10-Q 1 usa6302007fnl.txt CHANDLER (U.S.A.), INC. 6/30/2007 10-Q =============================================================================== UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------------------------------- FORM 10-Q X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE --- SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2007 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE --- SECURITIES EXCHANGE ACT OF 1934 For the Transition Period from to --------- --------- 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 Identification No.) incorporation or organization) 1010 MANVEL AVENUE, CHANDLER, OKLAHOMA 74834 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (405) 258-0804 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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large accelerated filer Accelerated filer Non-accelerated filer X --- --- --- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES NO X --- --- The number of common shares, $1.00 par value, of the registrant outstanding on July 31, 2007 was 2,484, which are owned by Chandler Insurance Company, Ltd. =============================================================================== Page i CHANDLER (U.S.A.), INC. INDEX ----- PART I - FINANCIAL INFORMATION ------------------------------ ITEM 1. FINANCIAL STATEMENTS: -------------------------------- Consolidated Balance Sheets as of June 30, 2007 and December 31, 2006 ..1 Consolidated Statements of Operations for the three months ended June 30, 2007 and 2006 ........................................2 Consolidated Statements of Operations for the six months ended June 30, 2007 and 2006 ........................................3 Consolidated Statements of Comprehensive Income for the three months ended June 30, 2007 and 2006 .................................4 Consolidated Statements of Comprehensive Income for the six months ended June 30, 2007 and 2006 .................................5 Consolidated Statements of Cash Flows for the six months ended June 30, 2007 and 2006 ........................................6 Notes to Interim Consolidated Financial Statements ....................7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND -------------------------------------------------------------------------- RESULTS OF OPERATIONS ..........................................11 --------------------- ITEM 4. CONTROLS AND PROCEDURES ........................................17 ---------------------------------- ITEM 4T. CONTROLS AND PROCEDURES ........................................17 -------------------------------- PART II - OTHER INFORMATION --------------------------- Item 1. Legal Proceedings ............................................18 Item 1A. Risk Factors .................................................18 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ..18 Item 3. Defaults Upon Senior Securities ..............................18 Item 4. Submission of Matters to a Vote of Security Holders ..........18 Item 5. Other Information ............................................18 Item 6. Exhibits .....................................................18 Signatures ...............................................................19 PAGE 1 CHANDLER (U.S.A.), INC. CONSOLIDATED BALANCE SHEETS (Amounts in thousands except share amounts)
June 30, December 31, 2007 2006 ------------- -------------- (Unaudited) ASSETS Investments Fixed maturities available for sale, at fair value Restricted (amortized cost $34,195 and $19,830 in 2007 and 2006, respectively) ..... $ 33,090 $ 19,151 Unrestricted (amortized cost $40,343 and $48,557 in 2007 and 2006, respectively) ... 39,289 47,228 Equity securities at fair value (cost $0 and $1,587 in 2007 and 2006, respectively).. 132 1,921 ------------- -------------- Total investments .................................................................. 72,511 68,300 Cash and cash equivalents ($141 and $450 restricted in 2007 and 2006, respectively) .. 18,246 21,403 Accrued investment income ............................................................ 5,454 5,022 Premiums receivable, less allowance for non-collection of $172 and $170 at 2007 and 2006, respectively ......................................................... 30,467 31,008 Reinsurance recoverable on paid losses ............................................... 1,487 1,087 Reinsurance recoverable on unpaid losses, less allowance for non-collection of $112 and $130 at 2007 and 2006, respectively ...................... 25,406 25,588 Reinsurance recoverable on unpaid losses from related parties ........................ 16,755 15,584 Prepaid reinsurance premiums ......................................................... 3,586 7,603 Prepaid reinsurance premiums to related parties ...................................... 14,248 13,506 Deferred policy acquisition costs .................................................... 1,634 845 Property and equipment, net .......................................................... 8,323 8,457 Amounts due from related parties ..................................................... 11,944 9,584 State insurance licenses, net ........................................................ 3,745 3,745 Other assets ......................................................................... 10,525 11,040 ------------- -------------- Total assets ......................................................................... $ 224,331 $ 222,772 ============= ============== LIABILITIES AND SHAREHOLDER'S EQUITY Liabilities Unpaid losses and loss adjustment expenses .......................................... $ 85,335 $ 83,253 Unearned premiums ................................................................... 51,273 53,217 Policyholder deposits ............................................................... 7,317 7,663 Accrued taxes and other payables .................................................... 6,511 5,119 Premiums payable .................................................................... 1,508 1,955 Premiums payable to related parties ................................................. 475 1,002 Senior debentures ................................................................... 6,979 6,979 Junior subordinated debentures issued to affiliated trusts .......................... 20,620 20,620 ------------- -------------- Total liabilities .................................................................. 180,018 179,808 ------------- -------------- 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 ................................................................. (14,935) (16,517) Accumulated other comprehensive income (loss): Unrealized loss on investments available for sale, net of deferred income taxes ..... (1,338) (1,105) ------------- -------------- Total shareholder's equity ......................................................... 44,313 42,964 ------------- -------------- Total liabilities and shareholder's equity ........................................... $ 224,331 $ 222,772 ============= ==============
See accompanying Notes to Interim Consolidated Financial Statements. PAGE 2 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (Amounts in thousands)
Three months ended June 30, ----------------------------- 2007 2006 ------------ ------------ Premiums and other revenues Direct premiums written and assumed .......................... $ 24,120 $ 25,199 Reinsurance premiums ceded ................................... (2,811) (3,477) Reinsurance premiums ceded to related parties ................ (6,562) (6,520) ------------ ------------ Net premiums written and assumed ........................... 14,747 15,202 Decrease in unearned premiums ................................ 1,123 1,786 ------------ ------------ Net premiums earned ........................................ 15,870 16,988 Investment income, net ......................................... 860 779 Interest income, net from related parties ...................... 248 191 Realized investment gains, net ................................. 26 133 Other income ................................................... 168 95 ------------ ------------ Total premiums and other revenues .......................... 17,172 18,186 ------------ ------------ Operating costs and expenses Losses and loss adjustment expenses, net of amounts ceded to related parties of $3,784 and $2,794 in 2007 and 2006, respectively ................................ 9,366 12,053 Policy acquisition costs, net of ceding commissions received from related parties of $2,495 and $2,483 in 2007 and 2006, respectively ................................ 3,032 2,753 General and administrative expenses .......................... 3,034 3,317 Interest expense ............................................. 678 667 ------------ ------------ Total operating costs and expenses ......................... 16,110 18,790 ------------ ------------ Income (loss) before income taxes .............................. 1,062 (604) Federal income tax benefit (provision) ......................... (394) 211 ------------ ------------ Net income (loss) ............................................ $ 668 $ (393) ============ ============
See accompanying Notes to Interim Consolidated Financial Statements. PAGE 3 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (Amounts in thousands)
Six months ended June 30, -------------------------------- 2007 2006 ------------- ------------ Premiums and other revenues Direct premiums written and assumed ....................... $ 51,453 $ 54,734 Reinsurance premiums ceded ................................ (2,313) (9,848) Reinsurance premiums ceded to related parties ............. (14,919) (12,771) ------------- ------------ Net premiums written and assumed ........................ 34,221 32,115 Decrease (increase) in unearned premiums .................. (1,331) 1,738 ------------- ------------ Net premiums earned ..................................... 32,890 33,853 Investment income, net ...................................... 2,020 1,496 Interest income, net from related parties ................... 460 369 Realized investment gains, net .............................. 61 189 Other income ................................................ 995 142 ------------- ------------ Total premiums and other revenues ......................... 36,426 36,049 ------------- ------------ Operating costs and expenses Losses and loss adjustment expenses, net of amounts ceded to related parties of $8,026 and $6,393 in 2007 and 2006, respectively ............................. 20,033 22,168 Policy acquisition costs, net of ceding commissions received from related parties of $5,674 and $4,848 in 2007 and 2006, respectively ............................. 6,282 5,924 General and administrative expenses ....................... 6,249 6,308 Interest expense .......................................... 1,355 1,322 ------------- ------------ Total operating costs and expenses ...................... 33,919 35,722 ------------- ------------ Income before income taxes .................................. 2,507 327 Federal income tax provision ................................ (925) (136) ------------- ------------ Net income ................................................ $ 1,582 $ 191 ============= ============
See accompanying Notes to Interim Consolidated Financial Statements. PAGE 4 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Amounts in thousands)
Three months ended June 30, -------------------------------- 2007 2006 ------------- ------------ Net income (loss) ........................................... $ 668 $ (393) ------------- ------------ Other comprehensive loss, before income tax: Unrealized losses on securities: Unrealized holding losses arising during period ......... (484) (740) Less: Reclassification adjustment for gains included in net income (loss) ..................................... (26) (133) ------------- ------------ Other comprehensive loss, before income tax ................. (510) (873) Income tax benefit related to items of other comprehensive loss ........................................ 174 297 ------------- ------------ Other comprehensive loss, net of income tax ................. (336) (576) ------------- ------------ Comprehensive income (loss) ................................. $ 332 $ (969) ============= ============
See accompanying Notes to Interim Consolidated Financial Statements. PAGE 5 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Amounts in thousands)
Six months ended June 30, -------------------------------- 2007 2006 ------------- ------------ Net income .................................................. $ 1,582 $ 191 ------------- ------------ Other comprehensive loss, before income tax: Unrealized losses on securities: Unrealized holding losses arising during period ......... (292) (1,228) Less: Reclassification adjustment for gains included in net income ............................................ (61) (189) ------------- ------------ Other comprehensive loss, before income tax ................. (353) (1,417) Income tax benefit related to items of other comprehensive loss ........................................ 120 482 ------------- ------------ Other comprehensive loss, net of income tax ................. (233) (935) ------------- ------------ Comprehensive income (loss) ................................. $ 1,349 $ (744) ============= ============
See accompanying Notes to Interim Consolidated Financial Statements. PAGE 6 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Amounts in thousands)
Six months ended June 30, ------------------------------ 2007 2006 ------------ ------------ OPERATING ACTIVITIES Net income .................................................................. $ 1,582 $ 191 Add (deduct): Adjustments to reconcile net income to cash provided by operating activities: Realized investment gains, net .......................................... (61) (189) Net (gains) losses on sale of property and equipment .................... 5 (1) Amortization and depreciation expense ................................... 706 680 Provision for non-collection of premiums ................................ 40 46 Provision for non-collection of reinsurance recoverables ................ 24 42 Net change in non-cash balances relating to operating activities: Accrued investment income ............................................. (432) 6 Premiums receivable ................................................... 501 2,699 Reinsurance recoverable on paid losses ................................ (441) (231) Reinsurance recoverable on unpaid losses .............................. 199 6,124 Reinsurance recoverable on unpaid losses from related parties ......... (1,171) (367) Prepaid reinsurance premiums .......................................... 4,017 1,988 Prepaid reinsurance premiums to related parties ....................... (742) 133 Deferred policy acquisition costs ..................................... (789) (677) Other assets .......................................................... 611 274 Unpaid losses and loss adjustment expenses ............................ 2,082 (5,640) Unearned premiums ..................................................... (1,944) (3,860) Policyholder deposits ................................................. (346) 103 Accrued taxes and other payables ...................................... 1,558 177 Premiums payable ...................................................... (447) 619 Premiums payable to related parties ................................... (527) 523 ------------ ------------ Cash provided by operating activities ................................... 4,425 2,640 ------------ ------------ INVESTING ACTIVITIES Unrestricted fixed maturities available for sale: Purchases ............................................................... (9,617) (995) Maturities .............................................................. 3,197 2,635 Equity securities available for sale: Purchases ............................................................... (5,278) (3,178) Sales ................................................................... 6,925 7,858 Investment in limited partnership ......................................... - (502) Cost of property and equipment purchased .................................. (297) (330) Proceeds from sale of property and equipment .............................. 14 46 ------------ ------------ Cash provided by (applied to) investing activities ...................... (5,056) 5,534 ------------ ------------ FINANCING ACTIVITIES Payments and loans from related parties ................................... 263 967 Payments and loans to related parties ..................................... (2,623) (580) Bank loan proceeds ........................................................ - 500 Payments on bank loan ..................................................... (166) - ------------ ------------ Cash provided by (applied to) financing activities ...................... (2,526) 887 ------------ ------------ Increase (decrease) in cash and cash equivalents during the period .......... (3,157) 9,061 Cash and cash equivalents at beginning of period ............................ 21,403 5,510 ------------ ------------ Cash and cash equivalents at end of period .................................. $ 18,246 $ 14,571 ============ ============
See accompanying Notes to Interim Consolidated Financial Statements. PAGE 7 CHANDLER (U.S.A.), INC. NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED JUNE 30, 2007 AND 2006 (Unaudited) NOTE 1. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements of Chandler (U.S.A.), Inc. ("Chandler USA") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. They do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. However, except as disclosed herein, there have been no material changes in the information included in Chandler USA's Annual Report on Form 10-K for the year ended December 31, 2006. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for the three and six month periods ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year. Certain reclassifications of prior year amounts have been made to conform to the 2007 presentation. The consolidated financial statements include the accounts of Chandler USA and all wholly owned subsidiaries that meet consolidation requirements including National American Insurance Company ("NAICO") and Chandler Insurance Managers, Inc. ("CIMI"). NOTE 2. SEGMENT INFORMATION Chandler USA has two reportable operating segments: property and casualty insurance and agency. The segments are managed separately due to the differences in the nature of the insurance products and services sold. Following the sale of a subsidiary in 2002 that was engaged in agency operations, agency operations were not significant on a consolidated basis and therefore not reported as a separate segment. Effective January 1, 2007, NAICO transferred its existing property and inland marine business in its standard lines and political subdivisions programs to Praetorian Insurance Company ("Praetorian") through an arrangement between Praetorian and CIMI. Under this arrangement, CIMI receives commission income for the business it produces for Praetorian. Since this new arrangement is expected to result in a significant increase in agency revenues, the agency segment is now reported separately. The following table presents a summary of Chandler USA's operating segments for the three and six month periods ended June 30, 2007 and 2006:
Property and casualty Intersegment Reported insurance Agency eliminations balances ------------ ------------ ------------ ------------ (In thousands) THREE MONTHS ENDED JUNE 30, 2007 Revenues from external customers (1) ........... $ 15,925 $ 113 $ - $ 16,038 Intersegment revenues .......................... 39 1,142 (1,181) - Segment profit (loss) before income taxes (2) .. 643 419 - 1,062 THREE MONTHS ENDED JUNE 30, 2006 Revenues from external customers (1) ........... $ 17,064 $ 19 $ - $ 17,083 Intersegment revenues .......................... - 677 (677) - Segment profit (loss) before income taxes (2) .. (1,289) 685 - (604) SIX MONTHS ENDED JUNE 30, 2007 Revenues from external customers (1) ........... $ 33,019 $ 866 $ - $ 33,885 Intersegment revenues .......................... 51 2,124 (2,175) - Segment profit (loss) before income taxes (2) .. 1,130 1,377 - 2,507 Segment assets ................................. 223,132 6,709 (5,510) 224,331 SIX MONTHS ENDED JUNE 30, 2006 Revenues from external customers (1) ........... $ 33,970 $ 25 $ - $ 33,995 Intersegment revenues .......................... - 1,339 (1,339) - Segment profit (loss) before income taxes (2) .. (1,019) 1,346 - 327 Segment assets ................................. 236,203 3,895 (3,361) 236,737 ------------------------------------------------------ (1) Consists of net premiums earned and other income. (2) Includes net realized investment gains.
PAGE 8 Net premiums earned and losses and loss adjustment expenses within the property and casualty insurance segment can be identified to Chandler USA designated insurance programs. Chandler USA's chief operating decision makers review net premiums earned and losses and loss adjustment expenses in assessing the performance of an insurance program. In addition, Chandler USA's chief operating decision makers consider many other factors such as the lines of business offered within an insurance program and the states in which the insurance programs are offered. Certain discrete financial information is not readily available by insurance program, including assets, interest income, and investment gains or losses, allocated to each insurance program. Chandler USA does not consider its insurance programs to be reportable segments, however, the following supplemental information pertaining to each insurance program's net premiums earned and losses and loss adjustment expenses is presented for the property and casualty insurance segment.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- ------------------------- 2007 2006 2007 2006 ------------ ------------ ---------- ------------ (In thousands) INSURANCE PROGRAM --------------------------------------- NET PREMIUMS EARNED Standard lines ........................ $ 15,223 $ 13,467 $ 30,728 $ 26,626 Political subdivisions ................ 944 1,443 1,934 2,917 Homeowners ............................ (304) 1,822 (10) 3,891 Surety bonds .......................... 62 44 129 111 Other (1) ............................. (55) 212 109 308 ------------ ------------ ---------- ------------ $ 15,870 $ 16,988 $ 32,890 $ 33,853 ============ ============ ========== ============ LOSSES AND LOSS ADJUSTMENT EXPENSES Standard lines ........................ $ 9,187 $ 7,368 $ 18,414 $ 15,398 Political subdivisions ................ 427 880 1,290 1,489 Homeowners ............................ (124) 1,308 (22) 2,013 Surety bonds .......................... (112) 2,319 (90) 3,202 Other (1) ............................. (12) 178 441 66 ------------ ------------ ---------- ------------ $ 9,366 $ 12,053 $ 20,033 $ 22,168 ============ ============ ========== ============ ------------------------------------------------------ (1) This program is comprised primarily of the run-off of other discontinued programs and NAICO's participation in various mandatory workers compensation pools.
NOTE 3. COMMITMENTS AND CONTINGENCIES During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for three years. During March 2004, the lease was extended for three years and during March 2007, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $13,834 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime which was 9.25% at June 30, 2007. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.9 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 $1.5 million. Chandler USA has guaranteed the obligations of Chandler Capital Trust I and Chandler Capital Trust II (the "Capital Trusts"). The Capital Trusts are wholly owned non-consolidated subsidiaries of Chandler USA that have a total of $20 million of trust preferred securities outstanding. Chandler USA guarantees payment of distributions and the redemption price of the trust preferred securities until the securities are redeemed in full. PAGE 9 NOTE 4. LITIGATION In October 1999, NAICO provided surety bonds for Gulsby Engineering, Inc. ("Gulsby") in connection with contracts between Gulf Liquids New River Project, LLC ("Gulf Liquids") and Gulsby for the construction of two gas processing plants in Louisiana. During 2001, Gulsby became unable to pay various vendors resulting in payments to vendors by NAICO totaling $20,182,499. In August 2001, NAICO filed suit in federal court in Louisiana alleging that Gulf Liquids had breached its obligations under the bonds by materially altering certain contracts and that, as a result, NAICO was exonerated on the bonds and should recover the amounts paid to vendors. In the fall of 2001, Gulsby and Bay Limited, another contractor with whom Gulsby had entered into a joint venture for the construction of other gas processing plants for Gulf Liquids, filed lawsuits relating to those plants in Houston, Texas. Gulf Liquids filed original actions and counterclaims. NAICO intervened in the Texas lawsuits and, in addition, sued Williams Energy Marketing and Trading (which later became Williams Power Company, Inc.) ("Williams") alleging fraud, breach of contract, tortious interference with contractual relations, conspiracy and alter ego. These claims were asserted against both Gulf Liquids and Williams. Gulf Liquids asserted counterclaims alleging breach of contract against NAICO and requesting contractual and statutory damages ranging from $40 million to $80 million. The cases were consolidated for trial in the 215th Judicial District Court in Harris County, Texas. The trial in the Harris County cases began in late April 2006, and concluded August 1, 2006. The jury found in favor of NAICO and Gulsby, Bay Limited and the joint venture between Gulsby and Bay Limited ("Gulsby-Bay Plant Partners") on all counts and fixed damages against Gulf Liquids and Williams totaling $402,568,089.53. The damages determined by the jury included a total of $325 million in punitive damages. Among other findings, the jury found: 1. Williams tortiously interfered with NAICO's contractual relationship with Gulsby and Gulf liquids; and 2. Williams fraudulently induced NAICO to issue the surety bonds; and 3. Williams defrauded NAICO after the bonds were issued; and 4. Williams' actions were malicious; and 5. Gulf Liquids fraudulently induced NAICO to issue the surety bonds; and 6. Gulf Liquids breached its obligations to NAICO under the bonds; and 7. Williams is responsible for the claims against Gulf Liquids because Gulf Liquids is the alter ego of Williams; and 8. There were material alterations (cardinal changes) to the contracts NAICO bonded. The amounts the jury found owing to NAICO include $20,182,499 in actual damages, against both Gulf Liquids and Williams, $20 million in punitive damages against Gulf Liquids, and $50 million in punitive damages against Williams. The verdicts in favor of Gulsby included $20,941,436 in actual damages against both Gulf Liquids and Williams, $25 million in punitive damages against Gulf Liquids and $60 million in punitive damages against Williams. NAICO is subrogated to any recovery by Gulsby to the extent of NAICO's losses on the bonds including loss adjustment expenses with interest from the date the losses and loss expenses were paid. A significant amount of NAICO's losses on the surety bonds were ceded to various reinsurers and NAICO will be required to reimburse these reinsurers in accordance with the agreements between NAICO and the reinsurers. On October 30, 2006, NAICO filed its Motion for Entry of Judgment requesting that the Trial Court enter judgment on the jury verdicts for a total of $100,577,559 plus court costs and anticipated attorney fees for appeals. Of the total requested judgment, $70,000,000 was punitive damages and $8,328,824 was prejudgment interest through November 1, 2006. Prejudgment interest accrues at the rate of $4,561 per day based upon an 8.25% interest rate. NAICO requested attorney fees of $4,566,236 through entry of judgment. The Trial Court denied that request on January 5, 2007. Gulsby has filed a separate motion for judgment that includes a request for fees. NAICO expects the Trial Court to enter final judgment during 2007. After judgment is entered, all parties may file post-judgment motions. The Court has entered several interlocutory orders since January 5, 2007 setting aside the verdicts in favor of NAICO on its claims against Gulf Liquids and Williams and all verdicts for punitive damages. The Court may modify these orders prior to entry of a final judgment. Following the Court's rulings on post-judgment motions, all parties may appeal all or any of those rulings or judgments. PAGE 10 During the third quarter of 2006, NAICO increased the estimated recovery on the surety bond claims related to the construction of the two gas processing plants which resulted in a decrease in losses and loss adjustment expenses incurred of $4.7 million. Unpaid losses and loss adjustment expenses decreased $22.7 million, reinsurance recoverable on unpaid losses and loss adjustment expenses decreased $16.8 million, and reinsurance recoverable on paid losses and loss adjustment expenses decreased $1.2 million as of June 30, 2007 as a result of increasing the estimated recovery. NAICO has also recorded $7.0 million of interest income for its estimate of prejudgment interest through June 30, 2007, including a recovery for a pre-verdict settlement with certain other parties. NOTE 5. NEW ACCOUNTING STANDARDS In February 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140." SFAS No. 155 amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This Statement also resolves issues addressed in Statement No. 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133. SFAS No. 140 is amended to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Chandler USA adopted SFAS No. 155 effective January 1, 2007. The adoption of SFAS No. 155 did not have a material impact on its consolidated financial statements. In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140." SFAS No. 156 amends SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 156 requires an entity to separately recognize financial assets as servicing assets or servicing liabilities each time it undertakes an obligation to service a financial asset by entering into certain kinds of servicing contracts. The entity must also initially measure all separately recognized servicing assets and servicing liabilities at fair value, if practicable. Servicing assets and servicing liabilities subsequently measured at fair value must be separately presented in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities are required. Chandler USA adopted SFAS No. 156 effective January 1, 2007. The adoption of SFAS No. 156 did not have a material impact on its consolidated financial statements. In July 2006, the FASB issued FASB Interpretation ("FIN") No. 48, "Accounting for Uncertainty in Income Taxes," which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109, "Accounting for Income Taxes." FIN 48 provides guidance regarding the recognition, measurement, presentation and disclosure of a tax position taken or expected to be taken in a tax return as well as the derecognition of a tax position previously recognized in the financial statements. Chandler USA adopted FIN 48 effective January 1, 2007. The adoption of FIN 48 did not have a material impact on its consolidated financial statements. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The statement does not require new fair value measurements, but is applied to the extent that other accounting pronouncements require or permit fair value measurements. The statement emphasizes that fair value is a market- based measurement that should be determined based on the assumptions that market participants would use in pricing an asset or liability. Companies will be required to disclose the extent to which fair value is used to measure assets and liabilities, the inputs used to develop the measurements, and the effect of certain of the measurements on earnings (or changes in net assets) for the period. Chandler USA will be required to adopt SFAS No. 157 as of January 1, 2008. Chandler USA does not expect this statement to have a material impact on its consolidated financial statements. In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R)." This statement requires the company to recognize the funded status of its defined benefit postretirement plans as an asset or liability in its financial statements. In addition, the statement eliminates the use of a measurement date that is different than the date of the company's year-end financial statements. Chandler USA has adopted SFAS No. 158 effective December 31, 2006. The adoption of SFAS No. 158 did not have a material impact on its consolidated financial statements. PAGE 11 In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115." SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value at specified election dates. Upon adoption, an entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Most of the provisions apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," applies to all entities with available for sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Chandler USA is currently evaluating the impact that SFAS No. 159 will have, if any, on its consolidated financial statements. In March 2007, the FASB ratified Emerging Issues Task Force Issue ("EITF") No. 06-10, ACCOUNTING FOR DEFERRED COMPENSATION AND POST RETIREMENT BENEFIT ASPECTS OF COLLATERAL ASSIGNMENT SPLIT-DOLLAR LIFE INSURANCE ARRANGEMENTS. EITF 06-10 provides guidance for determining a liability for the postretirement benefit obligation and for recognition and measurement of the associated asset based on the terms of the collateral assignment agreement. EITF 06-10 is effective for fiscal years beginning after December 15, 2007. Chandler USA has evaluated EITF 06-10 and has determined that its adoption is not expected to have a material impact on its consolidated financial statements. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS Some of the statements made in this Form 10-Q 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 including ongoing litigation matters. PAGE 12 RESULTS OF OPERATIONS PREMIUMS EARNED The following table sets 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 for the three and six month periods ended June 30, 2007 and 2006:
GROSS PREMIUMS EARNED NET PREMIUMS EARNED --------------------------- --------------------------- THREE MONTHS ENDED JUNE 30, 2007 2006 2007 2006 ---------------------------------- ------------ ------------ ------------ ------------ (In thousands) Standard lines ................... $ 24,687 $ 22,503 $ 15,223 $ 13,467 Political subdivisions ........... 1,271 3,880 944 1,443 Homeowners ....................... 28 2,691 (304) 1,822 Surety bonds ..................... 89 63 62 44 Other ............................ (54) 213 (55) 212 ------------ ------------ ------------ ------------ TOTAL ............................ $ 26,021 $ 29,350 $ 15,870 $ 16,988 ============ ============ ============ ============
GROSS PREMIUMS EARNED NET PREMIUMS EARNED --------------------------- --------------------------- SIX MONTHS ENDED JUNE 30, 2007 2006 2007 2006 ---------------------------------- ------------ ------------ ------------ ------------ (In thousands) Standard lines ................... $ 49,815 $ 44,769 $ 30,728 $ 26,626 Political subdivisions ........... 2,784 7,870 1,934 2,917 Homeowners ....................... 503 5,486 (10) 3,891 Surety bonds ..................... 184 158 129 111 Other ............................ 111 310 109 308 ------------ ------------ ------------ ------------ TOTAL ............................ $ 53,397 $ 58,593 $ 32,890 $ 33,853 ============ ============ ============ ============
Gross premiums earned decreased $3.3 million or 11% and $5.2 million or 9% in the second quarter and first six months of 2007, respectively, compared to the 2006 periods. Gross premiums earned in the homeowners program decreased $2.7 million and $5.0 million in the second quarter and first six months of 2007, respectively. This program was discontinued during 2006. Gross premiums earned for property and inland marine business in the standard lines and political subdivisions programs decreased $3.0 million and $5.7 million in the second quarter and first six months, respectively, due to the transfer of this business to Praetorian Insurance Company ("Praetorian") as explained further below. Partially offsetting these decreases were an increase in workers compensation and automobile liability premiums in the standard lines program. Effective January 1, 2007, the property and inland marine lines of insurance that were previously written by NAICO in the standard lines and political subdivisions programs are being written by Praetorian through an arrangement between Praetorian and CIMI. NAICO also transferred its existing property and inland marine business in these programs to Praetorian under this new arrangement effective January 1, 2007. Under this arrangement, CIMI receives commission income for the business it produces for Praetorian. CIMI is responsible for the payment of commissions to the producing agents, and is also responsible for providing underwriting and loss control services for this business. NAICO handles all claims for this business under a separate claims handling agreement with Praetorian. Management believes this new arrangement will allow Chandler USA's subsidiaries to offer more competitive property and inland marine programs for its agents. In addition, NAICO will no longer be required to purchase reinsurance for the significant insured values associated with this business. Net premiums earned decreased $1.1 million or 7% and $1.0 million or 3% for the second quarter and first six months of 2007, respectively. The decrease was due primarily to a decrease of $2.1 million and $3.9 million in the second quarter and first six months of 2007, respectively, in the discontinued homeowners program and a decrease of $385,000 and $705,000 in property and inland marine business that was transferred to Praetorian. The decrease in net premiums earned for the business transferred to Praetorian was much less than the decrease in gross premiums earned due to the significant amounts of reinsurance that NAICO had purchased for this business. This reinsurance was also cancelled which resulted in a significant decrease in reinsurance premiums ceded during the second quarter and first six months of 2007. PAGE 13 Gross premiums earned in the standard lines program increased $2.2 million or 10% and increased $5.0 million or 11% in the second quarter and first six months of 2007, respectively, compared to the 2006 periods. Gross premiums earned for workers compensation business increased $1.0 million and $2.8 million in the second quarter and first six months of 2007, respectively, and gross premiums earned for automobile liability increased $2.9 million and $4.7 million in these periods. A decrease in other liability premiums partially offset these increases. Net premiums earned increased $1.8 million and $4.1 million in the second quarter and first six months of 2007, respectively, due primarily to the increase in gross premiums earned. Gross premiums earned in the political subdivisions program decreased $2.6 million or 67% and $5.1 million or 65% in the second quarter and first six months of 2007, respectively, compared to the 2006 periods. The decrease in gross premiums earned is due primarily to the transfer of the property and inland marine business in this program to Praetorian as described previously, and to increased competition in the school districts portion of the program in Oklahoma. Net premiums earned in this program decreased $499,000 or 35% and $983,000 or 34% in the second quarter and first six months of 2007, respectively. The decrease in net premiums earned was significantly less than the decrease in gross premiums earned because of the significant amounts of reinsurance that NAICO had purchased for the property and inland marine lines of business in this program. In 2005, NAICO began writing homeowner and dwelling policies in the state of Texas through a managing general agent. NAICO discontinued this program during 2006 due primarily to increased catastrophe exposures. Gross and net premiums earned in the surety bond program experienced minor increases compared to the 2006 periods. NAICO is no longer actively marketing its surety bond program. NET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS At June 30, 2007, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate bonds and equity securities with approximately 20% 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 included $317,000 in the first quarter of 2007 in prejudgment interest income accrued for a favorable jury verdict in civil litigation in 2006 regarding certain surety bond claims. No prejudgment interest was accrued during the second quarter of 2007. See "LITIGATION" and Note 4 of Notes to Interim Consolidated Financial Statements. Net investment income, excluding interest income from related parties and the prejudgment interest accrual, increased $81,000 or 10% and $207,000 or 14% in the second quarter and first six months of 2007, respectively, due primarily to higher interest rates and an increase in cash and invested assets. Cash and invested assets were $90.8 million at June 30, 2007 compared to $87.6 million at June 30, 2006. Net interest income from related parties increased $57,000 or 30% and $91,000 or 25% in the second quarter and first six months of 2007, respectively, due primarily to higher interest rates and to an increase in the amount due from related parties. Net realized investment gains were $26,000 and $61,000 during the second quarter and first six months of 2007, respectively. Net realized investment gains were $133,000 and $189,000 during the second quarter and first six months of 2007. The net realized gains in 2007 and 2006 were from sales of equity securities. OTHER INCOME Other income was $168,000 and $995,000 in the second quarter and first six months of 2007, respectively, compared to $95,000 and $142,000 in the second quarter and first six months of 2006. The increase in the 2007 periods was due to the transfer of NAICO's property and inland marine business in the standard lines and political subdivisions programs to Praetorian under a new arrangement effective January 1, 2007. Under this arrangement, CIMI receives commission income for the business it produces for Praetorian. PAGE 14 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. Although such estimates are management's best estimates of the expected values, the ultimate liability for unpaid claims may vary from these values. The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 59.0% and 60.9% for the second quarter and first six months of 2007, compared to 71.0% and 65.5% in the corresponding 2006 periods. The decrease in the 2007 loss ratios was due primarily to a decrease in losses incurred related to prior accident years. In the second quarter of 2007, losses and loss adjustment expenses incurred related to prior accident years were $157,000 and increased the loss ratio by 1.0 percentage point. In the first six months of 2007, loss development was redundant by $301,000 which decreased the loss ratio by 0.9 percentage points. An increase in losses incurred in the 1997-2005 accident years of $4.9 million in the first six months of 2007 was offset by a reduction in losses incurred in the 2006 accident year of $5.2 million. During 2006, adverse loss development totaling $2.7 million and $3.8 million in the second quarter and first six months of 2006, respectively, increased the respective loss ratios by 15.8 and 11.2 percentage points. The adverse loss development in 2006 was due primarily to an increase in surety bond losses in the 2001 accident year. Weather-related losses from wind and hail totaled $48,000 and $70,000 in the second quarter and first six months of 2007 and increased the respective loss ratios by 0.3 and 0.2 percentage points. Weather-related losses totaled $446,000 and $559,000 in the second quarter and first six months of 2006, and increased the respective 2006 loss ratios by 2.6 and 1.7 percentage points. 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 the 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 anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded. The following table sets forth Chandler USA's policy acquisition costs for each of the three and six month periods ended June 30, 2007 and 2006:
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ---------------------- ---------------------- 2007 2006 2007 2006 ---------- ---------- ---------- ---------- (In thousands) Commissions expense ........................ $ 3,374 $ 3,525 $ 7,279 $ 8,150 Other premium related assessments .......... 263 221 521 502 Premium taxes .............................. 580 534 1,152 1,182 Excise taxes ............................... 66 65 149 128 Other expense .............................. 214 196 453 378 ---------- ---------- ---------- ---------- Total direct expenses ...................... 4,497 4,541 9,554 10,340 Indirect underwriting expenses ............. 1,457 1,496 2,920 2,999 Commissions received from reinsurers ....... (2,911) (3,195) (5,404) (6,738) Adjustment for deferred acquisition costs .. (11) (89) (788) (677) ---------- ---------- ---------- ---------- Net policy acquisition costs ............... $ 3,032 $ 2,753 $ 6,282 $ 5,924 ========== ========== ========== ==========
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 24.7% and 24.2% for the second quarter and first six months of 2007, compared to 24.0% and 24.4% in the corresponding year ago periods. Commissions expense as a percentage of gross written and assumed premiums was 14.0% and 14.1% in the second quarter and the first six months of 2007 compared to 14.0% and 14.9% in the corresponding 2006 periods. PAGE 15 Indirect underwriting expenses were 6.0% and 5.7% of total direct written and assumed premiums in the second quarter and first six months of 2007, respectively, compared to 5.9% and 5.5% in the corresponding 2006 periods. 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 percent of ceded reinsurance premiums were 31.1% and 31.4% in the second quarter and first six months of 2007, respectively, compared to 32.0% and 29.8% in the corresponding 2006 periods GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses were 11.6% and 11.5% of gross premiums earned and other income in the second quarter and first six months of 2007, respectively, compared to 11.5% and 10.7% for the corresponding 2006 periods. 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 overall premium volume. INTEREST EXPENSE Interest expense increased $11,000 and $33,000 in the second quarter and first six months of 2007, respectively, compared to the 2006 periods. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. The increase in the 2007 periods was due primarily to higher interest rates during 2007, as a portion of Chandler USA's junior subordinated debentures were issued with a floating interest rate. LIQUIDITY AND CAPITAL RESOURCES In the first six months of 2007, Chandler USA provided $4.4 million in cash from operations. Cash provided by operations included a decrease in prepaid reinsurance premiums of $3.3 million. This was partially offset by a decrease in unearned premiums of $1.9 million. Unpaid losses and loss adjustment expenses increased $2.1 million during the first six months of 2007. This was partially offset by an increase in reinsurance recoverable on unpaid losses of $1.0 million. In the first six months of 2006, Chandler USA provided $2.6 million in cash from operations. NAICO is required to deposit cash and securities with regulatory agencies in which it is licensed as a condition of conducting operations in the state. In addition, NAICO has deposited cash and securities into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer. At June 30, 2007, the total amount of cash and securities restricted as a result of these arrangements was $33.2 million which was an increase of $13.6 million from December 31, 2006. This increase was due to an increase in the amount of reinsurance that NAICO assumed during 2007. At June 30, 2007, Chandler USA's parent company, Chandler Insurance Company, Ltd., owed approximately $11.9 million to Chandler USA versus $9.6 million at December 31, 2006 under 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. During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for three years. During March 2004, the lease was extended for three years and during March 2007, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $13,834 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime which was 9.25% at June 30, 2007. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.9 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 $1.5 million. PAGE 16 Chandler USA is a holding company receiving cash principally through borrowings, subsidiary dividends and other payments, subject to various regulatory restrictions. The capacity of insurance companies to write insurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for Chandler USA's subsidiaries are funds generated from insurance premiums, investment income, capital contributions from Chandler USA and proceeds from sales and maturities of portfolio investments. The principal expenditures are payment of losses and loss adjustment expenses, insurance operating expenses and commissions. A significant portion of Chandler USA's consolidated assets represents assets of NAICO that may not be immediately transferable to Chandler USA in the form of shareholder dividends, loans, advances or other payments. Statutes and regulations governing NAICO and other insurance companies domiciled in Oklahoma regulate the payment of shareholder dividends and other payments by NAICO to Chandler USA. Under applicable Oklahoma statutes and regulations, NAICO is permitted to pay shareholder dividends only out of statutory earned surplus. To the extent NAICO has statutory earned surplus, NAICO may pay shareholder dividends only to the extent that such dividends are not defined as extraordinary dividends or distributions. If the dividends are, under applicable statutes and regulations, extraordinary dividends or distributions, regulatory approval must be obtained. Under the applicable Oklahoma statute, and subject to the availability of statutory earned surplus, the maximum shareholder dividend that may be declared (or cash or property distribution that may be made) by NAICO in any one calendar year without regulatory approval is the greater of (i) NAICO's statutory net income, excluding realized capital gains, for the preceding calendar year; or (ii) 10% of NAICO's statutory policyholders' surplus as of the preceding calendar year end, not to exceed NAICO's statutory earned surplus. As of December 31, 2006, NAICO had statutory earned surplus of $14.0 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2007 without the approval of the Oklahoma Department of Insurance is $5.2 million. NAICO paid a cash shareholder dividend of $1.6 million to Chandler USA in May 2007. NAICO did not pay any shareholder dividends to Chandler USA in 2006. In addition to the statutory limits described above, the amount of shareholder dividends and other payments to affiliates can be further limited by contractual or regulatory restrictions or other agreements with regulatory authorities restricting dividends and other payments, including regulatory restrictions that are imposed as a matter of administrative policy. If insurance regulators determine that payment of a shareholder dividend or other payments to an affiliate (such as payments under a tax sharing agreement, payments for employee or other services, or payments pursuant to a surplus note) would be hazardous to such insurance company's policyholders or creditors, the regulators may block such payments that would otherwise be permitted without prior approval. Historically, NAICO has played a significant role in the servicing of debt and other obligations of Chandler USA through the payment of shareholder dividends. These obligations include $7.0 million of 8.75% senior debentures due in 2014, $13.4 million of 9.75% junior subordinated debentures due in 2033, $7.2 million of floating rate junior subordinated debentures due in 2034 and the obligations under the sale and leaseback transaction discussed previously. Management's expectation is that Chandler Insurance or other subsidiaries will be able to meet these obligations in the future. It is possible that dividends from NAICO may be necessary to service Chandler USA's debt obligations. To the extent that the restrictions discussed previously limit NAICO's ability to pay shareholder dividends or other payments to Chandler USA, Chandler USA's ability to satisfy the debt obligations may also be limited. LITIGATION On August 1, 2006, a jury trial concluded in Harris County, Texas, related to the construction of two gas processing plants in Louisiana. NAICO had provided surety bonds in connection with the construction of these plants. The amounts the jury found owing to NAICO include approximately $20.2 million in actual damages and $70.0 million in punitive damages. The amounts the jury found owing to Gulsby included approximately $20.9 million in actual damages and $85.0 million in punitive damages. NAICO is subrogated to any recovery by Gulsby to the extent of NAICO's losses on the bonds including loss adjustment expenses with interest from the date the losses and loss expenses were paid. See Note 4 of Notes to Interim Consolidated Financial Statements for a discussion of this jury verdict. PAGE 17 On October 30, 2006, NAICO filed its Motion for Entry of Judgment requesting that the Trial Court enter judgment for a total of $100.6 million plus court costs and anticipated attorney fees for appeals. This amount includes $70.0 million in punitive damages, $8.3 million in prejudgment interest through October 31, 2006, and attorney fees of $4.6 million through entry of judgment. Prejudgment interest accrues at the rate of $4,561 per day based upon an 8.25% interest rate. The Trial Court denied the request for attorney fees on January 5, 2007. NAICO expects the Trial Court to enter final judgment during 2007. After judgment is entered, all parties may file post-judgment motions. The Court has entered several interlocutory orders since January 5, 2007 setting aside the verdicts in favor of NAICO on its claims against Gulf Liquids and Williams and all verdicts for punitive damages. The Court may modify these orders prior to entry of a final judgment. Following the Court's rulings on post-judgment motions, all parties may appeal all or any of those rulings or judgments. During the third quarter of 2006, NAICO increased the estimated recovery on the surety bond claims related to the construction of the two gas processing plants which resulted in a decrease in losses and loss adjustment expenses incurred of $4.7 million. In addition, unpaid losses and loss adjustment expenses decreased $22.7 million, reinsurance recoverable on unpaid losses and loss adjustment expenses decreased $16.8 million, and reinsurance recoverable on paid losses and loss adjustment expenses decreased $1.2 million. NAICO also recorded $6.6 million of interest income for its estimate of prejudgment interest through December 31, 2006 and recorded an additional $317,000 of prejudgment interest during the first quarter of 2007 including a recovery for a pre-verdict settlement with certain other parties. A.M. BEST RATING Effective May 2, 2007, A.M. Best Company affirmed the financial strength rating of B+ (Good) and the issuer credit rating (ICR) of "bbb-" of NAICO. Concurrently, A.M. Best has affirmed the ICR of "bb-" of NAICO's parent, Chandler USA, and the debt rating of "bb-" on Chandler USA's 8.75% senior unsecured debentures due 2014. The outlook for all ratings has been revised to stable from negative. NAICO's policyholders surplus has also increased from A.M. Best's financial size category VI to category VII ($50 million to $100 million). ITEM 4. 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 In addition and 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, the internal control over financial reporting. ITEM 4T. CONTROLS AND PROCEDURES Not applicable. PAGE 18 PART II. OTHER INFORMATION ----------------- Item 1. LEGAL PROCEEDINGS ----------------- Chandler USA and its subsidiaries are not parties to any 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. See Note 4 of Notes to Interim Consolidated Financial Statements for a discussion of a favorable jury verdict in civil litigation regarding certain surety bond claims. Item 1A. RISK FACTORS ------------ There have been no material changes from risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2006. Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS ----------------------------------------------------------- None. Item 3. DEFAULTS UPON SENIOR SECURITIES ------------------------------- None. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- None. Item 5. OTHER INFORMATION ----------------- None. Item 6. EXHIBITS -------- 31.1 Rule 13a-14(a)/15d-14(a) Certifications. 32.1 Section 1350 Certifications. PAGE 19 SIGNATURES ---------- Pursuant to the requirements 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. Date: August 6, 2007 CHANDLER (U.S.A.), INC. By: /s/ W. Brent LaGere -------------------------------------- W. Brent LaGere Chairman of the Board and Chief Executive Officer (Principal Executive Officer) By: /s/ Mark C. Hart -------------------------------------- Mark C. Hart Senior Vice President - Finance, Chief Financial Officer and Treasurer (Principal Accounting Officer)