC standards are designed to assist insurance regulators in analytically determining a level of capital and surplus that would be sufficient to withstand reasonably foreseeable adverse events associated with underwriting risk, investment risk, credit risk and loss reserve risk. NAICO is subject to the RBC standards. Based on available information, management believes NAICO complied with the RBC standards at December 31, 2001 and 2002. 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 2003 without the approval of the Oklahoma Department of Insurance is approximately $4.4 million. NAICO paid cash shareholder dividends totaling $2.5 million, $7.0 million and $3.5 million to Chandler USA in 2000, 2001 and 2002, respectively. The Oklahoma Department of Insurance approved the payment of the extraordinary dividend by NAICO to Chandler USA in 2001. PAGE F-16 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 $11.4 million as of December 31, 2002). NAICO paid approximately $294,000, $183,000 and $120,000 in policyholder dividends during 2000, 2001 and 2002, respectively. NOTE 7. INCOME TAXES Chandler USA and its wholly owned subsidiaries file a consolidated U.S. Federal income tax return. The income taxes reflected in the accompanying consolidated statements of operations differ from those expected using U.S. Federal enacted income tax rates as noted by the following:
2000 2001 2002 ---------- ---------- ---------- CONTINUING OPERATIONS: (In thousands) Computed income tax benefit at 34% ................ $ (1,512) $ (158) $ (1,607) Increase (decrease) in income taxes resulting from: Amortization of licenses and other intangibles .. 180 51 - Interest income on tax exempt securities ........ (147) (56) - Utilization of capital loss ..................... - - (270) Other, net ...................................... 132 179 197 ---------- ---------- ---------- Federal income tax provision (benefit) ............ $ (1,347) $ 16 $ (1,680) ========== ========== ========== DISCONTINUED OPERATIONS: Computed income tax provision (benefit) at 34% .... $ (348) $ (211) $ 149 Increase (decrease) in income taxes resulting from: Amortization of goodwill ........................ 208 208 - Other, net ...................................... 11 5 6 ---------- ---------- ---------- Federal income tax provision (benefit) ............ $ (129) $ 2 $ 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 was not reduced for income taxes. U.S. Federal income tax provision (benefit) from continuing operations consists of:
CURRENT DEFERRED TOTAL ---------- ---------- ---------- (In thousands) 2000 .............................................. $ (1,160) $ (187) $ (1,347) 2001 .............................................. (1,006) 1,022 16 2002 .............................................. (2,033) 353 (1,680)
Deferred income tax provision (benefit) from continuing operations relating to temporary differences includes the following components:
2000 2001 2002 ---------- ---------- ---------- (In thousands) Loss reserve discounts ............................ $ 486 $ 754 $ 152 Unearned premiums ................................. 481 256 (6) Deferred policy acquisition costs ................. (1,070) (151) 276 Reserve for uncollectible premiums receivable and reinsurance recoverables .................... (18) 161 (58) Depreciation and lease expense .................... (46) (52) 126 Other ............................................. (20) 54 (137) ---------- ---------- ---------- $ (187) $ 1,022 $ 353 ========== ========== ==========
PAGE F-17 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:
2001 2002 ---------- ---------- Deferred tax assets: Loss reserve discounts ..................................... $ 2,202 $ 2,050 Unearned premiums .......................................... 1,861 1,867 Reserve for uncollectible premiums receivable .............. 100 84 Compensated absences ....................................... 193 195 Net operating loss carryforwards - federal ................. - 1,887 Net operating loss carryforwards - state ................... 2,750 2,987 Net capital loss carryforward .............................. - 1,399 Other ...................................................... 516 125 Valuation allowance ........................................ (2,750) (4,386) ---------- ---------- Total deferred tax assets .................................... 4,872 6,208 ---------- ---------- Deferred tax liabilities: Depreciation and lease expense ............................. 716 842 Amortization of discount on fixed maturity investments ..... 212 222 Unrealized gain on investments available for sale .......... 197 891 Deferred policy acquisition costs .......................... (155) 121 Other ...................................................... 372 132 ---------- ---------- Total deferred tax liabilities ............................... 1,342 2,208 ---------- ---------- Net deferred tax assets ...................................... $ 3,530 $ 4,000 ========== ==========
At December 31, 2002, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $5.5 million which expires in 2022. In addition, Chandler USA, at December 31, 2002, had net operating loss carryforwards available for Oklahoma state tax purposes totaling approximately $49.8 million which expire in the years 2003 through 2022. Also at December 31, 2002, Chandler USA had a capital loss carryforward for U.S. Federal income taxes of $4.1 million which expires in 2007. A valuation allowance has been provided for the tax effect of the state net operating loss and net capital loss carryforwards since realization of such amounts is not considered more likely than not. NOTE 8. EMPLOYEE BENEFITS Chandler USA and its subsidiaries participate in a defined contribution retirement plan established under Section 401(k) of the Internal Revenue Code. All full time employees who have completed one year of service and attained age 21 may elect to participate in the 401(k) plan. Participants may contribute up to 15% 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 $4,100 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 $264,000, $272,000 and $282,000 for 2000, 2001 and 2002, respectively. NOTE 9. FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS. The estimated fair value amounts have been determined by Chandler USA, using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates of fair values presented herein are not necessarily indicative of the amounts that Chandler USA could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. PAGE F-18 A number of Chandler USA's significant assets (including deferred policy acquisition costs, property and equipment, reinsurance recoverables, prepaid reinsurance premiums, state insurance licenses and goodwill) 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, 2001 and 2002. The estimated fair values of Chandler USA's fixed-maturity and equity security investments are disclosed at Note 2. At December 31, 2002, the fair value of Chandler USA's debentures was estimated to be $23 million based on quoted market prices for similar securities. 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. NOTE 10. LITIGATION Chandler Insurance and certain of its subsidiaries and affiliates, including Chandler USA, were previously involved in various matters of litigation with CenTra, Inc. ("CenTra"). During the CenTra litigation, a Nebraska Federal Court had previously ordered CenTra to divest all shares of Chandler Insurance stock owned or controlled by it or its affiliates. In December 1999, Chandler Insurance acquired 1,989,200 shares of its own stock in exchange for payment of $15,204,758 to CenTra and its affiliates. During November 2000, Chandler Insurance acquired the remaining 1,142,625 of its common shares in exchange for payment of $6,882,500 to CenTra and its affiliates pursuant to a ruling of the U.S. District Court for the Western District of Oklahoma ("Oklahoma Court") in April 1997, which was upheld by the 10th Circuit Court of Appeals in September 2000. Following the execution of the judgment of the Nebraska Federal Court, CenTra filed pleadings in the Oklahoma Court claiming entitlement to post-judgment interest on the amounts Chandler Insurance was ordered to pay in exchange for the transfer of the shares. CenTra claimed that it was entitled to post-judgment interest amounting to approximately $2.5 million. The Oklahoma Court denied CenTra's claim for post-judgment interest in August 2002. In the CenTra litigation, certain officers and directors of Chandler USA and Chandler Insurance were named as defendants. In accordance with its Articles of Association, Chandler Insurance and its subsidiaries have advanced the litigation expenses of these persons in exchange for undertakings to repay such expenses if those persons are later determined to have breached the standard of conduct provided in the Articles of Association. These expenses together with certain other expenses may be recovered from Chandler Insurance's director and officer liability insurance policy (the "D&O Insurer"). As a result of various events in 1995, 1996 and 1997, Chandler Barbados and Chandler USA recorded estimated recoveries of costs from its D&O Insurer totaling $3,456,000 and $1,044,000, respectively, for reimbursable amounts previously paid that relate to allowable defense and litigation costs for such parties. Chandler Barbados and Chandler USA received payment for a 1995 claim during 1996 in the amount of $636,000 and $159,000, respectively. The balance of $2,820,000 and $885,000 is included in other assets in Chandler Barbados' and Chandler USA's respective balance sheets. Chandler Insurance and its subsidiaries contend they are entitled to a total of $5 million under the applicable insurance policy to the extent they have advanced reimbursable expenses. The D&O Insurer contends that certain policy provisions exclude coverage for these claims. On August 22, 2001, Chandler Insurance and its subsidiaries, including Chandler USA, filed an action in the State District Court in Oklahoma City, Oklahoma ("Oklahoma State Court") alleging that the director and officer liability insurance policies should be rescinded and seeking repayment of more than $5 million in premiums they previously paid. Chandler Insurance and its subsidiaries are currently involved in litigation with the insurer for payment of the policy balance or rescission and repayment of premiums previously paid. The litigation is pending in the Oklahoma State Court. The case is still in the early pleading stages and Chandler USA cannot predict the date of resolution or the outcome of this case. Chandler Insurance and its subsidiaries may or may not recover the remaining policy limits or the previously paid premiums and could incur significant costs in resolving this matter. 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. Transamerica owed NAICO approximately $1.5 million for reinsurance recoverables on paid losses and loss adjustment expenses as of December 31, 2002. NAICO is currently engaged in arbitration in order to enforce the terms of the reinsurance treaties. 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. PAGE F-19 NOTE 11. COMMITMENTS AND CONTINGENCIES REINSURANCE In the ordinary course of business, NAICO cedes insurance to other insurers and reinsurers under various reinsurance treaties that cover individual risks (facultative reinsurance) or entire classes of business (treaty reinsurance). Reinsurance provides greater diversification of business written and also reduces NAICO's exposure arising from high limits of liability or from hazards of an unusual nature. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In formulating its reinsurance programs, NAICO considers numerous factors, including the financial stability of the reinsurer, ability to provide sufficient collateral (if required), reinsurance coverage offered and price. NAICO has structured separate reinsurance programs for construction surety bonds, property (including inland marine), workers compensation, casualty (including automobile liability, general liability, umbrella liability and related professional liability) and automobile physical damage. Chandler Barbados reinsures NAICO for a portion of the risk on the construction surety bonds, workers compensation and casualty reinsurance programs. A portion of the risk that Chandler Barbados assumes from NAICO is reinsured by Chandler Insurance. 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, April 1 or July 1 of each year. NAICO renewed all January 1, 2003 reinsurance programs. At the present time, NAICO expects to renew the reinsurance programs that renew on April 1 or July 1, 2003, as applicable. 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, which resulted in a decrease in net premiums earned of $1,094,000 in 2000. NAICO did not accrue for any commutations during 2001 or 2002. Reliance Insurance Company ("Reliance") reinsured NAICO for certain workers compensation risks during 1998. At December 31, 2002, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses of approximately $2.8 million. During October 2001, the Commonwealth of Pennsylvania placed Reliance in liquidation. At this time, 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, 2002. 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 did not incur any charges for uncollectible reinsurance recoverables from unaffiliated reinsurers in 2000. During 2001 and 2002, NAICO incurred charges of $454,000 and $1.7 million, 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:
2000 2001 2002 ---------------------- ---------------------- ---------------------- WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED ----------- ---------- ----------- ---------- ----------- ---------- (In thousands) Direct ......... $ 197,041 $ 190,627 $ 158,741 $ 171,378 $ 139,876 $ 146,307 Assumed ........ 155 140 223 223 286 256 Ceded .......... (118,751) (105,248) (93,541) (101,616) (72,495) (79,606) ----------- ---------- ----------- ---------- ----------- ---------- Net premiums ... $ 78,445 $ 85,519 $ 65,423 $ 69,985 $ 67,667 $ 66,957 =========== ========== =========== ========== =========== ==========
PAGE F-20 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 $73.1 million, $99.9 million and $87.7 million for 2000, 2001 and 2002, 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, 2001 and 2002 were $24.2 million and $24.0 million, respectively. Receivables for deductibles, in most cases, are secured by cash deposits and letters of credit. At December 31, 2002, NAICO maintained custody of such letters of credit securing these and other transactions totaling approximately $14.5 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 2000, 2001 or 2002. NAICO's bail bond underwriting manager was responsible for gross written premiums of $2.5 million, $2.3 million and $2.3 million during 2000, 2001 and 2002, respectively. Approximately $25.9 million, or 26% of NAICO's reinsurance recoverables and prepaid reinsurance premiums at December 31, 2002 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, 2002.
CEDED REINSURANCE NET PREMIUMS FOR A.M. BEST REINSURANCE THE YEAR ENDED COMPANY NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2002 RATING - ---------------------------------------------------------- --------------- ------------------- --------- (Dollars in thousands) Swiss Reinsurance America Corporation .................... $ 34,661 $ 10,264 A++ Chandler Barbados ........................................ 17,798 24,115 -(2) GE Reinsurance Corporation ............................... 11,090 1,958 A+ Employers Reinsurance Corporation ........................ 6,869 10,151 A+ Red River Reinsurance, Ltd. .............................. 5,798 5,674 -(3) --------------- ------------------- Top five reinsurers .................................... $ 76,216 $ 52,162 =============== =================== All reinsurers ......................................... $ 98,575 $ 72,495 =============== =================== Percentage of total represented by top five reinsurers ... 77% 72% - ---------------------------------------------------------- (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, 2002. (2) Chandler Barbados owns 100% of the common stock of Chandler USA, which in turn owns 100% of the common stock of NAICO. Although Chandler Barbados 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, 2002, Chandler Barbados had cash and investments with a fair value of $18.7 million deposited in a trust account for the benefit of NAICO. (3) Red River Reinsurance, Ltd. ("Red River") is required to secure its reinsurance obligations by depositing acceptable securities in trust for NAICO's benefit. At December 31, 2002, Red River's reinsurance recoverables were collateralized by cash and investments with a fair value of $5.9 million deposited in a trust account for the benefit of NAICO and by premiums payable to Red River of approximately $766,000.
PAGE F-21 OTHER See Note 10 regarding contingencies relating to litigation matters. Chandler USA has an employment agreement with W. Brent LaGere, Chairman of the Board and Chief Executive Officer of Chandler USA and its subsidiaries. Under this agreement, Mr. LaGere's base compensation is established at not less than $250,000 per year. In the event that Mr. LaGere is terminated without cause, as defined in the agreement, he is entitled to receive his base compensation for the remainder of the term of the agreement, but in no event for more than 60 months. The agreement will terminate upon Mr. LaGere attaining age 70, unless earlier terminated by Chandler USA for cause. In addition to his base compensation, Mr. LaGere is eligible to receive certain benefits and bonuses from Chandler USA and its subsidiaries. Chandler USA has an employment agreement with Brenda B. Watson, an executive officer of NAICO and L&W. Under this agreement, Ms. Watson's base compensation is established at not less than $125,000 per year. The agreement terminates on December 31, 2003, unless earlier terminated by Chandler USA for cause, as defined in the agreement. In the event that Ms. Watson is terminated without cause, she is entitled to receive her base compensation through the termination date. In addition to her base compensation, Ms. Watson is eligible to receive certain benefits and to participate in an incentive bonus plan offered by 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 $921,000 and $1,049,000 at December 31, 2001 and 2002, 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 $798,000 and $1,808,000 at December 31, 2001 and 2002, respectively. NAICO may receive additional guaranty fund assessments in the future related to Reliance or other insolvent insurance companies. At this time, NAICO is unable to estimate the amount of such assessments. At December 31, 2002, 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 $541,000, $1,084,000 and $1,086,000 in 2000, 2001 and 2002, respectively. Future minimum lease payments are as follows:
(In thousands) 2003 .......................... $ 836 2004 .......................... 272 2005 .......................... 67 2006 .......................... 20 -------------- $ 1,195 ==============
During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment. Chandler USA agreed to lease the equipment for three years with monthly rental installments equal to the sum of (i) $22,167 plus (ii) interest on the unpaid lease balance at a floating interest rate of 1% over Chase Manhattan Bank Prime, which was 4.25% at December 31, 2002. The sale and leaseback transaction resulted in a reduction of property and equipment of $1.9 million and a deferred gain of $2.0 million which is included in accrued taxes and other payables. Chandler USA has exercised its option to repurchase the equipment at the end of the lease for approximately $3.0 million and will amortize the deferred gain into income over the final year of the lease. NOTE 12. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS Chandler USA leases and has made certain improvements to a rural property in which certain directors and/or officers of Chandler USA own interests. Under the lease, no cash rental is paid, but a subsidiary of 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 $265,000, $263,000 and $255,000 in expenses associated with this property during 2000, 2001 and 2002, respectively, including $9,000, $25,000 and $18,000 paid to Davenport Farms for reimbursement of certain expenses, such as utility and similar expenses, for the years 2000, 2001 and 2002, respectively. PAGE F-22 During 2001, Chandler USA and Chandler Barbados entered into 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, 2001 and 2002, Chandler Barbados owed approximately $7.9 million and $10.6 million, respectively, to Chandler USA, and Chandler USA earned $371,000 and $380,000 in interest income from Chandler Barbados during 2001 and 2002, respectively. NOTE 13. 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, 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 47%, 49% and 53% of gross written premiums in 2000, 2001 and 2002, respectively, while Texas accounted for approximately 42%, 41% 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, allocated to each insurance program. 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 2000 2001 2002 - ---------------------------------------------------- ---------- ---------- ---------- (In thousands) NET PREMIUMS EARNED Standard property and casualty ..................... $ 62,823 $ 53,130 $ 49,570 Political subdivisions ............................. 12,826 12,534 13,829 Surety bonds ....................................... 6,467 4,125 3,310 Other (1) .......................................... 3,403 196 248 ---------- ---------- ---------- $ 85,519 $ 69,985 $ 66,957 ========== ========== ========== LOSSES AND LOSS ADJUSTMENT EXPENSES Standard property and casualty ..................... $ 48,140 $ 37,707 $ 40,194 Political subdivisions ............................. 10,339 11,420 7,726 Surety bonds ....................................... 2,270 2,339 1,967 Other (1) .......................................... 4,250 1,084 825 ---------- ---------- ---------- $ 64,999 $ 52,550 $ 50,712 ========== ========== ========== - -------------------------------------- (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 F-23 NOTE 14. GOING PRIVATE TRANSACTION - PARENT COMPANY A special meeting of shareholders of Chandler USA's indirect parent, Chandler Insurance, was held on March 5, 2001. Three proposals which constitute a going private transaction were approved at the meeting, and Chandler Insurance completed the going private transaction in March 2001. Chandler Insurance financed the going private transaction through (i) a $2.4 million sale of Chandler Insurance Class A Common Shares to Messrs. LaGere and Paden, (ii) a $10.7 million intercompany loan from Chandler Barbados, and (iii) proceeds of approximately $735,000 from the exercise of outstanding Chandler Insurance options. Chandler USA loaned approximately $10.7 million to Chandler Barbados. Chandler USA's intercompany loan to Chandler Barbados was financed by a $3.8 million sale and leaseback transaction for certain equipment owned by Chandler USA and a $7.0 million dividend declared and paid by NAICO. NOTE 15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) A summary of the unaudited quarterly operating results during 2001 and 2002 follows:
First Second Third Fourth Total quarter quarter quarter quarter year --------- --------- --------- --------- --------- 2001 - -------------------------------------------- Net premiums earned ........................ $ 18,876 $ 18,067 $ 17,406 $ 15,636 $ 69,985 Interest income, net ....................... 1,148 881 858 1,116 4,003 Realized investment gains, net ............. 616 266 712 1,060 2,654 Income (loss) before income taxes .......... 370 (353) 397 (879) (465) Income (loss) from continuing operations ... 200 (257) 217 (641) (481) Income (loss) from discontinued operations.. (312) (95) (42) (173) (622) Net income (loss) .......................... (112) (352) 175 (814) (1,103) 2002 - -------------------------------------------- Net premiums earned ........................ $ 16,225 $ 17,126 $ 16,972 $ 16,634 $ 66,957 Interest income, net ....................... 695 798 665 762 2,920 Realized investment gains, net ............. 16 388 - 390 794 Income (loss) before income taxes .......... (136) 1,203 (71) (5,722) (4,726) Income (loss) from continuing operations ... (157) 761 (82) (3,568) (3,046) Income (loss) from discontinued operations.. 41 198 56 (11) 284 Gain on sale of subsidiary ................. - - - 671 671 Net income (loss) .......................... (116) 959 (26) (2,908) (2,091)
* * * * * * * PAGE F-24 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholder of Chandler (U.S.A.), Inc.: We have audited the consolidated statements of operations, comprehensive income, shareholder's equity and cash flows of Chandler (U.S.A.), Inc. and subsidiaries ("Chandler USA") for the year ended December 31, 2000 (none of which are presented herein). Our audits also included the financial statement schedules of condensed financial information of registrant and supplementary insurance information (neither of which are presented herein), reinsurance, valuation and qualifying accounts and supplemental information for property-casualty insurance underwriters (which are presented herein) for the year ended December 31, 2000. The 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 audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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 audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the results of operations and the cash flows of Chandler (USA), Inc. and subsidiaries for the year ended December 31, 2000, 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. As discussed in Note 10 to the consolidated financial statements, Chandler USA is involved in various legal proceedings, the outcome of which is uncertain. /s/ Deloitte & Touche LLP DELOITTE & TOUCHE LLP Tulsa, Oklahoma February 16, 2001 (March 5, 2001 as to Note 14) PAGE F-25 INDEPENDENT AUDITORS' REPORT 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, 2001 and 2002, and the related consolidated statements of operations, comprehensive income, cash flows and shareholder's equity for the years then ended. Our audit also included the financial statement schedules as of and for the years ended December 31, 2001 and 2002, 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 auditing standards generally accepted in the United States of America. 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, 2001 and 2002, and the results of its operations and its cash flows for the years then ended 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. As discussed in Note 4 to the consolidated financial statements, the Company sold its agency business segment in 2002. We audited the adjustments necessary to restate the 2000 consolidated financial statements to report the sale of the segment as a discontinued operation. In our opinion, such adjustments are appropriate and have been properly applied. /s/ Tullius Taylor Sartain & Sartain LLP TULLIUS TAYLOR SARTAIN & SARTAIN LLP Tulsa, Oklahoma February 7, 2003 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, 2002 (In thousands)
AMOUNT AT WHICH SHOWN IN THE TYPE OF INVESTMENT COST FAIR VALUE BALANCE SHEET - ------------------------------------------------- ------------ ------------ --------------- FIXED MATURITIES AVAILABLE FOR SALE: U.S. Treasury securities and obligations of U.S. government corporations and agencies .......... $ 37,135 $ 38,483 $ 38,483 Corporate obligations ........................... 11,173 11,525 11,525 Public utilities ................................ 6,791 7,031 7,031 ------------ ------------ --------------- 55,099 57,039 57,039 FIXED MATURITIES HELD TO MATURITY: U.S. Treasury securities and obligations of U.S. government corporations and agencies .......... 1,220 1,289 1,220 EQUITY SECURITIES AVAILABLE FOR SALE: Corporate stock ................................. - 681 681 ------------ ------------ --------------- Total investments ............................. $ 56,319 $ 59,009 $ 58,940 ============ ============ ===============
SEE INDEPENDENT AUDITORS' REPORT. 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, --------------------- 2001 2002 ---------- ---------- ASSETS Cash ............................................................ $ - $ 2,355 Premiums receivable ............................................. - 979 Amounts due from subsidiaries ................................... 2,075 1,762 Property and equipment, net ..................................... 876 825 Amounts due from related parties ................................ 7,880 10,582 Other assets .................................................... 4,288 4,870 Goodwill ........................................................ 2,350 - Investment in subsidiaries, net ................................. 54,594 52,036 ---------- ---------- Total assets .................................................... $ 72,063 $ 73,409 ========== ========== LIABILITIES AND SHAREHOLDER'S EQUITY Liabilities Accrued taxes and other payables .............................. $ 4,321 $ 4,081 Premiums payable .............................................. - 2,328 Debentures .................................................... 24,000 24,000 ---------- ---------- Total liabilities ............................................... 28,321 30,409 ---------- ---------- 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 ........................................... (17,225) (19,316) Accumulated other comprehensive income: Unrealized gain on investments held by subsidiary and available for sale, net of deferred income taxes ...................... 381 1,730 ---------- ---------- Total shareholder's equity ...................................... 43,742 43,000 ---------- ---------- Total liabilities and shareholder's equity ...................... $ 72,063 $ 73,409 ========== ==========
SEE INDEPENDENT AUDITORS' REPORT. 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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- Revenues Interest income, net ...................................... $ 19 $ 8 $ 7 Interest income, net from related parties ................. - 371 380 Commissions, fees and other income ........................ 798 618 765 ---------- ---------- ---------- Total revenues .......................................... 817 997 1,152 ---------- ---------- ---------- Operating costs and expenses General and administrative expenses ....................... 2,069 2,442 3,529 Interest expense .......................................... 2,214 2,213 2,213 ---------- ---------- ---------- Total operating costs and expenses ...................... 4,283 4,655 5,742 ---------- ---------- ---------- Loss from continuing operations before income tax benefit ... (3,466) (3,658) (4,590) Federal income tax benefit .................................. 979 1,143 1,729 ---------- ---------- ---------- Net loss from continuing operations before equity in net income (loss) of subsidiaries ...................... (2,487) (2,515) (2,861) Equity in net income (loss) of subsidiaries ................. (895) 2,025 133 ---------- ---------- ---------- Net loss from continuing operations ......................... (3,382) (490) (2,728) Loss from discontinued operations ........................... (613) (613) (34) Gain on sale of subsidiary .................................. - - 671 ---------- ---------- ---------- Net loss .................................................... $ (3,995) $ (1,103) $ (2,091) ========== ========== ==========
SEE INDEPENDENT AUDITORS' REPORT. 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, -------------------------------- 2000 2001 2002 ---------- ---------- ---------- OPERATING ACTIVITIES Net loss ...................................................... $ (3,995) $ (1,103) $ (2,091) Add (deduct): Adjustments to reconcile net loss to cash applied to operating activities: Net (income) loss of subsidiaries not distributed to parent.. 895 (2,025) (133) Net (gains) losses on sale of property and equipment ........ 6 2 (12) Gain on sale of subsidiary .................................. - - (671) Amortization and depreciation ............................... 1,306 834 222 Net change in non-cash balances relating to operating activities: Premiums receivable ....................................... - - 2,778 Amounts due from subsidiaries ............................. (690) 264 314 Other assets .............................................. (708) 1,121 1,428 Accrued taxes and other payables .......................... 520 (729) (692) Premiums payable .......................................... - - (3,200) ---------- ---------- ---------- Cash applied to operating activities ........................ (2,666) (1,636) (2,057) ---------- ---------- ---------- INVESTING ACTIVITIES Cost of property and equipment purchased ...................... (61) (682) (103) Proceeds from sale of property and equipment .................. 43 3,915 57 Proceeds from sale of subsidiary .............................. - - 3,247 Investment in subsidiary ...................................... - - (2) ---------- ---------- ---------- Cash provided by (applied to) investing activities .......... (18) 3,233 3,199 ---------- ---------- ---------- FINANCING ACTIVITIES Shareholder dividend from subsidiaries ........................ 2,500 7,000 3,915 Payments and loans from related parties ....................... 1,200 4,032 3,249 Payments and loans to related parties ......................... (1,016) (12,629) (5,951) ---------- ---------- ---------- Cash provided by (applied to) financing activities .......... 2,684 (1,597) 1,213 ---------- ---------- ---------- Increase in cash and cash equivalents ........................... - - 2,355 Cash and cash equivalents at beginning of year .................. - - - ---------- ---------- ---------- Cash and cash equivalents at end of year ........................ $ - $ - $ 2,355 ========== ========== ==========
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-30 SCHEDULE III CHANDLER (U.S.A.), INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands)
FUTURE POLICY AMORTI- BENEFITS, OTHER ZATION OF NET DEFERRED LOSSES, POLICY CLAIMS, DEFERRED PREMIUMS POLICY CLAIMS CLAIMS AND NET LOSSES 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, 2000 Property and casualty .. $ (12) $100,173 $ 74,198 $ 5,062 $ 85,519 $ 4,281 $ 64,999 $ 16,882 $ 12,812 $ 78,445 ========== ======== ======== ========== ========= ========= ========== =========== ========= ======== DECEMBER 31, 2001 Property and casualty .. $ (456) $ 84,756 $ 61,562 $ 4,600 $ 69,985 $ 4,003 $ 52,550 $ 10,869 $ 13,789 $ 65,423 ========== ======== ======== ========== ========= ========= ========== =========== ========= ======== 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 ========== ======== ======== ========== ========= ========= ========== =========== ========= ========
SEE INDEPENDENT AUDITORS' REPORT. 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, 2000 Property and casualty ........................... $ 197,041 $ (118,751) $ 155 $ 78,445 0.20 % ============ ============ ============ ============ ============ Year ended December 31, 2001 Property and casualty ........................... $ 158,741 $ (93,541) $ 223 $ 65,423 0.34 % ============ ============ ============ ============ ============ Year ended December 31, 2002 Property and casualty ........................... $ 139,876 $ (72,495) $ 286 $ 67,667 0.42 % ============ ============ ============ ============ ============
SEE INDEPENDENT AUDITORS' REPORT. 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: 2000 ............................................ $ 263 $ 179 $ (134) $ 308 ================ ================ ================ ================ 2001 ............................................ $ 308 $ 305 $ (315) $ 298 ================ ================ ================ ================ 2002 ............................................ $ 298 $ 444 $ (496) $ 246 ================ ================ ================ ================ Allowance for non-collection of reinsurance recoverables on paid and unpaid losses: 2000 ............................................ $ 577 $ - $ 95 $ 672 ================ ================ ================ ================ 2001 ............................................ $ 672 $ 454 $ (30) $ 1,096 ================ ================ ================ ================ 2002 ............................................ $ 1,096 $ 1,726 $ (55) $ 2,767 ================ ================ ================ ================
SEE INDEPENDENT AUDITORS' REPORT. 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, 2000 Property-casualty ........................................ $ - $ 69,534 =============== =============== Year ended December 31, 2001 Property-casualty ........................................ $ - $ 66,395 =============== =============== Year ended December 31, 2002 Property-casualty ........................................ $ - $ 50,296 =============== ===============
SEE INDEPENDENT AUDITORS' REPORT. EX-10.5 3 spa7fnledg.txt EXHIBIT 10.5 STOCK PURCHASE AGREEMENT PAGE 1 STOCK PURCHASE AGREEMENT This STOCK PURCHASE AGREEMENT, dated as of December 20, 2002 but effective as of December 1, 2002 (this "AGREEMENT"), is made and entered into by and among BROWN & BROWN, INC., a Florida corporation ("BUYER"); CHANDLER (U.S.A.), INC., an Oklahoma corporation (the "SHAREHOLDER"); CHANDLER INSURANCE COMPANY, LTD., a Cayman Islands corporation ("PARENT"; the Shareholder and Parent are sometimes collectively referred to herein as the "SELLERS"); NATIONAL AMERICAN INSURANCE COMPANY, an Oklahoma corporation ("NAICO"); W. BRENT LAGERE, a resident of the State of Oklahoma ("LAGERE"); and MARK T. PADEN, a resident of the State of Oklahoma (together with LaGere, each a "PRINCIPAL" and collectively, the "PRINCIPALS"). The Sellers, NAICO, and the Principals are sometimes collectively referred to herein as the "SELLING PARTIES". BACKGROUND The Shareholder owns all of the outstanding capital stock of LaGere & Walkingstick Insurance Agency, Inc., an Oklahoma corporation (the "COMPANY"). The Principals are the sole shareholders of Parent, which in turn is the indirect shareholder of the Shareholder. The Company is engaged primarily in the insurance agency business in the State of Oklahoma. The Shareholder wishes to sell all of the outstanding shares of the Company to Buyer, and Buyer desires to acquire such shares, upon the terms and conditions expressed in this Agreement (the "ACQUISITION"). Parent (including its subsidiaries), NAICO and the Principals are each an "affiliate" of the Company, as such term is defined in Rule 144(a)(1) under the Securities Act of 1933, as amended) (an "AFFILIATE"), and wish to enter into this Agreement to provide certain non-competition, indemnification and other assurances to Buyer as a material inducement for Buyer to enter into the Acquisition and the other transactions contemplated by this Agreement (collectively, the "CONTEMPLATED TRANSACTIONS"). THEREFORE, in consideration of the respective representations, warranties, covenants and agreements set forth herein, the receipt and sufficiency of which is hereby acknowledged, the parties, intending to be legally bound, each agree as follows: ARTICLE 1 THE ACQUISITION Section 1.1PURCHASE AND SALE OF SHARES. (a) On and subject to the terms and conditions of this Agreement, Buyer agrees to purchase one thousand (1,000) shares of common stock of the Company, par value $1.00 per share (the "COMPANY SHARES"), from the Shareholder, and the Shareholder agrees to sell all of the Company Shares to Buyer, free and clear of all Encumbrances (as defined below). The Company Shares constitute all of the issued and outstanding shares of capital stock of the Company as of the Closing Date. The Company Shares shall be sold to Buyer for the consideration specified in SECTION 1.2. (b) For purposes of this Agreement, the term "ENCUMBRANCE" means any charge, claim, community or other marital property interest, condition, equitable interest, lien, PAGE 2 option, pledge, security interest, mortgage, right of way, easement, encroachment, servitude, right of first option, right of first refusal or similar restriction, including any restriction on use, voting (in the case of any security or equity interest), transfer, receipt of income or exercise of any other attribute of ownership. Section 1.2 PURCHASE PRICE. (a) The purchase price for the Company Shares (the "TOTAL PURCHASE PRICE") shall be equal to: (i) An amount equal to eighty percent (80%) of the sum of: (A) 1.5 TIMES the average annual Core Revenue (as defined below) earned by the Company during the two (2)-year period ending November 30, 2004 (the "REGULAR ACCOUNTS EARN-OUT PERIOD") from those accounts within the Purchased Book of Business (as defined below) generating $50,000.00 or less in annual Core Revenue as of the Effective Date (as defined in SECTION 2.7 hereof) (the "REGULAR ACCOUNTS AMOUNT"); PLUS (B) 0.5 TIMES the actual annual contingent commissions received by the Company during the two (2) consecutive twelve (12)-month periods ending November 30, 2003 and November 30, 2004, respectively (the "CONTINGENT AMOUNT"); PLUS (C) 0.5 TIMES the annual Core Revenue earned by the Company during the three (3)-year period ending November 30, 2005 (the "LARGE ACCOUNTS EARN-OUT PERIOD") from those accounts, as renewed, within the Purchased Book of Business generating more than $50,000.00 in annual Core Revenue as of the Effective Date (the "LARGE ACCOUNTS AMOUNT"); MINUS (ii) The aggregate consideration to be paid to the Principals, Parent and NAICO for their respective Non-Compete Covenants and Non-Solicitation Covenants as defined under SECTION 6.5 hereof and as set forth in SCHEDULE 1.2(a)(ii) hereto (the "NONCOMPETE AMOUNT"); PROVIDED, HOWEVER, that neither the aggregate Noncompete Amount nor the allocation of the Noncompete Amount set forth in SCHEDULE 1.2(a)(ii) shall be deemed or construed to limit the amount recoverable by Buyer in the event of a breach of the covenants of any of the Selling Parties contained in SECTION 6.5, which amount shall rather be measured by the amount of any Adverse Consequences suffered or incurred by Buyer; PROVIDED, HOWEVER, that: (x) The minimum Purchase Price shall equal $3,607,680.37, which is equal to seventy-five percent (75%) of 1.5 TIMES $3,206,827.00, the Core Revenue generated by the Current Book of Business (as defined below) during the twelve (12)-month period ended November 30, 2002 (the "MINIMUM PURCHASE PRICE AMOUNT"); (y) The maximum Purchase Price shall equal $6,012,800.62, which is equal to one hundred twenty-five percent (125%) of 1.5 TIMES Core Revenue generated by the Current Book of Business during the twelve (12)-month period ended November 30, 2002 (the "MAXIMUM PURCHASE PRICE AMOUNT"); and PAGE 3 (z) Subject to the Minimum Purchase Price Amount, (i) in the event that the profit center formed to operate the Company's business (the "NEW PROFIT CENTER") does not maintain an average annual Operating Profit (as defined below) margin of at least twenty-five percent (25%) as of the end of the two (2)-year period ending November 30, 2004, then the amount of the Regular Accounts Amount payable at that time shall be reduced by an amount equal to the Regular Accounts Amount TIMES the difference between the New Profit Center's actual Operating Profit Margin and twenty-five percent (25%), and (ii) in the event that (A) NAICO's A.M. Best rating drops below "B++" at any time during the three (3)-year period following the Effective Date and Buyer exercises its right, as described below, to rewrite any business written with NAICO with Buyer's carriers, or (B) NAICO enters into receivership, makes an assignment for the benefit of creditors, or a petition for bankruptcy protection is filed voluntarily by NAICO or involuntarily against NAICO that is not dismissed within ten (10) days after such filing, any unearned, return premium amounts relating to business written with NAICO due to the accounts comprising the Purchased Book of Business shall be offset against any Purchase Price amounts otherwise due to the Shareholder. (b) As defined herein, the term: (i) "CORE REVENUE" means commission revenue net of any commissions paid to any third party producing agent or agency, or to any third party broker, but shall not include late fees charged to clients, contingent commissions, override commissions, first year life insurance commissions, any life insurance commissions for policies written on the lives of any director, officer or key employee of the Company, the Shareholder, Parent, NAICO, or any other Affiliate of any of the foregoing entities, or any family member of any director, officer or key employee of the Company, the Shareholder, Parent, NAICO, or any other Affiliate of any of the foregoing entities, or any income item (such as interest and countersignature fees) other than earned commissions and fees earned in lieu of commissions. Revenues generated from any one account shall not be included more than once in any twelve (12)-month period in determining Core Revenue for such period. Core Revenue shall be determined in accordance with generally accepted accounting principles and in any event in accordance with Buyer's standard accounting methodology and procedures. Specifically, direct bill revenue is recognized when received (cash basis) and agency bill revenue is recognized on the later of the effective date of the policy installment or the date the installment is billed to the customer. (ii) "PURCHASED BOOK OF BUSINESS" means (A) those active accounts (I.E., accounts that have not canceled or non-renewed) of the Company as of Closing, excluding any sub-brokered or co-brokered accounts (the "CURRENT BOOK OF BUSINESS"), PLUS (B) any new business generated by the New Profit Center during the two (2)-year or three (3)-year earn-out period, as applicable, MINUS (net of) (C) any business lost during the applicable Earn-Out Period and excluding any agency or book of business acquired by the New Profit Center during the Earn-Out Period. The Purchased Book of Business shall only include accounts that are one hundred percent (100%) owned as of the end of the Earn-Out Period; no revenue would be included for co-brokered or sub-brokered accounts. (iii) "OPERATING PROFIT" means the excess of revenues (excluding contingent commission revenues except as described below) over expenses, determined in PAGE 4 accordance with generally accepted accounting principles and in any event pursuant to Buyer's usual methods and conventions of accounting, as reflected in the pro forma profit and loss statement attached hereto as SCHEDULE 1.2(b)(iii) (the "PRO FORMA"). (A) Operating income as set forth in the Pro Forma reflects the annual average contingent commission revenues generated by the Company (whether or not actually received by the Company) over the sixty (60)-month period prior to Closing. Buyer shall determine the amount of profit-sharing and contingent commission revenue to be included within Operating Profit during the Regular Accounts Earn-Out Period by calculating the annual average profit-sharing and contingent commission revenues over the sixty (60)-month period prior to such determination (I.E., Buyer shall calculate the annual average for the sixty (60)-month period ending as of the end of the Regular Accounts Earn-Out Period). (B) Among other things in determining Operating Profit, direct bill commission revenue shall be deemed earned on the cash method and agency bill commission income shall be deemed earned on the later of the policy's effective date or the policy installment billing date. However, in no event shall there be more than twelve (12) months of revenue in any twelve (12) month-period. Further, as to any account (i) for which greater than $100,000 in commission revenue has been booked in the six (6)-month period prior to Closing, or (ii) which generates revenues, regardless of amount, in the form of fees rather than commissions, such commission or fee revenue (as the case may be) and related expense shall be treated as being earned and incurred pro-rata over the Regular Accounts Earn-Out Period. (C) Revenues during the Earn-Out Period shall exclude any life insurance commissions for policies written on the lives of any director, officer or key employee of the Company, the Shareholder, Parent, NAICO, or any other Affiliate of any of the foregoing entities, or any family member of any director, officer or key employee of the Company, the Shareholder, Parent, NAICO, or any other Affiliate of any of the foregoing entities. (D) Expenses shall include all standard corporate charges of Buyer as reflected in the Pro Forma, including but not limited to: an overhead charge based on revenues (net of commission and fee expenses) as calculated in the manner set forth in the Pro Forma (which shall be set at four percent (4.0%) for purposes of determining the Purchase Price); charges for insurance coverages allocated in the manner shown in the Pro Forma; charges up to the first $25,000.00 of any judgment or settlement amounts, and the full amount of all related legal fees, costs and expenses, with respect to any errors and omissions claim or unlawful discrimination or harassment claim after the Closing Date against the New Profit Center to which Buyer's errors and omissions (E&O) policy or employment practices liability (EPL) policy, as the case may be, must respond (Parent shall be responsible for the full amount of any deductibles or legal fees, costs or expenses for any such claims as to which its applicable tail policy must respond); one hundred percent (100%) of the profit center bonus payable to the New Profit Center for the applicable period, in accordance with Buyer's profit center bonus program as set forth in SCHEDULE 1.2(b)(iii)(D); but shall not include income Taxes or amortization expense. Expenses associated with the office relocation to the Oklahoma City metropolitan area shall also be excluded for purposes of determining Operating Profit, PROVIDED that, in the event such relocation occurs within the six-(6) month period following the Effective Date, any rental PAGE 5 expense attributable to the new office location shall not be excluded for purposes of determining Operating Profit. In determining Operating Profit, accounts receivable aged in excess of fifty-nine (59) days are written off as bad debt expense; PROVIDED, HOWEVER, that accounts receivable aged in excess of forty-five (45) days as of February 15, 2006 shall also be written off as bad debt expense. (E) Additionally, the Shareholder must immediately apply for and maintain a term life insurance policy on the life of Company employee Malinda Laird ("LAIRD") with limits at least equal to the Minimum Purchase Price Amount and with a term at least equal to the Large Accounts Earn-Out Period. Such term life insurance policy shall be assigned to Buyer pursuant to the Assignment of Life Insurance Policy described in SECTION 2.2(d) hereof, and must provide Buyer with the right to be informed if the premium for such policy has not been paid by Parent, as well as the right in such event to pay such premium (or, if such policy is canceled for non-payment, Buyer may obtain a term life insurance policy on the life of Laird with Buyer named as beneficiary). In the event Buyer must pay such premium for such assigned policy or, if canceled, must pay premium for a new term life policy, such premium shall be included as an expense within the New Profit Center income statement. (F) The Pro Forma sets forth the parties' current expectation as to revenues and expenses for the first twelve (12)-month measurement period of the Regular Accounts Earn-Out Period. In determining Operating Profit in the second and third twelve (12)-month measurement periods of the Regular Accounts Earn-Out Period, expenses shown in the Pro Forma for the first twelve (12)-month measurement period shall be subject to normal and prudent increases in the second and third twelve (12)-month measurement periods to reflect normal increases incident to the business, such as pay raises for non-commission employees that the parties expect shall average three and one-half percent (3.5%) per year, and otherwise in a manner consistent with Buyer's accounting methodology as of the Closing Date. Line item expenses may be decreased in certain cases, but only upon agreement of Buyer based on the most recent year's operating results of the New Profit Center. Without limiting the foregoing: (1) There shall be no material staff reductions unless dictated by a corresponding reduction in business or, in individual cases and with Buyer's reasonable prior written approval, unless there is a legitimate business reason unrelated to the determination of the Purchase Price. In addition, the method of revenue and expense recognition in the second twelve (12)-month measurement period must be consistently applied (I.E., the changeover from the Company's system of revenue and expense recognition to that of Buyer must be completed prior to the end of the first twelve (12)-month measurement period); (2) An amount equal to two-thirds (2/3) of any profit center bonus payable to the New Profit Center shall be allocated to the New Profit Center for distribution at the sole discretion of the New Profit Center Manager, and the remaining one-third (1/3) amount shall be allocated to Buyer; and (3) No Buyer acquisitions made in the Oklahoma City metropolitan area shall be merged into the New Profit Center until the Large Accounts Earn-Out Period is concluded, unless mutually agreed-upon by the parties (or, if Buyer nevertheless merges PAGE 6 any acquisition into the New Profit Center without such mutual agreement, any revenue or expenses attributable to such acquisition shall be excluded for purposes of determining Operating Profit for the New Profit Center). (G) It is the intention of the parties that the New Profit Center Manager shall have broad discretion to run the New Profit Center, within sound business practices and overall corporate policies existing as of the Closing Date. Notwithstanding the foregoing, Buyer shall not take action to increase expenses to the New Profit Center during the Earn-Out Period for the primary purpose of minimizing the Purchase Price. (c) Subject to SECTION 1.2(d), the Purchase Price shall be paid to the Shareholder as follows: (i) A down payment of $3,246,912.33 (the "DOWN PAYMENT AMOUNT"), which is equal to ninety percent (90%) of the Minimum Purchase Price Amount, shall be paid to the Shareholder at the Closing; (ii) The Non-Compete Amount shall be paid in appropriate amounts to the Principals, Parent and NAICO pursuant to SCHEDULE 1.2(a)(iv) hereto at the Closing; (iii) Buyer shall calculate and, subject to the Minimum and Maximum Purchase Price Amounts, pay (A) the first Contingent Amount, (B) the first Large Accounts Amount, and (C) the remaining ten percent (10%) of the Minimum Purchase Price Amount (the "HOLDBACK AMOUNT"), to the Shareholder on or before December 31, 2003; (iv) Buyer shall calculate the final Regular Accounts Amount, the second Contingent Amount and the second Large Accounts Amount, and, subject to the Minimum and Maximum Purchase Price Amounts, pay the resulting amounts, less the Minimum Purchase Price Amount (including the Holdback Amount), to the Shareholder on or before December 31, 2004; and (v) Buyer shall calculate and, subject to the Minimum and Maximum Purchase Price Amounts, pay the third and final Large Accounts Amount to the Shareholder on or before February 15, 2006. No portion of the Purchase Price shall bear interest. (d) The deferred portions of the Purchase Price described in CLAUSES (iii), (iv), AND (v) of SECTION 1.2(c) shall be subject to reduction by Buyer to offset any obligations of the Sellers under the indemnification provisions contained in ARTICLE 8 hereof. As additional security, at the Closing, the Shareholder, Buyer and Bank of Oklahoma , as trustee (the "TRUSTEE"), shall enter into a Trust Agreement substantially in the form of EXHIBIT 2.2(v)(ii) hereto (the "TRUST AGREEMENT"), pursuant to which the Shareholder shall deposit with the Trustee, and maintain a minimum aggregate balance during the term of the Trust Agreement of $500,000.00 in "Assets" (as defined in the Trust Agreement). Satisfaction of any indemnity obligations from the deferred portion of the Purchase Price and/or the Assets on deposit with the PAGE 7 Trustee pursuant to the Trust Agreement shall not operate to waive the indemnification obligations of the Sellers contained in ARTICLE 8 for damages incurred by Buyer in excess of such aggregate amounts. ARTICLE 2 CLOSING, ITEMS TO BE DELIVERED, FURTHER ASSURANCES, AND EFFECTIVE DATE Section 2.1 CLOSING. The consummation of the Acquisition (the "CLOSING") shall take place at 9 a.m., local time, on December 20, 2002 (the "CLOSING DATE"), at Buyer's office located at 401 E. Jackson Street, Suite 1700, Tampa, Florida 33602 unless another date or place is agreed to by the parties hereto. Section 2.2 CLOSING OBLIGATIONS. At the Closing: (a) The Shareholder shall deliver to Buyer: (i) Certificates representing the Company Shares to Buyer, with executed and notarized stock powers attached, for transfer to Buyer; (ii) A release in the form of EXHIBIT 2.2(a)(ii), executed by the Selling Parties (the "RELEASE"); (iii) Written opinion of the General Counsel of the Company, dated as of the Closing Date in substantially the form of EXHIBIT 2.2(a)(iii), with only such changes therein as shall be in form and substance reasonably satisfactory to Buyer (the "OPINION OF SHAREHOLDER'S COUNSEL"); (iv) An Employment agreement in the form of EXHIBIT 2.2(a)(iv), executed by Laird (the "LAIRD EMPLOYMENT AGREEMENT"); (v) Buyer's standard employment agreement, which contains confidentiality and non-solicitation provisions, executed by each employee of the Company whom Buyer wishes to retain (the "STAFF EMPLOYMENT AGREEMENTS"); (vi) The Trust Agreement in the form of EXHIBIT 2.2(a)(vi) hereto, duly executed by the Shareholder ; (vii) Written consent for the Acquisition, in form and substance reasonably acceptable to Buyer, obtained from those parties identified on SCHEDULE 3.5; (viii) Duly adopted resolutions of the Shareholder's Board of Directors satisfactory to Buyer in its sole discretion, approving the sale of the Company Shares in accordance with the terms and conditions of this Agreement (the "SHAREHOLDER BOARD RESOLUTIONS"); and PAGE 8 (ix) Duly adopted resolutions of the Company's Board of Directors satisfactory to Buyer in its sole discretion (A) providing that the Company shall no longer be a participating and/or adopting employer in the Shareholder's Employee Benefit Plans (as defined in SECTION 3.17 hereof), effective as of the date prior to the Closing Date, (B) authorizing the officers of the Company to terminate, effective as of the Effective Date, that certain Administrative Support Agreement by and among the Company, the Shareholder and NAICO, (C) terminating any life insurance policies procured by the Company for its benefit on the lives of any director, executive or other officer of the Company, together with any agreements to provide any of such life insurance policies at the expense of the Company, and (D) if applicable, terminating any and all leases of employee vehicles and any agreements with employees related to the provision of Company vehicles, or for the payment of a periodic vehicle allowance, by the Company, PROVIDED, however, that the Sellers may continue, in their name and at their sole expense, to continue any such vehicle leases or agreements, PROVIDED FURTHER, however, that the Company shall be (i) indemnified and held harmless by the Selling Parties in accordance with SECTION 8.2(b) hereof with respect to any acts or omissions of any individuals operating such vehicles, and (ii) maintained as a named insured on any auto insurance policies in place with respect to such vehicles (the "COMPANY BOARD RESOLUTIONS"); and (b) Buyer shall deliver to the Shareholder: (i) A check (or, upon the Shareholder's written request prior to the Closing Date, Buyer shall initiate a wire transfer of immediately available funds to one or more accounts designated by Shareholder ) for the Down Payment Amount; (ii) A promissory note with respect to the portion of the Holdback Amount to be paid pursuant to SECTION 1.4(c)(iii)(C) hereof, substantially in the form of EXHIBIT 2.2(b)(ii), executed by Buyer (the "PROMISSORY NOTE"); (iii) The Release, executed by Buyer; and (iv) The Trust Agreement, executed by Buyer. (c) Within ten (10) days after the issuance of the term life insurance policy described in SECTION 1.2(b)(iii)(E) hereof, the Shareholder shall deliver to Buyer an Assignment of Life Insurance Policy in the form of EXHIBIT 2.2(c), executed by the Shareholder (the "ASSIGNMENT OF LIFE INSURANCE POLICY"). Section 2.4 MUTUAL PERFORMANCE. At or prior to the Closing, the parties hereto shall also deliver to each other the agreements, certificates, and other documents and instruments referred to in ARTICLES 6 and 7 hereof. Section 2.5 THIRD PARTY CONSENTS. To the extent that the Company Shares may not be transferred to Buyer hereunder without the consent of another person which has not been obtained (including, without limitation, those persons described in SCHEDULE 3.5 hereof), this Agreement shall not constitute an agreement to transfer the same if an attempted transfer would constitute a breach thereof or be unlawful, and the Shareholder, at its expense, shall use its best efforts to obtain any PAGE 9 such required consent(s) as promptly as possible. If any such consent shall not be obtained or if any attempted transfer would be ineffective or would impair Buyer's rights so that Buyer would not in effect acquire the benefit of all such rights, the Shareholder, to the maximum extent permitted by law, shall act after the Closing as Buyer's agent in order to obtain for it the benefits thereunder and shall cooperate, to the maximum extent permitted by law, with Buyer in any other reasonable arrangement designed to provide such benefits to Buyer. Section 2.6 FURTHER ASSURANCES. From time to time after the Closing, at Buyer's request, the Shareholder shall execute, acknowledge and deliver to Buyer such other instruments of conveyance and transfer and shall take such other actions and execute and deliver such other documents, certifications and further assurances as Buyer may reasonably request in order to vest more effectively in Buyer, or to put Buyer more fully in possession of, the Company Shares. Each of the parties hereto shall cooperate with the others and execute and deliver to the other parties such other instruments and documents and take such other actions as may be reasonably requested from time to time by such other party as necessary to carry out, evidence and confirm the intended purposes of this Agreement. Section 2.7 EFFECTIVE DATE. The Effective Date of this Agreement and all related instruments executed at the Closing shall be December 1, 2002, unless otherwise specified. Notwithstanding the foregoing, the Company shall retain the risk of loss for errors and omissions committed up until the latter of the Effective Date or the Closing Date. ARTICLE 3 REPRESENTATIONS AND WARRANTIES OF THE SELLERS The Shareholder and Parent, jointly and severally, represent and warrant to Buyer as follows: Section 3.1 ORGANIZATION. The Company is a corporation organized and in good standing under the laws of the State of Oklahoma and its status is active. The Company has all requisite corporate power and authority and all necessary governmental approvals to own, lease, and operate its properties and to carry on its business as now being conducted. The Company is duly qualified to do business and is in good standing as a foreign corporation in each jurisdiction where the conduct of its insurance agency business requires it to be so qualified. Section 3.2 AUTHORITY. The Sellers each have the requisite power and authority to execute and deliver this Agreement and to consummate the transactions contemplated hereby (the "CONTEMPLATED TRANSACTIONS"). This Agreement has been duly executed and delivered by the Sellers and constitutes their valid and binding obligation, enforceable against the Sellers, as applicable, in accordance with its terms, subject to applicable bankruptcy, insolvency, reorganization or similar laws from time to time in effect relating to or affecting the enforcement of creditors' rights generally and general equitable principles. Section 3.3 CAPITALIZATION. The Company Shares constitute all of the issued and outstanding shares of capital stock of the Company. All of the Company Shares have been duly issued and are fully paid and nonassessable. All of the Company Shares are owned and held by the PAGE 10 Shareholder, free and clear of all Encumbrances whatsoever. There are no outstanding agreements, options, rights or privileges, whether preemptive or contractual, to acquire shares of capital stock or other securities of the Company. Section 3.4 CORPORATE RECORDS. The Sellers have delivered to Buyer correct and complete copies of the Articles of Incorporation and Bylaws of the Company, each as amended to date. The minute books containing the records of meetings of the shareholders, board of directors, and any committees of the board of directors, the stock certificate books, and the stock record books of the Company are correct and complete and have been made available for inspection by Buyer. The Company is not in default under or in violation of any provision of its Articles of Incorporation or Bylaws. Section 3.5 CONSENTS AND APPROVALS; NO VIOLATIONS. (a) Except as set forth in SCHEDULE 3.5, neither the execution, delivery or performance of this Agreement by Parent nor the consummation by them of the Contemplated Transactions nor compliance by them with any of the provisions hereof shall (i) conflict with or result in any breach of any Governing Documents (as defined below) of the Company or Parent, (ii) require any filing with, or permit, authorization, consent, or approval of, any court, arbitral tribunal, administrative agency or commission, or other governmental or regulatory authority or agency (each a "GOVERNMENTAL ENTITY"), (iii) result in a violation or breach of, or constitute a default (or give rise to any right of termination, amendment, cancellation, or acceleration) under, any of the terms, conditions, or provisions of any note, bond, mortgage, lease, license, agreement, or other instrument or obligation to which the Company or either of the Sellers is a party or by which the Company, either of the Sellers or any of their respective properties or assets may be bound, or (iv) violate any order, writ, injunction, decree, statute, rule or regulation applicable to the Company, either of the Sellers, or any of their respective properties or assets, except in the case of (iii) or (iv) above for violations, breaches or defaults that would not, individually or in the aggregate, have a Material Adverse Change (as defined in SECTION 3.7(b) hereof) on the Company or Buyer's ownership of the Company Shares. (b) As used herein, the term "GOVERNING DOCUMENTS" means, with respect to any particular entity: (i) if a corporation, the articles or certificate of incorporation and the bylaws; (ii) if a general partnership, the partnership agreement and any statement of partnership; (iii) if a limited partnership, the limited partnership agreement and the certificate of limited partnership; (iv) if a limited liability company, the articles of organization and operating agreement; (v) if another type of Person, any other charter or similar document adopted or filed in connection with the creation, formation or organization of the Person; (vi) all equityholders' agreements, voting agreements, voting trust agreements, joint venture agreements, registration rights agreements or other agreements or documents relating to the organization, management or operation of any Person or relating to the rights, duties and obligations of the equityholders of any Person; and (vii) any amendment or supplement to any of the foregoing. Section 3.6 NO THIRD PARTY OPTIONS. There are no existing agreements, options, commitments, or rights with, of or to any person to acquire any of the Company's assets, properties or rights, or any interests therein. PAGE 11 Section 3.7 FINANCIAL STATEMENTS; NO MATERIAL ADVERSE CHANGE; NO UNDISCLOSED LIABILITIES. (a) SCHEDULE 3.7(a) sets forth true and complete copies of (i) the Company's balance sheet at December 31, 2001 (the "YEAR-END BALANCE SHEET") and the related statement of income for the fiscal year then ended, and (ii) the Company's balance sheet (the "INTERIM BALANCE SHEET") at November 30, 2002 (the "BALANCE SHEET DATE") and the related statement of income for the eleven (11) months then ended (collectively, the "FINANCIAL STATEMENTS"). All of such Financial Statements were prepared in accordance with generally accepted accounting principles, consistently applied throughout the periods involved (subject, in the case of interim period statements, to normal recurring audit adjustments). Such balance sheets within the Financial Statements fairly present the financial position, assets, and liabilities (whether accrued, absolute, contingent or otherwise) of the Company at the dates indicated and such statements of income fairly present the results of operations for the periods then ended. The Company's financial books and records are accurate and complete in all material respects. The Company has not guaranteed any premium financing on behalf of its customers. (b) Since the Balance Sheet Date, there has not been any material adverse change in the business, operations, prospects, assets, liabilities, results of operations or condition (financial or other) of the Company or the Company's business (a "MATERIAL ADVERSE CHANGE"), and no event has occurred or circumstance exists that may result in such a Material Adverse Change. (c) Except as set forth in SCHEDULE 3.7(c), the Company has no Liabilities except for Liabilities reflected or reserved against in the Year-End Balance Sheet or the Interim Balance Sheet and current liabilities incurred in the Ordinary Course of Business of the Company (as defined in SECTION 3.8(b) hereof) since the Balance Sheet Date. Section 3.8 ORDINARY COURSE OF BUSINESS. (a) Since the Balance Sheet Date, the Company has carried on the Ordinary Course of Business in substantially the manner heretofore conducted and has taken no unusual actions in contemplation of the Contemplated Transactions, except with the consent of Buyer. All of the Company's accounts payable, including accounts payable to insurance carriers, are current and reflected properly on its books and records, and shall be paid in accordance with their terms at their recorded amounts. (b) As used herein, the term "ORDINARY COURSE OF BUSINESS" means an action taken by a Person but only if that action: (i) is consistent in nature, scope and magnitude with the past practices of such Person and is taken in the ordinary course of the normal, day-to-day operations of such Person; (ii) does not require authorization by the board of directors or shareholders of such Person (or by any Person or group of Persons exercising similar authority) and does not require any other separate or special authorization of any nature; and (iii) is similar in nature, scope and magnitude to actions customarily taken, without any separate or special authorization, in the ordinary course of the normal, day-to-day operations of other Persons that are in the same line of business as such Person. PAGE 12 Section 3.9 ABSENCE OF CERTAIN CHANGES AND EVENTS. Except as set forth in SCHEDULE 3.9, since the Balance Sheet Date, the Company has conducted its business only in the Ordinary Course of Business and there has not been any: (a) change in the Company's authorized or issued capital stock, grant of any stock option or right to purchase shares of capital stock of the Company or issuance of any security convertible into such capital stock; (b) amendment to the Governing Documents of the Company; (c) payment (except in the Ordinary Course of Business) or increase by the Company of any bonuses, salaries or other compensation to any shareholder, director, officer or employee, or entry into any employment, severance or similar Contract with any director, officer or employee; (d) adoption of, amendment to or increase in the payments to or benefits under, any Employee Benefit Plan (as defined in SECTION 3.17 hereof); (e) damage to or destruction or loss of any Acquired Asset, whether or not covered by insurance; (f) entry into, termination of or receipt of notice of termination of (i) any license, distributorship, dealer, sales representative, joint venture, credit or similar Contract to which the Company is a party, or (ii) any Contract or transaction involving a total remaining commitment by the Company of at least $5,000.00; (g) sale, lease or other disposition of any Asset or property of the Company (including the Intellectual Property Assets) or the creation of any Encumbrances on any Acquired Asset; (h) cancellation or waiver of any claims or rights with a value to the Company in excess of $5,000.00; (i) indication by any customer or supplier of an intention to discontinue or change the terms of its relationship with the Company; (j) material change in the accounting methods used by the Company; or (k) Contract by the Company to do any of the foregoing. Section 3.10 ASSETS. (a) The Company owns and holds, free and clear of any Encumbrances or third-party interests of any kind whatsoever (including insurance company payables), sole and exclusive right, title, and interests in and to the customer expiration records for those customers listed in SCHEDULE 3.10(a) (the "CURRENT BOOK OF BUSINESS"), together with the exclusive right to use such records and all customer accounts, copies of insurance policies and contracts in force, and all files, invoices and records pertaining to the customers, their contracts and PAGE 13 insurance policies, and all related information. All customer accounts listed in SCHEDULE 3.10(a) represent current customers of the Company and none of such accounts has been cancelled or transferred as of the date hereof. None of the accounts shown in SCHEDULE 3.10(a) represents business that has been brokered by the Company on behalf of a third party. (b) SCHEDULE 3.10(b) lists all material contracts, agreements and other written arrangements to which the Company is a party, including, without limitation, the following: (i) any written arrangement (or group of written arrangements) for the furnishing or receipt of services that calls for performance over a period of more than one (1) year; (ii) any written arrangement concerning a partnership or joint venture; (iii) any written arrangement (or group of written arrangements) under which the Company has created, incurred or assumed or may create, incur or assume indebtedness (including capitalized lease obligations) involving more than $10,000.00 or under which it has imposed (or may impose) a security interest on any of its assets, tangible or intangible; (iv) any employment or independent contractor agreement; (v) any written arrangement concerning confidentiality or non-competition; (vi) any written arrangement involving the Company and its present or former affiliates, officers, directors or shareholders; (vii) any written arrangement under which the consequences of a default or termination could have a Material Adverse Change on Buyer or the Company; or (viii) any other written arrangement (or group of related arrangements) either involving more than $10,000.00 or not entered into in the ordinary course of business. The Company is not a party to any verbal contract, agreement or other arrangement which, if reduced to written form, would be required to be listed in SCHEDULE 3.10(b). The Company has delivered to Buyer a correct and complete copy of each written arrangement, as amended to date, listed in SCHEDULE 3.10(b). Each such contract, agreement and written arrangement is valid and enforceable in accordance with its terms, and no party is in default under any provision thereof. (c) The Company owns or leases all tangible assets necessary for the conduct of its business. All equipment, inventory, furniture and other assets owned or used by the Company in its business are in a state of good repair and maintenance, having regard for the purposes of which they are used, and the purposes for which such assets are used and for which they are held by the Company are not in violation of any statute, regulation, covenant or restriction. The Company owns or leases all office furniture, fixtures and equipment in its offices located in Chandler, Oklahoma. PAGE 14 (d) All notes and accounts receivables of the Company are reflected properly on its books and records, are valid receivables subject to no set-offs or counterclaims either asserted to date or of which the Sellers or the Company has Knowledge, are presently current and collectible, and shall be collected in accordance with their terms at their recorded amounts. All of the Company's accounts payable, including accounts payable to insurance carriers, are current and reflected properly on its books and records, and shall be paid in accordance with their terms at their recorded amounts. Section 3.11 LITIGATION AND CLAIMS. (a) Except as disclosed in SCHEDULE 3.11, there is no Proceeding (as defined below) pending or, to the Knowledge of the Sellers or the Company, threatened against the Company, and no circumstances exist that could reasonably form a basis for such a Proceeding to be initiated or threatened. The Company is not subject to any outstanding order, writ, injunction or decree which, insofar as can be reasonably foreseen, individually or in the aggregate, in the future would have an Material Adverse Change on the Company or Buyer or would prevent either of the Sellers from consummating the Contemplated Transactions. No voluntary or involuntary petition in bankruptcy, receivership, insolvency, or reorganization with respect to Parent or the Company has been filed by or, to the Knowledge of Parent or the Company, against Parent or the Company, nor shall either of the Sellers or the Company file such a petition prior to the Closing Date or for one hundred (100) days thereafter, and if such petition is filed by others, the same shall be promptly discharged. Each of the Sellers is solvent on the date hereof and shall be solvent on the Closing Date. Neither of the Sellers nor the Company has, and at the Closing Date shall not have, made any assignment for the benefit of creditors, or admitted in writing insolvency or that its property at fair valuation shall not be sufficient to pay its debts, nor shall either of the Sellers permit any judgment, execution, attachment, or levy against them or their properties to remain outstanding or unsatisfied for more than ten (10) days. (b) For purposes of this Agreement, the term "PROCEEDING" means any action, arbitration, audit, charge, claim, complaint, demand, hearing, investigation, litigation, notice or suit (whether civil, criminal, administrative, judicial or investigative, whether formal or informal, whether public or private) commenced, brought, conducted or heard by or before, or otherwise involving, any Governmental Entity or arbitrator. Section 3.12 COMPLIANCE WITH APPLICABLE LAW. (a) The Company holds all permits, licenses, variances, exemptions, orders and approvals of all Governmental Entities necessary for the lawful conduct of the insurance agency business (collectively, the "PERMITS"), and the Company is in compliance with the terms of the Permits, except for possible violations that individually or in the aggregate do not, and, insofar as reasonably can be foreseen, in the future shall not, have an Material Adverse Change on its business. (b) The business of the Company is not being conducted in violation of any Legal Requirement, including, without limitation, (i) the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 and any applicable federal or state regulations promulgated pursuant thereto, or (ii) any Legal Requirement prohibiting the making or offering of any improper gifts, "kickbacks", contributions or other illegal or improper payments), except for possible violations that individually or in the aggregate do not, and, insofar as reasonably can be foreseen, in the future shall not, have an Material Adverse Change on its business. PAGE 15 (c) Without limiting the foregoing, the Company's revenues as set forth in the Financial Statements do not include any fees received in addition to, or in lieu of, commissions from any account, except as permitted by applicable Legal Requirements, and the Company is otherwise in compliance with applicable Legal Requirements regarding rebating, excess fees and charges, and other unfair insurance trade practices. Section 3.13 TAX RETURNS AND AUDITS. (a) The Company has timely filed all federal, state, local and foreign Tax (as defined below) returns, including all amended returns, in each jurisdiction where the Company is required to do so or has paid or made provision for the payment of any penalty or interests arising from the late filing of any such return, has correctly reflected all Taxes required to be shown thereon, and has fully paid or made adequate provision for the payment of all Taxes that have been incurred or are due and payable pursuant to such returns or pursuant to any assessment with respect to Taxes in such jurisdictions, whether or not in connection with such returns. The Company is not currently subject to any audits with respect to any federal, state, local or foreign Tax returns required to be filed and there are no unresolved audit issues with respect to prior years' Tax returns. There are no circumstances or pending questions relating to potential Tax liabilities nor claims asserted for Taxes or assessments of the Company that, if adversely determined, could result in a Tax liability that would have a Material Adverse Change on the Company or Buyer for any period. The Company has not executed an extension or waiver of any statute of limitations on the assessment or collection of any Tax due that is currently in effect. The Company is not holding any unclaimed property that it is required to surrender to any state taxing authority including, without limitation, any uncashed checks or unclaimed wages, and the Company has timely filed all unclaimed property reports required to be filed with such state taxing authorities. The Company does not purge its records of uncashed checks periodically. (b) For purposes of this Agreement, the term "TAX" means any income, gross receipts, license, payroll, employment, excise, severance, stamp, occupation, premium, property, environmental, windfall profit, customs, vehicle, airplane, boat, vessel or other title or registration, capital stock, franchise, employees' income withholding, foreign or domestic withholding, social security, unemployment, disability, real property, personal property, sales, use, transfer, value added, alternative, add-on minimum and other tax, fee, assessment, levy, tariff, charge or duty of any kind whatsoever and any interest, penalty, addition or additional amount thereon imposed, assessed or collected by or under the authority of any Governmental Entity or payable under any tax-sharing agreement or any other Contract. Section 3.14 NON-SOLICITATION COVENANTS. The Company is not a party to any agreement that restricts its ability to compete in the insurance agency industry or solicit specific insurance accounts. Section 3.15 INSURANCE POLICIES; ERRORS AND OMISSIONS, EMPLOYMENT PRACTICES LIABILITY AND EMPLOYEE DISHONESTY COVERAGE. (a) SCHEDULE 3.15(a) sets forth a complete and correct list of all insurance policies held by the Company with respect to its business (including, without limitation, errors and omissions (E&O), employment practices liability (EPL), and employee dishonesty coverage), and PAGE 16 true and complete copies of such policies have been delivered to Buyer. The Company has complied with all the provisions of such policies and the policies are in full force and effect. (b) The Company has not incurred any liability or taken or failed to take any action that may reasonably be expected to result in a liability for errors or omissions in the conduct of its insurance business or employment practices liability (EPL), except such liabilities as are fully covered by insurance. All errors and omissions (E&O) and EPL lawsuits and claims currently pending or threatened against the Company are set forth in SCHEDULE 3.11. The Company has E&O insurance coverage in force, with minimum liability limits of $10 million per claim and $10 million aggregate, with a deductible of $50,000.00 per claim. The Company has EPL insurance coverage in force, with minimum liability limits of $2 million per claim and $2 million aggregate, with a deductible of $5,000.00, and the Sellers shall provide to Buyer a certificate of insurance evidencing such coverage prior to or on the Closing Date. The Company has had the same or higher levels of E&O and EPL coverage continuously in effect for at least the past five (5) years. (c) SCHEDULE 3.15(c) sets forth a complete and correct list of all employee dishonesty losses incurred and/or claims made by the Company. The Company has employee dishonesty insurance coverage in force, with minimum limits of $2 million per occurrence and $2 million aggregate, with a deductible of $25,000.00, and the Sellers shall provide to Buyer a certificate of insurance evidencing such coverage prior to or on the Closing Date. The Company has complied with all the provisions of its employee dishonesty bonds or policies and the Company has an employee dishonesty bond or policy in full force and effect as of the Closing Date. Section 3.16 EMPLOYEES. Except as disclosed in SCHEDULE 3.10(b), all employees of the Company are employees at will, and the Company is not a party to any written contract of employment. None of the Company's employees is currently being treated for a major medical condition. Section 3.17 EMPLOYEE BENEFIT PLANS. SCHEDULE 3.17 lists each Employee Benefit Plan (as defined below) that the Company or any trade or business, whether or not incorporated, that together with the Company would be deemed a "single employer" within the meaning of Section 4001 of ERISA (as defined below) (a "COMPANY ERISA AFFILIATE") maintains or to which the Company or any Company ERISA Affiliate contributes. PAGE 17 (a) Each such Employee Benefit Plan (and each related trust, insurance contract, or fund) complies in form and in operation in all respects with the applicable requirements of ERISA, the Code, and other applicable laws. No such Employee Benefit Plan is under audit by the Internal Revenue Service or the Department of Labor. (b) All required reports and descriptions (including Form 5500 Annual Reports, Summary Annual Reports, PBGC-1s, and summary plan descriptions) have been filed or distributed appropriately with respect to each such Employee Benefit Plan. The requirements of Part 6 of Subtitle B of Title I of ERISA and of Code Section 4980B have been met with respect to each such Employee Benefit Plan that is an "EMPLOYEE WELFARE BENEFIT PLAN" as such term is defined in ERISA Section 3(1). (c) All contributions (including all employer contributions and employee salary reduction contributions) that are due have been paid to each such Employee Benefit Plan that is an "EMPLOYEE PENSION BENEFIT PLAN" as such term is defined in ERISA Section 3(2), and all contributions for any period ending on or before the Closing Date that are not yet due have been paid to each such Employee Pension Benefit Plan or accrued in accordance with the past custom and practice of the Company. All premiums or other payments for all periods ending on or before the Closing Date have been paid with respect to each such Employee Benefit Plan that is an Employee Welfare Benefit Plan. (d) Each such Employee Benefit Plan that is an Employee Pension Benefit Plan meets the requirements of a "qualified plan" under Code Section 401(a) and has received, within the last two (2) years, a favorable determination letter from the Internal Revenue Service. (e) The market value of assets under each such Employee Benefit Plan that is an Employee Pension Benefit Plan (other than any "Multiemployer Plan" as such term is defined in ERISA Section 3(37)) equals or exceeds the present value of all vested and nonvested liabilities thereunder determined in accordance with Pension Benefit Guaranty Corporation ("PBGC") methods, factors, and assumptions applicable to an Employee Pension Benefit Plan terminating on the date for determination. (f) The Company has delivered (or no later than sixty (60) days prior to the Closing Date shall deliver) to Buyer correct and complete copies of the plan documents and summary plan descriptions, the most recent Form 5500 Annual Report, and all related trust agreements, insurance contracts, and other funding agreements that implement each such Employee Benefit Plan. (g) With respect to each Employee Benefit Plan that the Company or any Company ERISA Affiliate maintains or ever has maintained or to which it contributes, ever has contributed, or ever has been required to contribute: (i) No such Employee Benefit Plan that is an Employee Pension Benefit Plan (other than any Multiemployer Plan) has been completely or partially terminated or been the subject of a "Reportable Event" (as such term is defined in ERISA Section 4043) as to which notices would be required to be filed with the PBGC. No Proceeding by the PBGC to PAGE 18 terminate any such Employee Pension Benefit Plan (other than any Multiemployer Plan) has been instituted or, to the Knowledge of the Sellers or the Company, threatened. (ii) There have been no "Prohibited Transactions" as defined in ERISA Section 406 and Code Section 4975 with respect to any such Employee Benefit Plan. No "Fiduciary" as defined in ERISA Section 3(21) has any liability for breach of fiduciary duty or any other failure to act or comply in connection with the administration or investment of the assets of any such Employee Benefit Plan. No Proceeding with respect to the administration or the investment of the assets of any such Employee Benefit Plan (other than routine claims for benefits) is pending or, to the Knowledge of the Sellers or the Company, threatened. None of the Sellers and the directors and officers (and employees with responsibility for employee benefits matters) of the Company has any Knowledge of any basis for any such Proceeding. (iii) The Company has not incurred, and none of the Company, the Sellers and the directors and officers (and employees with responsibility for employee benefits matters) of the Company has any reason to expect that the Company shall incur, any liability to the PBGC (other than PBGC premium payments) or otherwise under Title IV of ERISA (including any withdrawal liability) or under the Code with respect to any such Employee Benefit Plan that is an Employee Pension Benefit Plan. (iv) Neither the Company nor any Company ERISA Affiliate contributes to, nor has ever been required to contribute to, any Multiemployer Plan or has any liability (including withdrawal liability) under any Multiemployer Plan. (v) Neither the Company nor any Company ERISA Affiliate maintains or contributes, nor has ever maintained or contributed, or has ever been required to contribute to any Employee Welfare Benefit Plan providing medical, health, or life insurance or other welfare-type benefits for current or future retired or terminated employees, their spouses, or their dependents (other than in accordance with Code Section 4980B). As used in this Agreement, the term "EMPLOYEE BENEFIT PLAN" means any (a) nonqualified deferred compensation or retirement plan or arrangement that is an Employee Pension Benefit Plan, (b) qualified defined contribution retirement plan or arrangement that is an Employee Pension Benefit Plan, (c) qalified defined benefit retirement plan or arrangement that is an Employee Pension Benefit Plan (including any Multiemployer Plan), or (d) Employee Welfare Benefit Plan or material fringe benefit plan or program. Section 3.18 INTELLECTUAL PROPERTY. (a) Except as set forth on SCHEDULE 3.18, the Company has no trade name, service mark, patent, copyright, trademark or other Intellectual Property related to its business. (b) The Company has the right to use the Intellectual Property listed in SCHEDULE 3.18, and except as otherwise set forth therein, the Intellectual Property is, and will be on the Closing Date and the Effective Date, free and clear of all royalty obligations and Liens. There are no Proceedings pending, or to the Knowledge of the Sellers or the Company, threatened, asserting that the Company's use of any of the Intellectual Property listed on PAGE 19 SCHEDULE 3.18 infringes the rights of any Person. Neither the Sellers nor the Company has any Knowledge of any use of any of the Intellectual Property constituting an infringement thereof and neither of the Sellers has any right, claim or interest in or to any of the Intellectual Property. (c) The Company is not a party in any capacity to any franchise, license or royalty agreement respecting any of the Intellectual Property and there is no conflict with the rights of others in respect to any of the Intellectual Property now used in the conduct of its business. (d) The current software applications used by the Company in the operation of its business are set forth and described on SCHEDULE 3.18 hereto (the "SOFTWARE"). The Software, to the extent it is licensed from any third party licensor or it constitutes "off-the-shelf" software, is held by the Company under valid, binding and enforceable licenses and is fully transferable to the Buyers without any third party consent. All of the Company's computer hardware has validly licensed software installed therein. The Company has not sold, assigned, licensed, distributed or in any other way disposed of or encumbered the Software. (e) As used in this Agreement the term: (i) "INTELLECTUAL PROPERTY" and "INTELLECTUAL PROPERTY ASSETS" mean (A) all inventions (whether patentable or unpatentable and whether or not reduced to practice), all improvements thereto, and all patents, patent applications, and patent disclosures, together with all reissuances, continuations, continuations-in-part, revisions, extensions, and reexaminations thereof, (B) all trademarks, service marks, trade dress, logos, together with all translations, adaptations, derivations, and combinations thereof and including all goodwill associated therewith, and all applications, registrations, and renewals in connection therewith, (C) all copyrightable works, all copyrights, and all applications, registrations, and renewals in connection therewith, (D) all mask works and all applications, registrations, and renewals in connection therewith, (E) all trade secrets and Confidential Information (as defined below) including ideas, research and development, know-how, formulas, compositions, manufacturing and production processes and techniques, technical data, designs, drawings, specifications, customer and supplier lists, pricing and cost information, and business and marketing plans and proposals), (F) all computer software (including data and related documentation), (G) all registered domain names, website content, website related software, and all other Internet related tools and applications, (H) all other proprietary rights, and (I) all copies and tangible embodiments thereof (in whatever form or medium). (ii) "CONFIDENTIAL INFORMATION" includes any and all of the following information that has been or may hereafter be disclosed in any form, whether in writing, orally, electronically or otherwise, or otherwise made available by observation, inspection or otherwise by any Person or its Representatives (collectively, a "DISCLOSING PARTY") to another Person or its Representatives (collectively, a "RECEIVING PARTY"): (A) all information that is a trade secret under applicable trade secret or other law; (B) all information concerning product specifications, data, know-how, formulae, compositions, processes, designs, sketches, photographs, graphs, drawings, samples, inventions and ideas, past, current and planned research and development, current and planned manufacturing or distribution methods and processes, customer lists, current PAGE 20 and anticipated customer requirements, price lists, market studies, business plans, computer hardware, Software and computer software and database technologies, systems, structures and architectures; (C) all information concerning the business and affairs of the Disclosing Party (which includes historical and current financial statements, financial projections and budgets, Tax returns and accountants' materials, historical, current and projected sales, capital spending budgets and plans, business plans, strategic plans, marketing and advertising plans, publications, client and customer lists and files, contracts, the names and backgrounds of key personnel and personnel training techniques and materials, however documented), and all information obtained from review of the Disclosing Party's documents or property or discussions with the Disclosing Party regardless of the form of the communication; and (D) all notes, analyses, compilations, studies, summaries and other material prepared by the Receiving Party to the extent containing or based, in whole or in part, upon any information included in the foregoing. Section 3.19 REAL PROPERTY. (a) Within the last sixty (60) days prior to the Closing Date, the Company held marketable title in fee simple to the land and building located at 1006 Manvel Avenue, Chandler, Oklahoma 74834-3854 (the "REAL PROPERTY"), free and clear of all Encumbrances whatsoever, other than (i) zoning ordinances, (ii) easements, agreements and restrictions of record, none of which materially adversely affects the value of the Real Property, and (iii) real estate Taxes due and payable after the Closing Date (collectively, the "PERMITTED EXCEPTIONS"). Other than a lease of a portion of the Real Property to NAICO, no person or entity has any title to or interest in or right to possess the Real Property or any portion thereof, other than the Company. The Company has duly distributed all of its right, title and interest in and to the Real Property to the Shareholder prior to the Closing Date. (b) All real estate Taxes, installments of assessments and municipal liens such as water and sewer on the Real Property required to be paid by the Company prior to Closing have been or shall be paid prior to Closing, including any applicable interest or late fees. None of the Sellers or the Company has no Knowledge of, or have received no notice of, any assessments against the Real Property. Section 3.20 ENVIRONMENT, HEALTH, AND SAFETY. (a) The Company and its predecessors and affiliates have complied with all Environmental, Health, and Safety Laws, and no Proceeding has been filed, commenced or, to the Knowledge of the Sellers or the Company, threatened against it alleging any failure so to comply. Without limiting the generality of the preceding sentence, each of the Company and its predecessors and Affiliates has obtained and been in material compliance with all of the terms and conditions of all permits, licenses, and other authorizations that are required under, and has complied with all other limitations, restrictions, conditions, standards, prohibitions, requirements, obligations, schedules, and timetables that are contained in, all Environmental, Health, and Safety Laws. (b) The Company has no liability (and none of the Company and its predecessors and affiliates has handled or disposed of any substance, arranged for the disposal of any substance, exposed any employee or other individual to any substance or condition, or PAGE 21 owned or operated any property or facility in any manner that could form the basis for any present or future Proceeding against the Company giving rise to any liability) for damage to any site, location, or body of water (surface or subsurface), for any illness of or personal injury to, any employee or other individual, or for any reason under any Environmental, Health, and Safety Law. (c) No Hazardous Materials have been placed on or in any structure on the Real Property by the Company or, to the Knowledge of the Sellers or the Company, by any prior owner or user of the Real Property. No underground storage tanks for petroleum or any other substance, or underground piping or conduits are or to the Knowledge of the Sellers or the Company, have previously been located on the Real Property. To the Knowledge of the Sellers or the Company, no other party has caused the release of or contamination by Hazardous Materials on the Real Property. The Company has provided, or no later than sixty (60) days prior to the Closing Date (and thereafter, as such items are received by the Company) shall provide, Buyer with all environmental studies, records and reports in its possession or control, and all correspondence with any governmental entities, concerning environmental conditions of the Real Property. (d) All properties and equipment used in the business of the Company and its predecessors and affiliates have been free of asbestos, polychlorinated biphenyls (PCBs), methylene chloride, trichloroethylene, 1,2-trans-dichloroethylene, dioxins, dibenzofurans, and Extremely Hazardous Substances. (e) As used in this Agreement, the term: (i) "ENVIRONMENTAL, HEALTH, AND SAFETY LAWS" means the Comprehensive Environmental Response, Compensation and Liability Act of 1980, the Resource Conservation and Recovery Act of 1976, and the Occupational Safety and Health Act of 1970, each as amended, together with all other laws (including rules, regulations, codes, plans, injunctions, judgments, orders, decrees, rulings, and charges thereunder) of federal, state, local, and foreign governments (and all agencies thereof) concerning pollution or protection of the environment, public health and safety, or employee health and safety, including laws relating to emissions, discharges, releases, or threatened releases of pollutants, contaminants, or chemical, industrial, hazardous, or toxic materials or wastes into ambient air, surface water, ground water, or lands or otherwise relating to the manufacture, processing, distribution, use, treatment, storage, disposal, transport, or handling of pollutants, contaminants, or chemical, industrial, hazardous, or toxic materials or wastes; (ii) "EXTREMELY HAZARDOUS SUBSTANCE" has the meaning set forth in Section 302 of the Emergency Planning and Community Right-to-Know Act of 1986, as amended; and (iii) "HAZARDOUS MATERIALS" means any "toxic substance" as defined in 15 U.S.C. Sections 2601 ET SEQ. on the date hereof, including materials designated on the date hereof as "hazardous substances" under 42 U.S.C. Sections 9601 ET SEQ. or other applicable laws, and toxic, radioactive, caustic, or otherwise hazardous substances, including petroleum and its derivatives, asbestos, PCBs, formaldehyde, chlordane and heptachlor. PAGE 22 Section 3.22 DISCLOSURE. (a) None of the representations and warranties of the Shareholder set forth in this Agreement or in the attached Schedules, notwithstanding any investigation thereof by Buyer, contains any untrue statement of a material fact, or omits the statement of any material fact necessary to render the statements made not misleading. (b) Neither the Sellers nor the Company has any Knowledge of any fact that has specific application to the Company (other than general economic or industry conditions) and that may have a Material Adverse Change on the Company or Buyer that has not been set forth in this Agreement or the attached Schedules. ARTICLE 4 REPRESENTATIONS AND WARRANTIES OF BUYER Buyer represents and warrants to the Sellers as follows: Section 4.1 ORGANIZATION. Buyer is a corporation organized under the laws of the State of Florida and its status is active. Buyer has all requisite corporate power and authority and all necessary governmental approvals to own, lease and operate its properties and to carry on its business as now being conducted. Buyer is duly qualified or licensed to do business and is in good standing in each jurisdiction in which the property owned, leased, or operated by it or the nature of the business conducted by it makes such qualification or licensing necessary, except where the failure to be so duly qualified or licensed and be in good standing would not in the aggregate have a Material Adverse Change. Section 4.2 AUTHORITY. Buyer has the requisite corporate power and authority to execute and deliver this Agreement and to consummate the Contemplated Transactions. The execution, delivery and performance of this Agreement, and the consummation of the Contemplated Transactions, have been duly authorized by all necessary corporate action on the part of Buyer and no other corporate proceeding on the part of Buyer is necessary to authorize this Agreement or to consummate the Contemplated Transactions. This Agreement has been duly executed and delivered by Buyer and constitutes its valid and binding obligation, enforceable against Buyer in accordance with its terms, subject to applicable bankruptcy, insolvency, reorganization or similar laws from time to time in effect which offset creditors' rights generally and general equitable principles. Section 4.3 CONSENTS AND APPROVALS; NO VIOLATIONS. Neither the execution, delivery or performance of this Agreement by Buyer nor the consummation by it of the Contemplated Transactions nor compliance by it with any of the provisions hereof shall (a) conflict with or result in any breach of any provision of its Governing Documents, (b) require any filing with, or permit, authorization, consent or approval of, any Governmental Entity, or (c) result in a violation or breach of, or constitute a default under, any of the terms, conditions or provisions of any agreement or other instrument or obligation to which Buyer is a party or by which Buyer or any of its properties or assets may be bound. Section 4.4 SECURITIES LAW REPRESENTATIONS. (a) Buyer was granted access to the business premises, offices, properties, and business, corporate and financial books and records of the Company. Buyer was permitted to examine the foregoing records, to question officers of the PAGE 23 Company, and to make such other investigations as it considered appropriate to determine or verify the business and financial condition of the Company. The Sellers have furnished to Buyer all information regarding the business and affairs of the Company that Buyer requested. (b) Because of its considerable knowledge and experience in financial and business matters, Buyer is able to evaluate the merits, risks, and other factors bearing on the suitability of the Company Shares as an investment. (c) Buyer's annual income and net worth are such that it would not now be, and does not contemplate being, required to dispose of any investment in the Company Shares, including the risk of losing all or any part of its investment and the inability to sell, transfer, pledge, or otherwise dispose of any of the Company Shares for an indefinite period. Buyer recognizes that the Company Shares shall not be registered under the Securities Act of 1933 and shall therefore constitute "restricted securities," which means, among other things, that Buyer generally shall not be able to sell the Company Shares for a period of at least one (1) year following the Closing Date. (d) Buyer's acquisition of the Company Shares shall be solely for its own account, as principal, for investment, and not with a view to, or for resale in connection with, any underwriting or distribution. Section 4.5 DISCLOSURE. None of the representations and warranties of Buyer set forth in this Agreement, notwithstanding any investigation thereof by the Sellers, contains any untrue statement of a material fact, or omits the statement of any material fact necessary to render the statements made not misleading. ARTICLE 5 [INTENTIONALLY OMITTED] ARTICLE 6 ADDITIONAL AGREEMENTS Section 6.1 ACCESS TO INFORMATION. Upon reasonable notice, the Shareholder shall cause the Company to afford to the officers, employees, accountants, counsel, and other authorized representatives of Buyer full access, during the period prior to the Closing Date, to all of the properties, books, contracts, commitments, records, and senior management of the Company. Unless otherwise required by law, Buyer shall hold any such information that is nonpublic in confidence, shall not use such information in its business if the Acquisition does not close, and shall return such information if the Acquisition does not close. Section 6.2 EXPENSES. Whether or not the Acquisition is consummated, all costs and expenses incurred in connection with this Agreement and the Contemplated Transactions shall be paid by the party incurring such expenses. Section 6.3 BROKERS OR FINDERS. Each of the parties represents, as to itself, its subsidiaries and its affiliates, that no agent, broker, investment banker, financial advisor, or other firm or person is or shall be entitled to any broker's or finder's fee or any other commission or PAGE 24 similar fee in connection with any of the Contemplated Transactions, and each of the parties agrees to indemnify and hold the others harmless from and against any and all claims, liabilities, or obligations with respect to any fees, commissions, or expenses asserted by any person on the basis of any act or statement alleged to have been made by such party or its affiliate. Section 6.4 ADDITIONAL AGREEMENTS; BEST EFFORTS. Subject to the terms and conditions of this Agreement, each of the parties agrees to use its best efforts to take, or cause to be taken, all actions and to do, or cause to be done, all things necessary, proper, or advisable under applicable laws and regulations to consummate and make effective the Contemplated Transactions, including cooperating fully with the other parties. Section 6.5 NON-COMPETITION COVENANTS. (a) NON-COMPETE COVENANT. Each of the Selling Parties, on behalf of such party and any Affiliate thereof, each agree that it or he, as the case may be, shall not, for a period of five (5) years beginning on the Closing Date (the "RESTRICTED PERIOD"), engage in, or be or become the owner of an equity interest in, or otherwise consult with, be employed by, or participate in the business of, any entity (other than Buyer) engaged in the insurance agency business within the State of Oklahoma (the "RESTRICTED AREA"); PROVIDED, however, that the ownership or operation by the Shareholder, Parent, NAICO or their respective Affiliates of an entity engaged in (i) the marketing of annuity products to school district employees, (ii) the placement of surety bonds for general contractors whose principal place of business is located outside of the State of Oklahoma, or (iii) the placement in a wholesaler capacity of property and casualty insurance products to (A) school districts or (B) insureds engaged in the trucking business, shall not deemed a violation of this SECTION 6.5(a) (this covenant is referred to herein as the "NON-COMPETE COVENANT"). (b) NON-SOLICITATION COVENANT. Without limiting the foregoing, and subject to the requirements of 36 O.S. section 1220, none of the Selling Parties or any of their respective Affiliates (except NAICO, with regard to accepting or servicing business) shall, during the Restricted Period, (i) solicit, divert, accept business from, nor service, directly or indirectly, as insurance solicitor, insurance agent, insurance broker or otherwise, for its, his or her account or the account of any other agent, broker, or insurer, either as owner, shareholder, promoter, employee, consultant, manager or otherwise, any account that is part of the Purchased Book of Business, (ii) with respect to Parent, NAICO or any of their respective Affiliates, accept any Agent of Record (AOR) or Broker of Record (BOR) letters from any other insurance agents or brokers on any policies comprising the Purchased Book of Business that replace Company as the agent or broker for any such policy, or (iii) hire or directly or indirectly solicit any employees of Buyer or its Affiliates to work for any of the Selling Parties or any of their respective Affiliates, or any company that competes with Buyer or its Affiliates. In the event that Parent, NAICO or any of their respective Affiliates accepts any such Agent of Record or Broker of Record letters from any other insurance agents or brokers on any policies comprising the Purchased Book of Business, pay Buyer an amount equal to 1.5 times (ii) the aggregate annualized policy commissions on such policies that are subject to such AOR or BOR letters (the covenants set forth in this SECTION 6.5(b) are collectively referred to as the "NON-SOLICITATION COVENANT"). PAGE 25 (c) NON-DISPARAGEMENT COVENANT. After the Closing Date, none of the parties shall disparage any other party or any other party's shareholders, directors, officers, employees or agents. (d) The Selling Parties each acknowledge and agree that the Non-Compete Covenant and Non-Solicitation Covenant are being entered into voluntarily and for consideration and that, given the nature and geographic scope of the Company's business, the Restricted Period and the Restricted Area are reasonable in time and space. (e) Notwithstanding anything in this Agreement to the contrary, the covenants set forth in this SECTION 6.5 shall not be held invalid or unenforceable because of the scope of the territory or actions subject hereto or restricted hereby, or the period of time within which such covenants are imperative; but the maximum territory, the actions subject to such covenants, and the period of time in which such covenants are enforceable, respectively, are subject to determination by a final judgment of any court which had jurisdiction over the parties and subject matter. Section 6.6 REMEDY FOR BREACH OF COVENANTS. In the event of a breach of the provisions of SECTION 6.5, Buyer and the Company shall be entitled to injunctive relief as well as any other applicable remedies at law or in equity. Should a court of competent jurisdiction declare the covenants set forth in SECTION 6.5 unenforceable due to a unreasonable restriction, duration, geographical area or otherwise, the parties agree that such court shall be empowered and shall grant Buyer, the Company and their affiliates injunctive relief to the extent reasonably necessary to protect their respective interests. The Selling Parties each acknowledge that the covenants set forth in SECTION 6.5 represent an important element of the value of the Company Shares and were a material inducement for Buyer to enter into this Agreement. Section 6.7 SUCCESSOR RIGHTS. The covenants contained in SECTION 6.5 shall inure to the benefit of any successor in interests of Buyer by way of merger, consolidation, sale or other succession. Section 6.8 ERRORS AND OMISSIONS AND EMPLOYMENT PRACTICES LIABILITY COVERAGE. (a) On or prior to the Closing Date, the Sellers shall cause the Company to purchase, at the Company's expense, a tail coverage extension on each of the Company's errors and omissions (E&O) and employment practices liability (EPL) insurance policies. Such E&O tail coverage shall have minimum liability limits of at least $2 million per claim and $6 million aggregate with deductibles of no greater than $5,000.00 per claim and $15,000.00 in the aggregate. Such EPLI tail coverage shall have the same coverages and deductibles currently in effect. Both the E&O and EPLI tail coverages shall extend for a period of at least three (3) years from the Closing Date, and shall otherwise be in form reasonably acceptable to Buyer. A certificate of insurance evidencing each such coverage shall be delivered to Buyer at or prior to Closing. (b) In lieu of the above-described tail coverages, the Sellers may elect to maintain their existing E&O and EPL insurance policies in force during such three (3)-year PAGE 26 period, PROVIDED that (i) the Sellers maintain at least the minimum liability limits and deductibles set forth in SECTION 6.8(a) during such period, and (ii) the Company is maintained as a named insured on such policies during such period. Section 6.9 ENVIRONMENTAL PROTECTION POLICY. On or prior to the Closing Date, the Sellers shall cause the Company to purchase, at the Company's expense, an environmental protection policy with respect to the Real Property. Such coverage shall extend for a period of at least five (5) years from the Closing Date, shall have a coverage limit of at least $10 million, shall name Buyer as a named insured, and shall otherwise be in form acceptable to Buyer in its sole discretion. A certificate of insurance evidencing such coverage shall be delivered to Buyer at or prior to Closing. Section 6.10 CONFIDENTIALITY. Each of the parties agrees to maintain the terms of this Agreement, including the consideration payable by Buyer, in strict confidence and shall not disclose such terms to any third party without the prior written consent of all parties to this Agreement, unless required to do so by law. The parties understand and agree that disclosures required by applicable securities laws shall not be deemed a violation of this covenant. The provisions of this SECTION 6.10 shall not be deemed to prevent any party from disclosing the terms of this Agreement to their accountants, counsel, or other professionals engaged by such party. Notwithstanding any provision in this SECTION 6.10, each of the parties acknowledges and agrees that Buyer shall, promptly after the Closing, issue a press release (as to which the Sellers shall have a reasonable opportunity to review and comment) containing certain details with respect to the Contemplated Transactions including, but not limited to, the Company's estimated Core Revenue for the twelve (12)-month period ending November 30, 2002. Section 6.11 LIABILITY FOR TAXES; PREPARATION OF TAX RETURNS. (a) TAXABLE PERIODS ENDING ON OR BEFORE THE CLOSING DATE. The Shareholder shall be liable for, and shall indemnify and hold Buyer and the Company harmless against, all Taxes due or payable by or with respect to the Company for any taxable year (I.E., the taxable year ended December 31, 2001) or taxable period (I.E., the taxable period beginning on January 1, 2002 and ending on the Closing Date) ending on or prior to the Closing Date ("PRE-CLOSING TAXES"). (b) TAXABLE PERIODS ENDING AFTER THE CLOSING DATE. Buyer shall be liable for, and shall indemnify and hold the Shareholder harmless against, all Taxes due or payable with respect to the Company for any taxable year or taxable period ending after the Closing Date ("POST CLOSING TAXES"). (c) FILING OF TAX RETURNS. The Shareholder recognizes that income Tax returns must be prepared and filed for the Company as part of the consolidated income tax returns of Shareholder with respect to Pre-Closing Taxes as a result of this Acquisition and that the Shareholder is primarily responsible for preparing and filing these returns. The Shareholder therefore agrees to prepare and file these returns promptly after the Closing, at its expense. Buyer shall cause the Company to prepare and file all Tax returns with respect to Post-Closing Taxes. PAGE 27 Section 6.12 CHANGE OF COMPANY'S CORPORATE NAME. The parties each acknowledge and agree that, given the Company's close association in the insurance industry with the Shareholder and its Affiliates, Buyer shall promptly after the Closing cause the Company to amend its Certificate of Incorporation, changing the Company's corporate name to a new name (which will likely contain the words "Brown & Brown") that bears no resemblance to its current corporate name. ARTICLE 7 CONDITIONS Section 7.1 CONDITIONS TO EACH PARTY'S OBLIGATION. The respective obligations of each party to effect the Contemplated Transactions shall be subject to the satisfaction prior to or on the Closing Date of the following conditions: (a) APPROVALS. All authorizations, consents, orders, or approvals of, or declarations or filings with, or expirations of waiting periods imposed by, any Governmental Entity, the failure to obtain which would have a Material Adverse Change on the Company, shall have been filed, occurred, or been obtained. (b) NO INJUNCTIONS OR RESTRAINTS. No temporary restraining order, preliminary or permanent injunction, or other order issued by any court of competent jurisdiction or other legal restraint or prohibition preventing the consummation of the Contemplated Transactions shall be in effect. Section 7.2 CONDITIONS TO OBLIGATIONS OF BUYER. The obligation of Buyer to effect the Contemplated Transactions is subject to the satisfaction of the following conditions, unless waived by Buyer: (a) REPRESENTATIONS AND WARRANTIES. The representations and warranties of the Sellers set forth in this Agreement shall be true and correct in all material respects as of the Closing Date. (b) PERFORMANCE OF OBLIGATIONS BY THE SELLERS. The Sellers shall have performed all obligations required to be performed by them under this Agreement at or prior to the Closing Date. (c) DUE DILIGENCE. Buyer shall be satisfied, in its sole discretion, with the results of its due diligence investigation of the Company's business and records including, without limitation, (A) all due diligence with respect to the Real Property, (B) with respect to Buyer's personal interviews with certain key employees and all producers of the Company, (C) that all employment agreements, non-compete agreements and/or non-solicitation agreements between the Company and its employees are assignable and enforceable, (D) that none of the Company's insurance carriers as of Closing is rated less than "A-" by A.M. Best, other than NAICO, PROVIDED that if NAICO falls below a "B++" rating at any time during the three (3)-year period following the Effective Date (or, in any event, if at any time after the Closing Buyer PAGE 28 determines that it is in the Company's best interests to rewrite any business then-currently written with NAICO with other carriers), the parties each acknowledge and agree that Buyer shall have the right in its sole discretion to rewrite any business written with NAICO with other carriers, (E) Buyer having received certificates of insurance or other satisfactory evidence of the Company's purchase of the tail policies required under SECTION 6.8 hereof, and (F) that the Company has a Tangible Net Worth (as defined below) as of the Closing Date of at least seven percent (7%) of its Core Revenue for the twelve (12)-month period ended November 30, 2002. As defined herein, the term "TANGIBLE NET WORTH" means the difference of the Company's (1) total assets MINUS (2) those assets identified as "Intangibles" on the Company's balance sheet as of the Closing Date, MINUS (3) total liabilities, determined pursuant to the Company's balance sheet as of the Closing Date, as determined by Buyer's standard audit procedures and after appropriate reductions including, but not limited to, the cost of purchasing the E&O, EPL and employee dishonesty tail coverage policies required under SECTION 6.8 hereof, the cost of purchasing the Environmental Protection policy required under SECTION 6.9 hereof, and all distributions to the Shareholder including, without limitation, the distribution of all accounts receivable outstanding as of November 30, 2002 (the "DISTRIBUTED ACCOUNTS RECEIVABLE"). (d) OPINION OF THE SHAREHOLDER'S COUNSEL. The Shareholder shall have delivered to Buyer the executed Opinion of Shareholder's Counsel; (e) RELEASE. The Shareholder shall have delivered to Buyer the Release, executed by the Selling Parties; (f) LAIRD EMPLOYMENT AGREEMENT. Laird shall have executed and delivered to Buyer the Laird Employment Agreement; (g) STAFF EMPLOYEE AGREEMENTS. The Shareholder shall have delivered executed Staff Employment Agreements to Buyer; (h) ASSIGNMENT OF LIFE INSURANCE POLICY. The Shareholder shall have delivered to Buyer the executed Assignment of Life Insurance Policy; (i) TRUST AGREEMENT. The Shareholder shall have delivered to Buyer the Trust Agreement, duly executed by the Shareholder and the Trustee; (j) MATERIAL ADVERSE CHANGES. There shall have been no Material Adverse Change to the Company since the Balance Sheet Date; (k) APPOINTMENT BY INSURANCE CARRIERS. The Shareholder shall have delivered to Buyer written evidence satisfactory to Buyer in its commercially reasonable discretion that the Company's insurance carriers are willing to appoint Buyer as their agent as of the Closing Date; (l) COMPANY BOARD RESOLUTIONS. The Shareholder shall have delivered to Buyer a copy of the executed Company Board Resolutions; and PAGE 29 (m) NO ENCUMBRANCES. All Encumbrances on the Company Shares or any of the Company's assets shall have been satisfied and released prior to Closing. Section 7.3 CONDITIONS TO OBLIGATION OF THE SHAREHOLDER. The obligations of the Shareholder to effect the Contemplated Transactions are subject to the satisfaction of the following conditions, unless waived by the Shareholder: (a) REPRESENTATIONS AND WARRANTIES. The representations and warranties of Buyer set forth in this Agreement shall be true and correct in all material respects as of the Closing Date; (b) PERFORMANCE OF OBLIGATIONS BY BUYER. Buyer shall have performed in all material respects all obligations required to be performed by it under this Agreement at or prior to the Closing Date; (c) RELEASE. Buyer shall have executed and delivered the Release to the Shareholder; (d) TRUST AGREEMENT. Buyer shall have executed and delivered the Trust Agreement to the Shareholder; and (e) PROMISSORY NOTE. Buyer shall have executed and delivered the Promissory Note to the Shareholder. ARTICLE 8 INDEMNIFICATION Section 8.1 SURVIVAL OF REPRESENTATIONS, WARRANTIES, INDEMNITIES AND COVENANTS. (a) Subject to SECTION 8.1(b), the representations, warranties and indemnities set forth in this Agreement shall survive for a period of three (3) years from the Closing Date. All post-closing covenants shall survive the Closing for the period(s) specified in this Agreement or, if not specified, for a period of three (3) years following the Closing Date. If a party has received notice of a potential breach of a representation, covenant or warranty, or the occurrence of an otherwise potentially-indemnifiable event under this Agreement within such three (3)-year period, such party may preserve its right to assert a later claim for damages arising from such breach or event by delivering notice of same to the other party within the three (3)-year period. (b) Notwithstanding anything set forth in SECTION 8.1(a), all representations, warranties, covenants and indemnities in connection with any (i) any Liabilities with respect to any Employee Benefit Plans of the Company arising prior to the Closing Date, or (iii) any Tax liabilities of the Company arising prior to the Closing Date or of the Sellers arising at any time, shall survive until the expiration of the applicable statutes of limitation. Section 8.2 INDEMNIFICATION PROVISIONS FOR THE BENEFIT OF BUYER. (a) To the extent that any Diverting Employee (as defined below) diverts, on or before the one (1)-year anniversary of the Closing Date, any line of coverage which is part of PAGE 30 any account comprising the Purchased Book of Business, Buyer shall be indemnified by the Sellers (which obligations shall be joint and several) for an amount equal to (i) 1.5 TIMES (ii) the aggregate annualized policy commissions on such diverted lines of coverage, up to a maximum indemnifiable amount equal to the Down Payment Amount. For purposes of this Agreement, a "DIVERTING EMPLOYEE" means any person who is an employee of the Company to whom Buyer has extended an offer of employment but who does not become employed by Buyer, whether by virtue of refusing to sign Buyer's standard employment agreement or otherwise. (b) The parties agree that for a period of two (2) years commencing on the Closing Date, the Shareholder shall have a non-exclusive, royalty-free license to use of the name "LaGere & Walkingstick Insurance Agency, Inc." and the "L&W" logo for the purpose of bringing or participating in Proceedings in connection with the collection by the Shareholder of any then-outstanding Distributed Accounts Receivable; PROVIDED, however, that to the extent that (x) on or before the two (2)-year anniversary of the Closing Date, any Purchased Book of Business account (or line of coverage thereof) which comprises part of the Distributed Accounts Receivable cancels or non-renews due to the Shareholder taking commercially unreasonable actions in collecting or attempting collect the Distributed Accounts Receivable AND (y) the final Purchase Price is less than the Minimum Purchase Price Amount, Buyer shall be indemnified by the Sellers (which obligation shall be joint and several) for an amount equal to the sum of (i) any earned premium due and payable with respect to such canceled or non-renewed account or line of coverage PLUS (ii) 1.5 TIMES (B) the aggregate, annualized Core Revenue attributable to such canceled or non-renewed account or line of coverage LESS any amounts actually received by Buyer on such policies as commissions, up to a maximum indemnifiable amount equal to the amount by which the final Purchase Price is less than the Minimum Purchase Price Amount. (c) The Sellers, jointly and severally, agree to indemnify and hold Buyer, the Company and their respective officers, directors and affiliates harmless from and against any and all Adverse Consequences (as defined below) that any of such parties may suffer or incur (to the extent such Adverse Consequences are not fully covered and actually paid pursuant to applicable insurance) resulting from, arising out of, relating to, or caused by (i) the breach of any of the Selling Parties' representations, warranties, obligations or covenants contained herein, or (ii) the operation of the Company's insurance agency business or ownership of the Company Shares by the Shareholder on or prior to the Closing Date, including, without limitation, any claims or lawsuits based on (A) conduct of the Company, its employees or the Shareholder occurring before the Closing, (B) the Company's ownership of the Real Property before the Closing, or (C) any accounts receivable, notes receivable, or agreement of the Company distributed to or assumed by the Shareholder or any Affiliate thereof prior to the Closing. For purposes of this ARTICLE 8, the phrase "ADVERSE CONSEQUENCES" means all charges, complaints, actions, suits, proceedings, hearings, investigations, claims, demands, judgments, orders, decrees, stipulations, injunctions, damages, dues, penalties, fines, costs, amounts paid in settlement, liabilities (whether known or unknown, whether absolute or contingent, whether liquidated or unliquidated, and whether due or to become due), obligations, Taxes, liens, losses, expenses, and fees, including all attorneys' fees and court costs. For purposes of this SECTION 8.2, "Adverse Consequences" also specifically includes any Adverse Consequences attributable to any deductible(s) due and payable under the tail policies which the Sellers agree to purchase pursuant to SECTION 6.9 hereof and the Environmental Protection policy which the Sellers agree to purchase pursuant to SECTION 6.10 hereof. PAGE 31 (d) In addition to and without limiting the foregoing, the Sellers jointly and severally agree, from and after the Closing, to indemnify Buyer from and against the entirety of any Adverse Consequences Buyer may suffer resulting from, arising out of, relating to, in the nature of, or caused by any liability of the Company for the unpaid Taxes of any person or entity (including the Company) under United States Treasury Regulation Sections 1.1502-6 (or any similar provision of state, local, or foreign law), as a transferee or successor, by contract, or otherwise. Section 8.3 INDEMNIFICATION PROVISIONS FOR THE BENEFIT OF THE SELLING PARTIES. Buyer agrees to indemnify and hold the Selling Parties harmless from and against any and all Adverse Consequences the Selling Parties may suffer or incur resulting from, arising out of, relating to, or caused by (a) the breach of any of Buyer's representations, warranties, obligations or covenants contained herein, or (b) the operation of the insurance agency business of the Company or ownership of the Company Shares by Buyer after the Closing Date, including, without limitation, any claims or lawsuits based on conduct of Buyer or the Company occurring after the Closing. ARTICLE 9 [INTENTIONALLY OMITTED] ARTICLE 10 MISCELLANEOUS Section 10.1 NOTICES. All notices and other communications hereunder shall be in writing and shall be deemed given if delivered personally, telecopied (if confirmed), or mailed by registered or certified mail (return receipt requested) to the parties at the following addresses or at such other address for a party as shall be specified by like notice: (a) If to Buyer, to: Brown & Brown, Inc. 401 E. Jackson Street, Suite 1700 Tampa, Florida 33602 Telecopy No.: (813) 222-4464 Attn: Laurel L. Grammig, Esq. (b) If to the Selling Parties, to: Chandler (U.S.A.), Inc. 1010 Manvel Avenue Chandler, Oklahoma 74834 Telecopy No.: (405) 258-4574 Attn: R. Patrick Gilmore, Esq. Section 10.2 USE OF TERM "KNOWLEDGE". With respect to the term "KNOWLEDGE" as used herein: (a) an individual shall be deemed to have "Knowledge" of a particular fact or other matter if (i) such individual is actually aware of such fact or other matter, or (ii) a prudent individual could be expected to discover or otherwise become of such fact or other matter in the PAGE 32 course of conducting a reasonably comprehensive investigation concerning the existence of such fact or matter; and (b) a corporation or other business entity shall be deemed to have "Knowledge" of a particular fact or other matter if any individual who is serving, who has at any time in the twelve (12) months prior to the Closing Date served, as a director or officer of such corporation or business entity has, or at any time had, Knowledge of such fact or other matter. Section 10.3 COUNTERPARTS. This Agreement may be executed in two or more counterparts, all of which shall be considered one and the same agreement, and shall become effective when one or more counterparts have been signed by each of the parties and delivered to the other parties, it being understood that all parties need not sign the same counterpart. Section 10.4 ENTIRE AGREEMENT. This Agreement (including the documents and instruments referred to herein) constitutes the entire agreement and supersedes all prior agreements and understandings, both written and oral, among the parties with respect to the subject matter hereof. Section 10.5 JURISDICTION; SERVICE OF PROCESS; WAIVER OF JURY TRIAL. (a) Any Proceeding arising out of or relating to this Agreement or any of the Contemplated Transactions may be brought in the courts of the State of Florida, County of Hillsborough, or, if it has or can acquire jurisdiction, in the United States District Court for the Middle District of Florida, and each of the parties irrevocably submits to the exclusive jurisdiction of each such court in any such Proceeding, waives any objection it may now or hereafter have to venue or to convenience of forum, agrees that all claims in respect of the Proceeding shall be heard and determined only in any such court and agrees not to bring any Proceeding arising out of or relating to this Agreement or any of the Contemplated Transactions in any other court. The parties agree that either or both of them may file a copy of this SECTION 10.5(a) with any court as written evidence of the knowing, voluntary and bargained agreement between the parties irrevocably to waive any objections to venue or to convenience of forum. Process in any Proceeding referred to in the first sentence of this SECTION 10.5(a) may be served on any party anywhere in the world. (b) THE PARTIES HEREBY KNOWINGLY, VOLUNTARILY AND INTENTIONALLY WAIVE ANY RIGHT EITHER MAY HAVE TO A TRIAL BY JURY WITH RESPECT TO ANY PROCEEDING RELATED TO OR ARISING OUT OF, UNDER OR IN CONJUNCTION WITH THIS AGREEMENT OR ANY OTHER AGREEMENT, NOTE OR INSTRUMENT CONTEMPLATED HEREIN. Section 10.6 ASSIGNMENT. Except as contemplated in SECTION 6.7 hereof, neither this Agreement nor any of the rights, interests, or obligations hereunder shall be assigned by any of the parties hereto (whether by operation of law or otherwise) without the prior written consent of the other parties. This Agreement shall be binding upon, inure to the benefit of, and be enforceable by the parties and their respective successors and permitted assigns. Section 10.7 JOINT EFFORTS. This Agreement is the result of the joint efforts and negotiations of the parties hereto, with each party being represented, or having the opportunity to be represented, by legal counsel of its own choice, and no singular party is the author or drafter of the PAGE 33 provisions hereof. Each of the parties assumes joint responsibility for the form and composition of this Agreement and each party agrees that this Agreement shall be interpreted as though each of the parties participated equally in the composition of this Agreement and each and every provision and part hereof. The parties agree that the rule of judicial interpretation to the effect that any ambiguity or uncertainty contained in an agreement is to be construed against the party that drafted the agreement shall not be applied in the event of any disagreement or dispute arising out of this Agreement. Section 10.8 HEADINGS. All paragraph headings herein are inserted for convenience of reference only and shall not modify or affect the construction or interpretation of any provision of this Agreement. Section 10.9 SEVERABILITY. In the event that any provision, covenant, section, subsection, paragraph, or any portion thereof, of this Agreement is held by any court of competent jurisdiction to be illegal, invalid or unenforceable, either in whole or in part, the legality, validity or enforceability of the remaining provisions, covenants, sections, subsections, paragraphs, or portions thereof shall not be affected thereby, and each such provision, covenant, section, subsection, paragraph, or any portion thereof shall remain valid and enforceable to the fullest extent permitted by law. Section 10.10 ATTORNEYS' FEES AND COSTS. The prevailing party in any Proceeding brought to enforce the terms of this Agreement shall be entitled to an award of reasonable attorneys' fees and costs incurred in investigating and pursuing such action, both at the trial and appellate levels. Section 10.11 GOVERNING LAW. This Agreement shall be governed by and construed and enforced in accordance with internal Florida law without regard to conflicts-of-laws principles that would require the application of any other law. Section 10.12 AMENDMENT; WAIVER. This Agreement may not be amended, or any provision waived, except by an instrument in writing signed on behalf of each of the parties. * * * * * * * * * * [REMAINDER OF PAGE INTENTIONALLY LEFT BLANK - SIGNATURE PAGES FOLLOW] PAGE 34 IN WITNESS WHEREOF, the parties have signed or caused this Agreement to be signed by their respective officers thereunto duly authorized as of the date first written above. BUYER: BROWN & BROWN, INC. By: /s/ C. Roy Bridges ----------------------------------- Name: C. Roy Bridges Title: Regional Executive Vice President SHAREHOLDER: CHANDLER (U.S.A.), INC. By: /s/ R. Patrick Gilmore ----------------------------------- Name: R. Patrick Gilmore --------------------------------- Title: Senior Vice President -------------------------------- PARENT: CHANDLER INSURANCE COMPANY, LTD. By: /s/ W. Brent LaGere ----------------------------------- Name: W. Brent LaGere --------------------------------- Title: Chief Executive Officer -------------------------------- NAICO: NATIONAL AMERICAN INSURANCE COMPANY By: /s/ R. Patrick Gilmore ----------------------------------- Name: R. Patrick Gilmore --------------------------------- Title: Senior Vice President -------------------------------- PAGE 35 PRINCIPALS: /s/ W. Brent LaGere ---------------------------------------- W. Brent LaGere, individually /s/ Mark T. Paden ---------------------------------------- Mark T. Paden, individually PAGE 36 SCHEDULES AND EXHIBITS SCHEDULE 1.2(a)(ii): Non-Compete Amount SCHEDULE 1.2(b)(iii): Pro Forma SCHEDULE 1.2(b)(iii)(D): Profit Center Bonus Program SCHEDULE 3.5: Consents and Approvals SCHEDULE 3.7(a): Financial Statements SCHEDULE. 3.7(c): Undisclosed Liabilities SCHEDULE 3.9: Certain Changes and Events SCHEDULE 3.10(a): Current Book of Business SCHEDULE 3.10(b): Material Contracts SCHEDULE 3.11: Litigation and Claims SCHEDULE 3.15(a): Insurance Policies SCHEDULE 3.15(c): Employee Dishonesty Losses and/or Claims SCHEDULE 3.17: Employee Benefit Plans SCHEDULE 3.18: Intellectual Property Assets EXHIBIT 2.2(a)(ii): Release EXHIBIT 2.2(a)(iii): Opinion of the Shareholder's Counsel EXHIBIT 2.2(a)(iv): Laird Employment Agreement EXHIBIT 2.2(a)(vi): Trust Agreement EXHIBIT 2.2(b)(ii): Promissory Note EXHIBIT 2.2(c): Assignment of Life Insurance Policy EX-21.1 4 exh212003.txt EXHIBIT 21.1 SUBSIDIARIES OF THE REGISTRANT EXHIBIT 21.1 CHANDLER (U.S.A.), INC. AND SUBSIDIARIES SUBSIDIARIES OF THE REGISTRANT 1. National American Insurance Company, an Oklahoma corporation ("NAICO") that is a wholly owned subsidiary of Chandler USA. 2. Chandler Insurance Managers, Inc., an Oklahoma Corporation ("CIMI") that is a wholly owned subsidiary of Chandler USA. 3. Network Administrators, Inc., a Texas corporation ("Network") that is a wholly owned subsidiary of Chandler USA. EX-99.1 5 exh992003.txt EXHIBIT 99.1 CERTIFICATION EXHIBIT 99.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES - OXLEY ACT OF 2002 In connection with the Annual Report of Chandler (U.S.A.), Inc. (the "Company") on Form 10-K for the period ending December 31, 2002 as filed with the Securities and Exchange Commission (the "Report"), W. Brent LaGere, as Chief Executive Officer of the Company, and Mark C. Hart, as Chief Financial Officer of the Company, each hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes - Oxley Act of 2002, to the best of his knowledge, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ W. Brent LaGere --------------------------------------- W. Brent LaGere Chief Executive Officer March 4, 2003 /s/ Mark C. Hart --------------------------------------- Mark C. Hart Chief Financial Officer March 4, 2003 -----END PRIVACY-ENHANCED MESSAGE-----