-----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, TjlyGbhsTsu8fc8GGpfLbAb5B0Ruyhh6Xv0rpGWdf1xtOXuJOV0NHg6bq3YmJfCd Iane8PnGFN5NZitncobiWg== 0001083750-05-000005.txt : 20050322 0001083750-05-000005.hdr.sgml : 20050322 20050322112649 ACCESSION NUMBER: 0001083750-05-000005 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20041231 FILED AS OF DATE: 20050322 DATE AS OF CHANGE: 20050322 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: 05695922 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 usa10kfinaledgar.txt CHANDLER (U.S.A.), INC. 12/31/2004 10-K ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------------------------- FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004 COMMISSION FILE NUMBER: 1-15135 CHANDLER (U.S.A.), INC. (Exact name of registrant as specified in its charter) OKLAHOMA 73-1325906 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1010 MANVEL AVENUE, CHANDLER, OKLAHOMA 74834 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (405) 258-0804 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered -------------------------------- --------------------------------------------- 8.75% SENIOR DEBENTURES DUE 2014 AMERICAN STOCK EXCHANGE Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO ----- ----- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES NO X ----- ----- Aggregate market value of the voting stock held by non-affiliates of the registrant on June 30, 2004, the last business day of the registrant's most recently completed second fiscal quarter: None. The number of common shares, $1.00 par value, of the registrant outstanding on February 28, 2005 was 2,484, which are owned by Chandler Insurance Company, Ltd. DOCUMENTS INCORPORATED BY REFERENCE Registrant does not incorporate by reference in this report any annual report, proxy statement, or Rule 424 prospectus. ================================================================================ PAGE 1 PART I FORWARD-LOOKING STATEMENTS Some of the statements made in this Form 10-K report, as well as statements made by Chandler (U.S.A.), Inc. ("Chandler USA") in periodic press releases and oral statements made by Chandler USA's officials constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of Chandler USA to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such factors include, among other things, (i) general economic and business conditions; (ii) interest rate changes; (iii) competition and regulatory environment in which Chandler USA and its subsidiaries operate, including the ability to implement price increases; (iv) claims frequency; (v) claims severity; (vi) catastrophic events of unanticipated frequency or severity; (vii) the number of new and renewal policy applications submitted to National American Insurance Company ("NAICO") by its agents; (viii) the ability of NAICO to obtain adequate reinsurance in amounts and at rates that will not adversely affect its competitive position; (ix) the ability of NAICO to collect reinsurance recoverables; (x) the ability of NAICO to maintain favorable insurance company ratings; and (xi) various other factors. ITEM 1. BUSINESS GENERAL Chandler USA is an insurance holding company that provides administrative services to its wholly owned subsidiaries NAICO and Chandler Insurance Managers, Inc. ("CIMI"). Chandler USA is an Oklahoma corporation which is wholly owned by Chandler Insurance Company, Ltd. ("Chandler Insurance"), a privately owned Cayman Islands company. Chandler USA is headquartered in Chandler, Oklahoma, in facilities also occupied by NAICO and CIMI. NAICO is one of the leading commercial business insurance writers in Oklahoma, providing property and casualty coverage for businesses in various industries. NAICO has a network of independent agents, totaling approximately 130 at December 31, 2004, that market NAICO's insurance products. Independent agents originate substantially all of NAICO's business. NAICO is licensed to write property and casualty coverage in 45 states and the District of Columbia and is authorized by the United States Department of the Treasury to write surety bonds for contractors on federal projects. NAICO is currently rated as B++ (Very Good) by A.M. Best Company, an insurance rating agency. This rating is an independent opinion of a company's financial strength, operating performance and ability to meet its obligations to policyholders. CIMI is an underwriting manager for certain wholesale operations related to NAICO's school districts and trucking insurance. CIMI was established in December 2002. Prior to December 2003, Chandler USA was a wholly owned subsidiary of Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") which, in turn, was a wholly owned subsidiary of Chandler Insurance. In December 2003, Chandler Barbados was dissolved following the transfer of its assets, liabilities and business to Chandler Insurance. Chandler Insurance assumed the obligations of Chandler Barbados including those under its reinsurance agreements with NAICO pursuant to a Distribution Agreement and a General Conveyance. The reorganization of Chandler Barbados and Chandler Insurance was approved by the Cayman Islands Monetary Authority, the Supervisor of Insurance in Barbados and the Oklahoma Insurance Department. In December 2002, Chandler USA completed the sale of its wholly owned subsidiary, LaGere & Walkingstick Insurance Agency, Inc. ("L&W"), to Brown & Brown, Inc. L&W previously functioned as Chandler USA's agency segment and is presented as discontinued operations. See Note 4 to Consolidated Financial Statements for more information on the sale of L&W. INSURANCE PROGRAMS NAICO writes various property and casualty insurance products through three primary marketing programs. The programs are standard property and casualty, political subdivisions and surety bonds. PAGE 2 STANDARD PROPERTY AND CASUALTY PROGRAM NAICO offers workers compensation, automobile liability and physical damage, other liability (including general liability, products liability and umbrella liability) and property coverages under its standard property and casualty program. In marketing these products, NAICO targets companies in the construction, manufacturing, wholesale, service, oil and gas, trucking, and retail industries. NAICO writes this business principally in Oklahoma and Texas. POLITICAL SUBDIVISIONS PROGRAM Under the political subdivisions program, NAICO writes insurance policies primarily for school districts in Oklahoma. As of December 31, 2004 NAICO insured 232 school districts primarily in Oklahoma. The coverages offered include workers compensation, automobile liability, automobile physical damage, general liability, property and school board legal liability. NAICO has also written property and casualty insurance for municipalities, primarily in Oklahoma. During 2002 and 2003, NAICO significantly reduced its premium writings in this portion of the program and did not write any premiums during 2004. SURETY BOND PROGRAM NAICO writes surety bonds, commonly referred to as contract performance bonds, to secure the performance of contractors and suppliers on construction projects. A substantial portion of this business is written in Texas and Oklahoma. NAICO has also written bail bonds, which guarantee that the principal will discharge obligations set by the court, as well as other types of miscellaneous bonds. NAICO discontinued the bail bond portion of the program as of the end of 2003. The following table shows gross premiums earned and net premiums earned by insurance program for the years 2002, 2003 and 2004. The term "gross premiums earned" means gross premiums written (before reductions for premiums ceded to reinsurers) less the increases or plus the decreases in the gross unearned premium reserve for the unexpired portion of the policy term beyond the current accounting period. The term "net premiums earned" means gross premiums earned less reductions for earned premiums ceded to reinsurers. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
GROSS PREMIUMS EARNED NET PREMIUMS EARNED -------------------------- -------------------------- INSURANCE PROGRAMS 2002 2003 2004 2002 2003 2004 - ----------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Standard property and casualty .... $106,051 $ 93,193 $ 92,894 $ 49,570 $ 45,521 $ 54,278 Political subdivisions ............ 35,159 28,926 21,679 13,829 8,093 7,269 Surety bonds ...................... 5,104 3,908 2,788 3,310 2,724 1,993 Other (1) ......................... 249 252 507 248 245 502 -------- -------- -------- -------- -------- -------- TOTAL ............................. $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042 ======== ======== ======== ======== ======== ======== - ------------------------------- (1) This category is comprised primarily of the run-off of discontinued programs and NAICO's participation in various mandatory workers compensation pools and assigned risks.
PAGE 3 LINES OF INSURANCE The lines of insurance written by NAICO through its programs are workers compensation, automobile liability, other liability (including general liability, products liability and umbrella liability), automobile physical damage, property, surety and inland marine. The following table shows net premiums earned as a percentage of total net premiums earned by each line of insurance written by NAICO during the period indicated.
YEAR ENDED DECEMBER 31, ---------------------------------------------------- 2000 2001 2002 2003 2004 -------- -------- -------- -------- -------- Automobile liability .............. 20% 19% 25% 27% 28% Other liability ................... 25% 25% 25% 23% 28% Workers compensation .............. 25% 24% 22% 29% 27% Automobile physical damage ........ 13% 17% 14% 10% 9% Property .......................... 4% 7% 8% 5% 4% Surety ............................ 8% 6% 5% 5% 3% Inland marine ..................... 1% 2% 1% 1% 1% Accident and health ............... 4% -% -% -% -% -------- -------- -------- -------- -------- Total .......................... 100% 100% 100% 100% 100% ======== ======== ======== ======== ========
UNDERWRITING AND CLAIMS Independent insurance agents submit applications for insurance coverage for prospective customers to NAICO. NAICO reviews a prospective risk in accordance with its specific underwriting guidelines. If the risk is approved and coverage is accepted by the insured, NAICO issues an insurance policy. NAICO's claims department reviews and administers all claims. When a claim is received, it is reviewed and assigned to an in-house claim adjuster based on the type and geographic location of the claim, its severity and its class of business. NAICO's claims department is responsible for reviewing each claim, obtaining necessary documentation and establishing loss and loss adjustment expense reserves. NAICO's in-house claims staff handles and supervises the claims, coordinates with outside legal counsel and independent claims adjusters if necessary, and processes the claims to conclusion. REINSURANCE In the ordinary course of business, NAICO cedes insurance risks and a portion of the insurance premiums to its reinsurers under various reinsurance contracts that cover individual risks (facultative reinsurance) or entire classes of business (treaty reinsurance). Reinsurance provides greater diversification of insurance risk associated with business written and also reduces NAICO's exposure from high policy limits or from catastrophic events and hazards of an unusual nature. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In formulating its reinsurance programs, NAICO considers numerous factors, including the financial stability of the reinsurer, the reinsurer's ability to provide sufficient collateral (if required), reinsurance coverage offered and price. Treaty reinsurance may be ceded under treaties on both a pro rata or proportional basis (where the reinsurer shares proportionately in premiums and losses) and an excess of loss basis (where only losses above a specific amount are reinsured). The availability, costs and limits of reinsurance purchased varies from year to year based upon prevailing market conditions, reinsurers' underwriting results and NAICO's desired risk retention levels. A majority of NAICO's reinsurance programs renew on January 1 or July 1 of each year. NAICO renewed all January 1, 2005 reinsurance programs. At the present time, NAICO expects to renew the reinsurance programs that renew on July 1, 2005. NAICO has structured separate reinsurance programs for property (including inland marine), workers compensation, casualty (including automobile liability, general and products liability, umbrella liability and related professional liability), automobile physical damage and construction surety bonds. NAICO also purchases facultative reinsurance when it writes a risk with limits of liability exceeding the maximum limits of its treaties or when it otherwise considers such action appropriate. Chandler Insurance reinsures NAICO for a portion of the risk on NAICO's reinsurance programs. PAGE 4 Under the 2002 workers compensation reinsurance program, NAICO's net retention was 50% of the first $200,000 of loss per occurrence. Effective July 1, 2002, NAICO's net retention increased to 50% of the first $250,000 of loss per occurrence. Effective January 1, 2003, NAICO's net retention increased to 70% of the first $250,000 of loss per occurrence, and effective July 1, 2003, NAICO's net retention increased to 70% of the first $500,000 of loss per occurrence. Effective April 1, 2004, NAICO added 56% of the $500,000 excess of $500,000 of loss per occurrence layer to its net retention, and effective July 1, 2004, NAICO's net retention increased to 70% of the first $1,000,000 of loss per occurrence. Under the 2002 casualty reinsurance program, NAICO's net retention was 80% of the first $250,000 of loss per occurrence plus 40% of $250,000 excess of $250,000 of loss per occurrence. Effective July 1, 2002, NAICO's net retention decreased to 80% of the first $250,000 of loss per occurrence. Effective January 1, 2003, NAICO's net retention decreased to 70% of the first $250,000 of loss for occurrence, and effective July 1, 2003, NAICO's net retention increased to 70% of the first $500,000 of loss per occurrence. Effective April 1, 2004, NAICO added 56% of the $500,000 excess of $500,000 of loss per occurrence layer to its net retention, and effective July 1, 2004, NAICO's net retention increased to 70% of the first $1,000,000 of loss per occurrence. Effective July 1, 2004, NAICO increased its net retention for umbrella liability losses from 3.5% of the first $2,000,000 of loss per occurrence to 17.5% of the first $4,000,000 of loss per occurrence. Under the 2002 construction surety bond reinsurance program, NAICO's net retention was 50% of the first $1,000,000 plus 10% of $4,000,000 excess of $1,000,000 per principal (e.g., contractor). Effective January 1, 2003, NAICO increased its retention for the first $1,000,000 of loss per principal from 50% to 70%. NAICO elected not to renew its construction surety bond excess of loss reinsurance effective April 1, 2003 due to the decreased premium volume in this program and to the current market for this reinsurance. Effective April 1, 2003, NAICO retains 70% of the losses in this program. Under the 2002 property reinsurance program, NAICO retained 33% of the first $1,500,000 of risk for each loss per risk or location. Effective January 1, 2003, NAICO retains 23.1% of the first $1,500,000 of risk for each loss per risk or location. Effective January 1, 2004, NAICO retains 23.1% of the first $3,000,000 of risk for each loss per risk or location. Under the 2002 automobile physical damage reinsurance program, NAICO retained the first $500,000 of each loss per occurrence, plus 5% of amounts exceeding $500,000 of each loss per occurrence up to $1 million of each loss per occurrence. Effective January 1, 2003, NAICO retains 70% of the first $500,000 of each loss per occurrence, plus 3.5% of amounts exceeding $500,000 of each loss per occurrence up to $1 million of each loss per occurrence. Effective January 1, 2004, NAICO retains 70% of each loss per occurrence on automobile physical damage risks. NAICO purchases catastrophe protection for its automobile physical damage and certain property coverages to limit its retention for single loss occurrences involving multiple policies and/or policyholders resulting from perils such as floods, winds and severe storms. This catastrophe protection limits NAICO's net retained loss for both automobile physical damage and property losses to $1,000,000 for 2002, $700,000 for 2003 and $1,400,000 effective January 1, 2004 for each loss occurrence. On November 26, 2002, President Bush signed the Terrorism Risk Insurance Act of 2002 (the "Act"), establishing a program for commercial property and casualty losses, including workers compensation, resulting from foreign acts of terrorism. The Act requires commercial insurers to offer terrorism coverage on its commercial property and casualty lines of business. Each insurance company will be responsible for a deductible based on a percentage of direct earned premiums from the previous calendar year, which rises from 7% for losses occurring in 2003 to 10% in 2004 and 15% in 2005. The Federal Government will pay 90% of covered terrorism losses that exceed company deductibles. The Federal Government will be required to recoup the portion of any federal compensation paid to the extent that industry retentions are less than $10 billion for events in 2003, $12.5 billion for 2004 and $15 billion for 2005. The recoupment will be accomplished through a surcharge on all policyholders, not to exceed 3% of premiums in a given year. The Act is scheduled to expire on December 31, 2005. NAICO purchased quota share reinsurance for its deductible under the Act limiting NAICO's retention to 10% for 2003 and 15% for 2004 and 2005 of such deductible, subject to a reinsurance limit of $9,450,000 for 2003 and $10,625,000 for 2004 and 2005 for each loss occurrence. The reinsurance coverage is also limited to $9,450,000 for 2003 and $10,625,000 for 2004 and 2005 for all loss occurrences for any year. NAICO also purchased excess of loss reinsurance covering acts of terrorism that provides coverage of $20 million excess of $10 million for 2003, $10 million excess of $12.5 million for 2004 and $15 million excess of $12.5 million for 2005 of loss per occurrence based on NAICO's net retention. PAGE 5 The following table sets forth certain information related to NAICO's five largest reinsurers determined on the basis of net reinsurance recoverables as of December 31, 2004.
CEDED REINSURANCE NET PREMIUMS FOR A.M. BEST REINSURANCE THE YEAR ENDED COMPANY NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2004 RATING - -------------------------------------------- --------------- ----------------- ------------ (Dollars in thousands) Chandler Insurance ......................... $ 25,555 $ 30,055 -(2) Employers Reinsurance Corporation .......... 23,955 9,731 A Swiss Reinsurance America Corporation ...... 22,640 52 A+ Odyssey America Reinsurance Corporation .... 3,958 5,489 A GE Reinsurance Corporation ................. 3,605 (27) A --------------- ----------------- Top five reinsurers ..................... $ 79,713 $ 45,300 =============== ================= All reinsurers .......................... $ 87,945 $ 51,187 =============== ================= Percentage of total represented by top five reinsurers .......................... 91% 88% - -------------------------------------------- (1) Includes losses and loss adjustment expenses paid and outstanding, unpaid losses and loss adjustment expenses and prepaid reinsurance premiums recoverable from reinsurers as of December 31, 2004. (2) Chandler Insurance owns 100% of the common stock of Chandler USA, which in turn owns 100% of the common stock of NAICO. Although Chandler Insurance is not subject to the minimum capital, audit, reporting and other requirements imposed by regulation upon United States reinsurance companies, as a foreign reinsurer, it is required to secure its reinsurance obligations by depositing acceptable securities in trust for NAICO's benefit. At December 31, 2004, Chandler Insurance had cash and investments with a fair value of $28.6 million deposited in a trust account for the benefit of NAICO.
Transamerica Occidental Life Insurance Company ("Transamerica") reinsured NAICO for certain workers compensation risks during 1989, 1990 and 1991. Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed under the reinsurance treaties. On March 15, 2004, an arbitration panel ordered Transamerica to pay the losses and loss adjustment expenses owed to NAICO in the amount of $1,607,704 plus interest at 6%, or approximately $577,000, plus $25,000 in costs. NAICO has received payment for these amounts. Reliance Insurance Company ("Reliance") reinsured NAICO for certain workers compensation risks during 1998. At December 31, 2004, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses of approximately $3.3 million. During October 2001, the Commonwealth of Pennsylvania placed Reliance in liquidation. NAICO is unable to determine the amount of its reinsurance recoverables from Reliance that will ultimately be collected and has fully reserved the carrying value of such amounts as of December 31, 2003 and 2004. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to Chandler USA; consequently, adjustments to ceded losses and loss adjustment expenses are made for amounts deemed uncollectible. NAICO incurred charges of $1.7 million, $604,000 and $282,000 during 2002, 2003 and 2004, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible. PAGE 6 LOSS AND UNDERWRITING EXPENSE RATIOS The combined loss and underwriting expense ratio ("Combined Ratio") is the traditional measure of underwriting experience for property and casualty insurance companies. It is the sum of the ratios of (i) incurred losses and loss adjustment expenses to net premiums earned ("loss ratio") and (ii) underwriting expenses to net premiums written and assumed ("underwriting expense ratio"). The following table shows the underwriting experience of Chandler USA for the periods indicated by line of insurance written. Adjustments to reserves made in subsequent periods are reflected in the year of adjustment. In the following table, incurred losses include paid losses and loss adjustment expenses, net changes in case reserves for losses and loss adjustment expenses and net changes in reserves for incurred but not reported losses and loss adjustment expenses. See also "Reserves" and "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
YEAR ENDED DECEMBER 31, -------------------------------------------- 2000 2001 2002 2003 2004 -------- -------- -------- -------- -------- (Dollars in thousands) Other liability: Net premiums earned ........................ $ 20,992 $ 17,470 $ 16,458 $ 12,870 $ 18,044 Loss ratio ................................. 56% 57% 80% 94% 121% Automobile liability: Net premiums earned ........................ $ 17,517 $ 13,386 $ 16,526 $ 15,624 $ 17,742 Loss ratio ................................. 78% 70% 81% 49% 61% Workers compensation: Net premiums earned ........................ $ 21,161 $ 16,449 $ 14,808 $ 16,378 $ 17,371 Loss ratio ................................. 70% 105% 99% 72% 85% Automobile physical damage: Net premiums earned ........................ $ 11,434 $ 12,174 $ 9,552 $ 5,508 $ 5,933 Loss ratio ................................. 85% 52% 35% 36% 43% Property: Net premiums earned ........................ $ 3,377 $ 4,806 $ 5,543 $ 3,072 $ 2,611 Loss ratio ................................. 179% 93% 50% 74% 47% Surety: Net premiums earned ........................ $ 6,760 $ 4,125 $ 3,310 $ 2,723 $ 1,993 Loss ratio ................................. 33% 57% 59% 34% 134% Inland marine: Net premiums earned ........................ $ 1,088 $ 1,256 $ 760 $ 408 $ 348 Loss ratio ................................. 142% 143% 100% 54% 29% Accident and health: Net premiums earned ........................ $ 3,190 $ 319 $ - $ - $ - Loss ratio ................................. 161% 281% -% -% -% Total: Net premiums earned ........................ $ 85,519 $ 69,985 $ 66,957 $ 56,583 $ 64,042 Loss ratio ................................. 76% 75% 76% 66% 84% Underwriting expense ratio (1) ............. 30% 33% 34% 47% 34% -------- -------- -------- -------- -------- Combined ratio (1) ......................... 106% 108% 110% 113% 118% ======== ======== ======== ======== ======== - ---------------------------------------------- (1) Interest expense and certain litigation expenses are not considered underwriting expenses; therefore, such costs have been excluded from these ratios. The underwriting expense ratio for 2003 was impacted by a 23% decrease in net premiums written and assumed during 2003. Certain types of expenses are fixed in nature, resulting in an increased ratio for this period. See also "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
PAGE 7 RESERVES Insurance companies provide in their financial statements reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under their previously issued insurance policies and/or reinsurance contracts. In estimating reserves, insurance companies use various standardized methods based on historical experience and payment and reporting patterns for the type of risk involved. The application of these methods involves subjective determinations by the personnel of the insurance company. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount of and uncertainty in the estimates is affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs, such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that expand insurance coverage after the insurance policy was priced and sold. In recent years, certain of these factors have contributed to incurred amounts that were higher than original estimates. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims. NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO, and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Any changes in the estimates are reflected in current operating results. Such changes in estimates may be material. Salvage and subrogation recoverables are accrued using the "case basis" method for large recoverables and statistical estimates based on historical experience for smaller recoverables. Recoverable amounts deducted from Chandler USA's net liability for losses and loss adjustment expenses were approximately $5.7 million and $3.7 million at December 31, 2003 and 2004, respectively. NAICO's statutory-based reserves (reserves calculated in accordance with an insurer's domiciliary state insurance regulatory authorities) do not differ from its reserves reported on the basis of accounting principles generally accepted in the United States of America ("GAAP"). NAICO does not discount its reserves for unpaid losses or loss adjustment expenses. NAICO participates in various pools covering workers compensation risks for insureds who were unable to purchase this coverage from an insurance company on a voluntary basis. The consolidated financial statements reflect the reserves for unpaid losses and loss adjustment expenses and net premiums earned from its participation in the pools. There may be significant reporting lags between the occurrence of the insured loss and the time it is actually reported to the insurer. The inherent uncertainties in estimating insurance reserves are generally greater for casualty coverages, such as workers compensation, general and automobile liability, than for property coverages primarily due to the longer period of time that typically elapses before a definitive determination of ultimate loss can be made, which is also affected by changing theories of legal liability and changing political climates. There are significant additional uncertainties in estimating the amount of reserves required for environmental, asbestos-related and other latent exposure claims, including a lack of historical data, long reporting delays and complex unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different and frequently inconsistent conclusions as to when the loss occurred, what claims are covered, under what circumstances the insurer has an obligation to defend, how policy limits are determined and how policy exclusions are applied and interpreted. The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury and workers compensation claims have a much longer loss settlement period and may be paid out over several years. It is often necessary to adjust estimates of liability on a loss either upward or downward from the time a claim arises to the time of payment. Workers compensation indemnity benefit reserves are determined based on statutory benefits described by state law and are estimated based on the same factors generally discussed above which may include, where state law permits, inflation adjustments for rising benefits over time. Generally, the more costly automobile liability claims involve one or more severe bodily injuries or deaths. The ultimate cost of these types of claims is dependent on various factors including the relative liability of the parties involved, the number and severity of injuries and the legal jurisdiction where the incident occurred. PAGE 8 The following table sets forth a reconciliation of the beginning and ending reserves for losses and loss adjustment expenses which are net of reinsurance deductions for the years indicated.
YEAR ENDED DECEMBER 31, ------------------------------------------------- 2000 2001 2002 2003 2004 --------- --------- --------- --------- --------- (In thousands) Net balance at beginning of year .............. $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 --------- --------- --------- --------- --------- Net losses and loss adjustment expenses incurred related to: Current year .............................. 60,020 39,881 34,928 26,108 27,436 Prior years ............................... 4,979 12,669 15,784 11,092 26,345 --------- --------- --------- --------- --------- Total ................................... 64,999 52,550 50,712 37,200 53,781 --------- --------- --------- --------- --------- Net paid losses and loss adjustment expenses related to: Current year .............................. (33,661) (22,646) (13,283) (10,626) (10,222) Prior years ............................... (36,009) (43,799) (37,050) (30,422) (28,207) --------- --------- --------- --------- --------- Total ................................... (69,670) (66,445) (50,333) (41,048) (38,429) --------- --------- --------- --------- --------- Net balance at end of year .................... $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695 ========= ========= ========= ========= =========
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2001, 2002, 2003 and 2004 calendar years. The loss development occurred primarily in the 1997-2001 accident years. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results. During 2001, NAICO experienced adverse loss development totaling $12.7 million due primarily to increased loss severity in the standard property and casualty and political subdivisions programs. A substantial part of this loss development was for workers compensation losses in the 1999 accident year. NAICO's net retention for workers compensation losses increased substantially in 1999 due to the rescission of certain reinsurance treaties covering this line of business. Also contributing to the adverse loss development were provisions for potentially uncollectible reinsurance and deductibles of approximately $1.2 million during 2001, an increase in losses in the surety bond program and approximately $878,000 in losses for the runoff of a discontinued group accident and health program. During 2002, NAICO experienced adverse loss development totaling $15.8 million primarily in the standard property and casualty program including both liability lines and workers compensation. This adverse development was primarily due to an increase in loss severity within the 1997-2000 accident years. The adverse development included approximately $2.0 million for provisions for potentially uncollectible reinsurance and deductibles. During 2003, NAICO experienced adverse loss development totaling $11.1 million primarily in the standard property and casualty program. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1998-2001 accident years. A reduction in losses for the 2002 accident year partially offset this adverse development. The adverse loss development included approximately $1.3 million for provisions for potentially uncollectible reinsurance and deductibles. During 2004, NAICO experienced adverse loss development totaling $26.3 million primarily in the standard property and casualty and political subdivisions programs. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1997-2002 accident years. The adverse development in the 2002 accident year partially offset the reduction in losses for this accident year that was recorded during 2003. The adverse loss development included approximately $409,000 for provisions for potentially uncollectible reinsurance and deductibles. Reserves for unpaid losses and loss adjustment expenses, net of related reinsurance recoverables, were $44.7 million at December 31, 2004 compared to $29.3 million at December 31, 2003, an increase of $15.4 million or 52%. PAGE 9 The following table represents the development of net balance sheet reserves for 1995 through 2004. The top line of the table shows the net reserves at the balance sheet date for each of the indicated years. This represents the estimated amounts of claims and claim expenses, net of reinsurance deductions, arising in the current and all prior years that are unpaid at the balance sheet date, including the net reserve for incurred but not reported claims. The upper portion of the table shows the cumulative net amounts paid as of successive years with respect to that reserve liability. The estimate for unpaid losses and loss adjustment expenses changes as more information becomes known about the frequency and severity of claims for individual years. The next portion of the table shows the revised estimated amount of the previously recorded net reserve based on experience as of the end of each succeeding year. The heading "net cumulative (deficiency) redundancy" represents the cumulative aggregate change in the estimates over all prior years. The last portion of the table provides a reconciliation of the net amounts to the gross amounts before any deductions for reinsurance. The gross cumulative deficiency or redundancy results from the same factors as those described above for the net amounts, and is also impacted by development of large claims that exceed NAICO's net retention including umbrella and surety per principal losses where NAICO has little or no net retention. In evaluating the information in the following table, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For example, the amount of the deficiency recorded in 1998 for claims that occurred in 1995 will be included in the cumulative deficiency amount for years 1995, 1996, 1997 and 1998. This table does not present accident or policy year development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future deficiencies or redundancies based on this table.
DEVELOPMENT OF RESERVES AS OF DECEMBER 31, ----------------------------------------------------------------------------------------------------- 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 --------- --------- --------- --------- --------- ---------- ---------- ---------- --------- -------- (In thousands) Net reserve for unpaid losses and loss adjustment expenses .................... $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695 Net paid (cumulative) as of One year later .............. 31,768 28,572 30,330 23,896 36,009 43,799 37,050 30,422 28,207 Two years later ............. 44,471 40,857 42,934 34,966 58,979 66,141 60,560 51,375 Three years later ........... 49,262 45,668 49,735 45,390 72,052 81,635 77,413 Four years later ............ 51,101 47,995 56,306 51,364 80,860 91,403 Five years later ............ 52,126 50,700 58,843 55,445 86,257 Six years later ............. 54,040 51,878 60,821 58,062 Seven years later ........... 54,574 52,964 62,720 Eight years later ........... 55,294 54,407 Nine years later ............ 56,364 Net liability re-estimated as of One year later .............. 59,644 55,713 55,772 43,441 56,357 59,376 48,596 44,283 55,688 Two years later ............. 59,605 55,599 56,362 45,373 67,469 74,325 67,903 70,058 Three years later ........... 59,155 54,528 58,176 50,146 77,842 86,377 89,608 Four years later ............ 58,247 54,834 61,096 55,303 83,860 100,408 Five years later ............ 58,445 55,615 62,750 58,060 91,704 Six years later ............. 58,567 56,347 63,629 62,995 Seven years later ........... 59,013 56,879 67,608 Eight years later ........... 59,296 59,243 Nine years later ............ 61,152 Net cumulative (deficiency) redundancy .................. $ (2,812) $ (5,398) $(13,573) $(23,074) $(40,326) $ (53,701) $ (56,796) $ (36,867) $(26,345) $ - Supplemental gross data: Gross liability ............. $116,149 $ 78,114 $ 73,721 $ 80,701 $ 98,460 $ 100,173 $ 84,756 $ 92,606 $ 87,768 $108,233 Reinsurance recoverable ..... 57,809 24,269 19,686 40,780 47,082 53,466 51,944 59,415 58,425 63,538 --------- --------- --------- --------- --------- ---------- ---------- ---------- --------- -------- Net liability - end of year.. $ 58,340 $ 53,845 $ 54,035 $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695 ========= ========= ========= ========= ========= ========== ========== ========== ========= ======== Gross re-estimated liability - latest ....... $124,032 $ 98,346 $102,442 $131,420 $182,532 $ 244,570 $ 264,809 $ 203,881 $141,038 Re-estimated recoverable - latest .................... 62,924 39,147 34,878 68,425 90,828 144,162 175,201 133,823 85,350 --------- --------- --------- --------- --------- ---------- ---------- ---------- --------- Net re-estimated liability - latest ........ $ 61,108 $ 59,199 $ 67,564 $ 62,995 $ 91,704 $ 100,408 $ 89,608 $ 70,058 $ 55,688 ========= ========= ========= ========= ========= ========== ========== ========== ========= Gross cumulative (deficiency) redundancy .................. $ (7,883) $(20,232) $(28,721) $(50,719) $(84,072) $(144,397) $(180,053) $(111,275) $(53,270) ========= ========= ========= ========= ========= ========== ========== ========== =========
PAGE 10 INVESTMENTS Funds available for investment include Chandler USA's present capital as well as premiums received and retained under insurance policies and reinsurance agreements issued by NAICO. Until these funds are required to be used for the settlement of claims and the payment of operating expenses, they are invested with the objective of generating income, preserving principal and maintaining liquidity. Investments are purchased to support the investment strategies of Chandler USA and its subsidiaries, which are developed based on many factors including rate of return, maturity, credit risk, tax considerations, regulatory requirements and their mix of business. At the time of purchase, investments in debt securities that Chandler USA has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments in debt securities classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. Chandler USA has not classified any investments as trading account assets. Debt securities not classified as held to maturity or trading and equity securities are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of deferred income tax as a separate component of other comprehensive income until realized. Realized gains and losses on sales of securities are based on the specific identification method. Declines in the fair value of securities below their carrying value that are other than temporary are recognized in earnings. As of December 31, 2004, all of the investments of NAICO were in fixed-maturity investments (rated Aa3 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), mutual funds that invest in equity securities, interest-bearing money market accounts, collateralized repurchase agreements and common stock received in connection with an unaffiliated entity's conversion to a for-profit corporation. NAICO's investment portfolio is managed by the Investment Committee of its Board of Directors. For additional information, see Notes to Consolidated Financial Statements. DEBENTURES On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior debentures (the "Debentures") with a maturity date of July 16, 2014. The Debentures were priced at $1,000 each with an interest rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium. The indenture governing the Debentures was amended during 2003 to clarify that purchases of Debentures by Chandler USA through private treaty or on the open market for an agreed price of less than the sum of the principal amount and accrued interest are not considered to be a redemption of the Debentures, and that any such Debentures purchased by Chandler USA will be cancelled. Chandler USA purchased and cancelled $16.7 million and $275,000 principal amount of the Debentures during 2003 and 2004, respectively, and at December 31, 2004, there was $6,979,000 principal amount of the Debentures outstanding. Chandler USA's subsidiaries and affiliates are not obligated by the Debentures. Accordingly, the Debentures are effectively subordinated to all existing and future liabilities and obligations of Chandler USA's existing and future subsidiaries. For additional information, see "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." TRUST PREFERRED SECURITIES In May 2003, Chandler USA established Chandler Capital Trust I ("Trust I") by purchasing all of its common securities for $403,000. Trust I is a Delaware statutory business trust and is a wholly owned non-consolidated subsidiary of Chandler USA. On May 22, 2003, Trust I issued $13.0 million of capital securities (the "Trust I Preferred Securities") to InCapS Funding I, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust I used the proceeds from the issuance to purchase $13,403,000 of 9.75% junior subordinated debentures (the "Junior Debentures I") of Chandler USA. Distributions on the Junior Debentures I are payable quarterly at a fixed annual rate of 9.75%. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures I, with such deferred payments accruing interest compounded quarterly. The Junior Debentures I are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year. The Junior Debentures I are the sole assets of Trust I and Trust I will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust I Preferred Securities are payable quarterly at a fixed annual rate of 9.75%. Trust I may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust I Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust I Preferred Securities are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year. All payments by Trust I regarding the Trust I Preferred Securities are guaranteed by Chandler USA. PAGE 11 In December 2003, Chandler USA established Chandler Capital Trust II ("Trust II") by purchasing all of its common securities for $217,000. Trust II is a Delaware statutory business trust and is a wholly owned non-consolidated subsidiary of Chandler USA. On December 16, 2003, Trust II issued $7.0 million of capital securities (the "Trust II Preferred Securities") to InCapS Funding II, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust II used the proceeds from the issuance to purchase $7,217,000 of floating rate junior subordinated debentures (the "Junior Debentures II") of Chandler USA. Distributions on the Junior Debentures II are payable quarterly at a floating rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed 12.5% prior to January 8, 2009). The interest rate was 6.17% at December 31, 2004. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures II, with such deferred payments accruing interest compounded quarterly. The Junior Debentures II are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium. The Junior Debentures II are the sole assets of Trust II and Trust II will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust II Preferred Securities are payable quarterly at a floating rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed 12.5% prior to January 8, 2009). The interest rate was 6.17% at December 31, 2004. Trust II may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust II Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust II Preferred Securities are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium. All payments by Trust II regarding the Trust II Preferred Securities are guaranteed by Chandler USA. The sale of the Trust I Preferred Securities and the Trust II Preferred Securities during 2003 resulted in net proceeds of $19.3 million to Chandler USA, net of placement costs. Issuance costs in the amount of $711,000 have been capitalized and are being amortized over the stated maturity periods of thirty years. Chandler USA used $13.3 million of the proceeds to purchase $16.7 million principal amount of its outstanding Debentures during 2003. The Debentures purchased by Chandler USA were cancelled. The purchase and cancellation of the Debentures resulted in a pre-tax gain of $3.1 million during 2003, net of an adjustment to unamortized issuance costs, which is included in other income in the consolidated statement of operations. Chandler USA also contributed $5.0 million of the proceeds to NAICO to be used for general corporate purposes. In December 2003, the Financial Accounting Standards Board issued Revised Interpretation No. 46 ("FIN 46R"), CONSOLIDATION OF VARIABLE INTEREST ENTITIES. FIN 46R provides guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights. FIN 46R is used to determine whether consolidation is required or, alternatively, whether the variable-interest model under FIN 46R should be used to account for existing and new entities. Chandler USA adopted FIN 46R effective January 1, 2004. The result of adoption was the deconsolidation of the two capital trusts that were created during 2003 in connection with the issuance of trust preferred securities. Chandler USA now reports the $20.6 million of junior subordinated debentures that were issued to the capital trusts on its consolidated balance sheet, and the December 31, 2003 balances were restated accordingly. The adoption of FIN 46R had no effect on net earnings. EMPLOYEES AND ADMINISTRATION At December 31, 2004, Chandler USA and its subsidiaries had approximately 260 full-time employees. Chandler USA and its subsidiaries generally have enjoyed good relations with their employees. COMPETITION NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO. An insurance company's capacity to write insurance policies is dependent on a variety of factors including its net worth or "surplus," the lines of business written, the types of risk insured and its profitability. During much of the last decade, the industry has generally had excess underwriting capacity resulting in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO has been able to increase its pricing for most coverages from 2000 through 2004, which has generally been the trend industry wide. However, NAICO continues to experience competition in all of its programs. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates. PAGE 12 REGULATION REGULATION IN GENERAL NAICO is subject to regulation by government agencies in the jurisdictions in which it does business. The nature and extent of such regulation vary from jurisdiction to jurisdiction, but typically involve prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company, regulation of certain transactions entered into by an insurance company with any of its affiliates, approval of premium rates, forms and policies used for many lines of insurance, standards of solvency and minimum amounts of capital and surplus which must be maintained, establishment of reserves required to be maintained for unearned premiums, unpaid losses and loss adjustment expenses or for other purposes, limitations on types and amounts of investments, restrictions on the size of risks which may be insured by a single company, licensing of insurers and agents, deposits of securities for the benefit of policyholders and the filing of periodic reports with respect to financial condition and other matters. In addition, regulatory examiners perform periodic financial and market conduct examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders or creditors. NAICO is required to deposit securities with regulatory agencies in several states in which it is licensed as a condition of conducting operations in those states. In addition to the regulatory oversight of NAICO, Chandler Insurance is also subject to regulation under the laws of the Cayman Islands and Chandler USA and all of its affiliates are subject to regulation under the insurance laws of Oklahoma (the "Oklahoma Insurance Code"). The Oklahoma Insurance Code contains certain reporting requirements including those requiring Chandler Insurance, as the ultimate parent company, to file information relating to its capital structure, ownership, and financial condition and the general business operations of its insurance subsidiaries. The Oklahoma Insurance Code contains special reporting and prior approval requirements with respect to transactions among affiliates. NAICO is also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include redefinitions of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through re-pricing, if permitted by applicable regulations, of coverages or limitations or cessation of the affected business. INSURANCE REGULATION CONCERNING CHANGE OR ACQUISITION OF CONTROL NAICO is a domestic property and casualty insurance company organized under the Oklahoma Insurance Code. The Oklahoma Insurance Code provides that the acquisition or change of "control" of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Oklahoma Department of Insurance. A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company must generally file with the relevant insurance regulatory authority an application for change of control containing certain information required by statute and published regulations and provide a copy of such to the domestic insurer. In Oklahoma, control is generally presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing 10% or more of the voting securities of the insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. In addition, many state insurance regulatory laws contain provisions that require pre-notification to state agencies of a change in control of a non-domestic insurance company admitted in that state. While such pre-notification statutes do not authorize the state agency to disapprove the change of control, such statutes do authorize issuance of a cease and desist order with respect to the non-domestic insurer if certain conditions exist such as undue market concentration. Any future transactions that would constitute a change in control of Chandler Insurance or Chandler USA would also generally require prior approval by the Oklahoma Department of Insurance and would require pre-acquisition notification in those states which have adopted pre-acquisition notification provisions and in which the insurers are admitted. Because such requirements are primarily for the benefit of policyholders, they may deter, delay or prevent certain transactions that could be advantageous to the shareholders or creditors of Chandler USA. PAGE 13 RESTRICTIONS ON SHAREHOLDER DIVIDENDS A significant portion of Chandler USA's consolidated assets represents assets of NAICO that may not be immediately transferable to Chandler USA in the form of shareholder dividends, loans, advances or other payments. Statutes and regulations governing NAICO and other insurance companies domiciled in Oklahoma regulate the payment of shareholder dividends and other payments by NAICO to Chandler USA. Under applicable Oklahoma statutes and regulations, NAICO is permitted to pay shareholder dividends only out of statutory earned surplus. To the extent NAICO has statutory earned surplus, NAICO may pay shareholder dividends only to the extent that such dividends are not defined as extraordinary dividends or distributions. If the dividends are, under applicable statutes and regulations, extraordinary dividends or distributions, regulatory approval must be obtained. Under the applicable Oklahoma statute, and subject to the availability of statutory earned surplus, the maximum shareholder dividend that may be declared (or cash or property distribution that may be made) by NAICO in any one calendar year without regulatory approval is the greater of (i) NAICO's statutory net income, excluding realized capital gains, for the preceding calendar year; or (ii) 10% of NAICO's statutory policyholders' surplus as of the preceding calendar year end, not to exceed NAICO's statutory earned surplus. As of December 31, 2004, NAICO had statutory earned surplus of $3.8 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2005 without the approval of the Oklahoma Department of Insurance is $3.8 million. NAICO paid shareholder dividends to Chandler USA totaling $3.5 million in 2002 and $3.4 million in 2004. In addition to the statutory limits described above, the amount of shareholder dividends and other payments to affiliates permitted can be further limited by contractual or regulatory restrictions or other agreements with regulatory authorities restricting dividends and other payments, including regulatory restrictions that are imposed as a matter of administrative policy. If insurance regulators determine that payment of a shareholder dividend or other payments to an affiliate (such as payments under a tax sharing agreement, payments for employee or other services, or payments pursuant to a surplus note) would be hazardous to such insurance company's policyholders or creditors, the regulators may block such payments that would otherwise be permitted without prior approval. RISK-BASED CAPITAL The National Association of Insurance Commissioners has adopted a methodology for assessing the adequacy of statutory surplus of domestic property and casualty insurers. This methodology is described in the Risk Based Capital Model Act (the "RBC Model Act"). The RBC Model Act includes a risk-based capital requirement that requires insurance companies to calculate and report information under a risk-based formula which attempts to measure statutory capital and surplus needs based on the risks in the insurance company's mix of products and investment portfolio. The formula is designed to allow state insurance regulators to identify potential under-capitalized companies. Under the formula, an insurer determines its "risk-based capital" ("RBC") by taking into account certain risks related to the insurer's assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer's liabilities (including underwriting risks related to the nature and experience of its insurance business). The RBC rules provide for different levels of regulatory attention depending on the ratio of a company's total adjusted capital to its "authorized control level" of RBC. Insurers below the specific ratios are classified within certain levels, each of which requires specific corrective action. The levels and ratios are as follows:
Ratio of Total Adjusted Capital to Authorized Control Level RBC (Less than or equal to) ---------------------------------- Regulatory Event (1) -------------------- Company Action Level (2) ...... 2.0 Regulatory Action Level (3) ... 1.5 Authorized Control Level (4) .. 1.0 Mandatory Control Level (5) ... 0.7 - ---------------------------------- (1) When an insurer's ratio exceeds 2.0, it is not subject to regulatory attention under the RBC Model Act. (2) "Company Action Level" requires an insurer to prepare and submit an RBC Plan to the insurance commissioner of its state of domicile. After review, the insurance commissioner will notify the insurer if the Plan is satisfactory. PAGE 14 (3) "Regulatory Action Level" requires the insurer to submit an RBC Plan, or if applicable, a Revised RBC Plan to the insurance commissioner of its state of domicile. After examination or analysis, the insurance commissioner will issue an order specifying corrective actions to be taken. (4) "Authorized Control Level" authorizes the insurance commissioner to take such regulatory actions considered necessary to protect the best interest of the policyholders and creditors of an insurer which may include the actions necessary to cause the insurer to be placed under regulatory control (i.e., rehabilitation or liquidation). (5) "Mandatory Control Level" authorizes the insurance commissioner to take actions necessary to place the insurer under regulatory control (i.e., rehabilitation or liquidation).
The ratios of total adjusted capital to authorized control level RBC for NAICO were 6.7:1 and 4.8:1 at December 31, 2003 and 2004, respectively. Therefore, NAICO's total adjusted capital exceeds the level that would trigger regulatory attention pursuant to the risk-based capital requirement. NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS-IRIS RATIOS The National Association of Insurance Commissioners Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies 12 industry ratios and specifies "usual values" for each ratio. Departure from the "usual values," which fluctuate annually, on four or more ratios generally leads to inquiries from individual state insurance commissioners. NAICO had seven 2004 ratios that were outside of the "usual values," five of which resulted primarily from adverse loss development as explained below. NAICO's "change in net writings" for 2004 was 36% compared to a usual value of greater than (33%) and less than 33%. The increase was due primarily to the decrease in reinsurance purchased in 2004 which resulted in an increase in net premiums written of $18.6 million. NAICO's "two-year overall operating ratio" for 2004 was 107% compared to a usual value of less than 100%. Factors that contributed to NAICO's ratio include a lower ratio of investment income to net premiums earned due primarily to lower interest rates experienced during 2004, and to adverse loss development recorded during 2003 and 2004 for accident years prior to 2003. Excluding this loss development, the two-year overall operating ratio would have been 77% for 2004. NAICO's "investment yield" as calculated using the IRIS formula was 3.6% during 2004 compared to a usual value of greater than 4.5% and less than 10.0%. NAICO maintains a high-quality investment portfolio, with no non-investment grade bonds, derivative instruments or real estate investments (other than real estate occupied by the company). NAICO's investment yield is largely dependent upon prevailing levels of interest rates. The significant decline in interest rates in recent years had a significant impact on NAICO's investment yield. Moreover, in periods of relatively low interest rates, NAICO generally shortens maturities and accepts lower yields to reduce market risk for future rate increases. NAICO's "change in policyholders' surplus" for 2004 was (16%) compared to a usual value of greater than (10%) and less than 50%. The decrease in surplus was due to the adverse loss development experienced during 2004, and to the payment of a shareholder dividend in the amount of $3.4 million to Chandler USA. NAICO's "one-year reserve development to policyholders' surplus" and "two-year reserve development to policyholders' surplus" for 2004 were 50% and 78%, respectively, compared to usual values of less than 20% for each ratio. The primary reason for these unusual values was adverse loss development experienced during 2003 and 2004 related to the 1997 - 2002 accident years. This adverse loss development relates primarily to the workers compensation and other liability lines of business in NAICO's standard property and casualty and political subdivisions programs. Also contributing to the adverse loss development were provisions for potentially uncollectible reinsurance recoverables and deductibles of $1.3 million and $409,000 during 2003 and 2004, respectively. Statutory accounting requires that these write-downs of receivables and recoverables be reflected as prior year loss development. PAGE 15 NAICO's "estimated current reserve deficiency to policyholders' surplus" was 44% at December 31, 2004 compared to a usual value of less than 25%. The adverse loss development experienced in 2003 and 2004 related to prior accident years was primarily responsible for this ratio being outside of the normal range. NAICO experienced significant growth from 1996 through 2000, with gross premiums written increasing from $108 million in 1996 to $197 million in 2000. Since 2000, NAICO has implemented substantial price increases on most lines of business. NAICO also exited some classes of business and non-renewed accounts with unfavorable frequency and/or severity characteristics. These actions resulted in a reduction in gross premiums written from $197 million in 2000 to $122 million in 2004. Management believes that while the insured exposure base has been significantly reduced, the premium for that exposure has increased significantly. The calculation of this ratio assumes that factors that led to past under reserving will cause current under reserving without regard to changes in premium volume, premium rates, product mix, the amount of risk retained by NAICO and current reserving practices. EFFECT OF FEDERAL LEGISLATION Although the Federal Government does not directly regulate the business of insurance, federal initiatives often affect the insurance business in a variety of ways. Current and proposed federal measures which may significantly affect the insurance business include Federal Government participation in asbestos and other product liability claims, claims related to acts of terrorism, pension and other employee benefit plan regulation (ERISA), examination of the taxation of insurers and reinsurers, minimum levels of liability insurance and automobile safety regulations. Federal regulation of the health care industry may directly and indirectly impact the business of insurance. ITEM 2. PROPERTIES Chandler USA and its subsidiaries own and occupy four office buildings with approximately 127,000 square feet of usable space in Chandler, Oklahoma. Chandler USA believes such space is sufficient for its operations for the foreseeable future. ITEM 3. LEGAL PROCEEDINGS See Note 11 to Consolidated Financial Statements for a discussion of litigation matters. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 2004. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of the common stock of Chandler USA, its sole class of common equity on the date hereof, is owned by Chandler Insurance. Chandler USA has never paid cash dividends on its common shares. ITEM 6. SELECTED FINANCIAL DATA The selected financial data has been derived from the consolidated financial statements of Chandler USA and its subsidiaries, which appear in Item 15(a). The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 2000, and the related consolidated statement of operations, comprehensive income, shareholder's equity and cash flows for the year ended December 31, 2000 were audited by Deloitte & Touche LLP, independent auditors, whose independent auditors' report expressed an unqualified opinion and included an explanatory paragraph relating to litigation. The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 2001, 2002, 2003 and 2004 and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for the years ended December 31, 2001, 2002, 2003 and 2004 have been audited by Tullius Taylor Sartain & Sartain LLP, independent auditors, whose independent auditors' report expresses an unqualified opinion. The selected financial data should be read in conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and the consolidated financial statements of Chandler USA and the notes thereto appearing in Item 15(a). All periods have been restated to reflect the results of L&W as a discontinued operation. PAGE 16 ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
YEAR ENDED DECEMBER 31, ------------------------------------------------------ 2000 2001 2002 2003 2004 ---------- ---------- ---------- ---------- ---------- OPERATING DATA (1) (Dollars in thousands) Revenues Direct premiums written and assumed .......... $ 197,196 $ 158,964 $ 140,162 $ 118,444 $ 121,651 ========== ========== ========== ========== ========== Net premiums earned .......................... $ 85,519 $ 69,985 $ 66,957 $ 56,583 $ 64,042 Investment income, net ....................... 4,281 3,632 2,540 2,148 3,186 Interest income, net from related parties .... - 371 380 412 491 Realized investment gains, net ............... 144 2,654 794 2,351 652 Other income (2) ............................. 301 101 261 5,077 640 ---------- ---------- ---------- ---------- ---------- Total revenues .................................... 90,245 76,743 70,932 66,571 69,011 ---------- ---------- ---------- ---------- ---------- Operating expenses Losses and loss adjustment expenses .......... 64,999 52,550 50,712 37,200 53,781 Policy acquisition costs ..................... 16,882 10,869 10,239 11,278 11,039 General and administrative expenses .......... 10,557 11,549 12,473 13,486 12,380 Interest expense ............................. 2,255 2,240 2,234 2,441 2,397 ---------- ---------- ---------- ---------- ---------- Total operating expenses .......................... 94,693 77,208 75,658 64,405 79,597 ---------- ---------- ---------- ---------- ---------- Income (loss) from continuing operations before income taxes ................................ (4,448) (465) (4,726) 2,166 (10,586) Federal income tax benefit (provision) ............ 1,347 (16) 1,680 (192) 3,582 ---------- ---------- ---------- ---------- ---------- Income (loss) from continuing operations .......... (3,101) (481) (3,046) 1,974 (7,004) Income (loss) from discontinued operations ........ (894) (622) 284 - - Gain on sale of subsidiary ........................ - - 671 - - ---------- ---------- ---------- ---------- ---------- Net income (loss) ................................. $ (3,995) $ (1,103) $ (2,091) $ 1,974 $ (7,004) ========== ========== ========== ========== ========== Combined loss and underwriting expense ratio (3) .. 106% 108% 110% 113% 118% BALANCE SHEET DATA Cash and investments .............................. $ 104,760 $ 73,378 $ 68,276 $ 69,198 $ 86,913 Amounts due from related parties .................. - 7,880 10,582 9,642 10,891 Total assets ...................................... 273,498 234,809 229,855 218,213 237,297 Unpaid losses and loss adjustment expenses ........ 100,173 84,756 92,606 87,768 108,233 Amounts due to related parties .................... 717 - - - - Debentures ........................................ 24,000 24,000 24,000 7,254 6,979 Junior subordinated debentures issued to affiliated trusts ....................................... - - - 20,620 20,620 Total liabilities ................................. 228,647 191,067 186,855 174,374 201,105 Shareholder's equity .............................. 44,851 43,742 43,000 43,839 36,192 - ----------------------------------------------------- (1) All periods have been restated to reflect the results of L&W as a discontinued operation. See Note 4 to Consolidated Financial Statements for more information. (2) Other income included a $3.1 million gain on the purchase and cancellation of $16.7 million principal amount of Debentures in 2003, and $1.7 million and $368,000 for the amortization of the deferred gain on a sale and leaseback transaction in 2003 and 2004, respectively. For additional information, see "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." (3) Interest expense and certain litigation expenses are not considered underwriting expenses and have been excluded from this ratio.
PAGE 17 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL References to Chandler USA which follow within this Item 7 refer to Chandler USA and its subsidiaries on a consolidated basis unless otherwise indicated. Chandler USA is engaged in various property and casualty insurance operations through its wholly owned subsidiaries, NAICO and CIMI. NAICO writes various property and casualty insurance products through three separate marketing programs: standard property and casualty, political subdivisions and surety bonds. The lines of insurance written by NAICO are commercial coverages consisting of workers compensation, automobile liability, other liability (including general liability, products liability and umbrella liability), automobile physical damage, property, surety and inland marine. NAICO markets these products through a network of independent insurance agents. A portion of the insurance written by NAICO is reinsured by Chandler USA's parent Chandler Insurance. CIMI maintains certain wholesale operations related to NAICO's school districts and trucking insurance. SUMMARY OF RESULTS For the year ended December 31, 2004, Chandler USA had a net loss of $7.0 million compared to net income of $2.0 million for 2003 and a net loss of $2.1 million for 2002. For 2004 and 2003, the income (loss) from continuing operations was the same as the net income (loss). Loss from continuing operations was $3.0 million during 2002. Net income for 2003 included $3.1 million in gains on the purchase and cancellation of $16.7 million principal amount of Debentures, and $1.7 million for the amortization of the deferred gain on a sale and leaseback transaction. These transactions are discussed in more detail under "Other Income" and "Liquidity and Capital Resources." The net loss in 2004 is primarily due to the adverse loss development experienced by Chandler USA. See "Losses and Loss Adjustment Expenses." Many factors determine the profitability of an insurance company including regulation and rate competition; the frequency and severity of claims; the cost, availability and collectibility of reinsurance; interest rates; inflation; general business conditions; and jury awards, court decisions and legislation expanding the extent of coverage and the amount of compensation due for injuries and losses. DISCONTINUED OPERATIONS In December 2002, Chandler USA completed the sale of its wholly owned subsidiary L&W to Brown & Brown, Inc. for $3.6 million. Chandler USA recorded an after-tax gain of $671,000 on the sale in 2002 based on the minimum purchase price for the transaction. The gain on the sale may be increased depending on certain adjustments to the purchase price as defined in the terms of the transaction. Following the completion of the sale, L&W changed its name to Brown & Brown of Central Oklahoma, Inc. ("B&B"). L&W previously functioned as Chandler USA's agency segment and is presented as discontinued operations. B&B continues to be a significant producer of business for NAICO. Retail business produced by B&B and placed with NAICO constituted approximately 13% of NAICO's direct premiums written and assumed in 2004. Chandler USA agreed to indemnify Brown & Brown, Inc. for any breach of a representation, warranty or covenant made in connection with the sale for a period of three years, and has established a letter of credit in the amount of $500,000 for the benefit of Brown & Brown, Inc. as security. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with U.S. GAAP requires the application of accounting policies that often involve a significant degree of judgment. Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods. If management determines, as a result of its consideration of facts and circumstances, that changes in estimates and assumptions are appropriate, results of operations and financial position as reported in the consolidated financial statements may change significantly. Management has identified the following accounting policies as critical in understanding Chandler USA's reported financial results. PAGE 18 RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES Insurance companies provide in their financial statements reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under their previously issued insurance policies and reinsurance contracts. In estimating reserves, insurance companies use various standardized methods based on historical experience and payment and reporting patterns for the type of risk involved. The application of these methods necessarily involves subjective determinations by the personnel of the insurance company. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount of and uncertainty in the estimates is affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances, and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs, such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that expand insurance coverage after the insurance policy was priced and sold. In recent years, certain of these factors have contributed to incurred amounts that were significantly higher than original estimates. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims. NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Any changes in the estimates are reflected in current operating results. Such changes in estimates may be material. See Notes to Consolidated Financial Statements. The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury and workers compensation claims have a much longer loss settlement period and may be paid out over several years. It is often necessary to adjust estimates of liability on a loss either upward or downward between the time a claim arises and the time of payment. Workers compensation indemnity benefit reserves are determined based on statutory benefits prescribed by state law and are estimated based on the same factors generally discussed above which may include, where state law permits, inflation adjustments for rising benefits over time. Generally, the more costly automobile liability claims involve one or more severe bodily injuries or deaths. The ultimate cost of these types of claims is dependent on various factors including the relative liability of the parties involved, the number and severity of injuries and the legal jurisdiction where the incident occurred. NAICO does not ordinarily insure against environmental matters as that term is commonly used. However, in some cases, regulatory filings made on behalf of an insured can make NAICO directly liable to the regulatory authority for property damage, which could include environmental pollution. In those cases, NAICO ordinarily has recourse against the insured or the surety bond principal for amounts paid. NAICO has insured certain trucking companies and pest control operators who are required to provide proof of insurance which in some cases assures payment for cleanup and restoration of damage resulting from sudden and accidental release or discharge of contaminants or other substances which may be classified as pollutants. NAICO also provides surety bonds for construction contractors who use or have control of such substances and for contractors who remove and dispose of asbestos as a part of their contractual obligations. NAICO also insures independent oil and gas producers who may purchase coverage for the escape of oil, saltwater, or other substances which may be harmful to persons or property, but may not generally be classified as pollutants. NAICO maintains claims records which segregate this type of risk for the purpose of evaluating environmental risk exposure. Based upon the nature of such lines of business with NAICO's insureds, and current data regarding the limited severity and infrequency of such matters, it appears that potential environmental risks are not a significant portion of claim reserves and therefore would not likely have a material adverse impact, if any, on the financial condition of Chandler USA. NAICO's statutory-based reserves (reserves calculated in accordance with accounting practices prescribed or permitted by an insurer's domiciliary state insurance regulatory authorities for purposes of financial reporting to regulators) do not differ from its reserves reported on the basis of GAAP. NAICO does not discount its reserves for unpaid losses and loss adjustment expenses. REINSURANCE RECOVERABLES Reinsurance recoverables on unpaid losses and loss adjustment expenses are similarly subject to changes in estimates and assumptions. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In addition to factors noted above, estimates of reinsurance recoverables may prove uncollectible if the reinsurer is unable or unwilling to meet its responsibilities under the reinsurance contracts. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. PAGE 19 DEFERRED INCOME TAXES Chandler USA uses an asset and liability approach for accounting for income taxes. Deferred income taxes are recognized for the tax consequences of temporary differences and carryforwards by applying enacted tax rates applicable to future years to differences between the financial statement amounts and the tax bases of existing assets and liabilities. A valuation allowance is established if it is more likely than not that some portion of the deferred tax asset will not be realized. The determination of whether a valuation allowance is appropriate requires the exercise of management judgment. At December 31, 2004, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $11.8 million which begins to expire in 2023. Chandler USA has concluded that the deferred tax asset including the federal net operating loss carryforwards are more likely than not to be realized. Chandler USA anticipates that its future U.S. consolidated income tax will be sufficient to utilize the federal net operating losses within the required time. Chandler USA will continue to evaluate income generated in future periods in determining the reasonableness of its position. If Chandler USA determines that future income is insufficient to cause the realization of the federal net operating losses within the required time, a valuation allowance will be established. In addition, Chandler USA, at December 31, 2004, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $53.2 million which expire in the years 2005 through 2024. At December 31, 2004, Chandler USA also had a capital loss carryforward for U.S. Federal income taxes of $1.1 million which expires in 2007. A valuation allowance has been provided for the tax effect of the state net operating loss and the net capital loss carryforwards since realization of such amounts is not considered more likely than not. OTHER See Note 1 to Consolidated Financial Statements for information related to other accounting and reporting policies. ECONOMIC CONDITIONS The impact of a recession on Chandler USA would depend on its duration and severity. A prolonged downturn in the economy could result in decreased demand for NAICO's insurance products and an increase in uncollectible premiums and/or reinsurance recoverables. In addition, an economic downturn could result in an increase in the number of insurance claims if insureds decrease expenditures that promote safety. Much of NAICO's insurance business is concentrated in the Southwest and Midwest areas of the United States. Approximately $108 million, or 89%, of NAICO's direct written premiums in 2004 were in the states of Oklahoma and Texas. An economic downturn in these states could have a significant adverse impact on Chandler USA. A recession might also cause defaults on fixed-income securities or a decrease in the value of the equity mutual funds owned by NAICO. Management believes it has mitigated the impact of a recession by employing conservative underwriting practices and strict credit policies and maintaining a high-quality investment portfolio. Periods of inflation have varying effects on Chandler USA and its subsidiaries as well as other companies in the insurance industry. Inflation contributes to higher claims and related costs and operating costs as well as higher interest rates which generally provide for potentially higher interest rates on investable cash flow and decreases in the market value of existing fixed-income securities. Premium rates and commissions, however, are not significantly affected by inflation since competitive forces generally control such rates. COMPETITION NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO. A company's capacity to write insurance policies is dependent on a variety of factors including its net worth or "surplus," the lines of business written, the types of risk insured and its profitability. During much of the last decade, the industry has generally had excess underwriting capacity resulting in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO has been able to increase its pricing for most coverages from 2000 through 2004, which has generally been the trend industry wide. However, NAICO continues to experience competition in all of its programs. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates. PAGE 20 REGULATION NAICO is subject to regulation by government agencies in the jurisdictions in which it does business. The nature and extent of such regulations vary from jurisdiction to jurisdiction, but typically involve prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company, regulation of certain transactions entered into by an insurance company with any of its affiliates, approval of premium rates, forms and policies used for many lines of insurance, standards of solvency and minimum amounts of capital and surplus which must be maintained, establishment of reserves required to be maintained for unearned premiums, unpaid losses and loss adjustment expenses or for other purposes, limitations on types and amounts of investments, restrictions on the size of risks which may be insured by a single company, licensing of insurers and agents, deposits of securities for the benefit of policyholders and the filing of periodic reports with respect to financial condition and other matters. In addition, regulatory examiners perform periodic examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders or creditors. As an Oklahoma corporation, NAICO and any person controlling NAICO, directly or indirectly, are subject to the insurance laws of Oklahoma including laws concerning the change or acquisition of control and payment of shareholder and policyholder dividends by NAICO. In addition to the regulatory oversight of NAICO, Chandler Insurance is also subject to regulation under the laws of the Cayman Islands and Chandler USA and all of its affiliates are also subject to regulation under the Oklahoma Insurance Code. The Oklahoma Insurance Code contains certain reporting requirements including those requiring Chandler Insurance, as the ultimate parent company, to file information relating to its capital structure, ownership and financial condition and general business operations of its insurance subsidiaries. The Oklahoma Insurance Code contains special reporting and prior approval requirements with respect to transactions among affiliates. The Oklahoma Insurance Code also imposes certain requirements upon any person controlling or seeking to control an insurance company domiciled in Oklahoma. Control is generally presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing 10% or more of the voting securities of the insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Persons owning any securities of Chandler USA or Chandler Insurance must comply with the Oklahoma Insurance Code. See "BUSINESS - Regulation." Insurance companies are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include the redefinition of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through coverage re-pricing, if permitted by applicable regulations, or limitations or cessation of the affected business. PAGE 21 ANALYSIS OF INSURANCE PROGRAM RESULTS OF OPERATIONS The following tables summarize the net premiums earned and the financial year (losses incurred and recognized by Chandler USA regardless of the year in which the claim occurred) and accident year (losses incurred by Chandler USA for a particular year regardless of the period in which Chandler USA recognizes the costs) loss ratios (computed by dividing losses and loss adjustment expenses by net premiums earned) in each of the years presented. The first table is summarized by major insurance program and includes all lines of insurance written in each program. The second table is summarized by line of insurance written and includes all net premiums earned and net losses and loss adjustment expenses incurred from all insurance programs for that particular line. See "Premiums Earned" and "Losses and Loss Adjustment Expenses."
YEAR ENDED DECEMBER 31, ---------------------------------- 2002 2003 2004 ---------- ---------- ---------- (Dollars in thousands) INSURANCE PROGRAMS - ---------------------------------------- STANDARD PROPERTY AND CASUALTY Net premiums earned .................. $ 49,570 $ 45,521 $ 54,278 Financial year loss ratio ............ 81.1% 65.1% 79.0% Accident year loss ratio ............. 50.5% 48.4% 43.6% POLITICAL SUBDIVISIONS Net premiums earned .................. $ 13,829 $ 8,093 $ 7,269 Financial year loss ratio ............ 55.9% 70.7% 98.0% Accident year loss ratio ............. 34.7% 43.8% 37.9% SURETY BONDS Net premiums earned .................. $ 3,310 $ 2,724 $ 1,993 Financial year loss ratio ............ 59.4% 33.5% 134.4% Accident year loss ratio ............. 24.0% 31.1% 37.2% OTHER (1) Net premiums earned .................. $ 248 $ 245 $ 502 Financial year loss ratio ............ 332.7% 374.0% 215.3% Accident year loss ratio ............. 73.5% 110.1% 51.3% TOTAL Net premiums earned .................. $ 66,957 $ 56,583 $ 64,042 Financial year loss ratio ............ 75.7% 65.7% 84.0% Accident year loss ratio ............. 46.0% 47.1% 42.8% - -------------------------------- (1) This category is comprised primarily of the run-off of discontinued programs and NAICO's participation in various mandatory workers compensation pools.
PAGE 22
YEAR ENDED DECEMBER 31, ---------------------------------- 2002 2003 2004 ---------- ---------- ---------- (Dollars in thousands) LINES OF INSURANCE - --------------------------------------- OTHER LIABILITY Net premiums earned ................. $ 16,458 $ 12,870 $ 18,044 Financial year loss ratio ........... 80.2% 94.0% 120.9% Accident year loss ratio ............ 50.2% 44.5% 34.8% AUTOMOBILE LIABILITY Net premiums earned ................. $ 16,526 $ 15,624 $ 17,742 Financial year loss ratio ........... 81.2% 49.4% 61.2% Accident year loss ratio ............ 49.3% 41.6% 55.1% WORKERS COMPENSATION Net premiums earned ................. $ 14,808 $ 16,378 $ 17,371 Financial year loss ratio ........... 99.4% 71.8% 85.5% Accident year loss ratio ............ 53.5% 58.3% 41.8% AUTOMOBILE PHYSICAL DAMAGE Net premiums earned ................. $ 9,552 $ 5,508 $ 5,933 Financial year loss ratio ........... 35.3% 36.0% 42.9% Accident year loss ratio ............ 35.8% 35.0% 39.6% PROPERTY Net premiums earned ................. $ 5,543 $ 3,072 $ 2,611 Financial year loss ratio ........... 49.9% 73.7% 46.8% Accident year loss ratio ............ 33.9% 64.4% 36.3% SURETY Net premiums earned ................. $ 3,310 $ 2,723 $ 1,993 Financial year loss ratio ........... 59.4% 33.5% 134.4% Accident year loss ratio ............ 24.1% 31.1% 37.2% INLAND MARINE Net premiums earned ................. $ 760 $ 408 $ 348 Financial year loss ratio ........... 99.7% 54.1% 29.5% Accident year loss ratio ............ 46.2% 34.8% 21.6% TOTAL Net premiums earned ................. $ 66,957 $ 56,583 $ 64,042 Financial year loss ratio ........... 75.7% 65.7% 84.0% Accident year loss ratio ............ 46.0% 47.1% 42.8%
PAGE 23 PREMIUMS EARNED The following tables set forth premiums earned on a gross basis (before reductions for premiums ceded to reinsurers) and on a net basis (after such reductions) for each insurance program as well as each line of insurance for each year presented:
GROSS PREMIUMS EARNED NET PREMIUMS EARNED -------------------------- -------------------------- INSURANCE PROGRAMS 2002 2003 2004 2002 2003 2004 - ----------------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Standard property and casualty .......... $106,051 $ 93,193 $ 92,894 $ 49,570 $ 45,521 $ 54,278 Political subdivisions .................. 35,159 28,926 21,679 13,829 8,093 7,269 Surety bonds ............................ 5,104 3,908 2,788 3,310 2,724 1,993 Other ................................... 249 252 507 248 245 502 -------- -------- -------- -------- -------- -------- TOTAL ................................... $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042 ======== ======== ======== ======== ======== ========
GROSS PREMIUMS EARNED NET PREMIUMS EARNED -------------------------- -------------------------- LINES OF INSURANCE 2002 2003 2004 2002 2003 2004 - ----------------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Other liability ......................... $ 36,078 $ 34,715 $ 35,438 $ 16,458 $ 12,870 $ 18,044 Automobile liability .................... 27,143 27,538 26,660 16,526 15,624 17,742 Workers compensation .................... 41,958 29,821 26,995 14,808 16,378 17,371 Automobile physical damage .............. 10,745 9,146 9,154 9,552 5,508 5,933 Property ................................ 22,722 19,359 15,130 5,543 3,072 2,611 Surety .................................. 5,104 3,908 2,788 3,310 2,723 1,993 Inland marine ........................... 2,813 1,792 1,703 760 408 348 -------- -------- -------- -------- -------- -------- TOTAL ................................... $146,563 $126,279 $117,868 $ 66,957 $ 56,583 $ 64,042 ======== ======== ======== ======== ======== ========
Gross premiums earned decreased 14% and 7% in 2003 and 2004, respectively. These decreases were primarily the result of NAICO's continued efforts to improve underwriting profitability and increased competition within the Oklahoma school districts portion of the political subdivision program. Gross premiums earned in Texas decreased 18% and 3% in 2003 and 2004, respectively, and gross premiums earned in Oklahoma decreased 15% and 8% in 2003 and 2004. The workers compensation and property lines of business accounted for a significant portion of the decreases. A majority of NAICO's property premiums is written in the political subdivisions program. Net premiums earned decreased 15% in 2003 and increased 13% in 2004. The decrease in 2003 is primarily the result of the decrease in gross earned premiums during this period. The increase in 2004 is due primarily to changes in NAICO's reinsurance programs for certain excess of loss and quota share reinsurance. Effective January 1, 2004, NAICO discontinued a quota share reinsurance arrangement that covered casualty, workers compensation and physical damage risks produced by certain agents. Effective April 1, 2004, NAICO increased its net retention to include 56% of the layer covering $500,000 excess of $500,000 of loss per occurrence for its casualty and workers compensation risks, and effective July 1, 2004, NAICO increased its net retention to include 70% of this layer. These changes increased NAICO's net retention for these lines of business and also increased net premiums earned. Gross premiums earned in the standard property and casualty program decreased 12% and less than 1% in 2003 and 2004, respectively. The decrease in 2003 was due primarily to discontinuing certain accounts where rates were not believed to be adequate. Increases in premium rates partially offset the decrease in premium production. Gross premiums earned in Texas decreased $9.9 million and $685,000 in 2003 and 2004, respectively, and gross premiums earned in Oklahoma decreased $6.0 million in 2003 and increased $1.7 million in 2004. Net premiums earned decreased 8% in 2003 and increased 19% in 2004. The increase in 2004 is due primarily to reinsurance changes described above. Gross premiums earned in the political subdivision program decreased 18% and 25% in 2003 and 2004, respectively. The decrease in gross premiums earned is due primarily to increased competition in the school districts portion of the program in Oklahoma. Gross premiums earned for the municipality portion of the program decreased $2.3 million and $529,000 in 2003 and 2004, respectively, as NAICO discontinued writing most of these accounts in 2003 and did not write any in 2004. Net premiums earned decreased 41% and 10% in 2003 and 2004, respectively. The decrease in 2003 was due to the decrease in gross premiums earned, and to Chandler Insurance assuming a portion of the risk for the property and automobile physical damage coverages. The decrease in 2004 was due to a decrease in gross premiums earned and was partially offset by the reinsurance changes described above. PAGE 24 Gross premiums earned in the surety bond program decreased 23% and 29% in 2003 and 2004, respectively. The decreases are primarily due to stricter underwriting policies as NAICO continues to focus on improving underwriting profitability in this program and to the bail bond portion of the program that was discontinued in 2003. Gross premiums earned for the bail bond portion of the program decreased $1.1 million and $1.0 million in 2003 and 2004, respectively. Net premiums earned decreased 18% and 27% in 2003 and 2004, respectively. NAICO elected not to renew its construction surety bond excess of loss reinsurance effective April 1, 2003 due to the decreased premium volume in this program and to the current market for this reinsurance. Other programs in the preceding table include premiums from the runoff of various programs which are no longer offered by NAICO and NAICO's participation in various mandatory pools covering workers compensation for insureds that were unable to purchase this coverage from an insurance company on a voluntary basis. NET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS At December 31, 2004, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate bonds and mutual funds that invest in equity securities, with approximately 8% invested in cash and money market instruments. Income generated from this portfolio is largely dependent upon prevailing levels of interest rates. Chandler USA's portfolio contains no non-investment grade bonds or real estate investments. Chandler USA also receives interest income from related parties on intercompany loans. Net investment income from continuing operations, excluding interest income from related parties, decreased 15% in 2003 and increased 48% in 2004. The decrease in 2003 was due primarily to lower interest rates. The increase in 2004 was due primarily to NAICO receiving $577,000 in interest from an arbitration award in addition to an increase in fixed maturity investments during the year. Interest income from related parties was $380,000, $412,000 and $491,000 during 2002, 2003 and 2004, respectively. See Liquidity and Capital Resources. Net realized investment gains were $794,000, $2,351,000 and $652,000 in 2002, 2003 and 2004, respectively. Realized investment gains in 2003 included a gain of $1.7 million from the sale of 19,371 shares of common stock of Insurance Services Office, Inc. ("ISO"). NAICO received these shares in 1997 as a result of ISO converting to a for-profit corporation. The average net yield on the fixed maturity portfolio, including net realized investment gains, was 4.8%, 6.7% and 4.0% in 2002, 2003 and 2004, respectively. The average net yield on the fixed maturity portfolio, excluding net realized investment gains, was 3.7%, 3.2% and 3.2% for 2002, 2003 and 2004, respectively. Chandler USA excludes interest income from related parties when calculating its average net yield on the portfolio. Chandler USA's average net yield has been reduced by investment expenses to subsidize a premium finance program for certain insureds of NAICO. While such expenses reduce Chandler USA's average net yield, the premium finance program enhances cash flow by providing cash which is available for investment earlier than conventional deferred payment plans. Based on information provided by the premium finance company, the outstanding balance of premiums financed at December 31, 2004 was approximately $11.0 million. The average yield on the fixed maturity portfolio before deducting investment expenses was 4.4%, 3.6% and 3.6% in 2002, 2003 and 2004, respectively, excluding capital gains. OTHER INCOME During 2003, Chandler USA's other income included a $3.1 million gain on the purchase and cancellation of $16.7 million of its Debentures. In addition, the amortization of a deferred gain related to a sale and leaseback transaction increased other income by $1.7 million in 2003. During 2004, the remaining $368,000 of deferred gain was amortized into income. The deferred gain was amortized into income over the final year of the lease following the exercise of the option for Chandler USA to repurchase the equipment at the end of the lease. LOSSES AND LOSS ADJUSTMENT EXPENSES Chandler USA estimates losses and loss adjustment expenses based on historical experience and payment and reporting patterns for the type of risk involved. These estimates are based on data available at the time of the estimate and are periodically reviewed by independent professional actuaries. See "BUSINESS - Reserves." The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 75.7%, 65.7% and 84.0% in 2002, 2003 and 2004, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $1.5 million, $1.9 million and $761,000 in 2002, 2003 and 2004, respectively, and increased the respective loss ratios by 2.2, 3.4 and 1.2 percentage points. PAGE 25 NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2002, 2003 and 2004 calendar years. The loss development occurred primarily in the 1997-2001 accident years. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results. During 2002, NAICO experienced adverse loss development totaling $15.8 million primarily in the standard property and casualty program including both liability lines and workers compensation. This adverse development was primarily due to an increase in loss severity within the 1997-2000 accident years. The adverse development included approximately $2.0 million for provisions for potentially uncollectible reinsurance and deductibles. During 2003, NAICO experienced adverse loss development totaling $11.1 million primarily in the standard property and casualty program. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1998-2001 accident years. A reduction in losses for the 2002 accident year partially offset this adverse development. The adverse loss development included approximately $1.3 million for provisions for potentially uncollectible reinsurance and deductibles. During 2004, NAICO experienced adverse loss development totaling $26.3 million primarily in the standard property and casualty and political subdivisions programs. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1997-2002 accident years. The adverse development in the 2002 accident year partially offset the reduction in losses for this accident year that was recorded during 2003. The adverse loss development included approximately $409,000 for provisions for potentially uncollectible reinsurance and deductibles. Reserves for unpaid losses and loss adjustment expenses, net of related reinsurance recoverables, were $44.7 million at December 31, 2004 compared to $29.3 million at December 31, 2003, an increase of $15.4 million or 52%. Reliance reinsured NAICO for certain workers compensation risks during 1998. At December 31, 2004, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses of approximately $3.3 million. During October 2001, the Commonwealth of Pennsylvania placed Reliance in liquidation. NAICO is unable to determine the amount of its reinsurance recoverables from Reliance that will ultimately be collected and has fully reserved the carrying value of such amounts as of December 31, 2003 and 2004. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to Chandler USA; consequently, adjustments to ceded losses and loss adjustment expenses are made for amounts deemed uncollectible. During 2002, 2003 and 2004, NAICO incurred charges of $1.7 million, $604,000 and $282,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible. NAICO did not receive any claims related to the September 11, 2001 terrorist attacks on the World Trade Center and does not believe that it has any significant exposure to these and related losses. While several of NAICO's reinsurers did experience significant losses related to these attacks, it currently does not appear that these losses will impair the reinsurers' ability to pay claims. POLICY ACQUISITION COSTS Policy acquisition costs consist of costs associated with the acquisition of new and renewal business and generally include direct costs such as premium taxes, commissions to agents and ceding companies and premium-related assessments and indirect costs such as salaries and expenses of personnel who perform and support underwriting activities. NAICO also receives ceding commissions from reinsurers who assume premiums from NAICO under certain reinsurance contracts and the ceding commissions are accounted for as a reduction of policy acquisition costs. Direct policy acquisition costs and ceding commissions are deferred and amortized over the terms of the policies. When the sum of the anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded. PAGE 26 The following table sets forth Chandler USA's policy acquisition costs from continuing operations for each of the three years ended December 31, 2002, 2003 and 2004:
YEAR ENDED DECEMBER 31, -------------------------------- 2002 2003 2004 ---------- ---------- ---------- (In thousands) Commissions expense ........................ $ 20,151 $ 17,644 $ 16,078 Other premium related assessments .......... 1,397 1,159 1,137 Premium taxes .............................. 2,764 2,446 2,562 Excise taxes ............................... 240 260 301 Dividends to policyholders ................. 105 (52) - Other expense .............................. 567 598 458 ---------- ---------- ---------- Total direct expenses ...................... 25,224 22,055 20,536 Indirect underwriting expenses ............. 8,135 7,675 7,463 Commissions received from reinsurers ....... (22,309) (18,643) (17,068) Adjustment for deferred acquisition costs .. (811) 191 108 ---------- ---------- ---------- Net policy acquisition costs ............... $ 10,239 $ 11,278 $ 11,039 ========== ========== ==========
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.8%, 25.1% and 23.0% in 2002, 2003 and 2004, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 14.4%, 14.9% and 13.2%. The decrease in 2004 in commission expense was primarily due to a decrease in contingent commissions to agents that resulted from higher loss ratios than had been projected for these agents. Indirect underwriting expenses were 5.8%, 6.5% and 6.1% of total direct written and assumed premiums in 2002, 2003 and 2004, respectively. Indirect expenses include general overhead and administrative costs associated with the acquisition of new and renewal business, some of which is relatively fixed in nature, thus, the percentage of such expenses to direct written and assumed premiums will vary depending on Chandler USA's overall premium volume. Commissions received from reinsurers as a percentage of ceded reinsurance premiums were 30.8%, 28.0% and 33.3% in 2002, 2003 and 2004, respectively. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses from continuing operations were 8.5%, 10.7% and 10.5% of gross premiums earned in 2002, 2003 and 2004, respectively. An increase in employee related expenses and fees paid to state insurance departments contributed to the $1.0 million increase in expense in 2003. General and administrative expenses decreased $1.1 million in 2004 due primarily to a reduction in employee related expenses and to a recovery of certain litigation expenses of $359,000. General and administrative expenses have historically not varied in direct proportion to Chandler USA's revenues. A portion of such expenses is allocated to policy acquisition costs (indirect underwriting expenses) and loss and loss adjustment expenses based on various factors, including employee counts, salaries, occupancy and specific identification. Because certain types of expenses are fixed in nature, the percentage of such expenses to revenues will vary depending on Chandler USA's revenues. INTEREST EXPENSE Interest expense decreased less than 1% in 2002, increased 9% in 2003 and decreased 2% in 2004. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. FEDERAL INCOME TAXES Chandler USA's federal income tax benefit (provision) as a percentage of income (loss) from continuing operations before income taxes was 35.5%, 8.9% and 33.8% for 2002, 2003 and 2004, respectively. The decrease in 2003 was primarily due to offsetting taxable realized gains of $2.4 million against Chandler USA's capital loss carryforward which is fully reserved due to its realization not being considered more likely than not. PAGE 27 At December 31, 2004, Chandler USA had a net deferred tax asset of $7.4 million including $4.0 million related to federal net operating loss carryforwards which begin to expire in 2023. Chandler USA believes it is more likely than not that the deferred income tax asset including the federal net operating loss carryforwards will be realized through future earnings. As a result, a valuation allowance has not been recorded. Chandler USA used the same assumptions as in internal financial projections to estimate future taxable income. If Chandler USA's results are not as profitable as anticipated, a valuation allowance may have to be established for the federal net operating loss carryforwards and the other remaining deferred tax assets. LIQUIDITY AND CAPITAL RESOURCES Chandler USA is a holding company receiving cash principally through borrowings, subsidiary dividends and other payments, subject to various regulatory restrictions described in "Regulation" and the Notes to Consolidated Financial Statements. The capacity of insurance companies to write insurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for Chandler USA's subsidiaries are funds generated from insurance premiums, investment income, capital contributions from Chandler USA and proceeds from sales and maturities of portfolio investments. The principal expenditures are payment of losses and loss adjustment expenses, insurance operating expenses and commissions. NAICO maintains a liquid operating position and follows investment guidelines that are intended to provide for an acceptable return on investment while preserving capital, maintaining sufficient liquidity to meet obligations and keeping a sufficient margin of capital and surplus to ensure unimpaired ability to write insurance. As of December 31, 2004, all of NAICO's fixed-maturity investments were rated Aa3 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively. NAICO purchases investments to support its investment strategies which are developed based on many factors including rate of return, maturity, credit risk, tax considerations, regulatory requirements and its mix of business. As of December 31, 2004, all of the investments of NAICO were in fixed-maturity investments, mutual funds that invest in equity securities, interest-bearing money market accounts, collateralized repurchase agreements and common stock received in connection with an unaffiliated entity's conversion to a for-profit corporation. At the time of purchase, investments in debt securities that NAICO has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. NAICO has not classified any investments as trading account assets. Debt securities not classified as held to maturity or trading and equity securities are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of deferred income tax as a separate component of other comprehensive income until realized. Chandler USA used $7.5 million and $6.0 million in cash from operations during 2002 and 2003, respectively, and provided $20.2 million in cash from operations in 2004. Cash flow from operations was negatively impacted during 2002 and 2003 due to the decline in written premiums during these years since claim payments for any given year will include payments for claims on insurance policies written in prior years. The cash used by operations was largely funded from sales and maturities of investments and certain financing activities described below. The cash provided by operations in 2004 is due primarily to the decrease in reinsurance purchased in 2004 which resulted in an increase in net premiums written of $18.6 million. Cash flow from operations is positively impacted during times when net premiums written increase since a substantial portion of the claim payments for any given year will be made in future years. The cash provided by operations was used primarily to fund purchases of investments and loans to related parties. Cash flows from investing activities during 2003 and 2004 were primarily the result of normal purchases and sales of investment securities. During 2004, NAICO purchased $8.1 million of mutual funds that invest in equity securities. Net realized investment gains before income taxes were $794,000, $2,351,000 and $652,000 during 2002, 2003 and 2004, respectively, from the sale of investments. NAICO received proceeds of $31.5 million, $24.5 million and $23.8 million during 2002, 2003 and 2004, respectively, from the sale of available for sale securities prior to their maturity. The proceeds and related net realized investment gains in 2002 and 2003 provided cash for operating activities due to the decrease in written premiums. During 2003 and 2004, the market value of NAICO's available for sale fixed-income investments decreased by $500,000 and $581,000, respectively, due primarily to changes in interest rates experienced during this time. The average maturity of NAICO's fixed maturity investments was 5.0 years and 4.9 years at December 31, 2003 and 2004, respectively. Cash flows from investing activities also included proceeds from the sale of L&W in 2002 of $3.1 million net of cash disposed of as part of the sale. See Note 4 to Consolidated Financial Statements for more information. PAGE 28 Cash flows from financing activities during 2003 included $19.3 million in proceeds from the issuance of junior subordinated debentures net of related issuance costs and purchase of common securities of related trusts, less $12.8 million for payments to purchase $16.7 million principal amount of Chandler USA's Debentures. See Note 6 to Consolidated Financial Statements. NAICO is required to deposit securities with regulatory agencies in several states in which it is licensed as a condition of conducting operations in the state. At December 31, 2004, the total amount of cash and investments restricted as a result of these arrangements was $8.4 million. Chandler USA and Chandler Insurance are parties to an Intercompany Credit Agreement (the "Credit Agreement") covering intercompany loans between the parties. The Credit Agreement requires interest to be paid at the prime interest rate published in The Wall Street Journal each month, and balances owed by either party are payable at any time upon demand. At December 31, 2003 and 2004, Chandler USA had a receivable of $9.6 million and $10.9 million, respectively, under the Credit Agreement, and Chandler USA earned $380,000, $412,000 and $439,000 in interest income under the Credit Agreement during 2002, 2003 and 2004, respectively. During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for a three year term. During March 2004, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest on the unpaid lease balance at a floating interest rate of 1% over JP Morgan Chase Bank prime, which was 5.25% at December 31, 2004. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $2.4 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.9 million. See Note 12 to Consolidated Financial Statements. CONTRACTUAL OBLIGATIONS The following table provides the future payments due by period under contractual obligations as of December 31, 2004, aggregated by type of obligation:
LESS THAN 1-3 3-5 MORE THAN ONE YEAR YEARS YEARS 5 YEARS TOTAL ---------- --------- --------- --------- ---------- (In thousands) Future minimum rental payments under operating leases ....... $ 636 $ 543 $ - $ - $ 1,179 Capital leases .................. 52 50 - - 102 Debentures ...................... - - - 6,979 6,979 Junior subordinated debentures issued to affiliated trusts .. - - - 20,620 20,620 ---------- --------- --------- --------- ---------- Total ........................ $ 688 $ 593 $ - $ 27,599 $ 28,880 ========== ========= ========= ========= ==========
LITIGATION Certain officers and directors of Chandler USA and Chandler Insurance were named as defendants in certain litigation involving CenTra, Inc. ("CenTra"). This litigation was concluded in 2002. As a result of various events in 1995, 1996 and 1997 related to the CenTra litigation, Chandler Barbados and Chandler USA recorded estimated recoveries of costs from its Director and Officer Liability Insurance policy totaling $3,456,000 and $1,044,000, respectively, for reimbursable amounts previously paid that relate to allowable defense and litigation costs. Chandler Barbados and Chandler USA received payment for a 1995 claim during 1996 in the amount of $636,000 and $159,000, respectively. Chandler Insurance assumed Chandler Barbados' remaining receivable in December 2003 under the reorganization of these companies. During June 2004, Chandler Insurance and Chandler USA received payment in the amount of $558,000 and $167,000, respectively, in exchange for releasing certain insurers with respect to policies covering periods from June 28, 1997 up to June 28, 2002. During the third quarter of 2004, Chandler Insurance and its subsidiaries settled the remaining litigation with the insurer for policy periods from June 28, 1992 to June 28, 1997. Based on the terms of the settlement, Chandler Insurance and Chandler USA recorded additional estimated recoveries of $1,204,000 and $359,000, respectively, during the third quarter of 2004. Chandler Insurance and Chandler USA received payment of $3,527,000 and $1,053,000, respectively, during December 2004 and expect to receive payment of the remaining settlement funds of $497,000 and $192,000 during the first quarter of 2005. PAGE 29 Transamerica Occidental Life Insurance Company ("Transamerica") reinsured NAICO for certain workers compensation risks during 1989, 1990 and 1991. Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed under the reinsurance treaties. On March 15, 2004, an arbitration panel ordered Transamerica to pay the losses and loss adjustment expenses owed to NAICO in the amount of $1,607,704 plus interest at 6%, or approximately $577,000, plus $25,000 in costs. NAICO has received payment for these amounts. Chandler USA and its subsidiaries are not parties to any other material litigation other than as is routinely encountered in their respective business activities. While the outcome of these matters cannot be predicted with certainty, Chandler USA does not expect these matters to have a material adverse effect on its financial condition, results of operations or cash flows. NEW ACCOUNTING STANDARDS See Note 1 to Consolidated Financial Statements for a discussion of recently issued accounting pronouncements. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Chandler USA's consolidated balance sheets include a certain amount of assets and liabilities whose fair values are subject to market risk. Due to Chandler USA's significant investment in fixed-maturity investments, interest rate risk represents the largest market risk factor affecting Chandler USA's consolidated financial position. Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of those instruments. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative investments, liquidity of the instrument and other general market conditions. As of December 31, 2004, substantially all of the investments of NAICO were in fixed-maturity investments (rated Aa3 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), mutual funds that invest in equity securities, interest-bearing money market accounts and collateralized repurchase agreements. NAICO does not hold any investments classified as trading account assets or derivative financial instruments. The table below summarizes the estimated effects of hypothetical increases and decreases in interest rates on NAICO's fixed-maturity investment portfolio. It is assumed that the changes occur immediately and uniformly, with no effect given to any steps that management might take to counteract that change. The hypothetical changes in market interest rates reflect what could be deemed best and worst case scenarios. The fair values shown in the following table are based on contractual maturities. Significant variations in market interest rates could produce changes in the timing of repayments due to prepayment options available. The fair value of such instruments could be affected and, therefore, actual results might differ from those reflected in the following table:
Estimated fair value after Hypothetical hypothetical Fair value at change in change in December 31, interest rate interest rate ---------------------- (bp=basis points) ---------------------- 2003 2004 2003 2004 ---------- ---------- ----------------- ---------- ---------- (Dollars in thousands) (Dollars in thousands) Fixed-maturity investments... $ 61,980 $ 71,670 100 bp increase.. $ 59,226 $ 68,482 200 bp increase.. 56,663 65,501 100 bp decrease.. 64,946 75,083 200 bp decrease.. 68,146 78,744
The table above illustrates, for example, that an instantaneous 200 basis point increase in market interest rates at December 31, 2004 would reduce the estimated fair value of NAICO's fixed-maturity investments by approximately $6.2 million at that date. NAICO's portfolio of equity mutual funds has exposure to equity price risk. Equity price risk is defined as the potential loss in fair value resulting from an adverse change in prices. These mutual funds primarily invest in equity securities of large U.S. entities across a variety of industries. These funds are managed by the individual fund managers, and NAICO's Investment Committee monitors the performance of these mutual funds. The equity mutual funds are carried on the balance sheet at fair value. The changes in estimated fair value of the equity portfolio are presented as a component of shareholder's equity in accumulated other comprehensive income, net of taxes. PAGE 30 The table below summarizes NAICO's equity price risk and shows the effect of a hypothetical 20% increase and a 20% decrease in market prices as of December 31, 2004. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios.
Estimated fair value after Fair value at hypothetical December 31, Hypothetical change in prices ---------------------- price change ---------------------- 2003 2004 2003 2004 ---------- ---------- ----------------- ---------- ---------- (Dollars in thousands) (Dollars in thousands) Equity securities ............ $ 92 $ 8,373 20% increase ... $ 110 $ 10,048 20% decrease ... 74 6,698
Chandler USA is obligated for $7.0 million principal amount of Debentures that have a maturity date of July 16, 2014. The Debentures have a fixed interest rate of 8.75%. At December 31, 2004, the fair value of Chandler USA's Debentures was estimated to be $6.9 million based on the latest reported trade. Chandler USA's Debentures have not historically traded regularly, and settlement at the reported fair value may not be possible. The Debentures are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium, but may be purchased and cancelled by Chandler USA at a price of less than the sum of the principal amount and accrued interest at any time. Chandler USA is obligated for $13.4 million principal amount of junior subordinated debentures that mature in 2033 with a fixed interest rate of 9.75%, and $7.2 million principal amount of junior subordinated debentures that mature in 2034 with a floating rate of 4.10% over LIBOR, currently 6.17%. At December 31, 2004, the fair value of Chandler USA's junior subordinated debentures was estimated to be $20.6 million. During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for three years. The sale and leaseback transaction resulted in a deferred gain of $2.0 million which was amortized into income over the final year of the lease, resulting in other income of $1.7 million in 2003 and $368,000 in 2004. During March 2004, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest on the unpaid lease balance at a floating interest rate of 1% over JP Morgan Chase Bank prime, which was 5.25% at December 31, 2004. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $2.4 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.9 million. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 15(a)1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES As of the end of the period covered by this report and pursuant to Rule 13a-15 of the Securities Exchange Act of 1934 (the "Exchange Act"), Chandler USA's management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness and design of Chandler USA's disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act). Based upon that evaluation, Chandler USA's Chief Executive Officer and Chief Financial Officer concluded, as of the end of the period covered by this report, that Chandler USA's disclosure controls and procedures were effective in recording, processing, summarizing and reporting information required to be disclosed by Chandler USA, within the time periods specified in the Securities and Exchange Commission's rules and forms. CHANGES IN INTERNAL CONTROLS As of the end of the period covered by this report, there have been no changes in internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the quarter to which this report relates that have materially affected or are reasonably likely to materially affect, Chandler USA's internal control over financial reporting. ITEM 9B. OTHER INFORMATION None. PAGE 31 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS AND EXECUTIVE OFFICERS A brief description of each director and executive officer of Chandler USA is provided below. Directors hold office until the next annual meeting of shareholders or until their respective successors are duly elected and qualified. Executive officers are elected by the Board of Directors at its annual meeting and hold office until its next annual meeting or until their respective successors are duly elected and qualified. The current directors and executive officers of Chandler USA are as follows:
NAME AGE POSITION - ---------------------- --- --------------------------------------------------------------- W. Brent LaGere 59 Chairman of the Board, Chief Executive Officer, Compensation Committee Member and Director. Mark T. Paden 48 President, Chief Operating Officer, Compensation Committee Member and Director. Brenda B. Watson 64 Executive Vice President of NAICO and CIMI. Richard L. Evans 58 Senior Vice President and Director. R. Patrick Gilmore 53 Senior Vice President, Secretary, General Counsel and Director. Mark C. Hart 49 Vice President - Finance, Chief Financial Officer and Treasurer. M. Steven Blain 47 Vice President - Administration. Robert L. Rice 70 Audit Committee Chairman and Director. W. Scott Martin 54 Audit Committee Member and Director. William T. Keele 68 Director.
W. BRENT LAGERE has been a director, Chairman of the Board and Chief Executive Officer of Chandler USA since 1988 and of CIMI since December 2002. Since 1988, Mr. LaGere has served in officer and director capacities for various subsidiaries of Chandler USA pursuant to an employment contract with Chandler USA. Mr. LaGere serves as Chairman of the Board and Chief Executive Officer of Chandler Insurance and was a director of Chandler Barbados until December 2003. MARK T. PADEN has served as President of Chandler USA and NAICO since May 2001 and as Chief Operating Officer of Chandler USA and NAICO since May 1998. Mr. Paden has served as President and Chief Operating Officer of CIMI since December 2002. From May 1998 to May 2001, Mr. Paden also served as Executive Vice President of Chandler USA and NAICO. Mr. Paden has served as Chief Financial Officer of NAICO from January 1988 through May 2001 and also served as Vice President-Finance of NAICO from January 1988 through May 1998. Mr. Paden has been a director of Chandler USA since July 1988, NAICO since November 1992 and CIMI since December 2002. Mr. Paden also serves as a director and President of Chandler Insurance. BRENDA B. WATSON has been Executive Vice President of NAICO since August 1987 and of CIMI since December 2002. Since October 1988, she has served in officer and director capacities for various subsidiaries of Chandler USA. Ms. Watson has been a director of CIMI since December 2002. Ms. Watson also serves as Executive Vice President of Chandler Insurance. RICHARD L. EVANS has been a director of Chandler USA since May 1990. He has been Senior Vice President of Chandler USA and NAICO since March 1999, and served as Vice President of NAICO since 1987, and of Chandler USA since 1989. Mr. Evans also serves as Senior Vice President of Chandler Insurance. R. PATRICK GILMORE has served as General Counsel for Chandler USA and its subsidiaries since 1988 and currently serves as corporate Secretary and Senior Vice President. Mr. Gilmore has been a director of Chandler USA since May 1990 and NAICO since September 2000. PAGE 32 MARK C. HART has served as Vice President-Finance and Treasurer of Chandler USA and NAICO since May 1998, and has served as Chief Financial Officer of Chandler USA and NAICO since May 2001. Mr. Hart has also served as Vice President of Chandler USA since March 1994. Mr. Hart has served as Treasurer of CIMI since December 2002. Mr. Hart also serves as Vice President-Accounting, Chief Financial Officer and Treasurer of Chandler Insurance. M. STEVEN BLAIN has served as Vice President-Administration of Chandler USA and NAICO since August 2003. From November 1999 to August 2003, Mr. Blain was employed by NAICO in various capacities. Prior to his employment by NAICO in November 1999, Mr. Blain was Vice President - Operations and Chief Financial Officer for J.B. Pratt Foods, Inc. ROBERT L. RICE has been a director of Chandler USA since June 1993 and a director of NAICO since March 2000. He has for more than 20 years engaged in private practice as a Certified Public Accountant. W. SCOTT MARTIN has been a director of Chandler USA and NAICO since March 2000. Mr. Martin has been President of the Tulsa Loan Production Office with First Bank & Trust Company in Wagoner, Oklahoma since 1994. Mr. Martin also serves as a director of First Bank & Trust in Wagoner, Oklahoma, First Bank of Chandler in Chandler, Oklahoma, First National Bank in Burkburnett, Texas and The Bank of Union in Union City, Oklahoma. WILLIAM T. KEELE has been a director of Chandler USA and NAICO since May 2001. Mr. Keele has been President of Hallman & Keele, Inc., a construction and steel fabrication firm, since 1974. AUDIT COMMITTEE FINANCIAL EXPERT Chandler USA's Board of Directors has determined that Robert L. Rice, Chairman of the Audit Committee, is an "audit committee financial expert", as defined by Securities and Exchange Commission rules. Mr. Rice is an independent director, as that term is used in Item 7(d)(3)(IV) of Schedule 14A under the Securities Exchange Act of 1934. CODE OF ETHICS Chandler USA has adopted a Code of Ethics for Principal Executive and Senior Financial Officers, a copy of which was filed as Exhibit 14.1 to Chandler USA's Form 10-K for the fiscal year ended December 31, 2003. COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934 Based solely upon a review of Forms 3, 4 and 5, any amendments thereto furnished to Chandler USA pursuant to the rules of the Securities and Exchange Commission, or written representations from certain reporting persons presented to Chandler USA, all such reports required to be filed by reporting persons have been filed in a timely fashion during the fiscal year ended December 31, 2004. PAGE 33 ITEM 11. EXECUTIVE COMPENSATION The following table sets forth the compensation paid or to be paid by Chandler USA or any of its subsidiaries as well as certain other compensation paid or accrued, during the years indicated, to the Chairman and Chief Executive Officer and the four other highest paid executive officers of Chandler USA and its subsidiaries (the "Named Executives") for such period in all capacities in which they served.
SUMMARY COMPENSATION TABLE ANNUAL COMPENSATION (1) ------------------------------------------------------- OTHER ANNUAL ALL OTHER SALARY BONUS COMPENSATION COMPENSATION NAME AND PRINCIPAL POSITION YEAR ($) ($)(2) ($)(3) ($)(4) - --------------------------------------- -------- ---------- ---------- ------------ ------------ W. Brent LaGere 2004 $ 501,726 $ 719,943 $ 390,399 $ 90,362 Chairman of the Board and CEO 2003 489,602 574,456 795,994 94,131 of Chandler USA, NAICO and CIMI 2002 458,723 484,120 348,172 49,332 Mark T. Paden 2004 313,793 490,718 70,273 25,930 President and COO of Chandler USA, 2003 304,654 395,427 73,934 7,133 NAICO and CIMI 2002 295,481 403,348 77,861 5,749 Brenda B. Watson 2004 256,457 - N/A 11,450 Executive Vice President 2003 254,072 - N/A 18,860 of NAICO and CIMI 2002 244,448 - N/A 11,526 Richard L. Evans 2004 260,530 - N/A 8,700 Senior Vice President - Claims of 2003 254,875 - N/A 9,866 Chandler USA and NAICO 2002 245,899 4,500 N/A 7,928 R. Patrick Gilmore 2004 234,515 - N/A 13,600 Senior Vice President, Secretary and 2003 224,154 - N/A 7,240 General Counsel of Chandler USA, 2002 216,790 - N/A 5,405 NAICO and CIMI - --------------------------------------- (1) Amounts shown include cash and non-cash compensation earned and received by the Named Executives as well as amounts earned but deferred at their election. (2) All Named Executives are eligible to receive bonuses based upon various factors. (3) The amounts shown under this column represent various perquisites and other personal benefits including any associated tax reimbursements to the Named Executives. Amounts that did not exceed the lesser of $50,000 or 10% of the total annual salary and bonus for any Named Executive have been excluded. Substantially all of the amounts shown in this column represent payment of various personal expenses, none of which individually exceeded 25% of total perquisites for the Named Executive. Tax gross-ups for the personal expenses included in the amounts shown above were $167,145, $366,902 and $206,583 for Mr. LaGere in 2002, 2003 and 2004, respectively, and $33,231, $32,996 and $39,865 for Mr. Paden in 2002, 2003 and 2004, respectively. (4) The amounts shown under this column include contributions by Chandler USA's subsidiaries to a 401(k) plan ($5,100 for Mr. LaGere, $4,350 for Mr. Paden, $4,350 for Ms. Watson, $5,100 for Mr. Evans, and $4,100 for Mr. Gilmore), and the premiums paid or to be paid by Chandler USA's subsidiaries under life insurance arrangements with the Named Executives. A portion of the premiums ($33,600, $44,453 and $45,103 in 2002, 2003 and 2004, respectively) were paid under a split dollar life insurance plan. Under this plan, Chandler USA's subsidiaries pay the premiums for life insurance issued to the Named Executive. Repayment of the premiums is secured by the death benefit or the cash surrender value of the policy, if any, if the Named Executive cancels and surrenders the policy.
PAGE 34 OPTIONS EXERCISED AND HOLDINGS No options were granted to or exercised by the Named Executives during 2004 and there were no unexercised options held by the Named Executives as of December 31, 2004. DIRECTOR COMPENSATION Directors who are employees of Chandler USA do not receive additional compensation for serving as directors. Each non-employee director of Chandler USA is paid $1,000 per day for any meeting or committee meeting attended. However, if a non-employee director is attending meetings for two or more affiliates of Chandler USA on the same day, his compensation is $750 per day for any meeting or committee meeting of Chandler USA attended. If a non-employee director attends the meeting by telephonic conference, his compensation is $500 per day for any meeting or committee meetings so attended. EMPLOYMENT AGREEMENTS Chandler USA has an employment agreement with W. Brent LaGere, Chairman of the Board and Chief Executive Officer of Chandler USA and its subsidiaries. Under this agreement, Mr. LaGere's base compensation is established at not less than $250,000 per year. In the event that Mr. LaGere is terminated without cause, as defined in the agreement, he is entitled to receive his base compensation for the remainder of the term of the agreement, but in no event for more than 60 months. The agreement will terminate upon Mr. LaGere attaining age 70, unless earlier terminated by Chandler USA for cause. In addition to his base compensation, Mr. LaGere is eligible to receive certain benefits and bonuses from Chandler USA and its subsidiaries. PAGE 35 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the common stock of Chandler USA, its sole class of common equity, is owned by Chandler Insurance. The following table sets forth the number and percentage of outstanding shares of each class of the capital stock of Chandler Insurance that, as of February 28, 2005, are beneficially owned by (i) each director of Chandler USA and Chandler Insurance, (ii) Chandler USA's Chairman and Chief Executive Officer and each of Chandler USA's four other most highly compensated executive officers for services rendered for the fiscal year ended December 31, 2004 and (iii) all current directors and executive officers as a group:
BENEFICIAL OWNERSHIP ------------------------------------------------------- TYPE OF CAPITAL SHARES NUMBER OF NAME OF DIRECTOR OR EXECUTIVE OFFICER OF CHANDLER INSURANCE CAPITAL SHARES (1) PERCENT (2) - ---------------------------------------------------------- ------------------------ ------------------ ----------- W. Brent LaGere (3) ...................................... Class A Common Shares 500,661 80.0% Series A Preferred Shares 75,152 18.9% Mark T. Paden ............................................ Class A Common Shares 125,165 20.0% Series A Preferred Shares 17,610 4.4% Brenda B. Watson (4) ..................................... Series A Preferred Shares 18,024 4.5% Series B Preferred Shares 35,542 9.0% Richard L. Evans ......................................... Series A Preferred Shares 27,272 6.9% Series B Preferred Shares 32,250 8.1% R. Patrick Gilmore ....................................... Series B Preferred Shares 11,000 2.8% Robert L. Rice ........................................... - - -% W. Scott Martin .......................................... Series C Preferred Shares 19,000 3.0% William T. Keele (5) ..................................... Series C Preferred Shares 122,417 19.1% Steven R. Butler (6) ..................................... Series C Preferred Shares 3,200 *% All directors and officers as a group (10 persons) (7) ... Class A Common Shares 625,826 100.0% Series A Preferred Shares 141,586 35.6% Series B Preferred Shares 78,792 19.9% Series C Preferred Shares 144,617 22.5% - ---------------------------------------------------------- * Less than 1% (1) The rules of the SEC provide that, for the purposes hereof, a person is considered the "beneficial owner" of shares with respect to which the person, directly or indirectly, has or shares the voting or investment power, irrespective of his economic interest in the shares. Unless otherwise noted, each person identified possesses sole voting and investment power over the shares listed, subject to community property laws. The Preferred Shares of Chandler Insurance have no voting rights. The Series A Preferred Shares of Chandler Insurance are convertible to Class A Common Shares of Chandler Insurance. (2) Based on 625,826 Class A Common Shares of Chandler Insurance, 397,822 Series A Preferred Shares of Chandler Insurance, 396,126 Series B Preferred Shares of Chandler Insurance and 642,069 Series C Preferred Shares of Chandler Insurance outstanding on February 28, 2005. (3) Includes (i) 348,390 Class A Common Shares of Chandler Insurance owned by the W. Brent LaGere Irrevocable Trust (the "LaGere Trust") and (ii) 22,500 Class A Common Shares of Chandler Insurance owned by W&L Holding Corp. ("W&L Holding"), a corporation 100% of which is owned by the LaGere Trust. Mr. LaGere holds an irrevocable proxy for the Class A Common Shares owned by the LaGere Trust and W&L Holding. Mr. LaGere disclaims beneficial ownership of the shares held by the LaGere Trust and W&L Holding. The business address of Mr. LaGere is 1010 Manvel Avenue, Chandler, Oklahoma 74834. (4) Includes 8,027 Series A Preferred Shares of Chandler Insurance held by Ms. Watson's husband. Ms. Watson disclaims beneficial ownership of the shares owned by her husband. (5) Includes 63,787 Series C Preferred Shares of Chandler Insurance held by the Keele Family Ltd. Partnership, 4,062 shares held by Mr. Keele's wife and 23,911 shares held by Mr. Keele's children. Mr. Keele disclaims beneficial ownership of the shares owned by his wife and children. (6) Mr. Butler is a director, Vice President - Administration and Secretary of Chandler Insurance, and also served as a director and President of Chandler Barbados until December 2003. (7) Includes 3,528 Series A Preferred Shares of Chandler Insurance owned by one executive officer of Chandler USA not listed in the table above.
PAGE 36 SHAREHOLDERS HOLDING OVER FIVE PERCENT Listed below are persons, other than those listed previously, who are known by Chandler USA to own beneficially more than 5% of Chandler Insurance's Class A Common Shares as of February 28, 2005. Except as otherwise indicated, each of the persons named below has sole voting and investment power with respect to the common shares beneficially owned.
BENEFICIAL OWNERSHIP --------------------------------------- NAME OF SHAREHOLDER NUMBER OF SHARES (1) PERCENT (2) - -------------------------------------------------------- ---------------------- --------------- Malinda Laird, Matthew LaGere and Lance LaGere, Trustees of the W. Brent LaGere Irrevocable Trust 1010 Manvel Avenue, Chandler, Oklahoma 74834 ......... 370,890 (3) 59.3% - -------------------------------------------------------- (1) The rules of the SEC provide that, for the purposes hereof, a person is considered the "beneficial owner" of shares with respect to which the person, directly or indirectly, has or shares the voting or investment power, irrespective of his economic interest in the shares. Unless otherwise noted, each person identified possesses sole voting and investment power over the shares listed, subject to community property laws. (2) Based on 625,826 Class A Common Shares of Chandler Insurance outstanding on February 28, 2005. (3) Includes 370,890 Class A Common Shares of Chandler Insurance held by the LaGere Trust, of which 22,500 Class A Common Shares are directly owned by W&L Holding, which is 100% owned by the LaGere Trust. Mr. LaGere holds an irrevocable proxy for the Class A Common Shares owned by the LaGere Trust and W&L Holding.
OTHER MATTERS REGARDING BENEFICIAL OWNERSHIP For purposes of this report, unless otherwise indicated, Chandler USA has assumed that the following persons are affiliates: an entity's executive officers and directors or its managing partners, persons holding more than 10% of an entity, and those persons who are controlling, controlled by, or under common control with such officers, directors, managing partners, or shareholders. Statements of percentages of ownership are made based upon pertinent reporting requirements and guidelines specifically applicable to this report on Form 10-K. Determination of voting power under Chandler USA's Articles of Incorporation or applicable insurance holding company laws may be at variance with the above stated percentages. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for a three year term. During March 2004, the lease was extended for an additional three years. See Note 12 to Consolidated Financial Statements for additional information. The bank that participated in the sale and leaseback transaction has also established a letter of credit in the amount of $500,000 on behalf of Chandler USA for the benefit of Brown & Brown, Inc. as security in connection with the sale of L&W. Chandler USA paid a fee of $5,000 during 2004 to the bank for issuing the letter of credit. See Note 4 to Consolidated Financial Statements for additional information. W. Scott Martin, a director of NAICO and Chandler USA, is an officer and director of the bank that participated in these transactions, and is also a significant shareholder of the bank's holding company. Mr. Martin is also a director of the bank that Chandler USA and its subsidiaries use as their principal disbursement bank, and is a significant shareholder of the bank's holding company. The balance maintained by Chandler USA and each subsidiary is fully insured by the Federal Deposit Insurance Corporation, and Chandler USA and its subsidiaries pay customary service charges to the bank for the services provided. Chandler USA leases a rural property from Davenport Farms, Inc. ("Davenport Farms"), a corporation owned by Messrs. LaGere, Evans and Paden. Chandler USA has placed three mobile homes on the property, drilled a water well connected to the mobile homes and made other smaller improvements to the property. Its personnel maintain these improvements. These mobile homes and the property provide hunting, fishing, lodging, dining and other outdoor recreational activities for the entertainment of customers and business associates of Chandler USA and/or its subsidiaries. Chandler USA pays no rent to Davenport Farms but reimburses it for one-half of the utilities and for hunting supplies. Chandler USA has also agreed to indemnify Davenport Farms for claims arising out of its use of the property. Chandler USA retains the right to remove all structures located upon the property when the lease terminates. In 2002, 2003 and 2004, Chandler USA incurred approximately $255,000, $336,000 and $353,000, respectively, in expenses associated with its use of this property, including $18,000, $12,000 and $14,000 for reimbursement of certain expenses, such as utility and similar expenses, for the years 2002, 2003 and 2004, respectively. PAGE 37 NAICO purchases and sells investment securities through various brokerage firms including Raymond James & Associates, Inc., a subsidiary of Raymond James Financial, Inc. K.R. Price was a director of NAICO and Chandler USA from May 2001 until November 2004. Mr. Price is employed by Raymond James Financial Services, Inc. which is also a subsidiary of Raymond James Financial, Inc. Mr. Price received no compensation from NAICO's investment transactions during this time. During the fourth quarter of 2002, Chandler USA's board of directors approved the cancellation and release of certain judgments against three directors of Chandler USA and one executive officer of NAICO that resulted from the CenTra litigation. The amounts canceled included $233,122 for Mr. LaGere, $136,467 for Ms. Watson, $99,338 for Mr. Evans and $72,142 for Mr. Paden. The board's action followed a ruling during August 2002 by the U.S. District Court for the Western District of Oklahoma denying CenTra's claim for post-judgment interest from Chandler Insurance of approximately $2.5 million. Chandler USA believes that all transactions with directors, officers, or shareholders of Chandler USA and its subsidiaries are and will continue to be on terms no less favorable to Chandler USA and its subsidiaries than could be obtained from unaffiliated parties. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES AUDIT FEES The aggregate audit fees billed or to be billed by Tullius Taylor Sartain & Sartain LLP for the audit of Chandler USA's annual financial statements and review of financial statements included in Chandler USA's Form 10-Q and services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements were approximately $146,700, $149,600 and $155,000 for the years ended December 31, 2002, 2003 and 2004, respectively. AUDIT-RELATED FEES The aggregate fees billed for professional services rendered by Tullius Taylor Sartain & Sartain LLP for audit related services rendered in connection with the audits of employee benefit plans and consultation on accounting standards or transactions were $20,500, $18,675 and $18,150 for the years ended December 31, 2002, 2003 and 2004, respectively. TAX FEES The aggregate fees billed or to be billed for professional services rendered by Tullius Taylor Sartain & Sartain LLP for tax compliance, tax advice and tax planning were $40,430, $26,375 and $17,700 for the years ended December 31, 2002, 2003 and 2004, respectively. ALL OTHER FEES The aggregate fees billed by Tullius Taylor Sartain & Sartain LLP for professional services other than those reported in the categories above were $6,300 and $1,446 for the years ended December 31, 2002 and 2003, respectively. There were no other fees billed by Tullius Taylor Sartain & Sartain LLP for the year ended December 31, 2004. POLICY ON PRE-APPROVAL OR RETENTION OF INDEPENDENT AUDITORS All audit and permitted non-audit services for which Chandler USA engages Tullius Taylor Sartain & Sartain LLP require pre-approval by Chandler USA's Audit Committee. The percentage of Audit-Related Fees, Tax Fees and All Other Fees out of all fees paid to Tullius Taylor Sartain & Sartain LLP was 31.4%, 23.7% and 18.8% for the years ended December 31, 2002, 2003 and 2004, respectively. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) 1. FINANCIAL STATEMENTS. The consolidated balance sheets of Chandler USA and its subsidiaries as of December 31, 2003 and 2004, and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for each of the three years in the period ended December 31, 2004, together with the related notes thereto and the report of Tullius Taylor Sartain & Sartain LLP, independent auditors on such financial statements, are filed as a part of this Form 10-K. See accompanying Index on page F-1. PAGE 38 2. FINANCIAL STATEMENT SCHEDULES. The financial statement schedules listed in the accompanying index to consolidated financial statements and schedules are filed as part of this Form 10-K. All other schedules have been omitted since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule or because the information is included in the consolidated financial statements or the notes thereon. 3. EXHIBITS. 3.1 Certificate of Incorporation. (1) 3.2 Bylaws, as amended. (1) 4.1 Form of Indenture entered into by and between Chandler (U.S.A.), Inc. as issuer and U.S. Trust of Texas, N.A. as trustee. (1) 4.2 First Amendment to Indenture effective May 13, 2003 constituting the First Amendment to the Indenture dated as of July 16, 1999, between Chandler (U.S.A.), Inc., and The Bank of New York Trust Company of Florida, N.A. as successor trustee to U.S. Trust Company of Texas, N.A., as Trustee regarding the 8.75% senior debentures due 2014 issued by Chandler (U.S.A.), Inc. (3) 4.3 Second Amendment to Indenture effective December 1, 2003 constituting the Second Amendment to the Indenture dated as of July 16, 1999, between Chandler (U.S.A.), Inc., and The Bank of New York Trust Company of Florida, N.A. as successor trustee to U.S. Trust Company of Texas, N.A., as Trustee regarding the 8.75% senior debentures due 2014 issued by Chandler (U.S.A.), Inc. (5) 10.1 Employment Agreement, effective as of October 28, 1988, by and between Chandler (U.S.A.), Inc. and Brent LaGere. (1) 10.2 Employment Agreement, effective as of October 28, 1988, by and between Chandler (U.S.A.), Inc., and Brenda B. Watson (formerly Brenda B. Pair). (1) 10.3 Amendment to Employment Agreement, effective as of January 1, 1999, by and between Chandler (U.S.A.), Inc. and Brenda B. Watson. (1) 10.4 Intercompany Credit Agreement effective as of January 1, 2001, by and between Chandler (U.S.A.), Inc. and Chandler Insurance (Barbados), Ltd. (2) 10.5 Stock Purchase Agreement effective as of December 1, 2002, by and among Brown & Brown, Inc., Chandler (U.S.A.), Inc., Chandler Insurance Company, Ltd., National American Insurance Company, W. Brent LaGere and Mark T. Paden. (3) 10.6 Amended and Restated Declaration of Trust of Chandler Capital Trust I dated as of May 22, 2003 among Chandler (U.S.A.), Inc., as sponsor, Wilmington Trust Company, as Delaware trustee, Wilmington Trust Company, as institutional trustee, and W. Brent LaGere, Mark T. Paden and Mark C. Hart, as administrators. (4) 10.7 Indenture, dated as of May 22, 2003 among Chandler (U.S.A.), Inc., as issuer, and Wilmington Trust Company, as trustee. (4) 10.8 Guarantee Agreement, dated as of May 22, 2003 between Chandler (U.S.A.), Inc., as guarantor, and Wilmington Trust Company, as guarantee trustee. (4) 10.9 Capital Securities Subscription Agreement dated as of May 13, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust I, together as offerors, and InCapS Funding I, Ltd., as purchaser. (4) 10.10 Placement Agreement dated May 13, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust I, together as offerors, and Sandler O'Neill & Partners, L.P., as placement agent. (4) 10.11 Amended and Restated Declaration of Trust of Chandler Capital Trust II dated as of December 16, 2003 among Chandler (U.S.A.), Inc., as sponsor, Wilmington Trust Company, as Delaware trustee, Wilmington Trust Company, as institutional trustee, and W. Brent LaGere, Mark T. Paden and Mark C. Hart, as administrators. (6) PAGE 39 10.12 Indenture, dated as of December 16, 2003 among Chandler (U.S.A.), Inc., as issuer, and Wilmington Trust Company, as trustee. (6) 10.13 Guarantee Agreement, dated as of December 16, 2003 between Chandler (U.S.A.), Inc., as guarantor, and Wilmington Trust Company, as guarantee trustee. (6) 10.14 Capital Securities Subscription Agreement dated as of December 4, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust II, together as offerors, and InCapS Funding I, Ltd., as purchaser. (6) 10.15 Placement Agreement dated December 4, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust II, together as offerors, and Sandler O'Neill & Partners, L.P., as placement agent. (6) 14.1 Code of Ethics. (6) 21.1 Subsidiaries of the registrant. 31.1 Rule 13a-14(a)/15d-14(a) Certifications. 32.1 Section 1350 Certifications. -------------------- (1) Previously filed as an exhibit to Registration No. 333-76393 on Form S-1 and incorporated herein by reference. (2) Previously filed as an exhibit to Chandler USA's Annual Report on Form 10-K for the year ended December 31, 2001 and incorporated herein by reference. (3) Previously filed as an exhibit to Chandler USA's Annual Report on Form 10-K for the year ended December 31, 2002 and incorporated herein by reference. (4) Previously filed as an exhibit to Chandler USA's Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 and incorporated herein by reference. (5) Previously filed as an exhibit to Chandler USA's current report on Form 8-K dated December 1, 2003 and incorporated herein by reference. (6) Previously filed as an exhibit to Chandler USA's Annual Report on Form 10-K for the year ended December 31, 2003 and incorporated herein by reference. Copies of the foregoing exhibits filed with this Form 10-K or incorporated by reference are available from Chandler USA upon written request and payment of a reasonable copying fee. PAGE 40 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. CHANDLER (U.S.A.), INC. Date: March 1, 2005 By:/s/ W. Brent LaGere ---------------------------------------------------- W. Brent LaGere Chairman of the Board and Chief Executive Officer PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. Date: March 1, 2005 /s/ W. Brent LaGere ---------------------------------------------------- W. Brent LaGere, Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer) Date: March 1, 2005 /s/ Mark T. Paden ---------------------------------------------------- Mark T. Paden, President, Chief Operating Officer and Director Date: March 1, 2005 /s/ Mark C. Hart ---------------------------------------------------- Mark C. Hart, Vice President - Finance, Chief Financial Officer and Treasurer (Principal Financial Officer) Date: March 1, 2005 /s/ Richard L. Evans ---------------------------------------------------- Richard L. Evans, Senior Vice President and Director Date: March 1, 2005 /s/ R. Patrick Gilmore ---------------------------------------------------- R. Patrick Gilmore, Senior Vice President, Secretary, General Counsel and Director Date: March 1, 2005 /s/ Robert L. Rice ---------------------------------------------------- Robert L. Rice, Director Date: March 1, 2005 /s/ W. Scott Martin ---------------------------------------------------- W. Scott Martin, Director Date: March 1, 2005 /s/ William T. Keele ---------------------------------------------------- William T. Keele, Director PAGE F-1 CHANDLER (U.S.A.), INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
PAGES ----------------- FINANCIAL STATEMENTS Consolidated Balance Sheets as of December 31, 2003 and 2004 ................ F-2 Consolidated Statements of Operations for the years ended December 31, 2002, 2003 and 2004 .......................................... F-3 Consolidated Statements of Comprehensive Income for the years ended December 31, 2002, 2003 and 2004 .......................................... F-4 Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2003 and 2004 .......................................... F-5 Consolidated Statements of Shareholder's Equity for the years ended December 31, 2002, 2003 and 2004 .......................................... F-6 Notes to Consolidated Financial Statements .................................. F-7 through F-24 Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements and Financial Statement Schedules .................... F-25 SCHEDULES I Summary of Investments - Other Than Investments in Related Parties.... F-26 II Condensed Financial Information of Registrant ........................ F-27 through F-29 III Supplementary Insurance Information .................................. F-30 IV Reinsurance .......................................................... F-31 V Valuation and Qualifying Accounts .................................... F-32 VI Supplemental Information (for property-casualty insurance underwriters) ...................................................... F-33
PAGE F-2 CHANDLER (U.S.A.), INC. CONSOLIDATED BALANCE SHEETS (Amounts in thousands except share amounts)
DECEMBER 31, ---------------------------- 2003 2004 ------------ ------------ ASSETS Investments Fixed maturities available for sale, at fair value Restricted (amortized cost $7,622 and $8,421 in 2003 and 2004, respectively) ...... $ 7,677 $ 8,279 Unrestricted (amortized cost $53,549 and $63,636 in 2003 and 2004, respectively)... 54,303 63,391 Equity securities at fair value (cost $8,058 in 2004) ............................... 92 8,373 ------------ ------------ Total investments ................................................................. 62,072 80,043 Cash and cash equivalents ($601 and $141 restricted in 2003 and 2004, respectively).... 7,126 6,870 Premiums receivable, less allowance for non-collection of $133 and $119 at 2003 and 2004, respectively ..................................... 20,304 22,809 Reinsurance recoverable on paid losses, less allowance for non-collection of $2,934 and $3,035 at 2003 and 2004, respectively ................................. 9,036 2,172 Reinsurance recoverable on paid losses from related parties ........................... 271 83 Reinsurance recoverable on unpaid losses, less allowance for non-collection of $380 and $237 at 2003 and 2004 ................................................... 48,688 50,381 Reinsurance recoverable on unpaid losses from related parties ......................... 9,737 13,157 Prepaid reinsurance premiums .......................................................... 15,269 9,837 Prepaid reinsurance premiums to related parties ....................................... 9,521 12,315 Deferred policy acquisition costs ..................................................... 165 57 Property and equipment, net ........................................................... 9,879 9,110 Amounts due from related parties ...................................................... 9,642 10,891 State insurance licenses, net ......................................................... 3,745 3,745 Other assets .......................................................................... 12,758 15,827 ------------ ------------ Total assets .......................................................................... $ 218,213 $ 237,297 ============ ============ LIABILITIES AND SHAREHOLDER'S EQUITY Liabilities Unpaid losses and loss adjustment expenses .......................................... $ 87,768 $ 108,233 Unearned premiums ................................................................... 47,325 51,109 Policyholder deposits ............................................................... 4,807 4,912 Accrued taxes and other payables .................................................... 5,617 5,578 Premiums payable .................................................................... 983 3,674 Debentures .......................................................................... 7,254 6,979 Junior subordinated debentures issued to affiliated trusts .......................... 20,620 20,620 ------------ ------------ Total liabilities ................................................................. 174,374 201,105 ------------ ------------ Commitments and contingencies (Notes 11 and 12) Shareholder's equity Common stock, $1.00 par value, 50,000 shares authorized; 2,484 shares issued and outstanding .............................................. 2 2 Paid-in surplus .................................................................... 60,584 60,584 Accumulated deficit ................................................................ (17,342) (24,346) Accumulated other comprehensive income (loss): Unrealized gain (loss) on investments available for sale, net of deferred income taxes .......................................................... 595 (48) ------------ ------------ Total shareholder's equity ....................................................... 43,839 36,192 ------------ ------------ Total liabilities and shareholder's equity ........................................... $ 218,213 $ 237,297 ============ ============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-3 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands)
YEAR ENDED DECEMBER 31, -------------------------------------- 2002 2003 2004 ------------ ------------ ------------ Premiums and other revenues Direct premiums written and assumed ................................ $ 140,162 $ 118,444 $ 121,651 Reinsurance premiums ceded ......................................... (48,380) (40,612) (21,132) Reinsurance premiums ceded to related parties ...................... (24,115) (25,992) (30,055) ------------ ------------ ------------ Net premiums written and assumed ................................. 67,667 51,840 70,464 Decrease (increase) in unearned premiums ........................... (710) 4,743 (6,422) ------------ ------------ ------------ Net premiums earned .............................................. 66,957 56,583 64,042 Investment income, net ............................................... 2,540 2,148 3,186 Interest income, net from related parties ............................ 380 412 491 Realized investment gains, net ....................................... 794 2,351 652 Other income ......................................................... 261 5,077 640 ------------ ------------ ------------ Total premiums and other revenues ................................ 70,932 66,571 69,011 ------------ ------------ ------------ Operating costs and expenses Losses and loss adjustment expenses, net of amounts ceded to related parties of $16,936, $14,244 and $15,587 in 2002, 2003 and 2004, respectively ............................. 50,712 37,200 53,781 Policy acquisition costs, net of ceding commissions received from related parties of $8,199, $8,770 and $11,550 in 2002, 2003 and 2004, respectively ............................. 10,239 11,278 11,039 General and administrative expenses ................................ 12,473 13,486 12,380 Interest expense ................................................... 2,234 2,441 2,397 ------------ ------------ ------------ Total operating costs and expenses ............................... 75,658 64,405 79,597 ------------ ------------ ------------ Income (loss) from continuing operations before income taxes ......... (4,726) 2,166 (10,586) Federal income tax benefit (provision) ............................... 1,680 (192) 3,582 ------------ ------------ ------------ Income (loss) from continuing operations ............................. (3,046) 1,974 (7,004) Income from discontinued operations .................................. 284 - - Gain on sale of subsidiary ........................................... 671 - - ------------ ------------ ------------ Net income (loss) .................................................. $ (2,091) $ 1,974 $ (7,004) ============ ============ ============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-4 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in thousands)
YEAR ENDED DECEMBER 31, -------------------------------------- 2002 2003 2004 ------------ ------------ ------------ Net income (loss) .............................................................. $ (2,091) $ 1,974 $ (7,004) ------------ ------------ ------------ Other comprehensive income (loss), before income tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period .................... 2,838 631 (322) Less: Reclassification adjustment for gains included in net income (loss) .. (794) (2,351) (652) ------------ ------------ ------------ Other comprehensive income (loss), before income tax ........................... 2,044 (1,720) (974) Income tax benefit (provision) related to items of other comprehensive income (loss) .................................................. (695) 585 331 ------------ ------------ ------------ Other comprehensive income (loss), net of income tax ........................... 1,349 (1,135) (643) ------------ ------------ ------------ Comprehensive income (loss) .................................................... $ (742) $ 839 $ (7,647) ============ ============ ============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-5 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands)
YEAR ENDED DECEMBER 31, -------------------------------------- 2002 2003 2004 ------------ ------------ ------------ OPERATING ACTIVITIES Net income (loss) .............................................................. $ (2,091) $ 1,974 $ (7,004) Add (deduct): Adjustments to reconcile net income (loss) to cash provided by (applied to) operating activities: Realized investment gains, net ............................................. (794) (2,351) (652) Gain on sale of subsidiary ................................................. (671) - - Gain on retirement of debentures ........................................... - (3,106) (36) Net (gains) losses on sale of property and equipment ....................... 32 (1,661) (370) Amortization and depreciation .............................................. 1,602 1,470 1,525 Provision for non-collection of premiums ................................... 444 272 42 Provision for non-collection of reinsurance recoverables ................... 1,726 604 282 Net change in non-cash balances relating to operating activities: Premiums receivable ...................................................... (268) 3,433 (2,547) Reinsurance recoverable on paid losses ................................... (712) 1,449 6,439 Reinsurance recoverable on paid losses from related parties .............. 212 (191) 188 Reinsurance recoverable on unpaid losses ................................. (8,288) 1,798 (1,551) Reinsurance recoverable on unpaid losses from related parties ............ 361 (699) (3,420) Prepaid reinsurance premiums ............................................. 7,688 3,933 5,432 Prepaid reinsurance premiums to related parties .......................... (577) (841) (2,794) Deferred policy acquisition costs ........................................ (355) 190 108 Other assets ............................................................. (1,349) 2,427 (2,790) Unpaid losses and loss adjustment expenses ............................... 7,850 (4,838) 20,465 Unearned premiums ........................................................ (6,402) (7,835) 3,784 Policyholder deposits .................................................... (356) 563 105 Accrued taxes and other payables ......................................... 307 (752) 329 Premiums payable ......................................................... (5,864) (1,822) 2,691 ------------ ------------ ------------ Cash provided by (applied to) operating activities ......................... (7,505) (5,983) 20,226 ------------ ------------ ------------ INVESTING ACTIVITIES Unrestricted fixed maturities available for sale: Purchases .................................................................... (23,163) (33,378) (38,927) Sales ........................................................................ 31,460 22,806 23,772 Maturities ................................................................... 4,339 5,892 4,311 Equity securities available for sale: Purchases .................................................................... - - (8,058) Sales ........................................................................ - 1,720 36 Cost of property and equipment purchased ....................................... (373) (818) (208) Proceeds from sale of property and equipment ................................... 98 104 85 Net proceeds from sale of subsidiary ........................................... 3,058 - - ------------ ------------ ------------ Cash provided by (applied to) investing activities ......................... 15,419 (3,674) (18,989) ------------ ------------ ------------ FINANCING ACTIVITIES Proceeds from issuance of junior subordinated debentures, net .................. - 20,000 - Payment on retirement of debentures ............................................ - (12,782) (226) Debt issue costs ............................................................... - (711) (18) Payments and loans from related parties ........................................ 3,249 2,426 4,602 Payments and loans to related parties .......................................... (5,951) (1,486) (5,851) ------------ ------------ ------------ Cash provided by (applied to) financing activities ......................... (2,702) 7,447 (1,493) ------------ ------------ ------------ Increase (decrease) in cash and cash equivalents during the period ............. 5,212 (2,210) (256) Cash and cash equivalents at beginning of period ............................... 4,124 9,336 7,126 ------------ ------------ ------------ Cash and cash equivalents at end of period ..................................... $ 9,336 $ 7,126 $ 6,870 ============ ============ ============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-6 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY (Amounts in thousands)
Accumulated other Total Common Paid-in Accumulated comprehensive shareholder's stock surplus deficit income (loss) equity ----------- ----------- ----------- ------------- ------------- Balance, January 1, 2002 ................ $ 2 $ 60,584 $ (17,225) $ 381 $ 43,742 Net loss ................................ - - (2,091) - (2,091) Change in unrealized gain on investments available for sale, net of income tax ............... - - - 1,349 1,349 ----------- ----------- ----------- ------------- ------------- Balance, December 31, 2002 .............. 2 60,584 (19,316) 1,730 43,000 ----------- ----------- ----------- ------------- ------------- Net income .............................. - - 1,974 - 1,974 Change in unrealized gain on investments available for sale, net of income tax ............... - - - (1,135) (1,135) ----------- ----------- ----------- ------------- ------------- Balance, December 31, 2003 .............. 2 60,584 (17,342) 595 43,839 ----------- ----------- ----------- ------------- ------------- Net loss ................................ - - (7,004) - (7,004) Change in unrealized gain on investments available for sale, net of income tax ............... - - - (643) (643) ----------- ----------- ----------- ------------- ------------- Balance, December 31, 2004 .............. $ 2 $ 60,584 $ (24,346) $ (48) $ 36,192 =========== =========== =========== ============= =============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-7 CHANDLER (U.S.A.), INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2002, 2003 AND 2004 NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES (a) BASIS OF PRESENTATION Chandler (U.S.A.), Inc. ("Chandler USA") is a holding company organized and domiciled in Oklahoma. Chandler USA's wholly owned subsidiaries are engaged in various property and casualty insurance operations. The insurance products offered by Chandler USA through its subsidiary, National American Insurance Company ("NAICO"), include property and casualty insurance coverage primarily for businesses in various industries, political subdivisions and surety bonds for small contractors in the United States of America ("U.S."). The business is conducted through individual independent insurance agencies and underwriting managers, primarily in the Southwest and Midwest areas of the U.S. Chandler Insurance Managers, Inc. ("CIMI") is a wholly owned subsidiary of Chandler USA and serves as an underwriting manager for certain wholesale operations related to NAICO's school districts and trucking insurance. Chandler USA is wholly owned by Chandler Insurance Company, Ltd. ("Chandler Insurance"), a Cayman Islands company. Prior to December 2003, Chandler USA was a wholly owned subsidiary of Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") which, in turn, was a wholly owned subsidiary of Chandler Insurance. In December 2003, Chandler Barbados was dissolved following the transfer of its assets, liabilities and business to Chandler Insurance. Chandler Insurance assumed the obligations of Chandler Barbados including those under its reinsurance agreements with NAICO pursuant to a Distribution Agreement and a General Conveyance. The reorganization of Chandler Barbados and Chandler Insurance was approved by the Cayman Islands Monetary Authority, the Supervisor of Insurance in Barbados and the Oklahoma Insurance Department. In December 2002, Chandler USA completed the sale of its wholly owned subsidiary LaGere and Walkingstick Insurance Agency, Inc. ("L&W"). L&W previously functioned as Chandler USA's agency segment. All periods have been restated to reflect the results of L&W as a discontinued operation. See Note 4 for more information on the sale of L&W. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of the financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates. (b) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Chandler USA and all wholly owned subsidiaries that meet consolidation requirements including NAICO and CIMI. All significant intercompany accounts and transactions have been eliminated in consolidation. (c) IMPAIRMENT OF LONG-LIVED ASSETS Chandler USA periodically evaluates the carrying value of long-lived assets to be held and used when changes in events and circumstances warrant such a review. The carrying value of a long-lived asset is considered impaired when the separately identifiable anticipated undiscounted cash flow from such asset is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the long-lived asset. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that fair values are reduced for disposal costs. (d) REVENUE RECOGNITION Premiums are generally recognized as earned on a pro rata basis over the policy period, which is in proportion to the insurance protection provided. The portion of premiums that will be earned in the future are deferred and reported as unearned premiums. Amounts recorded for ceded reinsurance premiums are reported as prepaid reinsurance premiums and amortized over the remaining contract period in proportion to the amount of the insurance protection provided. Commission revenues are generally recognized when coverage is effective and premiums are billed. PAGE F-8 (e) PREMIUMS RECEIVABLE Premiums receivable are presented net of valuation allowances for estimated uncollectible amounts. Chandler USA determines the allowance for non-collection by regularly evaluating individual agent accounts and balances due from insureds, considering their financial condition and other appropriate factors. Such accounts are considered past due based on contractual terms for the agent or insured. Premiums receivable are written off when deemed uncollectible. Recoveries of accounts previously written off are recorded when received. (f) UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES Losses and loss adjustment expenses are charged to income as incurred. The reserve for unpaid losses and loss adjustment expenses represents the accumulation of estimates for reported losses and includes provisions for losses incurred but not reported based on data available at this time. The methods of determining such estimates and establishing resulting reserves are periodically reviewed and updated, and adjustments therefrom are necessary to maintain an adequate reserve for unpaid losses and loss adjustment expenses. As more fully explained in Note 3, such estimates are management's best estimates of the expected values. The actual results may vary from these values because the evaluation of losses is inherently subjective and susceptible to significant changing factors. (g) DEFERRED POLICY ACQUISITION COSTS Policy acquisition costs that vary with and are primarily related to the acquisition of new and renewal business (such as premium taxes, agent commissions, commissions received from reinsurers and a portion of other underwriting expenses) are deferred and amortized over the terms of the policies. When the sum of the anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded. Certain policy acquisition costs, such as policyholder dividends, are expensed directly. NAICO accrued expenses of $105,000 in 2002 and a credit of $52,000 during 2003 and less than $1,000 in 2004 for dividends to policyholders primarily on participating workers compensation policies. Gross written premiums for participating policies were $615,000, $50,000 and less than $1,000 in 2002, 2003 and 2004, respectively. (h) PROPERTY AND EQUIPMENT Real estate and improvements and other property and equipment are stated at cost and depreciated using the straight-line method over their useful lives which range from 3 to 31 years. Property and equipment consisted of the following at December 31:
2003 2004 ---------- ---------- (In thousands) Real estate and improvements .. $ 11,701 $ 11,714 Other property and equipment .. 9,206 9,010 ---------- ---------- 20,907 20,724 Accumulated depreciation ...... (11,028) (11,614) ---------- ---------- $ 9,879 $ 9,110 ========== ==========
Depreciation expense from continuing operations was approximately $916,000, $918,000 and $894,000 for 2002, 2003 and 2004, respectively. PAGE F-9 (i) INTANGIBLE ASSETS Intangible assets are stated at cost less accumulated amortization. Prior to 2002, the cost of state insurance licenses acquired was amortized over 40 years using the straight-line method. Effective January 1, 2002, the state insurance licenses are no longer amortized since they were determined to have indefinite lives but are reviewed at least annually for impairment. Chandler USA completed the required impairment tests during 2003 and 2004 and concluded that there has not been an impairment loss since the fair values exceeded their carrying values. The fair values were determined based on the present value of projected future net cash flows. Intangible assets included the following at December 31:
2003 2004 ---------- ---------- (In thousands) State insurance licenses ...... $ 5,991 $ 5,991 Accumulated amortization ...... (2,246) (2,246) ---------- ---------- $ 3,745 $ 3,745 ========== ==========
(j) POLICYHOLDER DEPOSITS NAICO requires certain policyholders to pay a deposit at inception of coverage to secure payment of future premiums and deductibles on claims incurred. It is expressly agreed between NAICO and the policyholder that the funds will be used by NAICO only in the event the policyholder fails to pay any premiums, deductibles or other charges when due. NAICO has established a liability for these deposits in an amount equal to that due the policyholders based on insurance premiums reported as of the balance sheet date. (k) INVESTMENTS At the time of purchase, investments in debt securities that Chandler USA has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments in debt securities classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. Chandler USA has not classified any investments as trading account assets. Debt securities not classified as held to maturity or trading and equity securities are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of deferred income tax as other comprehensive income until realized. Realized gains and losses on sales of securities are based on the specific identification method. Declines in the fair value of securities below their carrying value that are other than temporary are recognized in earnings. Chandler USA regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Some factors considered in evaluating whether or not a decline in fair value is other than temporary include Chandler USA's ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value; the duration and extent to which the fair value has been less than cost; and the financial condition and prospects of the issuer. (l) INCOME TAXES Chandler USA uses an asset and liability approach for accounting for income taxes. Deferred income taxes are recognized for the tax consequences of temporary differences and carryforwards by applying enacted tax rates applicable to future years to differences between the financial statement amounts and the tax bases of existing assets and liabilities. A valuation allowance is established if it is more likely than not that some portion of the deferred tax asset will not be realized. (m) CASH AND CASH EQUIVALENTS For purposes of the consolidated statements of cash flows, Chandler USA considers all highly liquid investments with original maturities of 14 days or less to be cash equivalents. For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value. PAGE F-10 (n) SUPPLEMENTAL CASH FLOW INFORMATION Cash payments for interest and income taxes, and noncash investing activities were as follows:
YEAR ENDED DECEMBER 31, -------------------------------- 2002 2003 2004 ---------- ---------- ---------- (In thousands) Cash payments (refunds) during the year for: Interest ...................................... $ 2,122 $ 2,809 $ 2,261 Income taxes .................................. (1,241) (300) - Transfers from (to) restricted securities, net .. $ (1,341) $ (563) $ (801)
(o) REINSURANCE Management believes all of NAICO's reinsurance contracts with reinsurers meet the criteria for risk transfer and the revenue and cost recognition provisions in order to be accounted for as reinsurance. As more fully explained in Note 12, reinsurance contracts do not relieve NAICO from its obligation to policyholders. In addition, failure of reinsurers to honor their obligations could result in losses to Chandler USA. (p) NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board ("FASB") periodically issues new accounting standards in a continuing effort to improve standards of financial accounting and reporting. Chandler USA has reviewed the recently issued pronouncements and concluded that the following new accounting standard is applicable to Chandler USA. In December 2004, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 153, EXCHANGES OF NONMONETARY ASSETS - AN AMENDMENT OF APB OPINION NO. 29. SFAS No. 153 amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153 is to be applied prospectively for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of SFAS No. 153 is not expected to have a material impact on Chandler USA's financial position or results of operations. NOTE 2. INVESTMENTS AND INVESTMENT INCOME Net investment income and realized investment gains from continuing operations are summarized in the following table. These amounts are net of investment expenses.
YEAR ENDED DECEMBER 31, -------------------------------- 2002 2003 2004 ---------- ---------- ---------- (In thousands) Interest on fixed-maturity investments ................. $ 2,755 $ 2,271 $ 2,746 Interest on cash equivalents ........................... 252 139 695 Dividend income on equity securities ................... - - 22 Interest on amounts due from related parties ........... 380 412 491 Investment expenses .................................... (467) (262) (277) ---------- ---------- ---------- Investment income, net ............................... 2,920 2,560 3,677 ---------- ---------- ---------- Realized gains, net - fixed-maturity investments ....... 794 631 616 Realized gains, net - equity securities ................ - 1,720 36 ---------- ---------- ---------- Realized investments gains, net ...................... 794 2,351 652 ---------- ---------- ---------- $ 3,714 $ 4,911 $ 4,329 ========== ========== ==========
Investment expenses include $244,000, $81,000 and $104,000 for the years ended December 31, 2002, 2003 and 2004, respectively, in expense to subsidize a premium finance program for certain insureds of NAICO with an unaffiliated premium finance company. PAGE F-11 The amortized cost of fixed maturities or cost of equity securities, gross unrealized gains or losses, fair value and carrying value of investments are as follows:
GROSS GROSS UNREALIZED UNREALIZED FAIR CARRYING DECEMBER 31, 2003 COST GAINS LOSSES VALUE VALUE - ---------------------------------------- ---------- ---------- ---------- ---------- ---------- FIXED MATURITIES AVAILABLE FOR SALE: (In thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies ......................... $ 38,565 $ 587 $ (141) $ 39,011 $ 39,011 Corporate obligations .................. 11,645 313 (90) 11,868 11,868 Public utilities ....................... 6,816 220 (20) 7,016 7,016 Mortgage-backed securities ............. 4,145 - (60) 4,085 4,085 ---------- ---------- ---------- ---------- ---------- $ 61,171 $ 1,120 $ (311) $ 61,980 $ 61,980 ========== ========== ========== ========== ========== EQUITY SECURITIES: Corporate stock ........................ $ - $ 92 $ - $ 92 $ 92 ========== ========== ========== ========== ==========
GROSS GROSS UNREALIZED UNREALIZED FAIR CARRYING DECEMBER 31, 2004 COST GAINS LOSSES VALUE VALUE - ---------------------------------------- ---------- ---------- ---------- ---------- ---------- FIXED MATURITIES AVAILABLE FOR SALE: (In thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies ......................... $ 31,884 $ 165 $ (225) $ 31,824 $ 31,824 Corporate obligations .................. 29,756 188 (429) 29,515 29,515 Public utilities ....................... 7,603 78 (95) 7,586 7,586 Mortgage-backed securities ............. 2,814 - (69) 2,745 2,745 ---------- ---------- ---------- ---------- ---------- $ 72,057 $ 431 $ (818) $ 71,670 $ 71,670 ========== ========== ========== ========== ========== EQUITY SECURITIES: Corporate stock ........................ $ 8,058 $ 315 $ - $ 8,373 $ 8,373 ========== ========== ========== ========== ==========
The fair value of Chandler USA's investments with sustained gross unrealized losses at December 31, 2004 is presented below:
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL ----------------------- ----------------------- ----------------------- UNREALIZED UNREALIZED UNREALIZED FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES ----------- ---------- ----------- ---------- ----------- ---------- (In thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies ....... $ 8,280 $ 148 $ 6,485 $ 77 $ 14,765 $ 225 Corporate securities .............. 19,089 397 1,991 32 21,080 429 Public utilities .................. 4,157 74 1,618 21 5,775 95 Mortgage-backed securities ........ - - 2,745 69 2,745 69 ----------- ---------- ----------- ---------- ----------- ---------- $ 31,526 $ 619 $ 12,839 $ 199 $ 44,365 $ 818 =========== ========== =========== ========== =========== ==========
Chandler USA regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Based on an evaluation of the issues, including, but not limited to, Chandler USA's intentions to sell or ability to hold the investments; the length of time and amount of the unrealized loss; and the credit ratings of the issuers of the investments, Chandler USA has concluded that the declines in the fair values of Chandler USA's investments at December 31, 2004 are temporary. PAGE F-12 Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The maturities of investments in fixed maturities at December 31, 2004 are shown below:
AVAILABLE FOR SALE ------------------------ AMORTIZED COST FAIR VALUE ------------ ---------- (In thousands) Due in one year or less ...................... $ 1,024 $ 1,021 Due after one year through five years ........ 34,921 34,801 Due after five years through ten years ....... 30,477 30,266 Due after ten years .......................... 2,821 2,837 ------------ ---------- 69,243 68,925 Mortgage-backed securities ................... 2,814 2,745 ------------ ---------- $ 72,057 $ 71,670 ============ ==========
Realized gains and losses from sales of investments are shown below:
GROSS REALIZED GAINS GROSS REALIZED LOSSES -------------------- --------------------- (In thousands) FIXED MATURITIES: 2002 ............ $ 904 $ 110 2003 ............ 631 - 2004 ............ 693 77 EQUITY SECURITIES: 2003 ............ 1,720 - 2004 ............ 36 -
NAICO is required by several states to deposit securities with state regulators as a condition of doing business in those states. At December 31, 2003, Chandler USA had deposited cash of approximately $500,000 into a trust account as security related to certain indemnification provisions related to its sale of L&W. This deposit was replaced by a $500,000 letter of credit in 2004 (See Note 4). As of December 31, 2003 and 2004, the carrying value of these deposits totaled approximately $8.3 million and $8.4 million, respectively. NOTE 3. UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES NAICO provides a reserve for estimated losses (reported and unreported) and loss adjustment expenses based on historical experience and payment reporting patterns for the type of risk involved. These estimates are based on data available at the time of the estimate and such estimates are periodically reviewed by independent professional actuaries. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount and uncertainty in the estimates are affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances, and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that define and expand insurance coverage subsequent to the time that the insurance policy was priced and sold. Salvage and subrogation recoverables are accrued using the "case basis" method for large recoverables and statistical estimates based on historical experience for smaller recoverables. Recoverable amounts deducted from NAICO's net liability for unpaid losses and loss adjustment expenses were approximately $5.7 million and $3.7 million at December 31, 2003 and 2004, respectively. Although such estimates are management's best estimates of the expected values, the ultimate liability for unpaid claims may vary from these values. NAICO does not discount the liability for unpaid losses and loss adjustment expenses. PAGE F-13 The following table sets forth a reconciliation of the beginning and ending unpaid losses and loss adjustment expenses which are net of reinsurance deductions.
YEAR ENDED DECEMBER 31, -------------------------------- 2002 2003 2004 ---------- ---------- ---------- (In thousands) Net balance at beginning of year ........................... $ 32,812 $ 33,191 $ 29,343 ---------- ---------- ---------- Net losses and loss adjustment expenses incurred related to: Current year ............................................ 34,928 26,108 27,436 Prior years ............................................. 15,784 11,092 26,345 ---------- ---------- ---------- Total ................................................ 50,712 37,200 53,781 ---------- ---------- ---------- Net paid losses and loss adjustment expenses related to: Current year ............................................ (13,283) (10,626) (10,222) Prior years ............................................. (37,050) (30,422) (28,207) ---------- ---------- ---------- Total ................................................ (50,333) (41,048) (38,429) ---------- ---------- ---------- Net balance at end of year ................................. $ 33,191 $ 29,343 $ 44,695 ========== ========== ==========
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2002, 2003 and 2004 calendar years. The loss development occurred primarily in the 1997-2001 accident years. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results. During 2002, NAICO experienced adverse loss development totaling $15.8 million primarily in the standard property and casualty program including both liability lines and workers compensation. This adverse development was primarily due to an increase in loss severity within the 1997-2000 accident years. The adverse development included approximately $2.0 million for provisions for potentially uncollectible reinsurance and deductibles. During 2003, NAICO experienced adverse loss development totaling $11.1 million primarily in the standard property and casualty program. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1998-2001 accident years. A reduction in losses for the 2002 accident year partially offset this adverse development. The adverse loss development included approximately $1.3 million for provisions for potentially uncollectible reinsurance and deductibles. During 2004, NAICO experienced adverse loss development totaling $26.3 million primarily in the standard property and casualty and political subdivisions programs. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1997-2002 accident years. The adverse development in the 2002 accident year partially offset the reduction in losses for this accident year that was recorded during 2003. The adverse loss development included approximately $409,000 for provisions for potentially uncollectible reinsurance and deductibles. Reserves for unpaid losses and loss adjustment expenses, net of related reinsurance recoverables, were $44.7 million at December 31, 2004 compared to $29.3 million at December 31, 2003, an increase of $15.4 million or 52%. NAICO does not ordinarily insure against environmental matters as that term is commonly used. However, in some cases, regulatory filings made by NAICO on behalf of an insured can make NAICO directly liable to the regulatory authority for property damage which could include environmental pollution. In those cases, NAICO ordinarily has recourse against the insured or the surety bond principal for amounts paid. NAICO has insured certain trucking companies and pest control operators that are required to provide proof of insurance which in some cases assures payment for clean-up and remediation of damage resulting from sudden and accidental release or discharge of contaminants or other substances which may be classified as pollutants. NAICO also provides surety bonds for construction contractors that use or have control of such substances and for contractors that remove and dispose of asbestos as a part of their contractual obligations. NAICO also insures independent oil and gas producers that may purchase coverage for the escape of oil, saltwater, or other substances which may be harmful to persons or property, but may not generally be classified as pollutants. NAICO maintains claims records which segregate this type of risk for the purpose of evaluating environmental risk exposure. Based upon the nature of such lines of business with insureds of NAICO, and current data regarding the limited severity and infrequency of such matters, it appears that potential environmental risks are not a significant portion of claims reserves and therefore would not likely have a material impact, if any, on the consolidated financial condition, results of operations or cash flows of Chandler USA. PAGE F-14 At this time, NAICO has not received any claims related to the September 11, 2001 terrorist attacks on the World Trade Center and does not believe that it has any significant exposure to these and related losses. While several of NAICO's reinsurers did experience significant losses related to these attacks, it currently does not appear that these losses will impair the reinsurers' ability to pay claims. NOTE 4. DISCONTINUED OPERATIONS In December 2002, Chandler USA completed the sale of its wholly owned subsidiary L&W to Brown & Brown, Inc. for $3.6 million. Chandler USA recorded an after-tax gain of $671,000 on the sale in 2002 based on the minimum purchase price for the transaction. The gain on the sale may be increased depending on certain adjustments to the purchase price as defined in the terms of the transaction. Following the completion of the sale, L&W changed its name to Brown & Brown of Central Oklahoma, Inc. ("B&B"). L&W previously functioned as Chandler USA's agency segment and is presented as discontinued operations. B&B continues to be a significant producer of business for NAICO. Retail business produced by B&B and placed with NAICO constituted approximately 13% of NAICO's direct premiums written and assumed in 2004. Chandler USA agreed to indemnify Brown & Brown, Inc. for any breach of a representation, warranty or covenant made in connection with the sale for a period of three years, and has established a letter of credit in the amount of $500,000 for the benefit of Brown & Brown, Inc. as security. NOTE 5. DEBENTURES On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior debentures (the "Debentures") with a maturity date of July 16, 2014. The Debentures were priced at $1,000 each with an interest rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium. The indenture governing the Debentures was amended during 2003 to clarify that purchases of Debentures by Chandler USA through private treaty or on the open market for an agreed price of less than the sum of the principal amount and accrued interest are not considered to be a redemption of the Debentures, and that any such Debentures purchased by Chandler USA will be cancelled. Chandler USA purchased and cancelled $16.7 million and $275,000 principal amount of the Debentures during 2003 and 2004, respectively, and at December 31, 2004, there were $6,979,000 principal amount of the Debentures outstanding. As of December 31, 2004, Chandler USA has capitalized $312,000 related to debt issuance costs for the Debentures. These costs are being amortized as interest expense over the term of the Debentures. When Debentures are purchased and cancelled by Chandler USA, debt issuance costs are reduced accordingly and reflected in the gain on retirement of debt which is included in other income in the consolidated statements of operations. Chandler USA's subsidiaries and affiliates are not obligated by the Debentures. Accordingly, the Debentures are effectively subordinated to all existing and future liabilities and obligations of Chandler USA's existing and future subsidiaries. The indenture governing the Debentures contains certain restrictive covenants, including covenants that limit subsidiary debt, issuance or sale of subsidiary stock, incurring of liens, sale-leaseback transactions for a period of more than three years, mergers, consolidations and sales of assets. At December 31, 2004, Chandler USA was in compliance with all covenants. NOTE 6. TRUST PREFERRED SECURITIES In May 2003, Chandler USA established Chandler Capital Trust I ("Trust I") by purchasing all of its common securities for $403,000. Trust I is a Delaware statutory business trust and is a wholly owned non-consolidated subsidiary of Chandler USA. On May 22, 2003, Trust I issued $13.0 million of capital securities (the "Trust I Preferred Securities") to InCapS Funding I, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust I used the proceeds from the issuance to purchase $13,403,000 of 9.75% junior subordinated debentures (the "Junior Debentures I") of Chandler USA. Distributions on the Junior Debentures I are payable quarterly at a fixed annual rate of 9.75%. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures I, with such deferred payments accruing interest compounded quarterly. The Junior Debentures I are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year. The Junior Debentures I are the sole assets of Trust I and Trust I will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust I Preferred Securities are payable quarterly at a fixed annual rate of 9.75%. Trust I may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust I Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust I Preferred Securities are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year. All payments by Trust I regarding the Trust I Preferred Securities are guaranteed by Chandler USA. PAGE F-15 In December 2003, Chandler USA established Chandler Capital Trust II ("Trust II") by purchasing all of its common securities for $217,000. Trust II is a Delaware statutory business trust and is a wholly owned non-consolidated subsidiary of Chandler USA. On December 16, 2003, Trust II issued $7.0 million of capital securities (the "Trust II Preferred Securities") to InCapS Funding II, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust II used the proceeds from the issuance to purchase $7,217,000 of floating rate junior subordinated debentures (the "Junior Debentures II") of Chandler USA. Distributions on the Junior Debentures II are payable quarterly at a floating rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed 12.5% prior to January 8, 2009). The interest rate was 6.17% at December 31, 2004. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures II, with such deferred payments accruing interest compounded quarterly. The Junior Debentures II are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium. The Junior Debentures II are the sole assets of Trust II and Trust II will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust II Preferred Securities are payable quarterly at a floating rate of 4.10% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not exceed 12.5% prior to January 8, 2009). The interest rate was 6.17% at December 31, 2004. Trust II may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust II Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust II Preferred Securities are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium. All payments by Trust II regarding the Trust II Preferred Securities are guaranteed by Chandler USA. The sale of the Trust I Preferred Securities and the Trust II Preferred Securities during 2003 resulted in net proceeds of $19.3 million to Chandler USA, net of placement costs. Issuance costs in the amount of $711,000 have been capitalized and are being amortized over the stated maturity periods of thirty years. Chandler USA used $13.3 million of the proceeds to purchase $16.7 million principal amount of its outstanding Debentures during 2003. The Debentures purchased by Chandler USA were cancelled. The purchase and cancellation of the Debentures resulted in a pre-tax gain of $3.1 million during 2003, net of an adjustment to unamortized issuance costs, which is included in other income in the consolidated statement of operations. Chandler USA also contributed $5.0 million of the proceeds to NAICO to be used for general corporate purposes. In December 2003, the Financial Accounting Standards Board issued Revised Interpretation No. 46 ("FIN 46R"), CONSOLIDATION OF VARIABLE INTEREST ENTITIES. FIN 46R provides guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights. FIN 46R is used to determine whether consolidation is required or, alternatively, whether the variable-interest model under FIN 46R should be used to account for existing and new entities. Chandler USA adopted FIN 46R effective January 1, 2004. The result of adoption was the deconsolidation of the two capital trusts that were created during 2003 in connection with the issuance of trust preferred securities. Chandler USA now reports the $20.6 million of junior subordinated debentures that were issued to the capital trusts on its consolidated balance sheet, and the December 31, 2003 balances were restated accordingly. The adoption of FIN 46R had no effect on net earnings. PAGE F-16 NOTE 7. SHAREHOLDER'S EQUITY CAPITAL STOCK In addition to the regulatory oversight of NAICO by the Oklahoma Department of Insurance, Chandler Insurance and Chandler USA are also subject to regulation under the insurance laws of Oklahoma (the "Oklahoma Insurance Code"). In addition to various reporting requirements imposed on Chandler Insurance and Chandler USA, the Oklahoma Insurance Code requires any person who seeks to acquire or exercise control over NAICO (which is presumed to exist if any person owns 10% or more of Chandler Insurance's or Chandler USA's outstanding voting stock) to file and obtain approval of certain applications with the Oklahoma Department of Insurance regarding their proposed ownership of such shares. STATUTORY FINANCIAL INFORMATION AND MINIMUM CAPITAL REQUIREMENTS NAICO is required to file financial statements with state regulatory authorities prepared on a statutory basis which differs from GAAP. Statutory net income (loss) and statutory capital and surplus of NAICO are as follows:
2002 2003 2004 -------- -------- -------- (In thousands) Statutory net income (loss) ........ $ (405) $ 1,447 $(7,482) Statutory capital and surplus ...... $44,073 $50,154 $41,458
The NAIC has adopted risk-based capital ("RBC") standards for domestic property and casualty insurance companies. The RBC standards are designed to assist insurance regulators in analytically determining a level of capital and surplus that would be sufficient to withstand reasonably foreseeable adverse events associated with underwriting risk, investment risk, credit risk and loss reserve risk. NAICO is subject to the RBC standards. Based on available information, management believes NAICO complied with the RBC standards at December 31, 2003 and 2004. At periodic intervals, various insurance regulatory authorities routinely examine the required statutory financial statements of NAICO as part of their legally prescribed oversight of the insurance industry. Based on these examinations, the regulators can direct such financial statements to be adjusted in accordance with their findings. DIVIDEND RESTRICTIONS The amount of cash shareholder dividends that NAICO can pay to Chandler USA within any one year without the approval of the Oklahoma Department of Insurance is generally limited to the greater of (i) statutory net income excluding realized capital gains for the preceding year, or (ii) 10% of statutory surplus as regards policyholders as of the preceding December 31 with such amount not to exceed NAICO's statutory earned surplus. Based on this criteria the maximum shareholder dividend NAICO may pay in 2005 without the approval of the Oklahoma Department of Insurance is approximately $3.8 million. NAICO paid cash shareholder dividends to Chandler USA totaling $3.5 million in 2002 and $3.4 million in 2004. The future payment of shareholder dividends also depends upon the earnings, financial position and cash requirements of Chandler USA, as well as regulatory limitations and such other factors as the board of directors may deem relevant. NAICO is subject to regulations which restrict its ability to pay dividends to policyholders. The maximum amount of available policyholder dividends is limited to statutory earned surplus (approximately $3.8 million as of December 31, 2004). NAICO paid approximately $120,000, $146,000 and $62,000 in policyholder dividends during 2002, 2003 and 2004, respectively. PAGE F-17 NOTE 8. INCOME TAXES Chandler USA and its wholly owned subsidiaries file a consolidated U.S. Federal income tax return. The income taxes reflected in the accompanying consolidated statements of operations differ from those expected using U.S. Federal enacted income tax rates as noted by the following:
2002 2003 2004 ---------- ---------- ---------- CONTINUING OPERATIONS: (In thousands) Computed income tax provision (benefit) at 34% ...... $ (1,607) $ 736 $ (3,599) Increase (decrease) in income taxes resulting from: Utilization of capital loss ....................... (270) (800) (248) Nondeductible expenses ............................ 197 256 265 ---------- ---------- ---------- Federal income tax provision (benefit) .............. $ (1,680) $ 192 $ (3,582) ========== ========== ========== DISCONTINUED OPERATIONS: Computed income tax provision at 34% ................ $ 149 $ - $ - Increase in income taxes resulting from: Other, net ........................................ 6 - - ---------- ---------- ---------- Federal income tax provision ........................ $ 155 $ - $ - ========== ========== ==========
The sale of L&W resulted in a capital loss for tax purposes as Chandler USA's tax basis in L&W exceeded the consideration received from the sale. Accordingly, the gain on the sale of $671,000 that was recorded in the consolidated statement of operations in 2002 was not reduced for income taxes. U.S. Federal income tax provision (benefit) from continuing operations consists of:
CURRENT DEFERRED TOTAL --------------- ---------------- -------------- (In thousands) 2002 ........................................ $ (146) $ (1,534) $ (1,680) 2003 ........................................ (904) 1,096 192 2004 ........................................ - (3,582) (3,582)
Deferred income tax provision (benefit) from continuing operations relating to temporary differences includes the following components:
2002 2003 2004 ------------- ------------ ------------ (In thousands) Loss reserve discounts ......................... $ 152 $ 276 $ (796) Unearned premiums .............................. (6) 249 (372) Deferred policy acquisition costs .............. 276 (65) (37) Reserve for uncollectible premiums receivable .. (58) 38 5 Depreciation and lease expense ................. 126 627 5 Discount on fixed maturity investments ......... 11 (218) 11 Net operating loss carryforwards ............... (1,887) 214 (2,345) Other .......................................... (148) (25) (53) ------------- ------------ ------------ $ (1,534) $ 1,096 $ (3,582) ============= ============ ============
PAGE F-18 The tax effect of temporary differences between the consolidated financial statement carrying amounts and tax bases of assets and liabilities that give rise to significant portions of the net deferred tax assets, which are included in other assets, at December 31, relate to the following:
2003 2004 ------------ ------------ (In thousands) Deferred tax assets: Loss reserve discounts ....................................... $ 1,774 $ 2,569 Unearned premiums ............................................ 1,617 1,989 Reserve for uncollectible premiums receivable ................ 45 40 Compensated absences ......................................... 231 242 Net operating loss carryforwards - federal ................... 1,673 4,019 Net operating loss carryforwards - state ..................... 3,037 3,194 Net capital loss carryforward ................................ 625 357 Other ........................................................ 110 119 Valuation allowance .......................................... (3,662) (3,551) ------------ ------------ Total deferred tax assets ...................................... 5,450 8,978 ------------ ------------ Deferred tax liabilities: Depreciation and lease expense ............................... 1,470 1,475 Amortization of discount on fixed maturity investments ....... 5 15 Unrealized gain (loss) on investments available for sale ..... 306 (25) Deferred policy acquisition costs ............................ 56 20 Other ........................................................ 124 91 ------------ ------------ Total deferred tax liabilities ................................. 1,961 1,576 ------------ ------------ Net deferred tax assets ........................................ $ 3,489 $ 7,402 ============ ============
At December 31, 2004, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $11.8 million which begins to expire in 2023. Chandler USA has concluded that the deferred tax asset including the federal net operating loss carryforwards are more likely than not to be realized. Chandler USA anticipates that its future U.S. consolidated income tax will be sufficient to utilize the federal net operating losses within the required time. Chandler USA will continue to evaluate income generated in future periods in determining the reasonableness of its position. If Chandler USA determines that future income is insufficient to cause the realization of the federal net operating losses within the required time, a valuation allowance will be established. In addition, Chandler USA, at December 31, 2004, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $53.2 million which expire in the years 2005 through 2024. At December 31, 2004, Chandler USA also had a capital loss carryforward for U.S. Federal income taxes of $1.1 million which expires in 2007. A valuation allowance has been provided for the tax effect of the state net operating loss and the net capital loss carryforwards since realization of such amounts is not considered more likely than not. NOTE 9. EMPLOYEE BENEFITS Chandler USA and its subsidiaries participate in a defined contribution retirement plan established under Section 401(k) of the Internal Revenue Code. All full time employees who have completed one year of service and attained age 21 may elect to participate in the 401(k) plan. Participants may contribute up to 25% of compensation, subject to certain limitations. Chandler USA matches 50% of the first $2,000, 40% of the next $3,000, 30% of the next $3,000 and 25% of the remaining employee contributions up to a maximum employer contribution of $5,100 per employee per year. In addition, Chandler USA may make additional annual contributions to the 401(k) plan at its discretion. Chandler USA's expense for 401(k) plan contributions from continuing operations was $282,000, $286,000 and $321,000 for 2002, 2003 and 2004, respectively. NOTE 10. FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS. The estimated fair value amounts have been determined by Chandler USA, using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates of fair values presented herein are not necessarily indicative of the amounts that Chandler USA could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. PAGE F-19 A number of Chandler USA's significant assets (including deferred policy acquisition costs, property and equipment, reinsurance recoverables, prepaid reinsurance premiums and state insurance licenses) and liabilities (including unpaid losses and loss adjustment expenses and unearned premiums) are not considered financial instruments. Based on the short term nature or other relevant characteristics, Chandler USA has concluded that the carrying value of other assets and liabilities considered financial instruments, such as cash equivalents, premiums receivable, policyholder deposits, accrued taxes and other payables, and premiums payable, approximates their fair value as of December 31, 2003 and 2004. The estimated fair values of Chandler USA's fixed-maturity and equity security investments are disclosed at Note 2. At December 31, 2004, the fair value of Chandler USA's Debentures was estimated to be $6.9 million based on the latest reported trade. Chandler USA's Debentures have not historically traded regularly, and settlement at the reported fair value may not be possible. The Debentures are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium, but may be purchased and cancelled by Chandler USA at a price of less than the sum of the principal amount and accrued interest at any time. Chandler USA is obligated for $13.4 million principal amount of junior subordinated debentures that mature in 2033 with a fixed interest rate of 9.75%, and $7.2 million principal amount of junior subordinated debentures that mature in 2034 with a floating rate of 4.10% over LIBOR, currently 6.17%. At December 31, 2004, the fair value of Chandler USA's junior subordinated debentures was estimated to be $20.6 million. NOTE 11. LITIGATION Certain officers and directors of Chandler USA and Chandler Insurance were named as defendants in certain litigation involving CenTra, Inc. This litigation was concluded in 2002. As a result of various events in 1995, 1996 and 1997 related to the CenTra litigation, Chandler Barbados and Chandler USA recorded estimated recoveries of costs from its Director and Officer Liability Insurance policy totaling $3,456,000 and $1,044,000, respectively, for reimbursable amounts previously paid that relate to allowable defense and litigation costs. Chandler Barbados and Chandler USA received payment for a 1995 claim during 1996 in the amount of $636,000 and $159,000, respectively. Chandler Insurance assumed Chandler Barbados' remaining receivable in December 2003 under the reorganization of these companies. During June 2004, Chandler Insurance and Chandler USA received payment in the amount of $558,000 and $167,000, respectively, in exchange for releasing certain insurers with respect to policies covering periods from June 28, 1997 up to June 28, 2002. During the third quarter of 2004, Chandler Insurance and its subsidiaries settled the remaining litigation with the insurer for policy periods from June 28, 1992 to June 28, 1997. Based on the terms of the settlement, Chandler Insurance and Chandler USA recorded additional estimated recoveries of $1,204,000 and $359,000, respectively, during the third quarter of 2004. Chandler Insurance and Chandler USA received payment of $3,527,000 and $1,053,000, respectively, during December 2004 and expect to receive payment of the remaining settlement funds of $497,000 and $192,000 during the first quarter of 2005. Transamerica Occidental Life Insurance Company ("Transamerica") reinsured NAICO for certain workers compensation risks during 1989, 1990 and 1991. Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed under the reinsurance treaties. On March 15, 2004, an arbitration panel ordered Transamerica to pay the losses and loss adjustment expenses owed to NAICO in the amount of $1,607,704 plus interest at 6%, or approximately $577,000, plus $25,000 in costs. NAICO has received payment for these amounts. Chandler USA and its subsidiaries are not parties to any other material litigation other than as is routinely encountered in their respective business activities. While the outcome of these matters cannot be predicted with certainty, Chandler USA does not expect these matters to have a material adverse effect on its financial condition, results of operations or cash flows. NOTE 12. COMMITMENTS AND CONTINGENCIES REINSURANCE In the ordinary course of business, NAICO cedes insurance to other insurers and reinsurers under various reinsurance treaties that cover individual risks (facultative reinsurance) or entire classes of business (treaty reinsurance). Reinsurance provides greater diversification of business written and also reduces NAICO's exposure arising from high limits of liability or from hazards of an unusual nature. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In formulating its reinsurance programs, NAICO considers numerous factors, including the financial stability of the reinsurer, ability to provide sufficient collateral (if required), reinsurance coverage offered and price. NAICO has structured separate reinsurance programs for property (including inland marine), workers compensation, casualty (including automobile liability, general and products liability, umbrella liability and related professional liability), automobile physical damage and construction surety bonds. Chandler Insurance reinsures NAICO for a portion of the risk on NAICO's reinsurance programs. PAGE F-20 In addition, NAICO purchases catastrophe protection to limit its retention for single loss occurrences involving multiple policies and/or policyholders, such as floods, winds and severe storms. NAICO also purchases facultative reinsurance when it writes a risk with limits of liability exceeding the maximum limits of its treaties or when it otherwise considers such action appropriate. Treaty reinsurance may be ceded under treaties on both a pro rata or proportional basis (where the reinsurer shares proportionately in premiums and losses) and an excess of loss basis (where only losses above a specific amount are reinsured). The availability, costs and limits of reinsurance purchased can vary from year to year based upon prevailing market conditions, reinsurers' underwriting results and NAICO's desired risk retention levels. A majority of NAICO's reinsurance programs renew on January 1 or July 1 of each year. NAICO renewed all January 1, 2005 reinsurance programs. At the present time, NAICO expects to renew the reinsurance programs that renew on July 1, 2005. NAICO periodically reviews certain prospective single year reinsurance treaties, subject to commutation provisions therein, to determine if it is advantageous to assume the estimated loss exposure on expired insurance policies covered by such treaties in exchange for return premiums. Commutation of such reinsurance treaties will be determined in future periods based on timely review of all available data. NAICO reviews the historical results for reinsurance contracts with similar commutation provisions and accrues for such commutations where a commutation election is considered probable. Reliance Insurance Company ("Reliance") reinsured NAICO for certain workers compensation risks during 1998. At December 31, 2004, NAICO had reinsurance recoverables from Reliance for paid and unpaid losses of approximately $3.3 million. During October 2004, the Commonwealth of Pennsylvania placed Reliance in liquidation. NAICO is unable to determine the amount of its reinsurance recoverables from Reliance that will ultimately be collected and has fully reserved the carrying value of such amounts as of December 31, 2003 and 2004. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to Chandler USA; consequently, adjustments to ceded losses and loss adjustment expenses are made for amounts deemed uncollectible. During 2002, 2003 and 2004, NAICO incurred charges of $1.7 million, $604,000 and $282,000, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible. The effect of reinsurance on premiums written and earned was as follows:
2002 2003 2004 ----------------------- ----------------------- ----------------------- WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED ----------- ---------- ----------- ---------- ----------- ---------- (In thousands) Direct ............. $ 139,876 $ 146,307 $ 118,247 $ 126,067 $ 121,146 $ 117,383 Assumed ............ 286 256 197 212 505 484 Ceded .............. (72,495) (79,606) (66,604) (69,696) (51,187) (53,825) ----------- ---------- ----------- ---------- ----------- ---------- Net premiums ....... $ 67,667 $ 66,957 $ 51,840 $ 56,583 $ 70,464 $ 64,042 =========== ========== =========== ========== =========== ==========
Losses and loss adjustment expenses are reported net of the effect of reinsurance recoveries and recoverables in the consolidated statements of operations. Ceded losses and loss adjustment expenses were $87.7 million, $83.9 million and $52.1 million for 2002, 2003 and 2004, respectively. SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK NAICO conducts its business through individual independent insurance agencies and underwriting managers. Certain of these underwriting managers have provided collateral to NAICO to secure a portion of the premiums receivable. Substantially all of the principal shareholders of the independent agencies and underwriting managers have provided personal guarantees for payment of premiums to NAICO. NAICO also requires certain policyholders to pay a deposit at the time of inception of coverage to secure payment of future premiums or other policy related obligations. Receivables under installment plans do not exceed the corresponding liability for unearned premiums. Total consolidated premiums receivable at December 31, 2003 and 2004 were $20.3 million and $22.8 million, respectively. Receivables for deductibles, in most cases, are secured by cash deposits and letters of credit. At December 31, 2004, NAICO maintained custody of such letters of credit securing these and other transactions totaling approximately $21.7 million, which is a reasonable estimate of their fair value. These letters of credit are not reflected in the accompanying consolidated financial statements. There were no unaffiliated independent insurance agents that produced 10% or more of NAICO's direct written and assumed premiums during 2002 or 2003. During 2004, one unaffiliated independent insurance agent produced approximately 13% of NAICO's direct written and assumed premiums. NAICO's bail bond underwriting manager was responsible for gross written premiums of $2.3 million, $1.2 million and $130,000 during 2002, 2003 and 2004, respectively. PAGE F-21 Approximately $29.1 million, or 33% of NAICO's reinsurance recoverables and prepaid reinsurance premiums at December 31, 2004 are collateralized by premiums payable to the reinsurers, securities pledged in trust or letters of credit for the benefit of NAICO. Chandler USA believes the above value of such collateral is a reasonable estimate of their fair value. NAICO's reinsurance contracts include provisions for offsets against premiums owed to the reinsurers. The following table sets forth certain information related to NAICO's five largest reinsurers determined on the basis of net reinsurance recoverables as of December 31, 2004.
CEDED REINSURANCE NET PREMIUMS FOR A.M. BEST REINSURANCE THE YEAR ENDED COMPANY NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2004 RATING - --------------------------------------------------------- --------------- ------------------- --------- (Dollars in thousands) Chandler Insurance ...................................... $ 25,555 $ 30,055 -(2) Employers Reinsurance Corporation ....................... 23,955 9,731 A Swiss Reinsurance America Corporation ................... 22,640 52 A+ Odyssey America Reinsurance Corporation ................. 3,958 5,489 A GE Reinsurance Corporation .............................. 3,605 (27) A --------------- ------------------- Top five reinsurers .................................. $ 79,713 $ 45,300 =============== =================== All reinsurers ....................................... $ 87,945 $ 51,187 =============== =================== Percentage of total represented by top five reinsurers .. 91% 88% - --------------------------------------------------------- (1) Includes losses and loss adjustment expenses paid and outstanding, unpaid losses and loss adjustment expenses and prepaid reinsurance premiums recoverable from reinsurers as of December 31, 2004. (2) Chandler Insurance owns 100% of the common stock of Chandler USA, which in turn owns 100% of the common stock of NAICO. Although Chandler Insurance is not subject to the minimum capital, audit, reporting and other requirements imposed by regulation upon United States reinsurance companies, as a foreign reinsurer, it is required to secure its reinsurance obligations by depositing acceptable securities in trust for NAICO's benefit. At December 31, 2004, Chandler Insurance had cash and investments with a fair value of $28.6 million deposited in a trust account for the benefit of NAICO.
OTHER See Note 11 regarding contingencies relating to litigation matters. Chandler USA has an employment agreement with W. Brent LaGere, Chairman of the Board and Chief Executive Officer of Chandler USA and its subsidiaries. Under this agreement, Mr. LaGere's base compensation is established at not less than $250,000 per year. In the event that Mr. LaGere is terminated without cause, as defined in the agreement, he is entitled to receive his base compensation for the remainder of the term of the agreement, but in no event for more than 60 months. The agreement will terminate upon Mr. LaGere attaining age 70, unless earlier terminated by Chandler USA for cause. In addition to his base compensation, Mr. LaGere is eligible to receive certain benefits and bonuses from Chandler USA and its subsidiaries. In addition, certain executives are eligible to receive bonuses based upon various factors. NAICO is subject to a variety of assessments related to insurance activities, including those by state guaranty funds and workers compensation second-injury funds. The amounts and timing of such assessments are beyond the control of NAICO. NAICO provides for these charges on a current basis by applying historical factors to premiums earned. Actual results may vary from these values and adjustments therefrom are necessary to maintain an adequate reserve for these assessments. The reserve for unpaid assessments was approximately $853,000 and $1,037,000 at December 31, 2003 and 2004, respectively. In certain cases, NAICO is permitted to recover a portion of its assessments generally as a reduction to premium taxes paid to certain states. NAICO has recorded receivables in the amount that it expects to recover of approximately $2,451,000 and $2,812,000 at December 31, 2003 and 2004, respectively. NAICO may receive additional guaranty fund assessments in the future related to insolvent insurance companies. At this time, NAICO is unable to estimate the amount of such assessments. PAGE F-22 At December 31, 2004, Chandler USA's subsidiaries were committed under noncancellable operating leases for certain equipment and office space. Rental payments under these leases for continuing operations were $1,086,000, $919,000 and $825,000 in 2002, 2003 and 2004, respectively. Future minimum lease payments are as follows:
(In thousands) 2005 .......................... $ 688 2006 .......................... 500 2007 .......................... 82 2008 .......................... 11 -------------- $ 1,281 ==============
During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for three years. The sale and leaseback transaction resulted in a deferred gain of $2.0 million which was amortized into income over the final year of the lease, resulting in other income of $1.7 million in 2003 and $368,000 in 2004. During March 2004, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest on the unpaid lease balance at a floating interest rate of 1% over JP Morgan Chase Bank prime, which was 5.25% at December 31, 2004. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $2.4 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.9 million. Chandler USA has guaranteed the obligations of Trust I and Trust II. It guarantees payment of distributions and the redemption price of the trust preferred securities until the securities are redeemed in full. The total redemption price of the trust preferred securities is $20.0 million. NOTE 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for a three year term. During March 2004, the lease was extended for an additional three years. See Note 12 to Consolidated Financial Statements for additional information. The bank that participated in the sale and leaseback transaction has also established a letter of credit in the amount of $500,000 on behalf of Chandler USA for the benefit of Brown & Brown, Inc. as security in connection with the sale of L&W. Chandler USA paid a fee of $5,000 during 2004 to the bank for issuing the letter of credit. See Note 4 to Consolidated Financial Statements for additional information. A director of NAICO and Chandler USA is an officer and director of the bank that participated in these transactions, and is also a significant shareholder of the bank's holding company. This director is also a director of the bank that Chandler USA and its subsidiaries use as their principal disbursement bank, and is a significant shareholder of the bank's holding company. The balance maintained by Chandler USA and each subsidiary is fully insured by the Federal Deposit Insurance Corporation, and Chandler USA and its subsidiaries pay customary service charges to the bank for the services provided. Chandler USA leases and has made certain improvements to a rural property in which certain directors and officers of Chandler USA own interests. Under the lease, no cash rental is paid. Chandler USA drilled a water well on the property and maintains certain structures it regularly uses. This property provides recreational activities for the entertainment of customers and business associates of Chandler USA's subsidiaries. Chandler USA incurred approximately $255,000, $336,000 and $353,000 in expenses associated with this property during 2002, 2003 and 2004, respectively, including $18,000, $12,000 and $14,000 for reimbursement of certain expenses, such as utility and similar expenses, for the years 2002, 2003 and 2004, respectively. Chandler USA and Chandler Insurance are parties to an Intercompany Credit Agreement (the "Credit Agreement") covering intercompany loans between the parties. The Credit Agreement requires interest to be paid at the prime interest rate published in The Wall Street Journal each month, and balances owed by either party are payable at any time upon demand. At December 31, 2003 and 2004, Chandler USA had a receivable of $9.6 million and $10.9 million, respectively, under the Credit Agreement, and Chandler USA earned $380,000, $412,000 and $439,000 in interest income under the Credit Agreement during 2002, 2003 and 2004, respectively. Chandler USA believes that all transactions with directors, officers or shareholders of Chandler USA and its subsidiaries are and will continue to be on terms no less favorable to Chandler USA and its subsidiaries than could be obtained from unaffiliated parties. PAGE F-23 NOTE 14. SEGMENT INFORMATION Chandler USA has one reportable operating segment for property and casualty insurance. In December 2002, Chandler USA sold L&W, which had previously been reported as Chandler USA's agency segment. The agency segment and certain items related to L&W have been restated and reported as discontinued operations for all periods presented. The insurance products reported in the property and casualty segment are underwritten by NAICO and are marketed through independent insurance agencies. NAICO underwrites various lines of property and casualty insurance, including surety bonds and workers compensation insurance. NAICO's main areas of concentration include the construction, manufacturing, oil and gas, trucking, wholesale, service and retail industries along with political subdivisions. The property and casualty segment operates primarily in Oklahoma and Texas, and other surrounding states. Oklahoma accounted for approximately 53%, 51% and 51% of gross written premiums in 2002, 2003 and 2004, respectively, while Texas accounted for approximately 37%, 36% and 37% of gross written premiums during the same years. Management evaluates the property and casualty segment's performance on the basis of growth in gross written premiums and income before income taxes. Chandler USA accounts for intercompany sales and transactions as if they were to third parties and attempts to set fees consistent with those that would apply in arm's length transactions with a non-affiliate. There can be no assurance the rates charged reflect those that would have been agreed upon following an arm's length negotiation. Net premiums earned and losses and loss adjustment expenses within the property and casualty segment can be identified to Chandler USA designated insurance programs. Chandler USA's chief operating decision makers review net premiums earned and losses and loss adjustment expenses in assessing the performance of an insurance program. In addition, Chandler USA's chief operating decision makers consider many other factors such as the lines of business offered within an insurance program and the states in which the insurance programs are offered. Certain discrete financial information is not readily available by insurance program, including assets, interest income, and investment gains or losses. Chandler USA does not consider its insurance programs to be reportable segments, however, the following supplemental information pertaining to each insurance program's net premiums earned and losses and loss adjustment expenses is presented for the property and casualty segment.
YEAR ENDED DECEMBER 31, -------------------------------- INSURANCE PROGRAM 2002 2003 2004 - ---------------------------------------------------- ---------- ---------- ---------- (In thousands) NET PREMIUMS EARNED Standard property and casualty ..................... $ 49,570 $ 45,521 $ 54,278 Political subdivisions ............................. 13,829 8,093 7,269 Surety bonds ....................................... 3,310 2,724 1,993 Other (1) .......................................... 248 245 502 ---------- ---------- ---------- $ 66,957 $ 56,583 $ 64,042 ========== ========== ========== LOSSES AND LOSS ADJUSTMENT EXPENSES Standard property and casualty ..................... $ 40,194 $ 29,650 $ 42,901 Political subdivisions ............................. 7,726 5,722 7,122 Surety bonds ....................................... 1,967 911 2,677 Other (1) .......................................... 825 917 1,081 ---------- ---------- ---------- $ 50,712 $ 37,200 $ 53,781 ========== ========== ========== - -------------------------------------- (1) This category is comprised primarily of the run-off of discontinued programs and NAICO's participation in various mandatory workers compensation pools.
PAGE F-24 NOTE 15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) A summary of the unaudited quarterly operating results during 2003 and 2004 follows:
First Second Third Fourth Total quarter quarter quarter quarter year --------- --------- --------- --------- --------- 2003 - -------------------------------------------- Net premiums earned ........................ $ 14,537 $ 14,421 $ 14,145 $ 13,480 $ 56,583 Investment income, net ..................... 596 662 625 677 2,560 Realized investment gains, net ............. 151 1,787 413 - 2,351 Income (loss) before income taxes .......... (311) 3,389 470 (1,382) 2,166 Net income (loss) .......................... (223) 2,791 398 (992) 1,974 2004 - -------------------------------------------- Net premiums earned ........................ $ 13,872 $ 16,732 $ 17,074 $ 16,364 $ 64,042 Investment income, net ..................... 1,238 749 853 837 3,677 Realized investment gains, net ............. 463 - 3 186 652 Loss before income taxes ................... (996) (4,921) (1,653) (3,016) (10,586) Net loss ................................... (580) (3,297) (1,178) (1,949) (7,004)
During the second quarter of 2003, realized investment gains included a gain of $1.7 million from the sale of 19,371 shares of common stock of Insurance Services Office, Inc. ("ISO"). NAICO received these shares in 1997 as a result of ISO converting to a for-profit corporation. Chandler USA recorded other income of $2.2 million and $879,000 in the second quarter and fourth quarter of 2003, respectively, related to the purchase and cancellation of Debentures. * * * * * * * PAGE F-25 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholder of Chandler (U.S.A.), Inc.: We have audited the accompanying consolidated balance sheets of Chandler (U.S.A.), Inc. and subsidiaries ("Chandler USA") as of December 31, 2003 and 2004, and the related consolidated statements of operations, comprehensive income, cash flows and shareholder's equity for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of Chandler USA's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Chandler USA at December 31, 2003 and 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ Tullius Taylor Sartain & Sartain LLP TULLIUS TAYLOR SARTAIN & SARTAIN LLP Tulsa, Oklahoma February 11, 2005 PAGE F-26 SCHEDULE I CHANDLER (U.S.A.), INC. AND SUBSIDIARIES SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES AS OF DECEMBER 31, 2004 (In thousands)
AMOUNT AT WHICH SHOWN IN THE TYPE OF INVESTMENT COST FAIR VALUE BALANCE SHEET - ------------------------------------------------- ------------ ------------ --------------- FIXED MATURITIES AVAILABLE FOR SALE: U.S. Treasury securities and obligations of U.S. government corporations and agencies .......... $ 31,884 $ 31,824 $ 31,824 Corporate obligations ........................... 29,756 29,515 29,515 Public utilities ................................ 7,603 7,586 7,586 Mortgage-backed securities ...................... 2,814 2,745 2,745 ------------ ------------ --------------- 72,057 71,670 71,670 EQUITY SECURITIES AVAILABLE FOR SALE: Corporate stock ................................. 8,058 8,373 8,373 ------------ ------------ --------------- Total investments ............................. $ 80,115 $ 80,043 $ 80,043 ============ ============ ===============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-27 SCHEDULE II CHANDLER (U.S.A.), INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER (U.S.A.), INC. (PARENT COMPANY ONLY) BALANCE SHEETS (In thousands except share amounts)
DECEMBER 31, --------------------- 2003 2004 ---------- ---------- ASSETS Cash ............................................................ $ 495 $ 64 Premiums receivable ............................................. 9 7 Amounts due from subsidiaries ................................... 1,437 1,276 Property and equipment, net ..................................... 1,057 981 Amounts due from related parties ................................ 9,642 10,891 Other assets .................................................... 3,610 4,479 Investment in subsidiaries, net ................................. 57,536 48,381 ---------- ---------- Total assets .................................................... $ 73,786 $ 66,079 ========== ========== LIABILITIES AND SHAREHOLDER'S EQUITY Liabilities Accrued taxes and other payables .............................. $ 2,073 $ 2,288 Debentures .................................................... 7,254 6,979 Junior subordinated debentures issued to affiliated trusts .... 20,620 20,620 ---------- ---------- Total liabilities ............................................... 29,947 29,887 ---------- ---------- Shareholder's equity Common stock, $1.00 par value, 50,000 shares authorized; 2,484 shares issued and outstanding ......................... 2 2 Paid-in surplus ............................................... 60,584 60,584 Accumulated deficit ........................................... (17,342) (24,346) Accumulated other comprehensive income (loss): Unrealized gain (loss) on investments held by subsidiary and available for sale, net of deferred income taxes ........ 595 (48) ---------- ---------- Total shareholder's equity ...................................... 43,839 36,192 ---------- ---------- Total liabilities and shareholder's equity ...................... $ 73,786 $ 66,079 ========== ==========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-28 SCHEDULE II CHANDLER (U.S.A.), INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER (U.S.A.), INC. (PARENT COMPANY ONLY) STATEMENTS OF OPERATIONS (In thousands)
YEAR ENDED DECEMBER 31, -------------------------------- 2002 2003 2004 ---------- ---------- ---------- Revenues Investment income, net ........................................... $ 7 $ 34 $ 2 Interest income, net from related parties ........................ 380 436 491 Other income ..................................................... 765 5,600 1,370 ---------- ---------- ---------- Total revenues ................................................... 1,152 6,070 1,863 ---------- ---------- ---------- Operating costs and expenses General and administrative expenses .............................. 3,529 3,175 2,505 Interest expense ................................................. 2,213 2,447 2,385 ---------- ---------- ---------- Total operating costs and expenses ............................. 5,742 5,622 4,890 ---------- ---------- ---------- Income (loss) from continuing operations before income tax benefit .. (4,590) 448 (3,027) Federal income tax benefit .......................................... 1,729 509 1,137 ---------- ---------- ---------- Net income (loss) from continuing operations before equity in net income (loss) of subsidiaries .............................. (2,861) 957 (1,890) Equity in net income (loss) of subsidiaries ......................... 133 1,017 (5,114) ---------- ---------- ---------- Net income (loss) from continuing operations ........................ (2,728) 1,974 (7,004) Loss from discontinued operations ................................... (34) - - Gain on sale of subsidiary .......................................... 671 - - ---------- ---------- ---------- Net income (loss) ................................................... $ (2,091) $ 1,974 $ (7,004) ========== ========== ==========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-29 SCHEDULE II CHANDLER (U.S.A.), INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER (U.S.A.), INC. (PARENT COMPANY ONLY) STATEMENTS OF CASH FLOWS (In thousands)
YEAR ENDED DECEMBER 31, -------------------------------- 2002 2003 2004 ---------- ---------- ---------- Operating activities Net income (loss) .............................................. $ (2,091) $ 1,974 $ (7,004) Add (deduct): Adjustments to reconcile net income (loss) to cash applied to operating activities: Net (income) loss of subsidiaries not distributed to parent .. (133) (1,017) 5,114 Net gains on sale of property and equipment .................. (12) (1,661) (371) Gain on sale of subsidiary ................................... (671) - - Gain on retirement of debentures ............................. - (3,106) (36) Amortization and depreciation ................................ 222 221 205 Net change in non-cash balances relating to operating activities: Premiums receivable ........................................ 2,778 970 2 Amounts due from subsidiaries .............................. 314 325 161 Other assets ............................................... 1,428 1,020 (922) Accrued taxes and other payables ........................... (692) (334) 581 Premiums payable ........................................... (3,200) (2,328) - ---------- ---------- ---------- Cash applied to operating activities ......................... (2,057) (3,936) (2,270) ---------- ---------- ---------- Investing activities Cost of property and equipment purchased ....................... (103) (471) (154) Proceeds from sale of property and equipment ................... 57 100 86 Proceeds from sale of subsidiary ............................... 3,247 - - Investment in subsidiary ....................................... (2) (5,620) - ---------- ---------- ---------- Cash provided by (applied to) investing activities ........... 3,199 (5,991) (68) ---------- ---------- ---------- Financing activities Shareholder dividend from subsidiaries ......................... 3,915 - 3,400 Proceeds from issuance of debentures ........................... - 20,620 - Payment on retirement of debentures ............................ - (12,782) (226) Debt issue costs ............................................... - (711) (18) Payments and loans from related parties ........................ 3,249 2,426 4,602 Payments and loans to related parties .......................... (5,951) (1,486) (5,851) ---------- ---------- ---------- Cash provided by financing activities ........................ 1,213 8,067 1,907 ---------- ---------- ---------- Increase (decrease) in cash and cash equivalents ................. 2,355 (1,860) (431) Cash and cash equivalents at beginning of year ................... - 2,355 495 ---------- ---------- ---------- Cash and cash equivalents at end of year ......................... $ 2,355 $ 495 $ 64 ========== ========== ==========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-30 SCHEDULE III CHANDLER (U.S.A.), INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands)
FUTURE POLICY AMORTI- BENEFITS, OTHER CLAIMS, ZATION OF NET DEFERRED LOSSES, POLICY LOSSES DEFERRED PREMIUMS POLICY CLAIMS CLAIMS AND NET AND POLICY OTHER WRITTEN ACQUISITION AND LOSS UNEARNED BENEFITS PREMIUM INTEREST SETTLEMENT ACQUISITION OPERATING AND COSTS EXPENSES PREMIUMS PAYABLE REVENUE INCOME EXPENSES COSTS EXPENSES ASSUMED ----------- --------- -------- ---------- --------- --------- ---------- ----------- --------- -------- YEAR ENDED DECEMBER 31, 2002 Property and casualty .. $ 355 $ 92,606 $ 55,160 $ 4,244 $ 66,957 $ 2,920 $ 50,712 $ 10,239 $ 14,707 $ 67,667 =========== ========= ======== ========== ========= ========= ========== =========== ========= ======== DECEMBER 31, 2003 Property and casualty .. $ 165 $ 87,768 $ 47,325 $ 4,807 $ 56,583 $ 2,560 $ 37,200 $ 11,278 $ 15,927 $ 51,840 =========== ========= ======== ========== ========= ========= ========== =========== ========= ======== DECEMBER 31, 2004 Property and casualty .. $ 57 $ 108,233 $ 51,109 $ 4,912 $ 64,042 $ 3,677 $ 53,781 $ 11,039 $ 14,777 $ 70,464 =========== ========= ======== ========== ========= ========= ========== =========== ========= ========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-31 SCHEDULE IV CHANDLER (U.S.A.), INC. AND SUBSIDIARIES REINSURANCE (Dollars in thousands)
ASSUMED PERCENTAGE CEDED TO FROM OF AMOUNT GROSS OTHER OTHER NET ASSUMED AMOUNT COMPANIES COMPANIES AMOUNT TO NET ------------ ------------ ------------ ------------ ------------ Year ended December 31, 2002 Property and casualty ........... $ 139,876 $ (72,495) $ 286 $ 67,667 0.42% ============ ============ ============ ============ ============ Year ended December 31, 2003 Property and casualty ........... $ 118,247 $ (66,604) $ 197 $ 51,840 0.38% ============ ============ ============ ============ ============ Year ended December 31, 2004 Property and casualty ........... $ 121,146 $ (51,187) $ 505 $ 70,464 0.72% ============ ============ ============ ============ ============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-32 SCHEDULE V CHANDLER (U.S.A.), INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (In thousands)
BALANCE AT PROVISION BALANCE BEGINNING FOR AT END OF PERIOD NON-COLLECTION WRITE-OFFS OF PERIOD ---------------- ---------------- ---------------- --------------- Allowance for non-collection of premiums receivable: 2002 ............................................ $ 298 $ 444 $ (496) $ 246 ================ ================ ================ =============== 2003 ............................................ $ 246 $ 272 $ (385) $ 133 ================ ================ ================ =============== 2004 ............................................ $ 133 $ 42 $ (56) $ 119 ================ ================ ================ =============== Allowance for non-collection of reinsurance recoverables on paid and unpaid losses: 2002 ............................................ $ 1,096 $ 1,726 $ (55) $ 2,767 ================ ================ ================ =============== 2003 ............................................ $ 2,767 $ 604 $ (57) $ 3,314 ================ ================ ================ =============== 2004 ............................................ $ 3,314 $ 282 $ (324) $ 3,272 ================ ================ ================ ===============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-33 SCHEDULE VI CHANDLER (U.S.A.), INC. AND SUBSIDIARIES SUPPLEMENTAL INFORMATION (FOR PROPERTY-CASUALTY INSURANCE UNDERWRITERS) (In thousands)
DISCOUNT PAID LOSSES AND DEDUCTED LOSS ADJUSTMENT FROM RESERVES EXPENSES --------------- --------------- Year ended December 31, 2002 Property-casualty .......................... $ - $ 50,333 =============== =============== Year ended December 31, 2003 Property-casualty .......................... $ - $ 41,048 =============== =============== Year ended December 31, 2004 Property-casualty .......................... $ - $ 38,429 =============== ===============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-34 INDEX TO EXHIBITS ----------------- Exhibit No. - ----------- 21.1 Subsidiaries of the registrant. 31.1 Rule 13a-14(a)/15d-14(a) Certifications. 32.1 Section 1350 Certifications. EX-21.1 2 exhibit211edgar.txt EXHIBIT 21.1 EXHIBIT 21.1 CHANDLER (U.S.A.), INC. AND SUBSIDIARIES SUBSIDIARIES OF THE REGISTRANT 1. National American Insurance Company, an Oklahoma corporation that is a wholly owned subsidiary of Chandler USA. 2. Chandler Insurance Managers, Inc., an Oklahoma corporation that is a wholly owned subsidiary of Chandler USA. 3. Network Administrators, Inc., a Texas corporation that is a wholly owned subsidiary of Chandler USA. 4. Chandler Capital Trust I, a Delaware corporation that is a wholly owned subsidiary of Chandler USA. 5. Chandler Capital Trust II, a Delaware corporation that is a wholly owned subsidiary of Chandler USA. EX-31.1 3 exhibit311edgar.txt EXHIBIT 31.1 EXHIBIT 31.1 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 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 report; 3. Based on my knowledge, the financial statements, and other financial information included in this 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 report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, 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 and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 1, 2005 /s/ W. Brent LaGere --------------------------------------- W. Brent LaGere Chairman of the Board and Chief Executive Officer EXHIBIT 31.1 (CONTINUED) CERTIFICATIONS 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 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 report; 3. Based on my knowledge, the financial statements, and other financial information included in this 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 report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, 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 and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 1, 2005 /s/ Mark C. Hart --------------------------------------- Mark C. Hart Vice President - Finance, Chief Financial Officer and Treasurer EX-32.1 4 exhibit32edgar.txt EXHIBIT 32.1 EXHIBIT 32.1 SECTION 1350 CERTIFICATIONS In connection with the Annual Report of Chandler (U.S.A.), Inc. (the "Company") on Form 10-K for the period ending December 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (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 1, 2005 /s/ Mark C. Hart --------------------------------------- Mark C. Hart Chief Financial Officer March 1, 2005 A signed original of this written statement required by Section 906 has been provided to Chandler (U.S.A.), Inc. and will be retained by Chandler (U.S.A.), Inc. and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----