10-K 1 cusa10kedgar07.txt CHANDLER (USA), INC. 12/31/07 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, 2007 COMMISSION FILE NUMBER: 1-15135 CHANDLER (U.S.A.), INC. (Exact name of registrant as specified in its charter) OKLAHOMA 73-1325906 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1010 MANVEL AVENUE, CHANDLER, OKLAHOMA 74834 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (405) 258-0804 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered -------------------------------- -------------------------------------------- 8.75% SENIOR DEBENTURES DUE 2014 AMERICAN STOCK EXCHANGE Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES NO X -- -- Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES NO X -- -- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO -- -- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X -- Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer Accelerated filer -- -- Non-accelerated filer X (Do not check if a smaller reporting company) -- Smaller reporting company -- Indicate by check mark whether the registrant is a shell company (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, 2007, 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 29, 2008 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 including ongoing litigation matters. 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 insurance products for businesses in various industries. NAICO has a network of independent agents, totaling approximately 197 at December 31, 2007, 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+ (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 and wholesaler that offers multiple insurance products for businesses in various industries and political subdivisions. INSURANCE PROGRAMS NAICO writes various property and casualty insurance products through two primary marketing programs. The programs are standard lines and political subdivisions. STANDARD LINES PROGRAM NAICO offers workers compensation, automobile liability and physical damage and other liability (including general liability, products liability and umbrella liability) coverages under its standard lines 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. NAICO has also written property and inland marine coverages in this 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 Insurance Company ("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. PAGE 2 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 is no longer required to purchase reinsurance for the significant insured values associated with this business. POLITICAL SUBDIVISIONS PROGRAM Under the political subdivisions program, NAICO writes insurance policies primarily for school districts in Oklahoma. As of December 31, 2007, NAICO insured 110 school districts in Oklahoma. The coverages offered include workers compensation, automobile liability, automobile physical damage, general liability and school board legal liability. NAICO has also written property and inland marine coverages in this program. Effective January 1, 2007, the property and inland marine lines of insurance are being written by Praetorian. HOMEOWNERS PROGRAM In 2005, NAICO began writing homeowners and dwelling fire and allied lines policies in the state of Texas through a managing general agent. NAICO discontinued this program during the second quarter of 2006 due primarily to increased catastrophic exposures. SURETY BOND PROGRAM NAICO has written surety bonds, commonly referred to as contract performance bonds, to secure the performance of contractors and suppliers on construction projects. NAICO has also written bail bonds, which guarantee that the principal will discharge obligations set by the court, as well as other types of miscellaneous bonds. NAICO discontinued the bail bond portion of the program as of the end of 2003. NAICO is no longer actively marketing its surety bond program. The following table shows gross premiums earned and net premiums earned by insurance program for the years 2005, 2006 and 2007. 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."
Standard lines ......................... $ 92,224 $ 91,153 $100,844 $ 54,979 $ 54,357 $ 62,342 Political subdivisions ................. 18,630 14,337 5,084 6,690 5,253 3,436 Homeowners ............................. 4,229 8,542 501 3,321 5,353 9 Surety bonds ........................... 930 278 266 669 193 186 Other (1) .............................. 406 550 214 401 548 212 -------- -------- -------- -------- -------- -------- TOTAL .................................. $116,419 $114,860 $106,909 $ 66,060 $ 65,704 $ 66,185 ======== ======== ======== ======== ======== ======== ------------------------------------------- (1) This category is comprised primarily of the run-off of discontinued programs and NAICO's participation in various mandatory workers compensation pools.
PAGE 3 LINES OF INSURANCE The lines of insurance written by NAICO through its programs are automobile liability, other liability (including general liability, products liability and umbrella liability), workers compensation, automobile physical damage, property (including homeowners multiple peril), surety and inland marine. The following table shows net premiums earned as a percentage of total net premiums earned by each line of insurance written by NAICO during the period indicated.
YEAR ENDED DECEMBER 31, -------------------------------------------- 2003 2004 2005 2006 2007 -------- -------- -------- -------- -------- Automobile liability ........ 27% 28% 29% 32% 40% Workers compensation ........ 29% 27% 25% 23% 27% Other liability ............. 23% 28% 27% 25% 23% Automobile physical damage .. 10% 9% 9% 8% 9% Property .................... 5% 4% 8% 11% 1% Inland marine ............... 1% 1% 1% 1% -% Surety ...................... 5% 3% 1% -% -% -------- -------- -------- -------- -------- Total 100% 100% 100% 100% 100% ======== ======== ======== ======== ========
NAICO discontinued its homeowners program during 2006, and has also transferred its property and inland marine business for the standard lines and political subdivisions programs to Praetorian effective January 1, 2007, through a new arrangement between Praetorian and CIMI. Because of these changes, NAICO's net premiums earned for property and inland marine business in 2007 were minimal. See "Insurance Programs" for more information. AGENCY AND BROKERAGE CIMI serves as a general agent for certain wholesale insurance operations related to NAICO's school districts and trucking insurance. Under its general agency agreement with NAICO, CIMI was appointed to accept, in accordance with NAICO's underwriting guidelines, certain surety bonds and property and casualty insurance. CIMI is also authorized to secure qualified insurance agents for NAICO and shall assist NAICO in coordinating the agents' activities. Effective January 1, 2007, CIMI administers certain property and inland marine business for Praetorian under a general agency agreement between the parties. CIMI receives commission income for its services under the agreement, and is responsible for the payment of commissions to the producing agents. CIMI is also responsible for providing underwriting and loss control services for this business. See "Insurance Programs" for more information. UNDERWRITING AND CLAIMS Independent insurance agents submit applications for commercial insurance policies for prospective customers to NAICO or CIMI. Prospective risks are reviewed in accordance with specific underwriting guidelines. If the risk is approved and coverage is accepted by the insured, an insurance policy is issued. NAICO's claims department reviews and administers all claims except claims associated with the homeowners program which are handled by the managing general agent for this program. When a claim is received, it is reviewed and assigned to an in-house claim adjuster based on the type and geographic location of the claim, its severity and its class of business. NAICO's claims department is responsible for reviewing each claim, obtaining necessary documentation and establishing loss and loss adjustment expense reserves. NAICO's in-house claims staff handles and supervises the claims, coordinates with outside legal counsel and independent claims adjusters if necessary, and processes the claims to conclusion. Effective January 1, 2007, NAICO also handles claims for the property and inland marine business placed by CIMI with Praetorian under a claims handling agreement with Praetorian. PAGE 4 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 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. The majority of NAICO's reinsurance programs renew on July 1 of each year. At the present time, NAICO expects to renew the reinsurance programs that expire on July 1, 2008. NAICO has structured separate reinsurance programs for 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 except for the homeowners program. Effective July 1, 2004, NAICO's net retention under the workers compensation reinsurance program was 100% of the first $1,000,000 of loss per occurrence. NAICO's excess of loss reinsurance covers workers compensation losses up to $30,000,000 effective July 1, 2002. Effective July 1, 2004, NAICO's net retention under the casualty reinsurance program was 70% of the first $1,000,000 of loss per occurrence. Effective July 1, 2005, NAICO increased its net retention to 70% of the first $2,000,000 of loss per occurrence, although most policies are issued with policy limits of $1,000,000 of loss per occurrence for casualty coverages. Effective July 1, 2004, NAICO's net retention for umbrella liability losses was 17.5% of the first $4,000,000 of loss per occurrence. Effective July 1, 2006, NAICO decreased its net retention for umbrella liability losses to 10.5% of the first $4,000,000 of loss per occurrence. Effective April 1, 2004, NAICO retains 70% of the losses in the construction surety bond portion of the surety bond program. Under the 2005 and 2006 property reinsurance programs, NAICO retained 23.1% of the first $3,000,000 of risk for each loss per risk or location. NAICO discontinued its property reinsurance program effective January 1, 2007 due to the transfer of its property business for the standard lines and political subdivisions programs to Praetorian. Under the 2005, 2006 and 2007 automobile physical damage reinsurance programs NAICO retained 70% of each loss per occurrence. NAICO has purchased catastrophe protection for automobile physical damage 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 automobile physical damage to $1,400,000 effective January 1, 2004 for each loss occurrence. In December 2007, the Terrorism Risk Insurance Program Reauthorization Act of 2007 (the "Act") extended the Terrorism Risk Insurance Act of 2002 (the "Act") through December 31, 2014. The Act, as modified, establishes a program for commercial property and casualty losses resulting from foreign and domestic acts of terrorism. The Act requires commercial insurers to offer terrorism coverage on certain commercial property and casualty lines of business. Effective January 1, 2006, commercial automobile liability and physical damage, professional liability, surety, burglary and theft and farm-owners multi-peril insurance coverages are excluded from the Act. Each insurance company will be responsible for a deductible of 20% of an insurer's direct earned premium. The Federal Government will pay 85% of covered terrorism losses that exceed company deductibles. PAGE 5 For 2007, NAICO purchased excess of loss reinsurance covering acts of terrorism that provided coverage of $24,900,000 excess of $100,000 for NAICO's deductible under the Act, as well as for acts of terrorism other than those covered under the Act. Effective July 1, 2007, terrorism coverage was included in the casualty reinsurance program and effective January 1, 2008, terrorism coverage was included in the workers compensation reinsurance program. 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, 2007.
CEDED REINSURANCE NET PREMIUMS FOR A.M. BEST REINSURANCE THE YEAR ENDED COMPANY NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2007 RATING ---------------------------------------------------------- --------------- ------------------ ----------- (Dollars in thousands) Chandler Insurance ....................................... $ 31,616 $ 27,959 (2) Employers Reinsurance Corporation ........................ 17,158 (1,354) A+ Swiss Reinsurance America Corporation .................... 17,078 431 A+ Markel Insurance Company ................................. 2,718 1,785 A Transatlantic Reinsurance Company ........................ 2,380 1,863 A+ --------------- ------------------ Top five reinsurers ................................. $ 70,950 $ 30,684 =============== ================== All reinsurers ...................................... $ 71,857 $ 35,649 =============== ================== Percentage of total represented by top five reinsurers ... 99% 86% ------------------------------------------------------------- (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, 2007. (2) Chandler Insurance owns 100% of the common stock of Chandler USA, which in turn owns 100% of the common stock of NAICO. Chandler Insurance does not have an A.M. Best Company rating. 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, 2007, Chandler Insurance had cash and investments, including accrued interest, with a fair value of $31.6 million deposited in a trust account for the benefit of NAICO.
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 $108,000, $97,000 and $356,000 during 2005, 2006 and 2007, respectively, in adjustments to ceded losses and loss adjustment expenses for amounts deemed uncollectible. LOSS AND UNDERWRITING EXPENSE RATIOS The combined loss and underwriting expense ratio ("Combined Ratio") is the traditional measure of underwriting experience for property and casualty insurance companies. It is the sum of the ratios of (i) incurred losses and loss adjustment expenses to net premiums earned ("loss ratio") and (ii) underwriting expenses to net premiums written and assumed ("underwriting expense ratio"). PAGE 6 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, ------------------------------------------------ 2003 2004 2005 2006 2007 -------- -------- -------- -------- -------- (Dollars in thousands) Automobile liability: Net premiums earned ......................... $ 15,624 $ 17,742 $ 19,126 $ 21,122 $ 26,469 Loss ratio .................................. 49% 61% 82% 99% 74% Workers compensation: Net premiums earned ......................... $ 16,378 $ 17,371 $ 16,475 $ 15,361 $ 17,861 Loss ratio .................................. 72% 85% 53% 63% 62% Other liability: Net premiums earned ......................... $ 12,870 $ 18,044 $ 18,052 $ 16,628 $ 15,137 Loss ratio .................................. 94% 121% 48% 57% 32% Automobile physical damage: Net premiums earned ......................... $ 5,508 $ 5,933 $ 5,807 $ 5,008 $ 6,096 Loss ratio .................................. 36% 43% 56% 63% 55% Property: Net premiums earned ......................... $ 3,072 $ 2,611 $ 5,594 $ 7,082 $ 279 Loss ratio .................................. 74% 47% 41% 41% 64% Surety: Net premiums earned ......................... $ 2,723 $ 1,993 $ 669 $ 194 $ 186 Loss ratio .................................. 34% 134% (255)% (459)% 1,119% Inland marine: Net premiums earned ......................... $ 408 $ 348 $ 337 $ 309 $ 157 Loss ratio .................................. 54% 29% 162% 30% 19% Total: Net premiums earned ......................... $ 56,583 $ 64,042 $ 66,060 $ 65,704 $ 66,185 Loss ratio .................................. 66% 84% 57% 69% 63% Underwriting expense ratio (1) .............. 47% 34% 35% 37% 39% -------- -------- -------- -------- -------- Combined ratio (1) ........................... 113% 118% 92% 106% 102% ======== ======== ======== ======== ======== ------------------------------------------------- (1) Interest expense and certain litigation expenses are not considered underwriting expenses; therefore, such costs have been excluded from these ratios. The underwriting expense ratio for 2003 was impacted by a 23% decrease in net premiums written and assumed during 2003. Certain types of expenses are fixed in nature, which resulted in an increased ratio for this period.
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 significantly higher than original estimates. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims. PAGE 7 NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO, and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Any changes in the estimates are reflected in current operating results. Such changes in estimates may be material. NAICO's statutory-based reserves (reserves calculated in accordance with an insurer's domiciliary state insurance regulatory authorities) do not differ from its reserves reported on the basis of accounting principles generally accepted in the United States of America ("GAAP"). NAICO does not discount its reserves for unpaid losses or loss adjustment expenses. Salvage and subrogation recoverables are accrued using the "case basis" method for large recoverables and statistical estimates based on historical experience for smaller recoverables. Recoverable amounts deducted from Chandler USA's net liability for losses and loss adjustment expenses were approximately $13.2 million and $11.1 million at December 31, 2006 and 2007, respectively. Included in these recoverable amounts were net recoverables of $10.8 million and $10.1 million in 2006 and 2007, respectively, related to a favorable jury verdict in civil litigation regarding certain surety bond claims during 2006. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" for more information related to this litigation. NAICO may or may not recover the above estimated recoveries and could incur significant costs in collecting these recoverables. NAICO participates in various pools covering workers compensation risks for insureds who were unable to purchase this coverage from an insurance company on a voluntary basis. The consolidated financial statements reflect the reserves for unpaid losses and loss adjustment expenses and net premiums earned from its participation in the pools. There may be significant reporting lags between the occurrence of the insured loss and the time it is actually reported to the insurer. The inherent uncertainties in estimating insurance reserves are generally greater for casualty coverages, such as workers compensation, general and automobile liability, than for property coverages primarily due to the longer period of time that typically elapses before a definitive determination of ultimate loss can be made, which is also affected by changing theories of legal liability and changing political climates. There are significant additional uncertainties in estimating the amount of reserves required for environmental, asbestos-related and other latent exposure claims, including a lack of historical data, long reporting delays and complex unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different and frequently inconsistent conclusions as to when the loss occurred, what claims are covered, under what circumstances the insurer has an obligation to defend, how policy limits are determined and how policy exclusions are applied and interpreted. 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, ------------------------------------------------------ 2003 2004 2005 2006 2007 ---------- ---------- ---------- ---------- ---------- (In thousands) Net balance at beginning of year ................. $ 33,191 $ 29,343 $ 44,695 $ 40,549 $ 42,081 ---------- ---------- ---------- ---------- ---------- Net losses and loss adjustment expenses incurred related to: Current year ................................. 26,108 27,436 30,985 41,644 40,194 Prior years .................................. 11,092 26,345 6,339 3,829 1,199 ---------- ---------- ---------- ---------- ---------- Total ...................................... 37,200 53,781 37,324 45,473 41,393 ---------- ---------- ---------- ---------- ---------- Net paid losses and loss adjustment expenses related to: Current year ................................. (10,626) (10,222) (11,171) (12,403) (12,494) Prior years .................................. (30,422) (28,207) (30,299) (31,538) (25,114) ---------- ---------- ---------- ---------- ---------- Total ...................................... (41,048) (38,429) (41,470) (43,941) (37,608) ---------- ---------- ---------- ---------- ---------- Net balance at end of year ....................... $ 29,343 $ 44,695 $ 40,549 $ 42,081 $ 45,866 ========== ========== ========== ========== ==========
NAICO has experienced a significant amount of incurred losses related to prior accident years during the 2003-2006 calendar years. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results. During 2003, NAICO experienced adverse loss development totaling $11.1 million primarily in the standard lines 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 lines and political subdivisions programs. This adverse development was due primarily to an increase in losses in the workers compensation and other liability lines of business in the 1997-2002 accident years. The adverse development in the 2002 accident year partially offset the reduction in losses for this accident year that was recorded during 2003. The adverse loss development included approximately $409,000 for provisions for potentially uncollectible reinsurance and deductibles. Reserves for unpaid losses and loss adjustment expenses, net of related reinsurance recoverables, were $44.7 million at December 31, 2004 compared to $29.3 million at December 31, 2003, an increase of $15.4 million or 52%. During 2005, NAICO experienced adverse loss development totaling $6.3 million primarily in the standard lines and political subdivisions programs. A portion of the adverse development was offset by favorable development of $1.8 million in the surety bond program, primarily in accident years 1994 and 2001 that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the workers compensation, other liability and automobile liability lines of business in the 2000, 2002 and 2003 accident years. The adverse loss development included approximately $108,000 for provisions for potentially uncollectible reinsurance. PAGE 9 During 2006, NAICO experienced adverse loss development totaling $3.8 million primarily in the standard lines program. A portion of the adverse development was offset by favorable development of $1.0 million in the surety bond program, primarily in the 2001 accident year, that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the automobile liability line of business in the 2005 accident year and in the workers compensation line of business in the 1997 and 1999 accident years. The adverse loss development included approximately $97,000 for provisions for potentially uncollectible reinsurance. During 2007, NAICO experienced adverse loss development totaling $1.2 million primarily in the surety bond program. During 2007, a portion of the estimated recoveries that were recorded in the surety bond program during 2006 were reduced based on a final judgment entered by the court regarding certain surety bond claims. The reduction of the estimated recoveries accounted for $1.8 million of the loss development during 2007. The adverse loss development included approximately $356,000 for provisions for potentially uncollectible reinsurance. The following table represents the development of net balance sheet reserves for 1998 through 2007. 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 2001 for claims that occurred in 1998 will be included in the cumulative deficiency amount for years 1998, 1999, 2000 and 2001. 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. PAGE 10
DEVELOPMENT OF RESERVES AS OF DECEMBER 31, ------------------------------------------------------------------------------------------------------ 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 --------- --------- ---------- ---------- ---------- --------- --------- --------- --------- --------- (In thousands) Net reserve for unpaid losses and loss adjustment expenses ... $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695 $ 40,549 $ 42,081 $ 45,866 Net paid (cumulative) as of One year later ............ 23,896 36,009 43,799 37,050 30,422 28,207 30,299 31,537 25,111 Two years later ........... 34,966 58,979 66,141 60,560 51,375 50,158 50,183 46,348 Three years later ......... 45,390 72,052 81,635 77,413 68,643 63,900 58,263 Four years later .......... 51,364 80,860 91,403 89,349 79,591 69,099 Five years later .......... 55,445 86,257 97,700 98,060 83,845 Six years later ........... 58,062 88,859 99,506 101,213 Seven years later ......... 59,135 89,346 101,257 Eight years later ......... 58,706 90,708 Nine years later .......... 59,514 Net liability re-estimated as of One year later ............ 43,441 56,357 59,376 48,596 44,283 55,688 51,034 44,378 43,280 Two years later ........... 45,373 67,469 74,325 67,903 70,058 61,369 50,989 50,909 Three years later ......... 50,146 77,842 86,377 89,608 73,962 61,216 57,175 Four years later .......... 55,303 83,860 100,408 91,520 74,805 66,153 Five years later .......... 58,060 91,704 102,370 91,700 79,781 Six years later ........... 62,995 92,084 104,227 96,161 Seven years later ......... 62,712 93,873 106,396 Eight years later ......... 63,775 95,812 Nine years later .......... 64,778 Net cumulative (deficiency) redundancy ................ $(24,857) $(44,434) $ (59,689) $ (63,349) $ (46,590) $(36,810) $(12,480) $(10,360) $ (1,199) $ - Supplemental gross data: Gross liability ........... $ 80,701 $ 98,460 $ 100,173 $ 84,756 $ 92,606 $ 87,768 $108,233 $109,541 $ 83,253 $100,590 Reinsurance recoverable ... 40,780 47,082 53,466 51,944 59,415 58,425 63,538 68,992 41,172 54,724 --------- --------- ---------- ---------- ---------- --------- --------- --------- --------- --------- Net liability-end of year.. $ 39,921 $ 51,378 $ 46,707 $ 32,812 $ 33,191 $ 29,343 $ 44,695 $ 40,549 $ 42,081 $ 45,866 ========= ========= ========== ========== ========== ========= ========= ========= ========= ========= Gross re-estimated liability - latest ...... $137,563 $192,297 $ 266,593 $ 300,102 $ 248,595 $182,331 $155,203 $133,425 $101,970 Re-estimated recoverable - latest .................. 72,785 96,485 160,197 203,941 168,814 116,178 98,028 82,516 58,690 --------- --------- ---------- ---------- ---------- --------- --------- --------- --------- Net re-estimated liability - latest ...... $ 64,778 $ 95,812 $ 106,396 $ 96,161 $ 79,781 $ 66,153 $ 57,175 $ 50,909 $ 43,280 ========= ========= ========== ========== ========== ========= ========= ========= ========= Gross cumulative (deficiency) redundancy ................ $(56,862) $(93,837) $(166,420) $(215,346) $(155,989) $(94,563) $(46,970) $(23,884) $(18,717) ========= ========= ========== ========== ========== ========= ========= ========= =========
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. PAGE 11 Investments are purchased to support the investment strategies of Chandler USA and its subsidiaries, which are developed based on many factors including rate of return, maturity, credit risk, tax considerations, regulatory requirements and their mix of business. At the time of purchase, investments in debt securities that Chandler USA has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments in debt and equity securities classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. Chandler USA has not classified any investments as trading account assets. Debt securities not classified as held to maturity or trading and equity securities are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of deferred income tax as a separate component of other comprehensive income until realized. Realized gains and losses on sales of securities are based on the specific identification method. Declines in the fair value of securities below their carrying value that are other than temporary are recognized in earnings. As of December 31, 2007, all of the investments of NAICO were in fixed-maturity investments (rated A2 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), certificates of deposit insured by the Federal Deposit Insurance Corporation ("FDIC"), 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. At December 31, 2007, 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 12 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 9.34% at December 31, 2007. 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 9.34% at December 31, 2007. 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. In December 2003, the Financial Accounting Standards Board issued Revised Interpretation No. 46 ("FIN 46R"), CONSOLIDATION OF VARIABLE INTEREST ENTITIES. FIN 46R provides guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights. FIN 46R is used to determine whether consolidation is required or, alternatively, whether the variable-interest model under FIN 46R should be used to account for existing and new entities. Chandler USA adopted FIN 46R effective January 1, 2004. The result of adoption was the deconsolidation of the two capital trusts that were created during 2003 in connection with the issuance of trust preferred securities. Chandler USA now reports the $20.6 million of junior subordinated debentures that were issued to the capital trusts on its consolidated balance sheet. The adoption of FIN 46R had no effect on net earnings. EMPLOYEES AND ADMINISTRATION At December 31, 2007, Chandler USA and its subsidiaries had approximately 201 full-time employees. Chandler USA and its subsidiaries generally have enjoyed good relations with their employees. COMPETITION NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO. An insurance company's capacity to write insurance policies is dependent on a variety of factors including its net worth or "surplus," the lines of business written, the types of risk insured and its profitability. During the late 1990's and into 2000, property and casualty insurance companies generally under priced their products, which resulted in poor underwriting results that were partially offset by investment returns. Interest rates decreased in 2000 and underwriting results continued to deteriorate for business written in the late 1990's and into 2000. These factors coupled with additional potential losses due to terrorism and lower investment returns caused the industry to increase pricing beginning in the latter half of 2001. Rate increases continued through 2003 and to a lesser extent in 2004, and the industry's underwriting results have improved. The pricing environment during 2005 through 2007 experienced downward pressure, particularly for larger accounts. NAICO was able to increase its pricing for most coverages from 2001 through 2005. However, the recent industry trend has been for insurers to maintain or reduce rate levels, and NAICO has reduced its pricing in certain situations and for certain coverages including workers compensation during 2006 and 2007. 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 13 REGULATION REGULATION IN GENERAL NAICO is subject to regulation by government agencies in the jurisdictions in which it does business. The nature and extent of such regulation vary from jurisdiction to jurisdiction, but typically involve prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company, regulation of certain transactions entered into by an insurance company with any of its affiliates, approval of premium rates, forms and policies used for many lines of insurance, standards of solvency and minimum amounts of capital and surplus which must be maintained, establishment of reserves required to be maintained for unearned premiums, unpaid losses and loss adjustment expenses or for other purposes, limitations on types and amounts of investments, restrictions on the size of risks which may be insured by a single company, licensing of insurers and agents, deposits of securities for the benefit of policyholders and the filing of periodic reports with respect to financial condition and other matters. In addition, regulatory examiners perform periodic financial and market conduct examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders or creditors. NAICO is required to deposit securities with regulatory agencies in several states in which it is licensed as a condition of conducting operations in those states. In addition to the regulatory oversight of NAICO, Chandler Insurance is also subject to regulation under the laws of the Cayman Islands and Chandler USA and all of its affiliates are subject to regulation under the insurance laws of Oklahoma (the "Oklahoma Insurance Code"). The Oklahoma Insurance Code contains certain reporting requirements including those requiring Chandler Insurance, as the ultimate parent company, to file information relating to its capital structure, ownership, and financial condition and the general business operations of its insurance subsidiaries. The Oklahoma Insurance Code contains special reporting and prior approval requirements with respect to transactions among affiliates. NAICO is also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include redefinitions of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through re-pricing, if permitted by applicable regulations, of coverages or limitations or cessation of the affected business. INSURANCE REGULATION CONCERNING CHANGE OR ACQUISITION OF CONTROL NAICO is a domestic property and casualty insurance company organized under the Oklahoma Insurance Code. The Oklahoma Insurance Code provides that the acquisition or change of "control" of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Oklahoma Department of Insurance. A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company must generally file with the relevant insurance regulatory authority an application for change of control containing certain information required by statute and published regulations and provide a copy of such to the domestic insurer. In Oklahoma, control is generally presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing 10% or more of the voting securities of the insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. In addition, many state insurance regulatory laws contain provisions that require pre-notification to state agencies of a change in control of a non-domestic insurance company admitted in that state. While such pre-notification statutes do not authorize the state agency to disapprove the change of control, such statutes do authorize issuance of a cease and desist order with respect to the non-domestic insurer if certain conditions exist such as undue market concentration. Any future transactions that would constitute a change in control of Chandler Insurance or Chandler USA would also generally require prior approval by the Oklahoma Department of Insurance and would require pre-acquisition notification in those states which have adopted pre-acquisition notification provisions and in which the insurers are admitted. Because such requirements are primarily for the benefit of policyholders, they may deter, delay or prevent certain transactions that could be advantageous to the shareholders or creditors of Chandler USA. RESTRICTIONS ON SHAREHOLDER DIVIDENDS A significant portion of Chandler USA's consolidated assets represents assets of NAICO that may not be immediately transferable to Chandler USA in the form of shareholder dividends, loans, advances or other payments. PAGE 14 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, 2007, NAICO had statutory earned surplus of $12.5 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 $5.0 million. NAICO paid shareholder dividends to Chandler USA totaling $1.6 million in 2007. 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. (3) "Regulatory Action Level" requires the insurer to submit an RBC Plan, or if applicable, a Revised RBC Plan to the insurance commissioner of its state of domicile. After examination or analysis, the insurance commissioner will issue an order specifying corrective actions to be taken. (4) "Authorized Control Level" authorizes the insurance commissioner to take such regulatory actions considered necessary to protect the best interest of the policyholders and creditors of an insurer which may include the actions necessary to cause the insurer to be placed under regulatory control (i.e., rehabilitation or liquidation). (5) "Mandatory Control Level" authorizes the insurance commissioner to take actions necessary to place the insurer under regulatory control (i.e., rehabilitation or liquidation).
PAGE 15 The ratios of total adjusted capital to authorized control level RBC for NAICO were 5.7:1 and 5.9:1 at December 31, 2006 and 2007, respectively. Therefore, NAICO's total adjusted capital exceeds the level that would trigger regulatory attention pursuant to the risk-based capital requirement. NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS-IRIS RATIOS The National Association of Insurance Commissioners Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies 13 industry ratios and specifies "usual values" for each ratio. Departure from the "usual values," which fluctuate annually, on four or more ratios generally leads to inquiries from individual state insurance commissioners. NAICO had two 2007 ratios that were outside of the "usual values" as explained below. NAICO's "investment yield" as calculated using the IRIS formula was 0.0% during 2007 compared to a usual value of greater than 3.0% and less than 6.5%. During 2007, NAICO reversed $4.1 million of accrued prejudgment interest income based on a final judgment entered by the court related to a favorable jury verdict in civil litigation regarding certain surety bond claims. Excluding the reversal of this prejudgment interest, NAICO's investment yield as calculated using the IRIS formula was 3.5%. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" for more information. NAICO maintains a high-quality investment portfolio, with no non-investment grade bonds, derivative instruments or real estate investments (other than real estate occupied by the company). NAICO's investment yield is largely dependent upon prevailing levels of interest rates. The significant decline in interest rates in recent years had a significant impact on NAICO's investment yield. Moreover, in periods of relatively low interest rates, NAICO generally shortens maturities and accepts lower yields to reduce market risk for future rate increases. NAICO's "two-year reserve development to policyholders' surplus" for 2007 was 21% compared to a usual value of less than 20%. The primary reason was adverse loss development experienced during 2006 related to the 2005 accident year. This adverse loss development related primarily to the automobile liability line of business in NAICO's standard lines program. EFFECT OF FEDERAL LEGISLATION Although the Federal Government does not directly regulate the business of insurance, federal initiatives often affect the insurance business in a variety of ways. Current and proposed federal measures which may significantly affect the insurance business include Federal Government participation in asbestos and other product liability claims, claims related to acts of terrorism, pension and other employee benefit plan regulation (ERISA), examination of the taxation of insurers and reinsurers, minimum levels of liability insurance and automobile safety regulations. Federal regulation of the health care industry may directly and indirectly impact the business of insurance. ITEM 1A. RISK FACTORS. Our business is subject to numerous risks and uncertainties, the outcome of which may adversely impact future results of operations and financial condition. The following risks, as well as other information included in this 2007 Annual Report on Form 10-K, should be considered carefully. IF OUR ACTUAL LOSSES EXCEED OUR LOSS RESERVES, OUR FINANCIAL RESULTS WOULD BE ADVERSELY AFFECTED. We maintain reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under our previously issued insurance policies and/or reinsurance contracts. These reserves do not represent an exact measurement of liability, but are estimates based upon historical data and anticipated future events. The process of estimating loss reserves is complex and imprecise. We periodically review the reserve estimates and the methods used to arrive at such reserve estimates, and we also retain independent professional actuaries who review such reserve estimates and methods. Any changes that result from these reviews are reflected in current operating results. If our estimates are incorrect and our reserves are inadequate, we are required to increase our reserves. An increase in reserves results in an increase in losses and a reduction in our net income for the period in which the deficiency is identified. Accordingly, an increase in reserves could have a material adverse effect on our results of operations, liquidity and financial condition. PAGE 16 CATASTROPHIC EVENTS AND ACTS OF TERRORISM CAN HAVE A SIGNIFICANT IMPACT ON OUR RESULTS OF OPERATIONS, LIQUIDITY AND FINANCIAL CONDITION. We are subject to claims arising out of catastrophes that may have a significant effect on our results of operations, liquidity and financial condition. Catastrophes can be caused by various events, including tornadoes, windstorms, hail, fires, severe winter weather, earthquakes, power outages and explosions, and may include man-made events such as terrorist attacks. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. We seek to reduce the impact of a catastrophe on our business through the purchase of catastrophe and terrorism reinsurance. Reinsurance does not relieve us of our direct liability to our policyholders. As long as the reinsurers meet their obligations, our net liability is limited to the amount of risk that we retain. Reinsurance, however, may prove inadequate if a major catastrophic loss exceeds the reinsurance limit or the reinsurers' financial capacity. OUR RESULTS MAY FLUCTUATE BASED ON MANY FACTORS, INCLUDING CYCLICAL CHANGES IN THE INSURANCE INDUSTRY. The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. The industry's profitability can be affected significantly by rising levels of claim costs that are not known by companies at the time they price their products. The property and casualty insurance industry historically is cyclical. The demand for property and casualty insurance can vary significantly, generally rising as the overall level of economic activity increases and falling as such activity decreases. The property and casualty insurance industry also has been very competitive. During the late 1990's and into 2000, property and casualty insurance companies generally under priced their products, which resulted in poor underwriting results that were partially offset by investment returns. Interest rates decreased in 2000 and underwriting results continued to deteriorate for business written in the late 1990's and into 2000. These factors coupled with additional potential losses due to terrorism and lower investment returns caused the industry to increase pricing beginning in the latter half of 2001. Rate increases continued through 2003 and to a lesser extent in 2004, and the industry's underwriting results have improved. The pricing environment during 2005 through 2007 experienced downward pressure, particularly for larger accounts. The recent industry trend has been for insurers to maintain or reduce rate levels, and NAICO has reduced its pricing in certain situations and for certain coverages including workers compensation during 2006 and 2007. Competition for profitable business in the past has resulted in pressure on pricing and less restrictive terms and conditions, contributing to the cyclical pricing and underwriting results. Our underwriting philosophy is to forego underwriting risks from which we are unable to obtain what we believe to be adequate premium rates. However, the fluctuations in demand and competition and the impact on us of other factors described above could have a material adverse effect on our business, results of operations and/or financial condition. OUR ABILITY TO REDUCE OUR EXPOSURE TO RISKS DEPENDS ON THE AVAILABILITY AND COST OF REINSURANCE. We transfer a portion of our risks insured under our policies and reinsurance contracts to other companies through reinsurance arrangements. These reinsurance arrangements reduce the potential impact of unusually severe or frequent losses. The amount and cost of reinsurance are subject, in large part, to prevailing market conditions that are beyond our control. Our ability to provide insurance at competitive premium rates and coverage limits on a continuing basis depends to a great extent upon our ability to obtain adequate reinsurance in amounts and at rates that will not adversely affect our competitive position. If we are unable to maintain such arrangements, then we would be forced to either bear the associated increase in net exposures or reduce the amount of risk that we underwrite. Either of these circumstances could have a material adverse effect on our results of operations, liquidity and/or financial condition. IF WE ARE UNABLE TO COLLECT FROM OUR REINSURERS ON A TIMELY BASIS, OUR FINANCIAL RESULTS WOULD BE ADVERSELY AFFECTED. We face a credit risk when we obtain reinsurance because we are still liable for the transferred risks if the reinsurer cannot meet the transferred obligations. Losses may not be recovered from our reinsurers until claims are paid and, in the case of certain long-term workers compensation and liability claims, the credit worthiness of our reinsurers may change before we can recover amounts to which we are entitled. The failure of any of our reinsurers to pay reinsurance claims on a timely basis could have a material adverse effect on our results of operations, liquidity and financial condition. THE FAIR VALUE OF OUR INVESTMENT PORTFOLIO AND OUR INVESTMENT INCOME COULD SUFFER AS A RESULT OF FLUCTUATIONS IN INTEREST RATES AND MARKET CONDITIONS. Our market risk generally represents the risk of gain or loss that may result from the potential change in the fair value of our investment portfolio as a result of fluctuations in prices and interest rates. A portion of our interest expense fluctuates with changes in interest rates as well. PAGE 17 Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of those instruments. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative investments, liquidity of the instrument and other general market conditions. Any significant decline in our investment income as a result of falling interest rates, decreased dividend payment rates or general market conditions would have an adverse effect on our results. Any significant decline in the market value of our investments would reduce our shareholder's equity and our policyholders' surplus, which could impact our ability to write additional business. WE MAY BE ADVERSELY IMPACTED BY A CHANGE IN OUR FINANCIAL STRENGTH RATING. Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors they believe are important to policyholders. Ratings are not recommendations to buy our securities. NAICO's ability to write business is most influenced by our rating from A.M. Best Company. A.M Best ratings are designed to assess an insurer's financial strength and ability to meet continuing obligations to policyholders. Currently, our rating from A.M. Best is "B+" (Good), with a stable outlook. NAICO's rating was downgraded to the current rating from "B++" effective June 21, 2005. The downgrade was primarily due to the significant net loss and decline in statutory surplus in 2004 which were driven by adverse loss reserve development on prior accident years. We believe that as a result of our improved surplus and operating performance in 2005, 2006 and 2007, our rating will remain at least at its current level. However, there can be no assurance that A.M. Best will not change its rating in the future. A rating downgrade from A.M. Best could adversely affect the business we write and our results of operations. WE DEPEND ON OUR INDEPENDENT INSURANCE AGENTS. We market and sell our insurance products through independent, non-exclusive insurance agencies. These agencies are not obligated to sell our insurance products, and generally they also sell our competitors' insurance products. As a result, our business depends in part on the marketing and sales efforts of these agencies. If we diversify and expand our business geographically, then we may need to expand our network of agencies to successfully market our products. If these agencies fail to market our products successfully, our business may be adversely impacted. Also, independent agents may decide to sell their businesses to banks, other insurance agencies or other businesses. Changes in ownership of agencies, or expansion of agencies through acquisition, could adversely affect an agency's ability to control growth and profitability, thereby adversely affecting our business. MUCH OF OUR BUSINESS IS CONCENTRATED IN THE SOUTHWEST AND MIDWEST AREAS OF THE UNITED STATES, WHICH TIES OUR PERFORMANCE TO THE ENVIRONMENTAL, BUSINESS, ECONOMIC AND REGULATORY CONDITIONS OF THESE REGIONS. During 2007, approximately 71% of our written premiums were in the states of Oklahoma and Texas. Unusually severe storms or other natural or man-made disasters that destroy property in these states could adversely affect our operations. Our revenues and profitability are also subject to prevailing economic and regulatory conditions in these states. An economic downturn in these states could have a significant adverse impact on our business. The loss of a significant amount of premiums written in either of these states, whether due to regulatory changes, competitive changes, economic downturns in these states or other reasons, would reduce our revenues and could have a material adverse effect on our results of operations, liquidity and/or financial condition. WE OPERATE IN A HIGHLY COMPETITIVE INDUSTRY. We compete with local, regional and national insurance companies in our selected lines of business. Many of these companies are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than we do. In addition, we face competition within each insurance agency that sells our insurance because we sell through independent agencies that represent more than one insurance company. The property and casualty insurance industry is highly competitive on the basis of product, price and service. If our competitors offer products with more coverage, or price their products more aggressively, our ability to grow or renew our business may be adversely impacted. The inability to compete effectively could materially reduce our customer base and revenues, and could adversely affect our results of operations, liquidity and financial condition. PAGE 18 WE ARE AN INSURANCE HOLDING COMPANY WITH NO DIRECT OPERATIONS, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO MEET OUR DEBT OBLIGATIONS. As a holding company with no business operations of its own, we receive cash principally through borrowings, subsidiary dividends and other payments from our subsidiaries and parent company to pay interest on and repay the principal of our debt. Statutes and regulations governing NAICO and other insurance companies domiciled in Oklahoma regulate the payment of shareholder dividends and other payments from NAICO to Chandler USA. To the extent that these restrictions limit NAICO's ability to pay dividends or other payments to us, our ability to satisfy our obligations may also be limited. Historically, NAICO has played a significant role in the servicing of debt and other obligations of Chandler USA through the payment of shareholder dividends. Management's expectation is that Chandler Insurance or other subsidiaries will be able to meet these obligations in the future. It is possible that dividends from NAICO may be necessary to service Chandler USA's debt obligations. To the extent that the restrictions discussed previously limit NAICO's ability to pay shareholder dividends or other payments to Chandler USA, Chandler USA's ability to satisfy the debt obligations may also be limited. WE ARE HEAVILY REGULATED IN THE STATES IN WHICH WE OPERATE. NAICO is subject to regulation by government agencies in the jurisdictions in which it does business. The nature and extent of such regulation vary from jurisdiction to jurisdiction, but typically involve prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company, regulation of certain transactions entered into by an insurance company with any of its affiliates, approval of premium rates, forms and policies used for many lines of insurance, standards of solvency and minimum amounts of capital and surplus which must be maintained, establishment of reserves required to be maintained for unearned premiums, unpaid losses and loss adjustment expenses or for other purposes, limitations on types and amounts of investments, restrictions on the size of risks which may be insured by a single company, licensing of insurers and agents, deposits of securities for the benefit of policyholders and the filing of periodic reports with respect to financial condition and other matters. In addition, regulatory examiners perform periodic financial and market conduct examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders or creditors. NAICO is also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include redefinitions of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through re-pricing, if permitted by applicable regulations, of coverages or limitations or cessation of the affected business. This extensive regulation of our business may affect the cost or demand for our products and may limit our ability to obtain rate increases or to take other actions that we might desire to increase our profitability. In addition, we may be unable to maintain all required approvals or comply fully with the wide variety of applicable laws and regulations, or the relevant authority's interpretation of such laws and regulations. LITIGATION AND LEGAL PROCEEDINGS AGAINST US COULD HAVE AN ADVERSE EFFECT ON OUR BUSINESS, RESULTS OF OPERATIONS AND/OR FINANCIAL CONDITION. Like other insurance companies, we are involved in lawsuits and legal proceedings in the normal course of our business, some of which involve claims for substantial amounts and the outcomes of which are unpredictable. This litigation is based on a variety of issues including insurance and claim settlement practices. ASSESSMENTS FOR GUARANTY FUNDS AND OTHER MANDATORY POOLING ARRANGEMENTS MAY REDUCE OUR PROFITABILITY. Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insureds as the result of impaired or insolvent insurance companies. These obligations are funded by assessments that are expected to continue in the future as a result of insolvencies. In addition, as a condition to the ability to conduct business in some states, insurance companies are required to participate in mandatory workers compensation shared market mechanisms or pooling arrangements, which provide workers compensation insurance coverage from private insurers. The effect of these assessments and mandatory shared market mechanism or changes in them could reduce our profitability in any given period or limit our ability to grow our business. PAGE 19 WE DEPEND ON KEY PERSONNEL. We believe that our future success will depend to a significant extent on our ability to attract and retain key employees, in particular our senior officers, and key management, information systems, underwriting, claims and corporate personnel. MANAGING TECHNOLOGY INITIATIVES AND MEETING NEW DATA SECURITY REQUIREMENTS PRESENT SIGNIFICANT CHALLENGES. While technological developments can streamline many business processes and ultimately reduce the cost of operations, technology initiatives can present short term cost and implementation risks. Data security is subject to increasing regulation. We face rising costs and competing time constraints in meeting compliance requirements of new and proposed regulations. The expanding volume and sophistication of computer viruses, hackers and other external hazards may increase the vulnerability of our data systems to security breaches. These increased risks and expanding regulatory requirements expose us to potential data loss and damages and significant increases in compliance costs. ITEM 1B. UNRESOLVED STAFF COMMENTS. Not applicable. ITEM 2. PROPERTIES. Chandler USA and its subsidiaries own and occupy four office buildings with approximately 127,000 square feet of usable space in Chandler, Oklahoma. Chandler USA believes such space is sufficient for its operations for the foreseeable future. ITEM 3. LEGAL PROCEEDINGS. See Note 10 to Consolidated Financial Statements for a discussion of litigation matters. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the quarter ended December 31, 2007. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES. 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 and the related consolidated statements of operations, comprehensive income, shareholder's equity and cash flows for each of the five years in the period ended December 31, 2007 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). PAGE 20 ITEM 6. SELECTED FINANCIAL DATA (CONTINUED).
YEAR ENDED DECEMBER 31, ------------------------------------------------- 2003 2004 2005 2006 2007 --------- --------- --------- --------- --------- (Dollars in thousands) OPERATING DATA Revenues Direct premiums written and assumed .................... $118,444 $121,651 $120,344 $113,043 $100,081 ========= ========= ========= ========= ========= Net premiums earned .................................... $ 56,583 $ 64,042 $ 66,060 $ 65,704 $ 66,185 Investment income, net (1) ............................. 2,148 3,186 2,798 9,801 (572) Interest income, net from related parties .............. 412 491 670 792 941 Realized investment gains, net ......................... 2,351 652 383 745 214 Other income (2) ....................................... 5,077 640 251 317 1,916 --------- --------- --------- --------- --------- Total revenues ........................................... 66,571 69,011 70,162 77,359 68,684 --------- --------- --------- --------- --------- Operating expenses Losses and loss adjustment expenses .................... 37,200 53,781 37,324 45,473 41,393 Policy acquisition costs ............................... 11,278 11,039 10,671 11,666 12,547 General and administrative expenses .................... 13,486 12,380 12,749 12,469 12,790 Interest expense ....................................... 2,441 2,397 2,535 2,690 2,703 --------- --------- --------- --------- --------- Total operating expenses ................................. 64,405 79,597 63,279 72,298 69,433 --------- --------- --------- --------- --------- Income (loss) before income taxes ........................ 2,166 (10,586) 6,883 5,061 (749) Federal income tax benefit (provision) ................... (192) 3,582 (2,450) (1,665) 87 --------- --------- --------- --------- --------- Net income (loss) ........................................ $ 1,974 $ (7,004) $ 4,433 $ 3,396 $ (662) ========= ========= ========= ========= ========= Combined loss and underwriting expense ratio (3) ......... 113% 118% 92% 106% 102% BALANCE SHEET DATA Cash and investments ..................................... $ 69,198 $ 86,913 $ 86,316 $ 89,703 $ 97,199 Amounts due from related parties ......................... 9,642 10,891 9,360 9,584 11,506 Total assets ............................................. 218,213 237,297 245,059 222,772 234,367 Unpaid losses and loss adjustment expenses ............... 87,768 108,233 109,541 83,253 100,590 Debentures ............................................... 7,254 6,979 6,979 6,979 6,979 Junior subordinated debentures issued to affiliated trusts ................................................. 20,620 20,620 20,620 20,620 20,620 Total liabilities ........................................ 174,374 201,105 205,373 179,808 190,763 Shareholder's equity ..................................... 43,839 36,192 39,686 42,964 43,604 ------------------------------------------------------------ (1) Net investment income included $577,000 in interest from an arbitration award in 2004, and $6.6 million for the accrual of prejudgment interest on a favorable jury verdict in 2006. In January 2008, the court entered a final judgment on this matter which resulted in the accrual of prejudgment interest being reduced by $4.1 million during 2007. For additional information, see "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." (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. Other income increased in 2007 due to a new arrangement between CIMI and Praetorian covering property and inland marine business previously written by NAICO. See "Insurance Programs" for more information. (3) Interest expense and certain litigation expenses are not considered underwriting expenses and have been excluded from this ratio.
PAGE 21 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 two separate marketing programs: standard lines and political subdivisions. 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. During 2005, NAICO began writing homeowner and dwelling fire and allied lines policies in the state of Texas through a managing general agent. NAICO discontinued its homeowners program during 2006, and has also transferred its property and inland marine business for the standard lines and political subdivisions programs to Praetorian effective January 1, 2007 through a new arrangement between Praetorian and CIMI. See "Insurance Programs" for more information. 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 is an underwriting manager and wholesaler that offers multiple insurance products for businesses in various industries and political subdivisions. SUMMARY OF RESULTS For the year ended December 31, 2007, Chandler USA had a net loss of $662,000 compared to net income of $3.4 million for 2006 and a net income of $4.4 million for 2005. The net loss in 2007 was primarily due to the reversal of a portion of the prejudgment interest income that was accrued during 2006 on a favorable jury verdict. This is discussed in more detail under "Litigation" and in Note 10 to Consolidated Financial Statements. Many factors determine the profitability of an insurance company including regulation and rate competition; the frequency and severity of claims; the cost, availability and collectibility of reinsurance; interest rates; inflation; general business conditions; and jury awards, court decisions and legislation expanding the extent of coverage and the amount of compensation due for injuries and losses. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with U.S. GAAP requires the application of accounting policies that often involve a significant degree of judgment. Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods. If management determines, as a result of its consideration of facts and circumstances, that changes in estimates and assumptions are appropriate, results of operations and financial position as reported in the consolidated financial statements may change significantly. Management has identified the following accounting policies as critical in understanding Chandler USA's reported financial results. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES Insurance companies provide in their financial statements reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under their previously issued insurance policies and reinsurance contracts. In estimating reserves, insurance companies use various standardized methods based on historical experience and payment and reporting patterns for the type of risk involved. The application of these methods necessarily involves subjective determinations by the personnel of the insurance company. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount of and uncertainty in the estimates is affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances, and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs, such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that expand insurance coverage after the insurance policy was priced and sold. In recent years, certain of these factors have contributed to incurred amounts that were significantly higher than original estimates. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims. PAGE 22 Estimating the ultimate loss and loss adjustment expense liability is a complex and judgmental process inasmuch as the amounts are based on management's informed estimates, assumptions and judgments using data currently available. The assumptions used in establishing reserves are regularly reviewed and updated by management as new data becomes available. Changes to estimates of previously established reserves are included in earnings in the period in which the estimate is changed. Such changes in estimates may be material. If the ultimate losses prove to differ substantially from the amounts previously recorded, the related adjustments could have a material adverse effect on Chandler USA's financial condition, results of operations and liquidity. NAICO's loss reserves consist of case reserves and reserves for incurred but not reported ("IBNR") claims. Case reserves are established by claims personnel based on a review of the facts known at the time the claim is reported, and are subsequently revised as more information about a claim becomes known. IBNR is computed using various actuarial methods and techniques and includes reserves for losses that have occurred but for which claims have not yet been reported, including provision for expected future development on case reserves. As of December 31, 2007, NAICO's case reserves and IBNR for each line of business are shown in the following table.
Gross reserves at December 31, 2007 Net reserves at December 31, 2007 ----------------------------------- --------------------------------- Case Total Case Total reserves IBNR reserves reserves IBNR reserves ----------- ----------- ----------- ---------- ---------- ----------- (In thousands) (In thousands) Automobile liability ......... $ 19,932 $ 19,111 $ 39,043 $ 14,227 $ 12,371 $ 26,598 Workers compensation ......... 25,253 19,037 44,290 10,336 6,945 17,281 Other liability .............. 5,535 33,058 38,593 4,069 9,324 13,393 Automobile physical damage ... 604 - 604 428 - 428 Property ..................... 62 11 73 25 8 33 Surety ....................... (22,108) 94 (22,014) (11,867) - (11,867) Accident and health .......... 1 - 1 - - - Inland marine ................ - - - - - - ----------- ----------- ----------- ---------- ---------- ----------- Total reserves .............. $ 29,279 $ 71,311 $ 100,590 $ 17,218 $ 28,648 $ 45,866 =========== =========== =========== ========== ========== ===========
NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Methods used include the paid loss development method, incurred loss development method, Bornhuetter-Ferguson method and loss ratio method. Most methods assume that past patterns in the historical data will be repeated in the future, as long as there are no significant changes in pertinent variables. The methods chosen are those that are believed to produce the most reliable indication at that particular evaluation date. While each of the methods produce point estimates for each period analyzed, management's best estimate is usually comprised of a combination of methods due to differences in conditions during each period. The selected estimate may be one method, or a weighted average of several methods, or a judgmental selection if management determines it is appropriate. The ultimate point estimate selected by management represents the amount that management believes is the most likely amount that will ultimately be paid to settle the net reserves recorded at a particular point in time. Reserves for losses and loss adjustment expenses are developed using multiple estimation methods that result in various point estimates for each insurance program. The estimate recorded by management is a function of detailed analysis of the historical trends and development factors resulting from the different methods. As a result of the variety of factors that must be considered by management there is a significant risk that actual incurred losses will develop differently from these estimates. The process of selecting the point estimate from the set of possible outcomes produced by the various actuarial methods discussed above is based upon the judgment of management. In making its selection, management considers recent trends in claims frequency and severity and other factors including, but not limited to, large loss activity, large case reserve additions, historical loss information, per claim information, NAICO's loss retention, legislative enactments, judicial decisions, and trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. Significant changes in claims development patterns from historical claims development patterns may cause a significant variation between current reserve estimates and the actual future paid amounts. Assumptions used in establishing loss reserves are regularly reviewed and updated by management as new data becomes available. The changes in these estimates, resulting from the review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of operations for the period in which such estimates are changed. Such changes in estimates may be material. See Notes to Consolidated Financial Statements. PAGE 23 The following table shows the recorded reserves and the high and low point estimates based on the results of the various actuarial methods described above as of December 31, 2007.
Insurance program Low High Recorded ------------------------------------------- --------- ---------- ---------- (In thousands) Gross Reserves -------------- Standard lines .......................... $104,808 $ 160,647 $ 110,098 Political subdivisions .................. 3,721 3,721 3,721 Homeowners .............................. 47 47 47 Surety bonds ............................ (22,014) (22,014) (22,014) Involuntary workers compensation pools .. 5,704 5,704 5,704 Other ................................... 3,034 3,034 3,034 --------- ---------- ---------- $ 95,300 $ 151,139 $ 100,590 ========= ========== ========== Net Reserves -------------- Standard lines .......................... $ 38,819 $ 83,584 $ 46,893 Political subdivisions .................. 1,358 2,064 2,033 Homeowners .............................. 35 35 35 Surety bonds ............................ (11,867) (11,867) (11,867) Involuntary workers compensation pools .. 5,704 5,704 5,704 Other ................................... 3,068 3,068 3,068 --------- ---------- ---------- $ 37,117 $ 82,588 $ 45,866 ========= ========== ==========
For the workers compensation portion of the standard lines program, NAICO's actuaries selected the results of the incurred loss development method for the 2006 and prior accident years. The 2007 accident year selection was based on a judgmentally selected loss ratio. For the casualty portion of this program, the actuaries relied on judgment in the selection of ultimate losses for all accident years. The 2004 through 2007 accident years were based on judgmentally selected loss ratios in order to adjust for the effect of case reserve strengthening that was recorded during these years. Ultimate loss selections for older accident years assume unreported losses are equal to case reserves as of December 31, 2007. The estimation methods chosen are those that are believed to produce the most reliable indication at that particular evaluation date for the losses being evaluated. The point estimates for the political subdivisions, homeowners and surety bond programs are less volatile as portions of these programs are in a run-off mode and can be estimated with more certainty. Surety bond reserves are actually a net receivable due to anticipated subrogation recoveries. Certain involuntary pools provided their own estimates and NAICO records these estimates plus an accrual to account for the lag time in reporting to NAICO. The actuarial methods used in the 2007 loss reserve analysis were similar to those used in the 2006 analysis. The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury, workers compensation and other liability claims have a much longer loss settlement period and may be paid out over several years. It is often necessary to adjust estimates of liability on a loss either upward or downward between the time a claim arises and the time of payment. Workers compensation indemnity benefit reserves are determined based on statutory benefits prescribed by state law and are estimated based on the same factors generally discussed above which may include, where state law permits, inflation adjustments for rising benefits over time. Generally, the more costly automobile liability claims involve one or more severe bodily injuries or deaths. Other liability claims include coverages protecting the insured against legal liability resulting from negligence, carelessness, or a failure to act causing property damage or personal injury to others. The estimation of loss reserves for other liability claims is affected by the timing of claims reporting, the applicable statute of limitations, the litigious climate and magnitude of jury awards, the unpredictability of judicial decisions regarding coverage issues and outside counsel costs. The ultimate cost of these types of claims is dependent on various factors including the relative liability of the parties involved, the number and severity of injuries and the legal jurisdiction where the incident occurred. NAICO does not ordinarily insure against environmental matters as that term is commonly used. However, in some cases, regulatory filings made on behalf of an insured can make NAICO directly liable to the regulatory authority for property damage, which could include environmental pollution. In those cases, NAICO ordinarily has recourse against the insured or the surety bond principal for amounts paid. NAICO has insured certain trucking companies and pest control operators who are required to provide proof of insurance which in some cases assures payment for cleanup and restoration of damage resulting from sudden and accidental release or discharge of contaminants or other substances which may be classified as pollutants. NAICO also provides surety bonds for construction contractors who use or have control of such substances and for contractors who remove and dispose of asbestos as a part of their contractual obligations. 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. PAGE 24 NAICO's statutory-based reserves (reserves calculated in accordance with accounting practices prescribed or permitted by an insurer's domiciliary state insurance regulatory authorities for purposes of financial reporting to regulators) do not differ from its reserves reported on the basis of GAAP. NAICO does not discount its reserves for unpaid losses and loss adjustment expenses. Management believes that its unpaid losses and related reinsurance recoverables are fairly stated as of December 31, 2007. However, estimating the ultimate claims liability is necessarily a complex and judgmental process inasmuch as the amounts are based on management's informed estimates, assumptions and judgments using data currently available. REINSURANCE RECOVERABLES Reinsurance recoverables on unpaid losses and loss adjustment expenses are similarly subject to changes in estimates and assumptions. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In addition to factors noted above, estimates of reinsurance recoverables may prove uncollectible if the reinsurer is unable or unwilling to meet its responsibilities under the reinsurance contracts. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. DEFERRED INCOME TAXES Chandler USA uses an asset and liability approach for accounting for income taxes. Deferred income taxes are recognized for the tax consequences of temporary differences and carryforwards by applying enacted tax rates applicable to future years to differences between the financial statement amounts and the tax bases of existing assets and liabilities. A valuation allowance is established if it is more likely than not that some portion of the deferred tax asset will not be realized. The determination of whether a valuation allowance is appropriate requires the exercise of management judgment. At December 31, 2007, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $1.3 million which begins to expire in 2025. Chandler USA has concluded that the deferred tax asset including the federal net operating loss carryforwards is more likely than not to be realized. Chandler USA anticipates that its future U.S. consolidated income will be sufficient to utilize the federal net operating losses within the required time. Chandler USA will continue to evaluate income generated in future periods in determining the reasonableness of its position. If Chandler USA determines that future income is insufficient to cause the realization of the federal net operating losses within the required time, a valuation allowance will be established. In addition, Chandler USA, at December 31, 2007, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $34.3 million which expire in the years 2008 through 2027. A valuation allowance has been provided for the tax effect of the state net operating loss since realization of such amount 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 $70.6 million, or 71%, of NAICO's direct written and assumed premiums in 2007 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 equity securities 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. PAGE 25 COMPETITION NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO. An insurance company's capacity to write insurance policies is dependent on a variety of factors including its net worth or "surplus," the lines of business written, the types of risk insured and its profitability. During the late 1990's and into 2000, property and casualty insurance companies generally under priced their products, which resulted in poor underwriting results that were partially offset by investment returns. Interest rates decreased in 2000 and underwriting results continued to deteriorate for business written in the late 1990's and into 2000. These factors coupled with additional potential losses due to terrorism and lower investment returns caused the industry to increase pricing beginning in the latter half of 2001. Rate increases continued through 2003 and to a lesser extent in 2004, and the industry's underwriting results have improved. The pricing environment during 2005 through 2007 experienced downward pressure, particularly for larger accounts. NAICO was able to increase its pricing for most coverages from 2001 through 2005. However, the recent industry trend has been for insurers to maintain or reduce rate levels, and NAICO has reduced its pricing in certain situations and for certain coverages including workers compensation during 2006 and 2007. NAICO continues to experience competition in all of its programs. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates. REGULATION NAICO is subject to regulation by government agencies in the jurisdictions in which it does business. The nature and extent of such regulations vary from jurisdiction to jurisdiction, but typically involve prior approval of the acquisition of control of an insurance company or of any company controlling an insurance company, regulation of certain transactions entered into by an insurance company with any of its affiliates, approval of premium rates, forms and policies used for many lines of insurance, standards of solvency and minimum amounts of capital and surplus which must be maintained, establishment of reserves required to be maintained for unearned premiums, unpaid losses and loss adjustment expenses or for other purposes, limitations on types and amounts of investments, restrictions on the size of risks which may be insured by a single company, licensing of insurers and agents, deposits of securities for the benefit of policyholders and the filing of periodic reports with respect to financial condition and other matters. In addition, regulatory examiners perform periodic examinations of insurance companies. Such regulation is generally intended for the protection of policyholders rather than shareholders or creditors. As an Oklahoma corporation, NAICO and any person controlling NAICO, directly or indirectly, are subject to the insurance laws of Oklahoma including laws concerning the change or acquisition of control and payment of shareholder and policyholder dividends by NAICO. In addition to the regulatory oversight of NAICO, Chandler Insurance is also subject to regulation under the laws of the Cayman Islands and Chandler USA and all of its affiliates are also subject to regulation under the Oklahoma Insurance Code. The Oklahoma Insurance Code contains certain reporting requirements including those requiring Chandler Insurance, as the ultimate parent company, to file information relating to its capital structure, ownership and financial condition and general business operations of its insurance subsidiaries. The Oklahoma Insurance Code contains special reporting and prior approval requirements with respect to transactions among affiliates. The Oklahoma Insurance Code also imposes certain requirements upon any person controlling or seeking to control an insurance company domiciled in Oklahoma. Control is generally presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing 10% or more of the voting securities of the insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Persons owning any securities of Chandler USA or Chandler Insurance must comply with the Oklahoma Insurance Code. See "BUSINESS - Regulation." Insurance companies are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include the redefinition of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through coverage re-pricing, if permitted by applicable regulations, or limitations or cessation of the affected business. PAGE 26 ANALYSIS OF INSURANCE PROGRAM RESULTS OF OPERATIONS The following tables summarize the net premiums earned and loss ratios (computed by dividing losses and loss adjustment expenses by net premiums earned) in each of the years presented. The "loss ratio" is based on losses recorded during the calendar year presented regardless of the accident year in which the claim occurred. The first table is summarized by major insurance program and includes all lines of insurance written in each program. The second table is summarized by line of insurance written and includes all net premiums earned and net losses and loss adjustment expenses incurred from all insurance programs for that particular line. See "Premiums Earned" and "Losses and Loss Adjustment Expenses."
YEAR ENDED DECEMBER 31, -------------------------------- 2005 2006 2007 ---------- ---------- ---------- (Dollars in thousands) INSURANCE PROGRAMS ---------------------------------------- STANDARD LINES Net premiums earned .................. $ 54,979 $ 54,357 $ 62,342 Loss ratio ........................... 61.0% 74.0% 59.5% POLITICAL SUBDIVISIONS Net premiums earned .................. $ 6,690 $ 5,253 $ 3,436 Loss ratio ........................... 61.2% 51.3% 46.1% HOMEOWNERS Net premiums earned .................. $ 3,321 $ 5,353 $ 9 Loss ratio ........................... 39.3% 47.0% (560.0)% SURETY BONDS Net premiums earned .................. $ 669 $ 193 $ 186 Loss ratio ........................... (254.7)% (78.8)% 1,119.1% OTHER (1) Net premiums earned .................. $ 401 $ 548 $ 212 Loss ratio ........................... 29.7% 37.5% 307.2% TOTAL Net premiums earned .................. $ 66,060 $ 65,704 $ 66,185 Loss ratio ........................... 56.5% 69.2% 62.5% ------------------------- (1) This category is comprised primarily of the run-off of discontinued programs and NAICO's participation in various mandatory workers compensation pools.
PAGE 27
YEAR ENDED DECEMBER 31, -------------------------------- 2005 2006 2007 ---------- ---------- ---------- (Dollars in thousands) LINES OF INSURANCE ---------------------------------------- AUTOMOBILE LIABILITY Net premiums earned .................. $ 19,126 $ 21,122 $ 26,469 Loss ratio ........................... 81.8% 99.5% 73.7% WORKERS COMPENSATION Net premiums earned .................. $ 16,475 $ 15,361 $ 17,861 Loss ratio ........................... 52.7% 63.3% 62.2% OTHER LIABILITY Net premiums earned .................. $ 18,052 $ 16,628 $ 15,137 Loss ratio ........................... 47.6% 56.9% 32.4% AUTOMOBILE PHYSICAL DAMAGE Net premiums earned .................. $ 5,807 $ 5,008 $ 6,096 Loss ratio ........................... 56.3% 62.6% 55.0% PROPERTY Net premiums earned .................. $ 5,594 $ 7,082 $ 279 Loss ratio ........................... 41.5% 41.3% 63.9% SURETY Net premiums earned .................. $ 669 $ 194 $ 186 Loss ratio ........................... (254.7)% (459.4)% 1,119.1% INLAND MARINE Net premiums earned .................. $ 337 $ 309 $ 157 Loss ratio ........................... 162.0% 30.0% 18.9% TOTAL Net premiums earned .................. $ 66,060 $ 65,704 $ 66,185 Loss ratio ........................... 56.5% 69.2% 62.5%
PAGE 28 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 2005 2006 2007 2005 2006 2007 -------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Standard lines ................. $ 92,224 $ 91,153 $100,844 $ 54,979 $ 54,357 $ 62,342 Political subdivisions ......... 18,630 14,337 5,084 6,690 5,253 3,436 Homeowners ..................... 4,229 8,542 501 3,321 5,353 9 Surety bonds ................... 930 278 266 669 193 186 Other .......................... 406 550 214 401 548 212 -------- -------- -------- -------- -------- -------- TOTAL .......................... $116,419 $114,860 $106,909 $ 66,060 $ 65,704 $ 66,185 ======== ======== ======== ======== ======== ======== GROSS PREMIUMS EARNED NET PREMIUMS EARNED ---------------------------- ---------------------------- LINES OF INSURANCE 2005 2006 2007 2005 2006 2007 -------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Automobile liability ........... $ 28,031 $ 31,615 $ 39,298 $ 19,126 $ 21,122 $ 26,469 Workers compensation ........... 25,769 23,562 28,337 16,475 15,361 17,861 Other liability ................ 33,944 31,744 28,995 18,052 16,628 15,137 Automobile physical damage ..... 8,914 7,720 9,021 5,807 5,008 6,096 Property ....................... 17,102 18,335 745 5,594 7,082 279 Surety ......................... 930 278 266 669 194 186 Inland marine .................. 1,729 1,606 247 337 309 157 -------- -------- -------- -------- -------- -------- TOTAL .......................... $116,419 $114,860 $106,909 $ 66,060 $ 65,704 $ 66,185 ======== ======== ======== ======== ======== ========
Gross premiums earned decreased 1% and 7% in 2006 and 2007, respectively. The decrease in 2006 was primarily the result of NAICO's continued efforts to improve underwriting profitability and to increased competition within the Oklahoma school districts portion of the political subdivisions program. The decrease in gross premiums earned in 2006 was partially offset by an increase in gross premiums earned in the homeowners program. The homeowners program was discontinued during 2006. The decrease in 2007 gross premiums earned was due primarily to the transfer of property and inland marine business in the standard lines and political subdivisions programs to Praetorian Insurance Company ("Praetorian") as explained further below and to the discontinuation of the homeowners program. The decrease in gross premiums earned in 2007 was partially offset by an increase in gross premiums earned in the standard lines program. Gross premiums earned in Texas decreased 12% and 29% in 2006 and 2007, respectively, and gross premiums earned in Oklahoma decreased less than 1% in 2006 and 14% in 2007. 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 is no longer required to purchase reinsurance for the significant insured values associated with this business. Net premiums earned decreased 1% in 2006 and increased 1% in 2007. An increase in net premiums earned in the homeowners program in 2006 partially offset the decreases in net premiums earned in the political subdivisions, standard lines and surety bond programs. Net premiums earned in the standard lines program increased during 2007, but the increase was partially offset by decreases in the political subdivisions and homeowners programs. 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. The reinsurance was also cancelled which resulted in a significant decrease in reinsurance premiums ceded during 2007. PAGE 29 Gross premiums earned in the standard lines program decreased 1% in 2006 and increased 11% in 2007. Gross premiums earned for workers compensation business decreased $2.3 million or 9% in 2006, but increased $5.1 million or 22% in 2007. NAICO has also increased premiums from trucking accounts in 2006 and 2007. Gross premiums earned from trucking accounts increased $8.9 million and $12.0 million in 2006 and 2007, respectively, while net premiums earned increased $5.3 million and $7.7 million in these periods. Net premiums earned in the standard lines program decreased 1% in 2006 and increased 15% in 2007. Gross premiums earned in the political subdivisions program decreased 23% and 65% in 2006 and 2007, respectively. 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 related to Oklahoma school districts. Net premiums earned decreased 21% and 35% in 2006 and 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 catastrophic exposures. Gross premiums earned in the surety bond program decreased 70% and 4% in 2006 and 2007, respectively. Net premiums earned decreased 71% and 4% in 2006 and 2007, respectively. NAICO is no longer actively marketing its surety bond program. 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, 2007, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate bonds and certificates of deposit insured by the FDIC, with approximately 34% 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 $6.6 million for the accrual of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims in 2006. During 2007, NAICO reversed $4.1 million of the prejudgment interest income based on a final judgment entered by the court. See Litigation and Note 10 of Notes to Consolidated Financial Statements. Net investment income, excluding interest income from related parties and the prejudgment interest, increased 13% in both 2006 and 2007. Interest income from related parties was $670,000, $792,000 and $941,000 during 2005, 2006 and 2007, respectively. The increases were due primarily to higher interest rates and to an increase in the amount loaned to Chandler Insurance during 2007. See Liquidity and Capital Resources. Net realized investment gains were $383,000, $745,000 and $214,000 in 2005, 2006 and 2007, respectively. The average net yield on the fixed maturity portfolio, including net realized investment gains, was 3.4%, 3.6% and 4.0% in 2005, 2006 and 2007, respectively. The average net yield on the fixed maturity portfolio, excluding net realized investment gains, was 3.4% for 2005, 3.6% for 2006 and 3.8% for 2007. 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, 2007 was approximately $12.8 million. The average yield on the fixed maturity portfolio before deducting investment expenses was 3.8% in 2005, 4.0% in 2006 and 4.2% in 2007, excluding net realized capital gains. OTHER INCOME Other income was $251,000, $317,000 and $1,916,000 during 2005, 2006 and 2007, respectively. The increase in 2007 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 30 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 56.5%, 69.2% and 62.5% in 2005, 2006 and 2007, respectively. Weather-related losses (net of applicable reinsurance) from wind and hail were $475,000, $727,000 and $109,000 in 2005, 2006 and 2007, respectively, and increased the respective loss ratios by 0.7, 1.1 and 0.2 percentage points. NAICO experienced a significant amount of incurred losses related to prior accident years during the 2005 and 2006 calendar years. Incurred losses related to prior accident years decreased $2.5 million or 40% in 2006 and decreased $2.6 million or 69% in 2007. The adverse loss development is generally the result of ongoing analysis of loss development trends for both liability and workers compensation lines of business, and includes provisions for potentially uncollectible reinsurance and deductibles. The development was primarily a function of more adverse frequency and severity patterns than previously anticipated. Since such development patterns were not present in the loss history available at the time the earlier estimates were prepared, they could therefore not be anticipated. NAICO adjusts reserves as experience develops and new information becomes known. Such adjustments are reflected in the results of operations in the periods in which the estimates are changed. The adverse development of losses from prior accident years results in higher calendar year loss ratios and reduced calendar year operating results. The following table sets forth the loss development by line of business during each of the calendar years shown.
Calendar years -------------------------------- 2005 2006 2007 ---------- ---------- ---------- (In thousands) Automobile liability ..................... $ 4,562 $ 3,028 $ (691) Workers compensation ..................... 1,387 994 1,314 Other liability .......................... 1,330 590 (1,796) Automobile physical damage ............... 255 261 65 Property ................................. 325 (47) (173) Surety ................................... (1,844) (986) 2,074 Accident and health ...................... (26) 4 394 Inland marine ............................ 350 (15) 12 ---------- ---------- ---------- $ 6,339 $ 3,829 $ 1,199 ========== ========== ==========
In 2005 and 2006, the majority of the adverse loss development was in the automobile liability line of business, as reserves were strengthened in the 1999-2005 accident years for this line of business. A portion of this adverse development was offset by favorable development in the surety line of business that resulted from an increase in estimated recoveries primarily in the 1994 and 2001 accident years. During 2007, a portion of these estimated recoveries were reduced based on a final judgment entered by the court regarding certain surety bond claims. The reduction of the estimated recoveries accounted for $1.8 million of the loss development for surety business during 2007. The 1997-2001 accident years have clearly been the problematic years where the loss development was so significant. During those years, NAICO's premium volume grew from $123 million in 1997 to $197 million in 2000, before dropping to $159 million in 2001. Much of that growth was attributable to the planned expansion of NAICO's Texas business. This growth occurred at a time when premium rates were very soft. The expansion into Texas began in the last half of 1996. NAICO had written business in Texas for many years with reasonably good experience. Based on this experience, management believed the economic and tort climates were similar to Oklahoma. This did not turn out as expected, especially in regards to business in south and east Texas. Because this expansion was primarily a casualty driven book of business, it took several years to realize that claims in many areas of Texas were more severe and emerged differently than Oklahoma claims. As the historical loss data picked up the development of these claims, the projections of ultimate losses became more accurate. PAGE 31 The following table sets forth the net reserves at the beginning of each accident year, the loss development incurred during each calendar year, and the re-estimated net reserves as of the beginning of each calendar year.
Accident years ------------------------------------------------------------------------------------------- Prior to 1999 1999 2000 2001 2002 2003 2004 2005 2006 Total -------- -------- -------- --------- -------- -------- -------- -------- -------- --------- (In thousands) Reserves at beginning of 2005 .... $ 4,579 $ 610 $ 3,695 $ 3,242 $ 6,524 $ 8,833 $17,212 $ - $ - $ 44,695 Development during 2005 .......... (283) 664 1,582 (50) 1,992 1,777 657 - - 6,339 -------- -------- -------- --------- -------- -------- -------- -------- -------- --------- Re-estimated reserves at beginning of 2005 ............... $ 4,296 $ 1,274 $ 5,277 $ 3,192 $ 8,516 $10,610 $17,869 $ - $ - $ 51,034 ======== ======== ======== ========= ======== ======== ======== ======== ======== ========= Reserves at beginning of 2006 .... $ 3,255 $ (255) $ 1,579 $ (2,444) $ 3,188 $ 5,896 $ 9,525 $19,805 $ - $ 40,549 Development during 2006 .......... 1,063 726 68 (1,678) 663 (996) 108 3,875 - 3,829 -------- -------- -------- --------- -------- -------- -------- -------- -------- --------- Re-estimated reserves at beginning of 2006 ............... $ 4,318 $ 471 $ 1,647 $ (4,122) $ 3,851 $ 4,900 $ 9,633 $23,680 $ - $ 44,378 ======== ======== ======== ========= ======== ======== ======== ======== ======== ========= Reserves at beginning of 2007 .... $ 4,714 $ (447) $ 329 $(11,030) $ 1,610 $ 2,132 $ 3,492 $12,051 $29,230 $ 42,081 Development during 2007 .......... 1,004 935 230 2,292 515 (39) 1,249 345 (5,332) 1,199 -------- -------- -------- --------- -------- -------- -------- -------- -------- --------- Re-estimated reserves at beginning of 2007 ............... $ 5,718 $ 488 $ 559 $ (8,738) $ 2,125 $ 2,093 $ 4,741 $12,396 $23,898 $ 43,280 ======== ======== ======== ========= ======== ======== ======== ======== ======== =========
During 2005, NAICO experienced adverse loss development totaling $6.3 million primarily in the standard lines and political subdivisions programs. A portion of the adverse development was offset by favorable development of $1.8 million in the surety bond program, primarily in accident years 1994 and 2001 that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the workers compensation, other liability and automobile liability lines of business in the 2000, 2002 and 2003 accident years. The adverse loss development included approximately $108,000 for provisions for potentially uncollectible reinsurance. During 2006, NAICO experienced adverse loss development totaling $3.8 million primarily in the standard lines program. A portion of the adverse development was offset by favorable development of $1.0 million in the surety bond program, primarily in the 2001 accident year, that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the automobile liability line of business in the 2005 accident year and in the workers compensation line of business in the 1997 and 1999 accident years. The adverse loss development included approximately $97,000 for provisions for potentially uncollectible reinsurance. During 2007, NAICO experienced adverse loss development totaling $1.2 million primarily in the surety bond program. During 2007, a portion of the estimated recoveries that were recorded in the surety bond program during 2006 were reduced based on a final judgment entered by the court regarding certain surety bond claims. The reduction of the estimated recoveries accounted for $1.8 million of the loss development during 2007. The adverse loss development included approximately $356,000 for provisions for potentially uncollectible reinsurance. In the last six years, management has undertaken several initiatives to improve the quality and profitability of business. These initiatives included significant rate increases, changes in coverage forms that limit or eliminate coverage, reduction or elimination of classes of business that have not been profitable, reduction or elimination of business in geographic areas that have not been profitable and increased emphasis on risk selection. Management has also improved case reserving which improves the overall reserving accuracy and also leads to better underwriting decisions. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to Chandler USA; consequently, adjustments to ceded losses and loss adjustment expenses are made for amounts deemed uncollectible. During 2005, 2006 and 2007, NAICO incurred charges of $108,000, $97,000 and $356,000, 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. PAGE 32 POLICY ACQUISITION COSTS Policy acquisition costs consist of costs associated with the acquisition of new and renewal business and generally include direct costs such as premium taxes, commissions to agents and ceding companies and premium-related assessments and indirect costs such as salaries and expenses of personnel who perform and support underwriting activities. NAICO also receives ceding commissions from reinsurers who assume premiums from NAICO under certain reinsurance contracts and the ceding commissions are accounted for as a reduction of policy acquisition costs. Direct policy acquisition costs and ceding commissions are deferred and amortized over the terms of the policies. When the sum of the anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded. The following table sets forth Chandler USA's policy acquisition costs for each of the three years ended December 31, 2005, 2006 and 2007:
YEAR ENDED DECEMBER 31, -------------------------------- 2005 2006 2007 ---------- ---------- ---------- (In thousands) Commissions expense .............................. $ 17,186 $ 15,933 $ 13,987 Other premium related assessments ................ 960 1,061 1,020 Premium taxes .................................... 2,205 2,020 2,014 Excise taxes ..................................... 272 272 280 Other expense .................................... 723 730 789 ---------- ---------- ---------- Total direct expenses ............................ 21,346 20,016 18,090 Indirect underwriting expenses ................... 6,384 6,296 5,906 Commissions received from reinsurers ............. (15,891) (15,026) (11,176) Adjustment for deferred acquisition costs ........ (1,168) 380 (273) ---------- ---------- ---------- Net policy acquisition costs ..................... $ 10,671 $ 11,666 $ 12,547 ========== ========== ==========
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 23.0% in 2005, 23.3% in 2006 and 24.0% in 2007. For these periods, commission expense as a percentage of gross written and assumed premiums was 14.3%, 14.1% and 14.0%. Indirect underwriting expenses were 5.3%, 5.6% and 5.9% of total direct written and assumed premiums in 2005, 2006 and 2007, respectively. The increase in the 2007 percentage was due primarily to the transfer of the property and inland marine business in the standard lines and political subdivisions programs to Praetorian. The transfer reduced direct premiums written by approximately $4.5 million in 2007. 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 31.6%, 31.1% and 31.4% in 2005, 2006 and 2007, respectively. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses were 10.9%, 10.8% and 11.8% of gross premiums earned and other income in 2005, 2006 and 2007, respectively. The increase in the 2007 percentage was due primarily to the transfer of the property and inland marine business in the standard lines and political subdivisions programs to Praetorian. Gross premiums earned for property and inland marine business in these programs decreased $10.9 million in 2007. 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 increased 6% in 2006 and increased less than 1% in 2007. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. The increase in 2006 was due primarily to the increase in interest rates during the period, as a portion of Chandler USA's junior subordinated debentures were issued with a floating interest rate. PAGE 33 FEDERAL INCOME TAXES Chandler USA's federal income tax benefit (provision) as a percentage of income (loss) before income taxes was 35.6%, 32.9% and 11.6% for 2005, 2006 and 2007, respectively. The 2007 percentage decreased due primarily to the impact of nondeductible expenses on the net loss before income taxes. At December 31, 2007, Chandler USA had a net deferred tax asset of $3.4 million including $455,000 related to federal net operating loss carryforwards which begin to expire in 2025. Chandler USA believes it is more likely than not that the deferred income tax asset including the federal net operating loss carryforwards will be realized through future earnings. As a result, a valuation allowance has not been recorded. Chandler USA used the same assumptions as in internal financial projections to estimate future taxable income. If Chandler USA's results are not as profitable as anticipated, a valuation allowance may have to be established for the federal net operating loss carryforwards and the other remaining deferred tax assets. LIQUIDITY AND CAPITAL RESOURCES Chandler USA is a holding company receiving cash principally through borrowings, subsidiary dividends and other payments, subject to various regulatory restrictions described in "Regulation" and the Notes to Consolidated Financial Statements. The capacity of insurance companies to write insurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for Chandler USA's subsidiaries are funds generated from insurance premiums, investment income, capital contributions from Chandler USA and proceeds from sales and maturities of portfolio investments. The principal expenditures are payment of losses and loss adjustment expenses, insurance operating expenses and commissions. A significant portion of Chandler USA's consolidated assets represents assets of NAICO that may not be immediately transferable to Chandler USA in the form of shareholder dividends, loans, advances or other payments. Statutes and regulations governing NAICO and other insurance companies domiciled in Oklahoma regulate the payment of shareholder dividends and other payments by NAICO to Chandler USA. Under applicable Oklahoma statutes and regulations, NAICO is permitted to pay shareholder dividends only out of statutory earned surplus. To the extent NAICO has statutory earned surplus, NAICO may pay shareholder dividends only to the extent that such dividends are not defined as extraordinary dividends or distributions. If the dividends are, under applicable statutes and regulations, extraordinary dividends or distributions, regulatory approval must be obtained. Under the applicable Oklahoma statute, and subject to the availability of statutory earned surplus, the maximum shareholder dividend that may be declared (or cash or property distribution that may be made) by NAICO in any one calendar year without regulatory approval is the greater of (i) NAICO's statutory net income, excluding realized capital gains, for the preceding calendar year; or (ii) 10% of NAICO's statutory policyholders' surplus as of the preceding calendar year end, not to exceed NAICO's statutory earned surplus. As of December 31, 2007, NAICO had statutory earned surplus of $12.5 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2008 without the approval of the Oklahoma Department of Insurance is $5.0 million. NAICO paid shareholder dividends to Chandler USA totaling $1.6 million during 2007. 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 below. 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. PAGE 34 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, 2007, all of NAICO's fixed-maturity investments were rated A2 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, 2007, all of the investments of NAICO were in fixed-maturity investments, certificates of deposit insured by the FDIC, 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 $131,000 in cash from operations in 2005 and provided $4.4 million and $8.7 million in cash from operations in 2006 and 2007, respectively. During 2005, net premiums written decreased slightly which attributed to Chandler USA using only $131,000 in cash from operations. In 2005, the increase in premium receivables and reinsurance recoverables on unpaid losses were offset by Chandler USA's net income and an increase in unearned premium. The cash provided by operations in 2006 included a decrease in reinsurance recoverable on unpaid losses of $29.2 million, but this was largely offset by a decrease in unpaid losses and loss adjustment expenses of $26.3 million. These decreases were primarily the result of recording additional estimated recoveries related to a favorable jury verdict in civil litigation regarding certain surety bond claims during 2006. The cash provided by operations in 2007 included an increase in unpaid losses and loss adjustment expenses of $17.3 million, but this was offset in part by an increase in reinsurance recoverable on unpaid losses of $10.6 million. These increases were primarily the result of reducing the estimated recoveries on certain surety bond claims based on a final judgment entered by the court. See "Litigation." Cash flows from investing activities were primarily the result of normal purchases and sales of investment securities. Net realized investment gains before income taxes were $383,000, $745,000 and $214,000 during 2005, 2006 and 2007, respectively, from the sale of investments. NAICO received proceeds of $2.5 million, $21.3 million and $17.6 million during 2005, 2006 and 2007, respectively, from the sale of available for sale securities prior to their maturity. The market value of NAICO's available for sale fixed-income investments decreased by $1.6 million and $1,000 in 2005 and 2006, respectively, and increased $2.2 million in 2007 due primarily to changes in interest rates experienced during this time. The average maturity of NAICO's fixed maturity investments was 3.4 years and 2.6 years at December 31, 2006 and 2007, respectively. Cash flows from financing activities were primarily the result of payments and loans between Chandler USA and Chandler Insurance. 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, 2006 and 2007, Chandler USA had a receivable of $9.6 million and $11.5 million, respectively, under the Credit Agreement, and Chandler USA earned $614,000, $733,000 and $881,000 in interest income under the Credit Agreement during 2005, 2006 and 2007, respectively. 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, 2007, the total amount of cash and investments restricted as a result of these arrangements was $8.0 million. In addition, NAICO has deposited $24.9 million of cash and investments into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer. 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 three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest, which was 8.25% at December 31, 2007, on the unpaid lease balance which is a floating interest rate of 1% over JP Morgan Chase Bank prime. 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. 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. See Note 11 to Consolidated Financial Statements. PAGE 35 CONTRACTUAL OBLIGATIONS The following table provides the future payments due by period under contractual obligations as of December 31, 2007, aggregated by type of obligation:
LESS THAN 1-3 3-5 MORE THAN ONE YEAR YEARS YEARS 5 YEARS TOTAL ---------- --------- --------- --------- --------- (In thousands) Unpaid losses and loss adjustment expenses (1) ....................... $ 38,981 $ 42,140 $ 15,181 $ 4,288 $ 100,590 Future minimum rental payments under operating leases ............. 568 541 - - 1,109 Guaranteed residual value of operating lease (2) ................ - 1,518 - - 1,518 Capital leases ....................... 58 77 11 - 146 Debentures ........................... - - - 6,979 6,979 Junior subordinated debentures issued to affiliated trusts ........ - - - 20,620 20,620 ---------- --------- --------- --------- --------- Total .............................. $ 39,607 $ 44,276 $ 15,192 $ 31,887 $ 130,962 ========== ========= ========= ========= ========= ---------------------------------------- (1) The amounts presented are estimates of the dollar amounts and time period in which NAICO expects to pay out its gross unpaid losses and loss adjustment expenses. These amounts are based on historical payment patterns and do not represent actual contractual obligations. The actual payment amount and the related timing of those amounts could differ significantly from these estimates. (2) This amount represents the specified maximum deficiency that Chandler USA could be required to make up under the sale and leaseback transaction described previously.
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. On August 1, 2006, the jury trial concluded in Harris County, Texas, related to the construction of two gas processing plants in Louisiana. The amounts the jury found owing to NAICO included approximately $20.2 million in actual damages and $70.0 million in punitive damages. See Note 10 of Notes to Consolidated Financial Statements for a discussion of this jury verdict. 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 December 31, 2006 as a result of increasing the estimated recovery. NAICO also recorded $6.6 million of interest income for its estimate of prejudgment interest through December 31, 2006, including a recovery for a pre-verdict settlement with certain other parties. PAGE 36 On January 28, 2008, the court entered a final judgment denying Gulf Liquid's claims against NAICO and Gulsby, denying all of NAICO's claims against Gulf Liquids and Williams, and entering judgment for Gulsby against Gulf Liquids for $15,651,927 plus interest at 7.25% compounded annually from January 28, 2008 until paid. The court also ordered Gulf Liquids to pay Gulsby's taxable court costs, estimated at $100,000. All parties may appeal all or any of these judgments. In the fourth quarter of 2007, as a result of this final judgment, NAICO decreased the estimated recovery on the surety bond claims related to the construction of the two gas processing plants which resulted in an increase in losses and loss adjustment expenses incurred of $1.8 million. Unpaid losses and loss adjustment expenses increased $12.7 million and reinsurance recoverable on unpaid losses and loss adjustment expenses increased $10.9 million as of December 31, 2007 as a result of decreasing the estimated recovery. NAICO also decreased accrued interest income by $4.5 million for its estimate of prejudgment interest income. 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, 2007, substantially all of the investments of NAICO were in fixed-maturity investments (rated A2 or A+ or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), certificates of deposit insured by the FDIC, 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 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 Fair value at Hypothetical change in December 31, change in interest rate ---------------------- interest rate ---------------------- 2006 2007 (bp=basis points) 2006 2007 ---------- ---------- ----------------- ---------- ---------- (Dollars in thousands) (Dollars in thousands) Fixed-maturity investments ... $ 66,379 $ 63,057 100 bp increase $ 64,392 $ 61,526 200 bp increase 62,520 60,068 100 bp decrease 68,431 64,644 200 bp decrease 70,613 66,312
The table above illustrates, for example, that an instantaneous 200 basis point increase in market interest rates at December 31, 2007 would reduce the estimated fair value of NAICO's fixed-maturity investments by approximately $3.0 million at that date. PAGE 37 NAICO's portfolio of equities and 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. The 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 equities and equity mutual funds are carried on the balance sheet at fair value. The changes in estimated fair value of the equity portfolio are presented as a component of shareholder's equity in accumulated other comprehensive income, net of taxes. The table below summarizes NAICO's equity price risk and shows the effect of a hypothetical 20% increase and a 20% decrease in market prices as of December 31, 2006 and 2007. 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, change in prices ---------------------- Hypothetical ---------------------- 2006 2007 price change 2006 2007 ---------- ---------- ----------------- ---------- ---------- (Dollars in thousands) (Dollars in thousands) Equity securities ........ $ 1,921 $ 141 20% increase .... $ 2,305 $ 169 20% decrease .... 1,537 113
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, 2007, the fair value of Chandler USA's Debentures was estimated to be $5.8 million based on the latest reported trade. Chandler USA's Debentures have not historically traded regularly, and settlement at the reported fair value may not be possible. The Debentures are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium, but may be purchased and cancelled by Chandler USA at a price of less than the sum of the principal amount and accrued interest at any time. Chandler USA is obligated for $13.4 million principal amount of junior subordinated debentures that mature in 2033 with a fixed interest rate of 9.75%, and $7.2 million principal amount of junior subordinated debentures that mature in 2034 with a floating rate of 4.10% over LIBOR. The interest rate was 9.34% at December 31, 2007. At December 31, 2007, the fair value of Chandler USA's junior subordinated debentures was estimated to be $22.5 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 three years with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest, which was 8.25% at December 31, 2007, on the unpaid lease balance which is a floating interest rate of 1% over JP Morgan Chase Bank prime. 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. 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 38 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(T). 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. MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Securities Exchange Act of 1934 (the "Exchange Act"). Under the supervision and with the participation of Chandler USA's management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of our internal control over financial reporting based on the framework in INTERNAL CONTROL-INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Based on our evaluation under that framework and applicable SEC rules, our management concluded that our internal control over financial reporting was effective as of December 31, 2007. This annual report does not include an attestation report of Chandler USA's registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by Chandler USA's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit Chandler USA to provide only management's report in this annual report. 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 39 PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. 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 62 Chairman of the Board, Chief Executive Officer, Compensation Committee Member and Director. Mark T. Paden 51 President, Compensation Committee Member and Director. Lance A. LaGere 27 Executive Vice President and Chief Operating Officer. Richard L. Evans 61 Senior Vice President and Director. R. Patrick Gilmore 56 Senior Vice President, Secretary, General Counsel and Director. Mark C. Hart 52 Senior Vice President-Finance, Chief Financial Officer and Treasurer. M. Steven Blain 50 Vice President-Administration. Robert L. Rice 73 Audit Committee Chairman and Director. W. Scott Martin 57 Audit Committee Member and Director. William T. Keele 71 Audit Committee Member and Director.
W. BRENT LAGERE has been a director, Chairman of the Board and Chief Executive Officer of Chandler USA since 1988 and of CIMI since December 2002. Since 1988, Mr. LaGere has served in officer and director capacities for various subsidiaries of Chandler USA pursuant to an employment contract with Chandler USA. Mr. LaGere serves as Chairman of the Board and Chief Executive Officer of Chandler Insurance. 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 from May 1998 to February 2006. Mr. Paden has served as President of CIMI since December 2002 and Chief Operating Officer of CIMI from December 2002 to February 2006. 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. LANCE A. LAGERE has served as Executive Vice President of NAICO since January 2006, and of Chandler USA and CIMI since February 2006. Mr. LaGere has also served as Chief Operating Officer of these companies since February 2006. From December 2002 to December 2005, Mr. LaGere was a retail insurance agent for Brown & Brown of Central Oklahoma, Inc. From June 2002 to December 2002, Mr. LaGere was a retail insurance agent for LaGere & Walkingstick Insurance Agency, Inc., which was a wholly owned subsidiary of Chandler USA until its sale to Brown & Brown, Inc. in December 2002. Mr. LaGere was also appointed as Executive Vice President of Chandler Insurance during 2006, pending approval by the Cayman Islands Monetary Authority. Mr. LaGere is the son of W. Brent LaGere, Chairman of the Board and Chief Executive Officer of Chandler USA. 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. PAGE 40 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. MARK C. HART has served as Senior Vice President-Finance and Treasurer of Chandler USA and NAICO since May 1998, and has served as Chief Financial Officer of Chandler USA and NAICO since May 2001. Mr. Hart has also served as Vice President of Chandler USA since March 1994. Mr. Hart has served as Treasurer of CIMI since December 2002. Mr. Hart also serves as Vice President-Accounting, Chief Financial Officer and Treasurer of Chandler Insurance. M. STEVEN BLAIN has served as Vice President-Administration of Chandler USA and NAICO since August 2003. From November 1999 to August 2003, Mr. Blain was employed by NAICO in various capacities. Prior to his employment by NAICO in November 1999, Mr. Blain was Vice President-Operations and Chief Financial Officer for J.B. Pratt Foods, Inc. ROBERT L. RICE has been a director of Chandler USA since June 1993 and a director of NAICO since March 2000. He has for more than 20 years engaged in private practice as a Certified Public Accountant. W. SCOTT MARTIN has been a director of Chandler USA and NAICO since March 2000. Mr. Martin has been President of the Tulsa Loan Production Office with First Bank & Trust Company in Wagoner, Oklahoma since 1994. Mr. Martin also serves as a director of First Bank & Trust in Wagoner, Oklahoma, First Bank of Chandler in Chandler, Oklahoma, First National Bank in Burkburnett, Texas and First Bank in Ketchum, Oklahoma. Mr. Martin is also the Manager for Basin Management, LLC. 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 Audit Committee is composed of Messrs. Rice, Martin and Keele, with Mr. Rice serving as Chairman. Chandler USA's Board of Directors has determined that Mr. Rice 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, 2007. ITEM 11. EXECUTIVE COMPENSATION. COMPENSATION DISCUSSION AND ANALYSIS This section provides information regarding the compensation of our Chief Executive Officer, Chief Financial Officer and, in addition, our three most highly compensated executive officers. Collectively, we refer to these executives as the named executive officers. Our executive compensation program is developed and monitored by our Compensation Committee which consists of our Chief Executive Officer and our President. COMPENSATION PROGRAM OBJECTIVES Our overall goal in compensating executive officers is to attract, retain and motivate key executives who are critical to our future success. We want to reinforce our goal to grow our business profitably and to reward each executive's contributions toward this goal. Our decisions with respect to executive officer salaries and incentives are influenced by the executive's level of responsibility and function within Chandler USA as well as the overall performance and profitability of Chandler USA. PAGE 41 EXECUTIVE COMPENSATION ELEMENTS Our Compensation Committee reviews the performance results of each named executive officer and establishes individual compensation levels. Our executive compensation program consists of base salaries, cash bonuses and perquisites. BASE SALARIES The purpose of the base salary is to reflect each executive's job responsibilities and to reward each executive's job performance. During 2007, the following base salaries were approved for our named executive officers:
PERCENTAGE NAMED EXECUTIVE OFFICER 2007 BASE SALARY INCREASE -------------------------------------------- ---------------- ---------- W. Brent LaGere ............................ $ 561,830 2.8% Mark T. Paden .............................. 343,726 3.0% Richard L. Evans ........................... 285,381 3.0% R. Patrick Gilmore ......................... 256,014 3.0% Mark C. Hart ............................... 177,268 3.0%
Base annual salaries are evaluated at least annually on the officer's anniversary date for each of the named executive officers. This evaluation includes recommendations from the Chief Operating Officer for certain of the executive officers. At that time, the Compensation Committee determines the base salary adjustment for each executive officer. The factors that influence the determination include the executive's experience, performance, changes in responsibilities and budgetary considerations. 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. CASH BONUSES While the company does not have a formal incentive bonus program, all of the named executive officers are eligible to receive cash bonuses. The amount of cash bonuses to be paid are determined at the discretion of the Compensation Committee. During 2007, the Compensation Committee awarded cash bonuses to the named executive officers as shown in the Summary Compensation Table that follows. These cash bonuses were paid during the years in which they are reported. PERQUISITES Each of the named executive officers participate in employee benefit plans generally available to our employees, including medical, life insurance, disability plans and our defined contribution 401(k) retirement plan. Other perquisites such as company provided automobiles, additional disability and life insurance are also provided to certain named executive officers. In addition, various personal expenses are paid for on behalf of our Chief Executive Officer and President, and these expenses and related income tax gross-ups are reported as "All Other Compensation" in the Summary Compensation Table that follows. The amount and nature of the personal expenses to be paid are determined at the discretion of the Compensation Committee. ROLE OF EXECUTIVE OFFICERS IN DETERMINING COMPENSATION Our Compensation Committee consists of our Chief Executive Officer and President. These two individuals also own 100% of the outstanding common stock of our ultimate parent company. As such, they determine the levels of their own compensation including cash bonuses and perquisites. They also determine the levels of compensation, with input from the Chief Operating Officer, for each of the other named executive officers. PAGE 42 The following table sets forth the compensation paid or to be paid by Chandler USA or any of its subsidiaries as well as all other compensation paid or accrued to the Chief Executive Officer, Chief Financial Officer, and the three other most highly compensated executive officers of Chandler USA and its subsidiaries during the years indicated.
SUMMARY COMPENSATION TABLE ALL OTHER NAME AND PRINCIPLE POSITION YEAR SALARY BONUS COMPENSATION(1) TOTAL --------------------------------------------- ---- ---------- ---------- --------------- ------------ W. Brent LaGere, Chairman of the Board 2007 $ 549,255 $ 504,777 $ 1,432,763 $ 2,486,795 and CEO 2006 537,544 574,269 819,886 1,931,699 Mark T. Paden, President 2007 342,891 183,000 155,994 681,885 2006 332,904 563,432 98,204 994,540 Richard L. Evans, Senior 2007 284,688 8,000 22,972 315,660 Vice President - Claims 2006 276,396 - 21,383 297,779 R. Patrick Gilmore, Senior Vice President, 2007 251,043 8,000 14,867 273,910 Secretary and General Counsel 2006 243,731 - 13,102 256,833 Mark C. Hart, Senior Vice President - Finance, 2007 175,332 15,000 6,225 196,557 Chief Financial Officer and Treasurer 2006 170,225 - 6,100 176,325 ------------------------------------------------------- (1) The amounts shown in this column include matching contributions under Chandler USA's 401(k) plan, life and disability insurance premiums and various perquisites and tax gross-ups as detailed below.
SUPPLEMENTAL TABLE FOR ALL OTHER COMPENSATION 401(K) LIFE OTHER COMPANY INSURANCE PERSONAL TAX NAMED EXECUTIVE OFFICER YEAR MATCH (1) PREMIUMS (2) EXPENSES (3) GROSS-UPS (4) TOTAL ------------------------- ---- --------- ------------ ------------ ------------- ---------- W. Brent LaGere 2007 $ 6,225 $ 100,280 $ 729,179 $ 597,079 $1,432,763 2006 6,100 75,953 429,622 308,211 819,886 Mark T. Paden 2007 6,225 15,882 72,953 60,934 155,994 2006 6,100 3,900 54,615 33,589 98,204 Richard L. Evans 2007 6,225 5,000 8,111 3,636 22,972 2006 6,100 5,000 6,557 3,726 21,383 R. Patrick Gilmore 2007 6,225 2,000 5,188 1,454 14,867 2006 6,100 2,000 3,474 1,528 13,102 Mark C. Hart 2007 6,225 - - - 6,225 2006 6,100 - - - 6,100 ---------------------------------- (1) The amounts shown in this column reflect company matching contributions under our 401(k) plan. (2) The amounts shown in this column reflect the premiums paid or to be paid under life insurance arrangements with the named executive officers. A portion of the premiums for each year ($30,153 for Mr. LaGere, $2,500 for Mr. Paden, $5,000 for Mr. Evans and $2,000 for Mr. Gilmore) were paid under a split dollar life insurance plan. Under this plan, Chandler USA or its subsidiaries pay the premiums for life insurance issued to the named executive officer. Repayment of the premiums is secured by the death benefit or the cash surrender value of the policy, if any, if the named executive officer cancels and surrenders the policy. PAGE 43 (3) The amounts shown in this column reflect various personal expenses, none of which individually exceeded the greater of $25,000 or ten percent of total perquisites for each named executive officer except as disclosed below. Personal expenses included company provided automobiles, payment of disability insurance premiums and sporting event tickets for Messrs. LaGere, Paden, Evans and Gilmore. In addition, the amounts shown for Mr. LaGere and Mr. Paden include automobile lease payments for each of their spouses, gasoline and other automobile related expenses for their spouses and other family members, club memberships and related expenses, payments for personal insurance premiums, personal flights on company provided aircraft and payments for miscellaneous personal expenses. The incremental cost to the company of the personal use of company provided aircraft is calculated based on the variable operating cost per flight hour. Mr. LaGere's personal expenses also included home and housing related expenses, legal and estate planning services, computer purchases, expenses related to personal investments, payments related to personally owned watercraft of $99,009 in 2007 and payments for personal charges on personal credit cards of $316,529 during 2007. (4) The amounts shown in this column represent the income tax gross-ups for each of the named executive officers that relate to certain personal expenses and life insurance premiums.
COMPENSATION OF DIRECTORS 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. Each non-employee director is also paid $1,500 per day for any NAICO board meeting 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. As Chairman of the Audit Committee, Mr. Rice's compensation for audit committee meetings is 150% of the applicable meeting fee. The following table sets forth the compensation earned by our non- employee directors during the years indicated.
DIRECTOR COMPENSATION FEES EARNED NAME YEAR OR PAID IN CASH TOTAL ----------------------------------- -------- --------------- ---------- Robert L. Rice .................... 2007 $ 12,375 $ 12,375 2006 12,375 12,375 W. Scott Martin ................... 2007 11,250 11,250 2006 10,750 10,750 William T. Keele .................. 2007 11,250 11,250 2006 10,750 10,750
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Chandler USA's Compensation Committee consists of W. Brent LaGere and Mark T. Paden. Mr. LaGere is the Chief Executive Officer of Chandler USA and its subsidiaries, and is also a director of Chandler USA's sole shareholder Chandler Insurance. Mr. Paden is President of Chandler USA and its subsidiaries, and is also a director of Chandler Insurance. Chandler Insurance has no employees and does not have a compensation committee. COMPENSATION COMMITTEE REPORT The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis section with management and, based on such review and discussion, recommended to our Board of Directors that it be included in this Annual Report on Form 10-K. March 17, 2008 Compensation Committee: W. Brent LaGere Mark T. Paden PAGE 44 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. 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 29, 2008, are beneficially owned by (i) each director of Chandler USA and Chandler Insurance, (ii) each of the named executive officers 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 21.0% Mark T. Paden .............................................. Class A Common Shares 125,165 20.0% Series A Preferred Shares 17,610 4.9% Richard L. Evans ........................................... Series A Preferred Shares 27,272 7.6% Series B Preferred Shares 32,250 34.1% R. Patrick Gilmore ......................................... Series B Preferred Shares 11,000 11.6% Mark C. Hart ............................................... Series A Preferred Shares 3,528 1.0% Robert L. Rice ............................................. - - -% W. Scott Martin ............................................ Series C Preferred Shares 19,000 3.0% William T. Keele (4) ....................................... Series C Preferred Shares 122,417 19.1% All directors and officers as a group (8 persons) .......... Class A Common Shares 625,826 100.0% Series A Preferred Shares 123,562 34.5% Series B Preferred Shares 43,250 45.7% Series C Preferred Shares 141,417 22.0% ------------------------------------------------------------- (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, 357,991 Series A Preferred Shares of Chandler Insurance, 94,696 Series B Preferred Shares of Chandler Insurance and 642,069 Series C Preferred Shares of Chandler Insurance outstanding on February 29, 2008. (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 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 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.
PAGE 45 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 29, 2008. Except as otherwise indicated, each of the persons named below has sole voting and investment power with respect to the common shares beneficially owned.
BENEFICIAL OWNERSHIP ------------------------------------ NAME OF SHAREHOLDER NUMBER OF SHARES (1) PERCENT (2) -------------------------------------------------------------------- -------------------- -------------- Malinda K. LaGere Laird, Matthew C. LaGere and Lance A. LaGere, Successor Co-Trustees of the W. Brent LaGere Irrevocable Trust 1010 Manvel Avenue, Chandler, Oklahoma 74834 ..................... 370,890 (3) 59.3 % -------------------------------------------------------------------- (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 29, 2008. (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.
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, AND DIRECTOR INDEPENDENCE. Transactions with related persons are reviewed and approved by the Board of Directors of Chandler USA or, in certain situations, by the Board of Directors of one of its subsidiary companies. 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 three years, and during March 2007 the lease was extended for an additional three years. See Note 11 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 FDIC, and Chandler USA and its subsidiaries pay customary service charges to the bank for the services provided. During the second quarter of 2006, CIMI purchased two limited partnership units in Basin Drilling #2 LP for $2,000, and purchased 8% cumulative subordinated debentures in the amount of $500,000. The timing of payment of interest and principal on the debentures is subject to various restrictions contained in the cumulative subordinated debenture note. Interest has been paid through September 30, 2007. The purpose of the partnership is to own and operate an oil and gas drilling rig. CIMI financed the purchase with a $500,000 variable rate bank loan. CIMI paid off the balance of this bank loan in December 2007. The partnership is managed by Basin Management, LLC ("BMLLC") who is the General Partner. W. Scott Martin, a director of NAICO and Chandler USA, is the Manager for BMLLC, and is also a director of the bank and a significant shareholder of the bank holding company that provided the bank loan described above. PAGE 46 Chandler USA leases a rural property from Davenport Farms, Inc. ("Davenport Farms"), a corporation owned by W. Brent LaGere, Richard L. Evans and Mark T. 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 2005, 2006 and 2007, Chandler USA incurred approximately $313,000, $308,000 and $302,000, respectively, in expenses associated with its use of this property, including $10,000, $11,000 and $3,000 for reimbursement of certain expenses, such as utility and similar expenses, for the years 2005, 2006 and 2007, respectively. DIRECTOR INDEPENDENCE Chandler USA is a privately held corporation with only debt securities listed on the American Stock Exchange ("AMEX"). The AMEX requires that a majority of the directors be "independent directors" as defined in the AMEX Company Guide. Chandler USA has relied upon an exception to this requirement which is provided for companies listing only debt securities. The Board of Directors has determined that Messrs. Rice, Martin and Keele are independent directors. 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 $178,900 and $186,400 for the years ended December 31, 2006 and 2007, 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 $21,000 and $18,500 for the years ended December 31, 2006 and 2007, 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 $20,750 and $39,675 for the years ended December 31, 2006 and 2007, respectively. ALL OTHER FEES There were no fees billed by Tullius Taylor Sartain & Sartain LLP for professional services other than those reported in the categories above for the years ended December 31, 2006 and 2007. 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 18.9% and 23.8% for the years ended December 31, 2006 and 2007, respectively. PAGE 47 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, 2006 and 2007, 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, 2007, together with the related notes thereto and the report of Tullius Taylor Sartain & Sartain LLP, independent auditors on such financial statements, are filed as a part of this Form 10-K. See accompanying Index on page F-1. 2. FINANCIAL STATEMENT SCHEDULES. The financial statement schedules listed in the accompanying index to consolidated financial statements and schedules are filed as part of this Form 10-K. All other schedules have been omitted since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule or because the information is included in the consolidated financial statements or the notes thereon. 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) PAGE 48 10.9 Capital Securities Subscription Agreement dated as of May 13, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust I, together as offerors, and InCapS Funding I, Ltd., as purchaser. (4) 10.10 Placement Agreement dated May 13, 2003 among Chandler (U.S.A.), Inc. and Chandler Capital Trust I, together as offerors, and Sandler O'Neill & Partners, L.P., as placement agent. (4) 10.11 Amended and Restated Declaration of Trust of Chandler Capital Trust II dated as of December 16, 2003 among Chandler (U.S.A.), Inc., as sponsor, Wilmington Trust Company, as Delaware trustee, Wilmington Trust Company, as institutional trustee, and W. Brent LaGere, Mark T. Paden and Mark C. Hart, as administrators. (6) 10.12 Indenture, dated as of December 16, 2003 among Chandler (U.S.A.), Inc., as issuer, and Wilmington Trust Company, as trustee. (6) 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 II, 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 49 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 17, 2008 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 17, 2008 /s/ W. Brent LaGere ---------------------------------------------------- W. Brent LaGere, Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer) Date: March 17, 2008 /s/ Mark T. Paden ---------------------------------------------------- Mark T. Paden, President and Director Date: March 17, 2008 /s/ Mark C. Hart ---------------------------------------------------- Mark C. Hart, Senior Vice President - Finance, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer) Date: March 17, 2008 /s/ Richard L. Evans ---------------------------------------------------- Richard L. Evans, Senior Vice President and Director Date: March 17, 2008 /s/ R. Patrick Gilmore ---------------------------------------------------- R. Patrick Gilmore, Senior Vice President, Secretary, General Counsel and Director Date: March 17, 2008 /s/ Robert L. Rice ---------------------------------------------------- Robert L. Rice, Director Date: March 17, 2008 /s/ W. Scott Martin ---------------------------------------------------- W. Scott Martin, Director Date: March 17, 2008 /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, 2006 and 2007 ................................. F-2 Consolidated Statements of Operations for the years ended December 31, 2005, 2006 and 2007 ......................................................... F-3 Consolidated Statements of Comprehensive Income for the years ended December 31, 2005, 2006 and 2007 ......................................................... F-4 Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2006 and 2007 ......................................................... F-5 Consolidated Statements of Shareholder's Equity for the years ended December 31, 2005, 2006 and 2007 ......................................................... F-6 Notes to Consolidated Financial Statements ................................................... F-7 through F-26 Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements and Financial Statement Schedules ........................................................ F-27 SCHEDULES I Summary of Investments - Other Than Investments in Related Parties .................. F-28 II Condensed Financial Information of Registrant ....................................... F-29 through F-31 III Supplementary Insurance Information ................................................. F-32 IV Reinsurance ......................................................................... F-33 V Valuation and Qualifying Accounts ................................................... F-34 VI Supplemental Information (for property-casualty insurance underwriters) ............. F-35
PAGE F-2 CHANDLER (U.S.A.), INC. CONSOLIDATED BALANCE SHEETS (Amounts in thousands except share amounts)
DECEMBER 31, ----------------------- 2006 2007 ---------- ---------- ASSETS Investments Fixed maturities available for sale, at fair value Restricted (amortized cost $19,830 and $32,416 in 2006 and 2007, respectively) ......... $ 19,151 $ 32,670 Unrestricted (amortized cost $48,557 and $30,484 in 2006 and 2007, respectively) ....... 47,228 30,387 Equity securities at fair value (cost $1,587 and $0 in 2006 and 2007, respectively) ...... 1,921 141 Short-term investments ................................................................... - 1,045 ---------- ---------- Total investments ...................................................................... 68,300 64,243 Cash and cash equivalents ($450 and $146 restricted in 2006 and 2007, respectively) ........ 21,403 32,956 Accrued investment income .................................................................. 5,022 874 Premiums receivable, less allowance for non-collection of $170 and $134 at 2006 and 2007, respectively .......................................... 31,008 28,128 Reinsurance recoverable on paid losses ..................................................... 1,087 1,100 Reinsurance recoverable on unpaid losses, less allowance for non-collection of $130 and $239 at 2006 and 2007, respectively .......................................... 25,588 36,036 Reinsurance recoverable on unpaid losses from related parties .............................. 15,584 18,688 Prepaid reinsurance premiums ............................................................... 7,603 3,105 Prepaid reinsurance premiums to related parties ............................................ 13,506 12,928 Deferred policy acquisition costs .......................................................... 845 1,118 Property and equipment, net ................................................................ 8,457 8,255 Amounts due from related parties ........................................................... 9,584 11,506 State insurance licenses, net .............................................................. 3,745 3,745 Other assets ............................................................................... 11,040 11,685 ---------- ---------- Total assets ............................................................................... $ 222,772 $ 234,367 ========== ========== LIABILITIES AND SHAREHOLDER'S EQUITY Liabilities Unpaid losses and loss adjustment expenses ............................................... $ 83,253 $ 100,590 Unearned premiums ........................................................................ 53,217 46,389 Policyholder deposits .................................................................... 7,663 7,947 Accrued taxes and other payables ......................................................... 5,119 5,777 Premiums payable ......................................................................... 1,955 2,263 Premiums payable to related parties ...................................................... 1,002 198 Debentures ............................................................................... 6,979 6,979 Junior subordinated debentures issued to affiliated trusts ............................... 20,620 20,620 ---------- ---------- Total liabilities ...................................................................... 179,808 190,763 ---------- ---------- Commitments and contingencies (Notes 10 and 11) Shareholder's equity Common stock, $1.00 par value, 50,000 shares authorized; 2,484 shares issued and outstanding .................................................... 2 2 Paid-in surplus .......................................................................... 60,584 60,584 Accumulated deficit ...................................................................... (16,517) (17,179) Accumulated other comprehensive income (loss): Unrealized gain (loss) on investments available for sale, net of deferred income taxes.. (1,105) 197 ---------- ---------- Total shareholder's equity ............................................................. 42,964 43,604 ---------- ---------- Total liabilities and shareholder's equity ................................................. $ 222,772 $ 234,367 ========== ==========
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, -------------------------------------- 2005 2006 2007 ------------ ------------ ------------ Premiums and other revenues Direct premiums written and assumed .................................... $ 120,344 $ 113,043 $ 100,081 Reinsurance premiums ceded ............................................. (23,060) (21,098) (7,690) Reinsurance premiums ceded to related parties .......................... (27,158) (27,156) (27,959) ------------ ------------ ------------ Net premiums written and assumed . .................................... 70,126 64,789 64,432 Decrease (increase) in unearned premiums ............................... (4,066) 915 1,753 ------------ ------------ ------------ Net premiums earned ................................................... 66,060 65,704 66,185 Investment income (loss), net ....... ................................... 2,798 9,801 (572) Interest income, net from related parties ............................... 670 792 941 Realized investment gains, net .......................................... 383 745 214 Other income ............................................................ 251 317 1,916 ------------ ------------ ------------ Total premiums and other revenues ..................................... 70,162 77,359 68,684 ------------ ------------ ------------ Operating costs and expenses Losses and loss adjustment expenses, net of amounts ceded to related parties of $13,200, $14,007 and $16,808 in 2005, 2006 and 2007, respectively .................................. 37,324 45,473 41,393 Policy acquisition costs, net of ceding commissions received from related parties of $10,498, $10,445 and $10,633 in 2005, 2006 and 2007, respectively .................................. 10,671 11,666 12,547 General and administrative expenses .................................... 12,749 12,469 12,790 Interest expense ....................................................... 2,535 2,690 2,703 ------------ ------------ ------------ Total operating costs and expenses .................................... 63,279 72,298 69,433 ------------ ------------ ------------ Income (loss) before income taxes ....................................... 6,883 5,061 (749) Federal income tax benefit (provision) .................................. (2,450) (1,665) 87 ------------ ------------ ------------ Income (loss) ........................................................... $ 4,433 $ 3,396 $ (662) ============ ============ ============
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, -------------------------------------- 2005 2006 2007 ------------ ------------ ------------ Net income (loss) ............................................................ $ 4,433 $ 3,396 $ (662) ------------ ------------ ------------ Other comprehensive income (loss), before income tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period .................... (1,040) 566 2,187 Less: Reclassification adjustment for gains included in net income (loss) .. (383) (745) (214) ------------ ------------ ------------ Other comprehensive income (loss), before income tax ......................... (1,423) (179) 1,973 Income tax benefit (provision) related to items of other comprehensive income (loss) ................................................. 484 61 (671) ------------ ------------ ------------ Other comprehensive income (loss), net of income tax ......................... (939) (118) 1,302 ------------ ------------ ------------ Comprehensive income ......................................................... $ 3,494 $ 3,278 $ 640 ============ ============ ============
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, -------------------------------------- 2005 2006 2007 ------------ ------------ ------------ OPERATING ACTIVITIES Net income (loss) ...................................................... $ 4,433 $ 3,396 $ (662) Add (deduct): Adjustments to reconcile net income (loss) to cash provided by (applied to) operating activities: Realized investment gains, net ....................................... (383) (745) (214) Net (gains) losses on sale of property and equipment ................. (2) 20 (6) Amortization and depreciation ........................................ 1,486 1,379 1,431 Provision for non-collection of premiums ............................. 176 80 19 Provision for non-collection of reinsurance recoverables ............. 108 97 356 Net change in non-cash balances relating to operating activities: Accrued investment income ........................................... 28 (4,135) 4,148 Premiums receivable ................................................. (5,713) (2,742) 2,861 Reinsurance recoverable on paid losses .............................. (875) 1,647 (260) Reinsurance recoverable on paid losses from related parties ......... 83 - - Reinsurance recoverable on unpaid losses ............................ (4,263) 29,164 (10,557) Reinsurance recoverable on unpaid losses from related parties ....... (1,127) (1,300) (3,104) Prepaid reinsurance premiums ........................................ 74 2,160 4,498 Prepaid reinsurance premiums to related parties ..................... 68 (1,259) 578 Deferred policy acquisition costs ................................... (1,168) 380 (273) Other assets ........................................................ 2,676 2,129 (1,373) Unpaid losses and loss adjustment expenses .......................... 1,308 (26,288) 17,337 Unearned premiums ................................................... 3,925 (1,817) (6,828) Policyholder deposits ............................................... 772 1,979 284 Accrued taxes and other payables .................................... (357) (441) 997 Premiums payable .................................................... (1,493) (226) 308 Premiums payable to related parties ................................. 113 889 (804) ------------ ------------ ------------ Cash provided by (applied to) operating activities ................... (131) 4,367 8,736 ------------ ------------ ------------ INVESTING ACTIVITIES Short-term investments: Purchases ............................................................. - - (1,330) Maturities ............................................................ - - 285 Unrestricted fixed maturities available for sale: Purchases ............................................................. (6,158) (995) (13,585) Sales ................................................................. 2,091 - 10,120 Maturities ............................................................ 1,770 5,809 8,588 Equity securities available for sale: Purchases ............................................................. (500) (13,620) (5,811) Sales ................................................................. 380 21,336 7,457 Cost of property and equipment purchased ............................... (413) (688) (696) Proceeds from sale of property and equipment ........................... 70 71 50 Investment in limited partnership ...................................... - (502) - ------------ ------------ ------------ Cash provided by (applied to) investing activities ................... (2,760) 11,411 5,078 ------------ ------------ ------------ FINANCING ACTIVITIES Payments and loans from related parties ................................ 2,513 1,747 2,164 Payments and loans to related parties .................................. (982) (1,971) (4,086) Bank loan proceeds ..................................................... - 500 - Payments on bank loan .................................................. - (161) (339) ------------ ------------ ------------ Cash provided by (applied to) financing activities ................... 1,531 115 (2,261) ------------ ------------ ------------ Increase (decrease) in cash and cash equivalents during the period ..... (1,360) 15,893 11,553 Cash and cash equivalents at beginning of period ....................... 6,870 5,510 21,403 ------------ ------------ ------------ Cash and cash equivalents at end of period ............................. $ 5,510 $ 21,403 $ 32,956 ============ ============ ============
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, 2005 ......... $ 2 $ 60,584 $ (24,346) $ (48) $ 36,192 Net income ....................... - - 4,433 - 4,433 Change in unrealized loss on investments available for sale, net of income tax ......... - - - (939) (939) ----------- ----------- ----------- ------------- ------------- Balance, December 31, 2005 ....... 2 60,584 (19,913) (987) 39,686 ----------- ----------- ----------- ------------- ------------- Net income ....................... - - 3,396 - 3,396 Change in unrealized loss on investments available for sale, net of income tax ......... - - - (118) (118) ----------- ----------- ----------- ------------- ------------- Balance, December 31, 2006 ....... 2 60,584 (16,517) (1,105) 42,964 ----------- ----------- ----------- ------------- ------------- Net loss ......................... - - (662) - (662) Change in unrealized loss on investments available for sale, net of income tax ......... - - - 1,302 1,302 ----------- ----------- ----------- ------------- ------------- Balance, December 31, 2007 ....... $ 2 $ 60,584 $ (17,179) $ 197 $ 43,604 =========== =========== =========== ============= =============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-7 CHANDLER (U.S.A.), INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2005, 2006 AND 2007 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 products primarily for businesses in various industries, political subdivisions, homeowners insurance in Texas and surety bonds for small contractors in the United States of America ("U.S."). The business is conducted through individual independent insurance agencies and underwriting managers, primarily in the Southwest and Midwest areas of the U.S. Chandler Insurance Managers, Inc. ("CIMI") is a wholly owned subsidiary of Chandler USA and is an underwriting manager and wholesaler that offers multiple insurance products for businesses in various industries and political subdivisions. 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 or premiums are billed, whichever is later. Commission revenues are reported net of commissions paid to producing agents. (e) PREMIUMS RECEIVABLE Premiums receivable are presented net of valuation allowances for estimated uncollectible amounts. Chandler USA determines the allowance for non-collection by regularly evaluating individual agent accounts and balances due from insureds, considering their financial condition and other appropriate factors. Such accounts are considered past due based on contractual terms for the agent or insured. Premiums receivable are written off when deemed uncollectible. Recoveries of accounts previously written off are recorded when received. PAGE F-8 (f) UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES Losses and loss adjustment expenses are charged to income as incurred. The reserve for unpaid losses and loss adjustment expenses represents the accumulation of estimates for reported losses and includes provisions for losses incurred but not reported based on data available at this time. The methods of determining such estimates and establishing resulting reserves are periodically reviewed and updated, and adjustments therefrom are necessary to maintain an adequate reserve for unpaid losses and loss adjustment expenses. As more fully explained in Note 3, such estimates are management's best estimates of the expected values. The actual results may vary from these values because the evaluation of losses is inherently subjective and susceptible to significant changing factors. (g) DEFERRED POLICY ACQUISITION COSTS Policy acquisition costs that vary with and are primarily related to the acquisition of new and renewal business (such as premium taxes, agent commissions, commissions received from reinsurers and a portion of other underwriting expenses) are deferred and amortized over the terms of the policies. When the sum of the anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded. Certain policy acquisition costs, such as policyholder dividends, are expensed directly. (h) PROPERTY AND EQUIPMENT Real estate and improvements and other property and equipment are stated at cost and depreciated using the straight-line method over their useful lives which range from 3 to 31 years. Property and equipment consisted of the following at December 31:
2006 2007 ---------- ---------- (In thousands) Real estate and improvements ... $ 11,889 $ 11,967 Other property and equipment ... 8,408 8,577 ---------- ---------- 20,297 20,544 Accumulated depreciation ....... (11,840) (12,289) ---------- ---------- $ 8,457 $ 8,255 ========== ==========
Depreciation expense was approximately $815,000, $780,000 and $854,000 for 2005, 2006 and 2007, respectively. (i) INTANGIBLE ASSETS Intangible assets are stated at cost less accumulated amortization. Prior to 2002, the cost of state insurance licenses acquired was amortized over 40 years using the straight-line method. Effective January 1, 2002, the state insurance licenses are no longer amortized since they were determined to have indefinite lives but are reviewed at least annually for impairment. Chandler USA completed the required impairment tests during 2006 and 2007 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:
2006 2007 ---------- ---------- (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. PAGE F-9 (k) INVESTMENTS At the time of purchase, investments in debt securities that Chandler USA has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost; all other debt securities are reported at fair value. Investments in debt and equity securities classified as trading are actively and frequently bought and sold with the objective of generating income on short-term differences in price. Realized and unrealized gains and losses on securities classified as trading account assets are recognized in current operations. Chandler USA has not classified any investments as trading account assets. Debt securities not classified as held to maturity or trading and equity securities are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of deferred income tax as other comprehensive income until realized. Realized gains and losses on sales of securities are based on the specific identification method. Declines in the fair value of securities below their carrying value that are other than temporary are recognized in earnings. Chandler USA regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Some factors considered in evaluating whether or not a decline in fair value is other than temporary include Chandler USA's ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value; the duration and extent to which the fair value has been less than cost; and the financial condition and prospects of the issuer. (l) INCOME TAXES Chandler USA uses an asset and liability approach for accounting for income taxes. Deferred income taxes are recognized for the tax consequences of temporary differences and carryforwards by applying enacted tax rates applicable to future years to differences between the financial statement amounts and the tax bases of existing assets and liabilities. A valuation allowance is established if it is more likely than not that some portion of the deferred tax asset will not be realized. (m) CASH AND CASH EQUIVALENTS For purposes of the consolidated statements of cash flows, Chandler USA considers all highly liquid investments with original maturities of 14 days or less to be cash equivalents. For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value. (n) SUPPLEMENTAL CASH FLOW INFORMATION Cash payments for interest and income taxes, and noncash investing activities were as follows:
YEAR ENDED DECEMBER 31, -------------------------------- 2005 2006 2007 ---------- ---------- ---------- (In thousands) Cash payments during the year for: Interest ....................................... $ 2,447 $ 2,608 $ 2,649 Income taxes ................................... 160 - 25 Transfers to restricted securities, net .......... $ (3,429) $ (8,127) $ (12,726)
(o) REINSURANCE Management believes all of NAICO's reinsurance contracts with reinsurers meet the criteria for risk transfer and the revenue and cost recognition provisions in order to be accounted for as reinsurance. As more fully explained in Note 11, reinsurance contracts do not relieve NAICO from its obligation to policyholders. In addition, failure of reinsurers to honor their obligations could result in losses to Chandler USA. PAGE F-10 (p) NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board ("FASB") periodically issues new accounting standards in a continuing effort to improve standards of financial accounting and reporting. Chandler USA has reviewed the recently issued pronouncements and concluded that the following new accounting standards are applicable to Chandler USA. In February 2006, the 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 Chandler USA's 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 Chandler USA's 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 No. 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 No. 48 effective January 1, 2007. The adoption of FIN No. 48 did not have a material impact on Chandler USA's 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 Chandler USA's consolidated financial statements. PAGE F-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 No. 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 No. 06-10 is effective for fiscal years beginning after December 15, 2007. Chandler USA has evaluated EITF No. 06-10 and has determined that its adoption is not expected to have a material impact on its consolidated financial statements. In December 2007, the FASB issued SFAS No. 141(R), "Business Combinations," which requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at full fair value. Under SFAS No. 141(R), all business combinations will be accounted for by applying the acquisition method (referred to as the purchase method in SFAS No. 141, "Business Combinations"). SFAS No. 141 (R) is effective for fiscal years beginning on or after December 15, 2008 and is to be applied to business combinations occurring after the effective date. Chandler USA does not expect the adoption of SFAS No. 141(R) to have a material impact on its consolidated financial statements. In December 2007, the FASB issued FASB No. 160, "Noncontrolling Interests in Consolidated Financial Statements," which requires noncontrolling interests (previously referred to as minority interests) to be treated as a separate component of equity, not as a liability or other item outside of permanent equity. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. Chandler USA does not expect the adoption of SFAS No. 160 to have a material impact on its consolidated financial statements. NOTE 2. INVESTMENTS AND INVESTMENT INCOME Net investment income and realized investment gains are summarized in the following table. These amounts are net of investment expenses.
YEAR ENDED DECEMBER 31, -------------------------------- 2005 2006 2007 ---------- ---------- ---------- (In thousands) Interest on fixed-maturity investments ................... $ 2,791 $ 2,829 $ 2,818 Interest on short-term investments and cash equivalents .. 159 574 1,069 Dividend income on equity securities ..................... 135 58 11 Prejudgment interest related to litigation ............... - 6,648 (4,148) Investment expenses ...................................... (287) (308) (322) ---------- ---------- ---------- Investment income, net ................................. 2,798 9,801 (572) ---------- ---------- ---------- Realized gains, net - fixed-maturity investments ......... 3 - 154 Realized gains, net - equity securities .................. 380 745 60 ---------- ---------- ---------- Realized investments gains, net ........................ 383 745 214 ---------- ---------- ---------- $ 3,181 $ 10,546 $ (358) ========== ========== ==========
During 2006, NAICO recorded $6.6 million of interest income for its estimate of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims. During 2007, NAICO reversed $4.1 million of the prejudgment interest income based on a final judgment entered by the court. See Note 10 for more information related to this litigation. Investment expenses include $137,000, $164,000 and $193,000 for the years ended December 31, 2005, 2006 and 2007, respectively, in expense to subsidize a premium finance program for certain insureds of NAICO with an unaffiliated premium finance company. PAGE F-12 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, 2006 COST GAINS LOSSES VALUE VALUE ------------------------------------------ ---------- ---------- ---------- ---------- ---------- FIXED MATURITIES AVAILABLE FOR SALE: (In thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies .......................... $ 37,393 $ - $ (946) $ 36,447 $ 36,447 Corporate obligations .................... 23,004 - (825) 22,179 22,179 Public utilities ......................... 6,376 - (163) 6,213 6,213 Mortgage-backed securities ............... 1,614 - (74) 1,540 1,540 ---------- ---------- ---------- ---------- ---------- $ 68,387 $ - $ (2,008) $ 66,379 $ 66,379 ========== ========== ========== ========== ========== EQUITY SECURITIES: Corporate stock .......................... $ 1,587 $ 334 $ - $ 1,921 $ 1,921 ========== ========== ========== ========== ==========
GROSS GROSS UNREALIZED UNREALIZED FAIR CARRYING DECEMBER 31, 2007 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 .......................... $ 38,723 $ 516 $ (67) $ 39,172 $ 39,172 Corporate obligations .................... 18,703 49 (246) 18,506 18,506 Public utilities ......................... 4,287 2 (58) 4,231 4,231 Mortgage-backed securities ............... 1,187 - (39) 1,148 1,148 ---------- ---------- ---------- ---------- ---------- $ 62,900 $ 567 $ (410) $ 63,057 $ 63,057 ========== ========== ========== ========== ========== EQUITY SECURITIES: Corporate stock .......................... $ - $ 141 $ - $ 141 $ 141 ========== ========== ========== ========== ==========
At December 31, 2006 and 2007, Chandler USA did not hold any fixed maturity investments that exceeded 10% of shareholder's equity. The fair value of Chandler USA's investments with sustained gross unrealized losses at December 31, 2007 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 .......... $ - $ - $ 14,636 $ (67) $ 14,636 $ (67) Corporate securities ................. - - 15,449 (246) 15,449 (246) Public utilities ..................... - - 2,544 (58) 2,544 (58) Mortgage-backed securities ........... - - 1,147 (39) 1,147 (39) ----------- ---------- ----------- ---------- ----------- ---------- $ - $ - $ 33,776 $ (410) $ 33,776 $ (410) =========== ========== =========== ========== =========== ==========
The unrealized losses of Chandler USA's fixed maturity investments were caused by interest rate increases. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Chandler USA regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Based on an evaluation of the issues, including, but not limited to, Chandler USA's intentions to sell or ability to hold the investments; the length of time and amount of the unrealized loss; and the credit ratings of the issuers of the investments, Chandler USA does not consider these investments to be other-than-temporarily impaired at December 31, 2007. PAGE F-13 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, 2007 are shown below:
AVAILABLE FOR SALE ------------------------ AMORTIZED COST FAIR VALUE ------------ ---------- (In thousands) Due in one year or less .......................... $ 17,743 $ 17,663 Due after one year through five years ............ 30,472 30,592 Due after five years through ten years ........... 11,812 11,966 Due after ten years .............................. 1,686 1,688 ------------ ---------- 61,713 61,909 Mortgage-backed securities ....................... 1,187 1,148 ------------ ---------- $ 62,900 $ 63,057 ============ ==========
Realized gains and losses from sales of investments are shown below:
2005 2006 2007 -------- -------- -------- (In thousands) FIXED MATURITIES: Gross realized gains ............................. $ 20 $ - $ 191 Gross realized losses ............................ (17) - (37) -------- -------- -------- Total net realized gains ........................ $ 3 $ - $ 154 ======== ======== ======== EQUITY SECURITIES: Gross realized gains ............................. $ 380 $ 855 $ 229 Gross realized losses ............................ - (110) (169) -------- -------- -------- Total net realized gains ........................ $ 380 $ 745 $ 60 ======== ======== ========
NAICO is required by several states to deposit securities with state regulators as a condition of doing business in those states. As of December 31, 2006 and 2007, the carrying value of these deposits totaled approximately $7.7 million and $8.0 million, respectively. In addition, NAICO has deposited $24.9 million of cash and investments into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer. 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 Chandler USA's net liability for losses and loss adjustment expenses were approximately $13.2 million and $11.1 million at December 31, 2006 and 2007, respectively. Included in these recoverable amounts were net recoverables of $10.8 million and $10.1 million in 2006 and 2007, respectively, related to a favorable jury verdict in civil litigation regarding certain surety bond claims during 2006. See Note 10 for more information related to this litigation. NAICO may or may not recover the above estimated recoveries and could incur significant costs in collecting these recoverables. PAGE F-14 Although such estimates are management's best estimates of the expected values, the ultimate liability for unpaid claims may vary from these values. NAICO does not discount the liability for unpaid losses and loss adjustment expenses. The following table sets forth a reconciliation of the beginning and ending unpaid losses and loss adjustment expenses which are net of reinsurance deductions.
YEAR ENDED DECEMBER 31, ---------------------------------- 2005 2006 2007 ---------- ---------- ---------- (In thousands) Net balance at beginning of year .......................... $ 44,695 $ 40,549 $ 42,081 ---------- ---------- ---------- Net losses and loss adjustment expenses incurred related to: Current year ............................................ 30,985 41,644 40,194 Prior years ............................................. 6,339 3,829 1,199 ---------- ---------- ---------- Total ................................................. 37,324 45,473 41,393 ---------- ---------- ---------- Net paid losses and loss adjustment expenses related to: Current year ............................................ (11,171) (12,403) (12,494) Prior years ............................................. (30,299) (31,538) (25,114) ---------- ---------- ---------- Total ................................................. (41,470) (43,941) (37,608) ---------- ---------- ---------- Net balance at end of year ................................ $ 40,549 $ 42,081 $ 45,866 ========== ========== ==========
NAICO experienced a significant amount of incurred losses related to prior accident years during the 2005 and 2006 calendar years. Incurred losses related to prior accident years decreased $2.5 million or 40% in 2006 and decreased $2.6 million or 69% in 2007. 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 2005, NAICO experienced adverse loss development totaling $6.3 million primarily in the standard property and casualty and political subdivisions programs. A portion of the adverse development was offset by favorable development of $1.8 million in the surety bond program, primarily in accident years 1994 and 2001 that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the workers compensation, other liability and automobile liability lines of business in the 2000, 2002 and 2003 accident years. The adverse loss development included approximately $108,000 for provisions for potentially uncollectible reinsurance. During 2006, NAICO experienced adverse loss development totaling $3.8 million primarily in the standard lines program. A portion of the adverse development was offset by favorable development of $1.0 million in the surety bond program, primarily in the 2001 accident year, that resulted from the estimated recoveries discussed previously. The adverse development was due primarily to an increase in losses in the automobile liability line of business in the 2005 accident year and in the workers compensation line of business in the 1997 and 1999 accident years. During 2007, NAICO experienced adverse loss development totaling $1.2 million primarily in the surety bond program. During 2007, a portion of the estimated recoveries that were recorded in the surety bond program during 2006 were reduced based on a final judgment entered by the court regarding certain surety bond claims. The reduction of the estimated recoveries accounted for $1.8 million of the loss development during 2007. The adverse loss development included approximately $356,000 for provisions for potentially uncollectible reinsurance. PAGE F-15 NAICO does not ordinarily insure against environmental matters as that term is commonly used. However, in some cases, regulatory filings made by NAICO on behalf of an insured can make NAICO directly liable to the regulatory authority for property damage which could include environmental pollution. In those cases, NAICO ordinarily has recourse against the insured or the surety bond principal for amounts paid. NAICO has insured certain trucking companies and pest control operators that are required to provide proof of insurance which in some cases assures payment for clean-up and remediation of damage resulting from sudden and accidental release or discharge of contaminants or other substances which may be classified as pollutants. NAICO also provides surety bonds for construction contractors that use or have control of such substances and for contractors that remove and dispose of asbestos as a part of their contractual obligations. NAICO also insures independent oil and gas producers that may purchase coverage for the escape of oil, saltwater, or other substances which may be harmful to persons or property, but may not generally be classified as pollutants. NAICO maintains claims records which segregate this type of risk for the purpose of evaluating environmental risk exposure. Based upon the nature of such lines of business with insureds of NAICO, and current data regarding the limited severity and infrequency of such matters, it appears that potential environmental risks are not a significant portion of claims reserves and therefore would not likely have a material impact, if any, on the consolidated financial condition, results of operations or cash flows of Chandler USA. At this time, NAICO has not received any claims related to the September 11, 2001 terrorist attacks on the World Trade Center and does not believe that it has any significant exposure to these and related losses. While several of NAICO's reinsurers did experience significant losses related to these attacks, it currently does not appear that these losses will impair the reinsurers' ability to pay claims. NOTE 4. DEBENTURES On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior debentures (the "Debentures") with a maturity date of July 16, 2014. The Debentures were priced at $1,000 each with an interest rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium. The indenture governing the Debentures was amended during 2003 to clarify that purchases of Debentures by Chandler USA through private treaty or on the open market for an agreed price of less than the sum of the principal amount and accrued interest are not considered to be a redemption of the Debentures, and that any such Debentures purchased by Chandler USA will be cancelled. Chandler USA purchased and cancelled $16.7 million and $275,000 principal amount of the Debentures during 2003 and 2004, respectively, and at December 31, 2007, there were $6,979,000 principal amount of the Debentures outstanding. As of December 31, 2007, Chandler USA has capitalized $214,000 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, 2007, Chandler USA was in compliance with all covenants. NOTE 5. TRUST PREFERRED SECURITIES In May 2003, Chandler USA established Chandler Capital Trust I ("Trust I") by purchasing all of its common securities for $403,000. Trust I is a Delaware statutory business trust and is a wholly owned non-consolidated subsidiary of Chandler USA. On May 22, 2003, Trust I issued $13.0 million of capital securities (the "Trust I Preferred Securities") to InCapS Funding I, Ltd., an unaffiliated company established under the laws of the Cayman Islands, in a private transaction. Trust I used the proceeds from the issuance to purchase $13,403,000 of 9.75% junior subordinated debentures (the "Junior Debentures I") of Chandler USA. Distributions on the Junior Debentures I are payable quarterly at a fixed annual rate of 9.75%. Chandler USA may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Junior Debentures I, with such deferred payments accruing interest compounded quarterly. The Junior Debentures I are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year. The Junior Debentures I are the sole assets of Trust I and Trust I will distribute any cash payments it receives thereon to the holders of its preferred and common securities. Distributions on the Trust I Preferred Securities are payable quarterly at a fixed annual rate of 9.75%. Trust I may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust I Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust I Preferred Securities are subject to a mandatory redemption on May 23, 2033, but they may be redeemed after five years at a premium of half the fixed rate coupon declining ratably to par in the 10th year. All payments by Trust I regarding the Trust I Preferred Securities are guaranteed by Chandler USA. PAGE F-16 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 9.34% at December 31, 2007. 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 9.34% at December 31, 2007. Trust II may defer these payments for up to 20 consecutive quarters, but not beyond the maturity of the Trust II Preferred Securities, with such deferred payments accruing interest compounded quarterly. The Trust II Preferred Securities are subject to a mandatory redemption on January 8, 2034, but they may be redeemed after five years without penalty or premium. All payments by Trust II regarding the Trust II Preferred Securities are guaranteed by Chandler USA. The sale of the Trust I Preferred Securities and the Trust II Preferred Securities during 2003 resulted in net proceeds of $19.3 million to Chandler USA, net of placement costs. As of December 31, 2007, issuance costs in the amount of $622,000 have been capitalized and are being amortized over the stated maturity periods of thirty years. In December 2003, the Financial Accounting Standards Board issued Revised Interpretation No. 46 ("FIN 46R"), CONSOLIDATION OF VARIABLE INTEREST ENTITIES. FIN 46R provides guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights. FIN 46R is used to determine whether consolidation is required or, alternatively, whether the variable-interest model under FIN 46R should be used to account for existing and new entities. Chandler USA adopted FIN 46R effective January 1, 2004. The result of adoption was the deconsolidation of the two capital trusts that were created during 2003 in connection with the issuance of trust preferred securities. Chandler USA reports the $20.6 million of junior subordinated debentures that were issued to the capital trusts on its consolidated balance sheet. The adoption of FIN 46R had no effect on net earnings. NOTE 6. SHAREHOLDER'S EQUITY CAPITAL STOCK In addition to the regulatory oversight of NAICO by the Oklahoma Department of Insurance, Chandler Insurance Company Ltd. ("Chandler Insurance"), Chandler USA's parent company, and Chandler USA are also subject to regulation under the insurance laws of Oklahoma (the "Oklahoma Insurance Code"). In addition to various reporting requirements imposed on Chandler Insurance and Chandler USA, the Oklahoma Insurance Code requires any person who seeks to acquire or exercise control over NAICO (which is presumed to exist if any person owns 10% or more of Chandler Insurance's or Chandler USA's outstanding voting stock) to file and obtain approval of certain applications with the Oklahoma Department of Insurance regarding their proposed ownership of such shares. STATUTORY FINANCIAL INFORMATION AND MINIMUM CAPITAL REQUIREMENTS NAICO is required to file financial statements with state regulatory authorities prepared on a statutory basis which differs from GAAP. Statutory net income and statutory capital and surplus of NAICO are as follows:
2005 2006 2007 -------- -------- -------- (In thousands) Statutory net income .............. $ 5,915 $ 3,789 $ 1,037 Statutory capital and surplus ..... $ 47,285 $ 51,663 $ 50,250
During 2005, the Oklahoma Insurance Code was amended to allow domestic insurers to admit office equipment, furniture and other such property constituting less than 3% of its otherwise admitted assets. This prescribed accounting practice increased NAICO's statutory capital and surplus by $510,000, $404,000 and $305,000 at December 31, 2005, 2006 and 2007, respectively. There is no difference between NAICO's statutory net income under the National Association of Insurance Commissioners' ("NAIC") ACCOUNTING PRACTICES AND PROCEDURES manual and practices prescribed by the Oklahoma Insurance Code. PAGE F-17 The Oklahoma Insurance Commissioner has the right to permit other specific practices that deviate from prescribed practices. NAICO does not have any such permitted practices. The NAIC has adopted risk-based capital ("RBC") standards for domestic property and casualty insurance companies. The RBC standards are designed to assist insurance regulators in analytically determining a level of capital and surplus that would be sufficient to withstand reasonably foreseeable adverse events associated with underwriting risk, investment risk, credit risk and loss reserve risk. NAICO is subject to the RBC standards. Based on available information, management believes NAICO complied with the RBC standards at December 31, 2006 and 2007. 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 2008 without the approval of the Oklahoma Department of Insurance is approximately $5.0 million. NAICO paid cash shareholder dividends to Chandler USA totaling $1.6 million in 2007. NAICO did not pay any shareholder dividends during 2005 and 2006. 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 $12.5 million as of December 31, 2007). NAICO paid approximately $4,000 in policyholder dividends during 2006, respectively. NAICO did not pay any policyholder dividends during 2005 or 2007. NOTE 7. INCOME TAXES Chandler USA and its wholly owned subsidiaries file a consolidated U.S. Federal income tax return. The income taxes reflected in the accompanying consolidated statements of operations differ from those expected using U.S. Federal enacted income tax rates as noted by the following:
2005 2006 2007 ---------- ---------- ---------- (In thousands) Computed income tax provision (benefit) at 34% ................... $ 2,340 $ 1,721 $ (255) Increase (decrease) in income taxes resulting from: Utilization of capital loss carryforward ....................... (104) (253) (73) Nondeductible meals and entertainment expenses ................. 164 163 150 Other nondeductible expenses ................................... 50 34 91 ---------- ---------- ---------- Federal income tax provision (benefit) ........................... $ 2,450 $ 1,665 $ (87) ========== ========== ==========
U.S. Federal income tax provision (benefit) consists of:
CURRENT DEFERRED TOTAL ---------- ---------- ---------- (In thousands) 2005 ............................................................. $ 160 $ 2,290 $ 2,450 2006 ............................................................. - 1,665 1,665 2007 ............................................................. - (87) (87)
PAGE F-18 Deferred income tax provision (benefit) relating to temporary differences includes the following components:
2005 2006 2007 ---------- ---------- ---------- (In thousands) Loss reserve discounts ........................................... $ 454 $ 66 $ 9 Unearned premiums ................................................ (256) 62 119 Deferred policy acquisition costs ................................ 397 (129) 93 Investment in limited partnerships ............................... (126) (152) (40) Alternative minimum tax .......................................... (160) - - Reserve for uncollectible premiums receivable .................... (36) 18 12 Depreciation and lease expense ................................... (106) (70) (49) Discount on fixed maturity investments ........................... 26 23 21 Accrual of prejudgment interest income ........................... - 1,410 (1,410) Net operating loss carryforwards ................................. 2,076 530 1,118 Other ............................................................ 21 (93) 40 ---------- ---------- ---------- $ 2,290 $ 1,665 $ (87) ========== ========== ==========
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:
2006 2007 ------------ ------------ (In thousands) Deferred tax assets: Loss reserve discounts ...................................... $ 2,049 $ 2,040 Unearned premiums ........................................... 2,183 2,064 Compensated absences ........................................ 227 191 Net operating loss carryforwards - federal .................. 1,572 455 Net operating loss carryforwards - state .................... 3,230 2,057 Net capital loss carryforward ............................... 818 - Investment in limited partnership ........................... 278 318 Unrealized loss on investments available for sale ........... 569 - Other ....................................................... 262 306 Valuation allowance ......................................... (4,048) (2,057) ------------ ------------ Total deferred tax assets ..................................... 7,140 5,374 ------------ ------------ Deferred tax liabilities: Depreciation and lease expense .............................. 1,300 1,252 Accrual of prejudgment interest income ...................... 1,410 - Deferred policy acquisition costs ........................... 287 380 Unrealized gain on investments available for sale ........... - 101 Other ....................................................... 150 194 ------------ ------------ Total deferred tax liabilities ................................ 3,147 1,927 ------------ ------------ Net deferred tax assets ....................................... $ 3,993 $ 3,447 ============ ============
At December 31, 2007, Chandler USA had a net operating loss carryforward available for U.S. Federal income taxes of $1.3 million which begins to expire in 2025. Chandler USA has concluded that the deferred tax asset including the federal net operating loss carryforwards are more likely than not to be realized. Chandler USA anticipates that its future U.S. consolidated income will be sufficient to utilize the federal net operating losses within the required time. Chandler USA will continue to evaluate income generated in future periods in determining the reasonableness of its position. If Chandler USA determines that future income is insufficient to cause the realization of the federal net operating losses within the required time, a valuation allowance will be established. In addition, Chandler USA, at December 31, 2007, had net operating loss carryforwards available for Oklahoma state income taxes totaling approximately $34.3 million which expire in the years 2008 through 2027. At December 31, 2006, Chandler USA had a capital loss carryforward for U.S. Federal income taxes of $2.4 million. The balance of the capital loss carryforward expired 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. PAGE F-19 NOTE 8. EMPLOYEE BENEFITS Chandler USA and its subsidiaries participate in a defined contribution retirement plan established under Section 401(k) of the Internal Revenue Code. All full time employees who have completed one year of service and attained age 21 may elect to participate in the 401(k) plan. Participants may contribute up to 25% of compensation, subject to certain limitations. Chandler USA matches 50% of the first $2,000, 40% of the next $3,000, 30% of the next $3,000 and 25% of the remaining employee contributions up to a maximum employer contribution of $6,225 per employee per year. In addition, Chandler USA may make additional annual contributions to the 401(k) plan at its discretion. Chandler USA's expense for 401(k) plan contributions was $315,000, $307,000 and $288,000 for 2005, 2006 and 2007, respectively. NOTE 9. FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS. The estimated fair value amounts have been determined by Chandler USA using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates of fair values presented herein are not necessarily indicative of the amounts that Chandler USA could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. 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, 2006 and 2007. The estimated fair values of Chandler USA's fixed-maturity and equity security investments are disclosed at Note 2. At December 31, 2007, the fair value of Chandler USA's Debentures was estimated to be $5.8 million based on the latest reported trade. Chandler USA's Debentures have not historically traded regularly, and settlement at the reported fair value may not be possible. The Debentures are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium, but may be purchased and cancelled by Chandler USA at a price of less than the sum of the principal amount and accrued interest at any time. Chandler USA is obligated for $13.4 million principal amount of junior subordinated debentures that mature in 2033 with a fixed interest rate of 9.75%, and $7.2 million principal amount of junior subordinated debentures that mature in 2034 with a floating rate of 4.10% over LIBOR. The interest rate at December 31, 2007 was 9.34%. At December 31, 2007, the fair value of Chandler USA's junior subordinated debentures was estimated to be $22.5 million. NOTE 10. 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. PAGE F-20 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 included $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. 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 December 31, 2006 as a result of increasing the estimated recovery. NAICO also recorded $6.6 million of interest income for its estimate of prejudgment interest through December 31, 2006, including a recovery for a pre-verdict settlement with certain other parties. On January 28, 2008, the court entered a final judgment denying Gulf Liquid's claims against NAICO and Gulsby, denying all of NAICO's claims against Gulf Liquids and Williams, and entering judgment for Gulsby against Gulf Liquids for $15,651,927 plus interest at 7.25% compounded annually from January 28, 2008 until paid. The court also ordered Gulf Liquids to pay Gulsby's taxable court costs, estimated at $100,000. All parties may appeal all or any of these judgments. In the fourth quarter of 2007, as a result of this final judgment, NAICO decreased the estimated recovery on the surety bond claims related to the construction of the two gas processing plants which resulted in an increase in losses and loss adjustment expenses incurred of $1.8 million. Unpaid losses and loss adjustment expenses increased $12.7 million and reinsurance recoverable on unpaid losses and loss adjustment expenses increased $10.9 million as of December 31, 2007 as a result of decreasing the estimated recovery. NAICO also decreased accrued interest income by $4.5 million for its estimate of prejudgment interest income. NOTE 11. COMMITMENTS AND CONTINGENCIES REINSURANCE In the ordinary course of business, NAICO cedes insurance to other insurers and reinsurers under various reinsurance treaties that cover individual risks (facultative reinsurance) or entire classes of business (treaty reinsurance). Reinsurance provides greater diversification of business written and also reduces NAICO's exposure arising from high limits of liability or from hazards of an unusual nature. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. In formulating its reinsurance programs, NAICO considers numerous factors, including the financial stability of the reinsurer, ability to provide sufficient collateral (if required), reinsurance coverage offered and price. PAGE F-21 NAICO has structured separate reinsurance programs for workers compensation, casualty (including automobile liability, general and products liability, umbrella liability and related professional liability), automobile physical damage and construction surety bonds. NAICO discontinued its property reinsurance program effective January 1, 2007 due to the transfer of its commercial property business to another insurance company. Chandler Insurance reinsures NAICO for a portion of the risk on NAICO's reinsurance programs except for the homeowners program. 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 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. The majority of NAICO's reinsurance programs renew on July 1 of each year. At the present time, NAICO expects to renew the reinsurance programs that expire on July 1, 2008. NAICO periodically reviews certain prospective single year reinsurance treaties, subject to commutation provisions therein, to determine if it is advantageous to assume the estimated loss exposure on expired insurance policies covered by such treaties in exchange for return premiums. Commutation of such reinsurance treaties will be determined in future periods based on timely review of all available data. NAICO reviews the historical results for reinsurance contracts with similar commutation provisions and accrues for such commutations where a commutation election is considered probable. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to Chandler USA; consequently, adjustments to ceded losses and loss adjustment expenses are made for amounts deemed uncollectible. During 2005, 2006 and 2007, NAICO incurred charges of $108,000, $97,000 and $356,000, 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:
2005 2006 2007 ----------------------- ----------------------- ----------------------- WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED ----------- ---------- ----------- ---------- ----------- ---------- (In thousands) Direct ........... $ 119,051 $ 115,849 $ 104,037 $ 109,637 $ 85,836 $ 93,487 Assumed .......... 1,293 570 9,006 5,223 14,245 13,422 Ceded ............ (50,218) (50,359) (48,254) (49,156) (35,649) (40,724) ----------- ---------- ----------- ---------- ----------- ---------- Net premiums ..... $ 70,126 $ 66,060 $ 64,789 $ 65,704 $ 64,432 $ 66,185 =========== ========== =========== ========== =========== ==========
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 $50.3 million, $10.2 million and $39.5 million for 2005, 2006 and 2007, respectively. SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK NAICO conducts its business through individual independent insurance agencies and underwriting managers. NAICO 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, 2006 and 2007 were $31.0 million and $28.1 million, respectively. Receivables for deductibles, in most cases, are secured by cash deposits and letters of credit. At December 31, 2007, NAICO maintained custody of such letters of credit securing these and other transactions totaling approximately $26.9 million, which is a reasonable estimate of their fair value. These letters of credit are not reflected in the accompanying consolidated financial statements. During 2005 and 2006, one unaffiliated independent insurance agent produced approximately 12% of NAICO's direct written and assumed premiums in each year. There were no unaffiliated independent insurance agents that produced 10% or more of NAICO's direct written and assumed premiums during 2007. PAGE F-22 Approximately $32.3 million, or 45% of NAICO's reinsurance recoverables and prepaid reinsurance premiums at December 31, 2007 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, 2007.
CEDED REINSURANCE NET PREMIUMS FOR A.M. BEST REINSURANCE THE YEAR ENDED COMPANY NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 2007 RATING ------------------------------------------------------------- --------------- ------------------ ----------- (Dollars in thousands) Chandler Insurance ....................................... $ 31,616 $ 27,959 (2) Employers Reinsurance Corporation ........................ 17,158 (1,354) A+ Swiss Reinsurance America Corporation .................... 17,078 431 A+ Markel Insurance Company ................................. 2,718 1,785 A Transatlantic Reinsurance Company ........................ 2,380 1,863 A+ --------------- ------------------ Top five reinsurers ................................. $ 70,950 $ 30,684 =============== ================== All reinsurers ...................................... $ 71,857 $ 35,649 =============== ================== Percentage of total represented by top five reinsurers ... 99% 86% ------------------------------------------------------------- (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, 2007. (2) Chandler Insurance owns 100% of the common stock of Chandler USA, which in turn owns 100% of the common stock of NAICO. Chandler Insurance does not have an A.M. Best Company rating. 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, 2007, Chandler Insurance had cash and investments, including accrued interest, with a fair value of $31.6 million deposited in a trust account for the benefit of NAICO.
OTHER See Note 10 regarding contingencies relating to litigation matters. Chandler USA has an employment agreement with W. Brent LaGere, Chairman of the Board and Chief Executive Officer of Chandler USA and its subsidiaries. Under this agreement, Mr. LaGere's base compensation is established at not less than $250,000 per year. In the event that Mr. LaGere is terminated without cause, as defined in the agreement, he is entitled to receive his base compensation for the remainder of the term of the agreement, but in no event for more than 60 months. The agreement will terminate upon Mr. LaGere attaining age 70, unless earlier terminated by Chandler USA for cause. In addition to his base compensation, Mr. LaGere is eligible to receive certain benefits and bonuses from Chandler USA and its subsidiaries. In addition, certain executives are eligible to receive bonuses based upon various factors. NAICO is subject to a variety of assessments related to insurance activities, including those by state guaranty funds and workers compensation second-injury funds. The amounts and timing of such assessments are beyond the control of NAICO. NAICO provides for these charges on a current basis by applying historical factors to premiums earned. Actual results may vary from these values and adjustments therefrom are necessary to maintain an adequate reserve for these assessments. The reserve for unpaid assessments which is included in accrued taxes and other payables was approximately $914,000 and $903,000 at December 31, 2006 and 2007, 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 which are included in other assets in the amount that it expects to recover of approximately $2,870,000 and $2,847,000 at December 31, 2006 and 2007, respectively. NAICO may receive additional guaranty fund assessments in the future related to insolvent insurance companies. At this time, NAICO is unable to estimate the amount and timing of such assessments. PAGE F-23 At December 31, 2007, Chandler USA's subsidiaries were committed under noncancellable operating and capital leases for certain equipment and office space. Rental payments under these leases were $780,000, $777,000 and $648,000 in 2005, 2006 and 2007, respectively. Future minimum lease payments are as follows:
(In thousands) 2008 .......................... $ 626 2009 .......................... 507 2010 .......................... 110 2011 .......................... 11 2012 .......................... - -------------- $ 1,254 ==============
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 with monthly rental installments equal to the sum of (i) $17,512 plus (ii) interest on the unpaid lease balance at a floating interest rate of 1% over JP Morgan Chase Bank prime, which was 8.25% at December 31, 2007. 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. 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 Trust I and Trust II. It guarantees payment of distributions and the redemption price of the trust preferred securities until the securities are redeemed in full. The total redemption price of the trust preferred securities is $20.0 million. NOTE 12. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for a three year term. During March 2004, the lease was extended for three years, and during March 2007 the lease was extended for an additional three years. See Note 11 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. During the second quarter of 2006, CIMI purchased two limited partnership units in Basin Drilling #2 LP for $2,000, and purchased 8% cumulative subordinated debentures in the amount of $500,000. The timing of payment of interest and principal on the debentures is subject to various restrictions contained in the cumulative subordinated debenture note. Interest on the debentures has been paid through September 30, 2007. The purpose of the partnership is to own and operate an oil and gas drilling rig. CIMI financed the purchase with a $500,000 variable rate bank loan. CIMI paid off the balance of this bank loan in December 2007. The partnership is managed by Basin Management, LLC ("BMLLC") who is the General Partner. A director of NAICO and Chandler USA is the Manager for BMLLC, and is also a director of the bank and a significant shareholder of the bank holding company that provided the bank loan described above. 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 $313,000, $308,000 and $302,000 in expenses associated with this property during 2005, 2006 and 2007, respectively, including $10,000, $11,000 and $3,000 for reimbursement of certain expenses, such as utility and similar expenses, for the years 2005, 2006 and 2007, respectively. PAGE F-24 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, 2006 and 2007, Chandler USA had a receivable of $9.6 million and $11.5 million, respectively, under the Credit Agreement, and Chandler USA earned $614,000, $733,000 and $881,000 in interest income under the Credit Agreement during 2005, 2006 and 2007, respectively. NOTE 13. 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 resulted in a significant increase in agency revenues, the agency segment is now reported separately. The agency segment accounted for 0.0%, 4.1% and 7.0% of 2005, 2006 and 2007 consolidated revenues before intersegment eliminations, respectively. CIMI is an underwriting manager and wholesaler that offers multiple insurance products for businesses in various industries and political subdivisions. A large portion of certain classes of business produced by CIMI is placed with NAICO. Management evaluates the agency segment's performance on the basis of commission income generated 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. PAGE F-25 The following table presents a summary of Chandler USA's operating segments for the years ended December 31:
PROPERTY AND INTERSEGMENT REPORTED CASUALTY AGENCY ELIMINATIONS BALANCES -------------------------------------------------------- (In thousands) 2005 Revenues from external customers .......................... $ 66,268 $ 43 $ - $ 66,311 Intersegment revenues ..................................... 1,963 8 (1,971) - Interest income, net ...................................... 3,468 - - 3,468 Interest expense .......................................... 2,535 - - 2,535 Segment profit (loss) before income taxes (1) ............. 4,902 1,981 - 6,883 Segment assets ............................................ 244,907 2,394 (2,242) 245,059 Depreciation and amortization ............................. 1,486 - - 1,486 2006 Revenues from external customers .......................... $ 65,888 $ 133 $ - $ 66,021 Intersegment revenues ..................................... - 3,150 (3,150) - Interest income, net ...................................... 10,572 21 - 10,593 Interest expense .......................................... 2,668 22 - 2,690 Segment profit (loss) before income taxes (1) ............. 1,819 3,242 - 5,061 Segment assets ............................................ 222,004 5,914 (5,146) 222,772 Depreciation and amortization ............................. 1,379 - - 1,379 2007 Revenues from external customers .......................... $ 66,753 $ 1,348 $ - $ 68,101 Intersegment revenues ..................................... 99 3,737 (3,836) - Interest income, net ...................................... 41 328 - 369 Interest expense .......................................... 2,686 17 - 2,703 Segment profit (loss) before income taxes (1) ............. (2,463) 1,714 - (749) Segment assets ............................................ 232,482 7,772 (5,887) 234,367 Depreciation and amortization ............................. 1,431 - - 1,431 --------------------------------------------------- (1) Includes net realized investment gains. The following table shows the detail of intersegment eliminations for segment assets shown in the previous table:
2005 2006 2007 -------- -------- -------- (In thousands) Segment asset eliminations Investment in subsidiaries ............................. $ 1 $ 1 $ 1 Elimination of intersegment receivables ................ 2,241 5,145 5,886 -------- -------- -------- $ 2,242 $ 5,146 $ 5,887 ======== ======== ========
PAGE F-26 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 2005 2006 2007 ---------------------------------------------------------- ---------- ---------- ---------- (In thousands) NET PREMIUMS EARNED Standard lines ........................................... $ 54,979 $ 54,357 $ 62,342 Political subdivisions ................................... 6,690 5,253 3,436 Homeowners ............................................... 3,321 5,353 9 Surety bonds ............................................. 669 193 186 Other (1) ................................................ 401 548 212 ---------- ---------- ---------- $ 66,060 $ 65,704 $ 66,185 ========== ========== ========== LOSSES AND LOSS ADJUSTMENT EXPENSES Standard lines ........................................... $ 33,512 $ 40,212 $ 37,122 Political subdivisions ................................... 4,091 2,693 1,584 Homeowners ............................................... 1,306 2,515 (48) Surety bonds ............................................. (1,704) (152) 2,082 Other (1) ................................................ 119 205 653 ---------- ---------- ---------- $ 37,324 $ 45,473 $ 41,393 ========== ========== ========== -------------------------- (1) This category is comprised primarily of the run-off of discontinued programs and NAICO's participation in various mandatory workers compensation pools.
NOTE 14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) A summary of the unaudited quarterly operating results during 2006 and 2007 follows:
First Second Third Fourth Total quarter quarter quarter quarter year --------- --------- --------- --------- -------- 2006 ----------------------------------------------------- Net premiums earned ................................ $ 16,865 $ 16,988 $ 16,029 $ 15,822 $65,704 Investment income, net ............................. 895 970 7,366 1,362 10,593 Realized investment gains, net ..................... 56 133 352 204 745 Income (loss) before income taxes .................. 931 (604) 2,737 1,997 5,061 Net income (loss) .................................. 584 (393) 1,875 1,330 3,396 2007 ----------------------------------------------------- Net premiums earned ................................ $ 17,020 $ 15,870 $ 16,510 $ 16,785 $66,185 Investment income, net ............................. 1,372 1,108 1,166 (3,277) 369 Realized investment gains, net ..................... 35 26 34 119 214 Income (loss) before income taxes .................. 1,445 1,062 921 (4,177) (749) Net income (loss) .................................. 914 668 514 (2,758) (662)
Net investment income included $6.3 million and $324,000 in the third and fourth quarters of 2006, respectively, for the accrual of prejudgment interest on a favorable jury verdict in civil litigation regarding certain surety bond claims. The accrual of prejudgment interest was decreased by $4.5 million in the fourth quarter of 2007, based on a final judgment entered by the court. See Note 10 for more information related to this litigation. * * * * * * * PAGE F-27 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholder of Chandler (U.S.A.), Inc.: We have audited the consolidated balance sheets of Chandler (U.S.A.), Inc. and subsidiaries ("Chandler USA") as of December 31, 2006 and 2007, 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, 2007. Our audits also included the financial statement schedules of Chandler USA listed in Item 15(a). 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 as of December 31, 2006 and 2007, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007 in conformity with U.S. generally accepted accounting principles. 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. We were not engaged to examine management's assertion about the effectiveness of Chandler USA's internal control over financial reporting as of December 31, 2007 included in the accompanying Management's Report on Internal Control Over Financial Reporting and, accordingly, we do not express an opinion thereon. /s/ Tullius Taylor Sartain & Sartain LLP TULLIUS TAYLOR SARTAIN & SARTAIN LLP Tulsa, Oklahoma March 27, 2008 PAGE F-28 SCHEDULE I CHANDLER (U.S.A.), INC. AND SUBSIDIARIES SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES AS OF DECEMBER 31, 2007 (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 ....... $ 38,723 $ 39,172 $ 39,172 Corporate obligations ......................... 18,703 18,506 18,506 Public utilities .............................. 4,287 4,231 4,231 Mortgage-backed securities .................... 1,187 1,148 1,148 ------------ ---------- --------------- 62,900 63,057 63,057 EQUITY SECURITIES AVAILABLE FOR SALE: Corporate stock ............................... - 141 141 Short-term investments ........................ 1,045 1,045 1,045 ------------ ---------- --------------- Total investments .......................... $ 63,945 $ 64,243 $ 64,243 ============ ========== ===============
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) BALANCE SHEETS (In thousands except share amounts)
DECEMBER 31, --------------------- 2006 2007 ---------- ---------- ASSETS Property and equipment, net ........................................ 829 1,021 Amounts due from related parties ................................... 9,584 11,506 Other assets ....................................................... 3,678 2,561 Investment in subsidiaries, net .................................... 59,669 61,562 ---------- ---------- Total assets ....................................................... $ 73,760 $ 76,650 ========== ========== LIABILITIES AND SHAREHOLDER'S EQUITY Liabilities Accrued taxes and other payables .................................. $ 1,892 $ 2,169 Amounts due to subsidiaries ....................................... 1,305 3,278 Debentures ........................................................ 6,979 6,979 Junior subordinated debentures issued to affiliated trusts ........ 20,620 20,620 ---------- ---------- Total liabilities .................................................. 30,796 33,046 ---------- ---------- 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 ............................................... (16,517) (17,179) Accumulated other comprehensive income (loss): Unrealized gain (loss) on investments held by subsidiary and available for sale, net of deferred income taxes ........................... (1,105) 197 ---------- ---------- Total shareholder's equity ......................................... 42,964 43,604 ---------- ---------- Total liabilities and shareholder's equity. ........................ $ 73,760 $ 76,650 ========== ==========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-30 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, ---------------------------------- 2005 2006 2007 ---------- ---------- ---------- Revenues Investment income, net ................................. $ 3 $ 4 $ 8 Interest income, net from related parties .............. 670 792 941 Other income ........................................... 908 1,334 1,020 ---------- ---------- ---------- Total revenues ....................................... 1,581 2,130 1,969 ---------- ---------- ---------- Operating costs and expenses General and administrative expenses .................... 2,749 3,116 3,587 Interest expense ....................................... 2,519 2,649 2,665 ---------- ---------- ---------- Total operating costs and expenses ................... 5,268 5,765 6,252 ---------- ---------- ---------- Loss before income tax benefit ........................... (3,687) (3,635) (4,283) Federal income tax benefit ............................... 1,198 1,606 1,430 ---------- ---------- ---------- Net loss before equity in net income of subsidiaries ................................. (2,489) (2,029) (2,853) Equity in net income of subsidiaries ..................... 6,922 5,425 2,191 ---------- ---------- ---------- Net income (loss) ........................................ $ 4,433 $ 3,396 $ (662) ========== ========== ==========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-31 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, ---------------------------------- 2005 2006 2007 ---------- ---------- ---------- Operating activities Net income (loss) ......................................... $ 4,433 $ 3,396 $ (662) Add (deduct): Adjustments to reconcile net income (loss) to cash provided by (applied to) operating activities: Net income of subsidiaries not distributed to parent ..... (6,922) (5,425) (2,191) Net (gain) loss on sale of property and equipment ........ (7) 8 (6) Amortization and depreciation ............................ 210 218 243 Net change in non-cash balances relating to operating activities: Premiums receivable ..................................... 7 - - Amounts due from subsidiaries ........................... 1,128 148 - Other assets ............................................ (121) 809 1,059 Accrued taxes and other payables ........................ (234) (162) 277 Amounts due to subsidiaries ............................. - 1,306 1,973 ---------- ---------- ---------- Cash provided by (applied to) operating activities ....... (1,506) 298 693 ---------- ---------- ---------- Investing activities Cost of property and equipment purchased .................. (130) (145) (420) Proceeds from sale of property and equipment .............. 67 45 49 ---------- ---------- ---------- Cash applied to investing activities ..................... (63) (100) (371) ---------- ---------- ---------- Financing activities Shareholder dividend from subsidiaries .................... - - 1,600 Payments and loans from related parties ................... 2,513 1,747 2,164 Payments and loans to related parties ..................... (982) (1,971) (4,086) ---------- ---------- ---------- Cash provided by (applied to) financing activities ....... 1,531 (224) (322) ---------- ---------- ---------- Decrease in cash ........................................... (38) (26) - Cash at beginning of year .................................. 64 26 - ---------- ---------- ---------- Cash at end of year ........................................ $ 26 $ - $ - ========== ========== ===========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-32 SCHEDULE III CHANDLER (U.S.A.), INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (IN THOUSANDS)
FUTURE POLICY AMORTI- BENEFITS, OTHER CLAIMS, ZATION OF NET DEFERRED LOSSES, POLICY LOSSES DEFERRED PREMIUMS POLICY CLAIMS CLAIMS AND NET AND POLICY OTHER WRITTEN ACQUISITION AND LOSS UNEARNED BENEFITS PREMIUM INTEREST SETTLEMENT ACQUISITION OPERATING AND COSTS EXPENSES PREMIUMS PAYABLE REVENUE INCOME EXPENSES COSTS EXPENSES ASSUMED ----------- --------- -------- ---------- --------- --------- ---------- ----------- --------- -------- DECEMBER 31, 2005 Property and casualty ... $ 1,225 $ 109,541 $ 55,034 $ 5,684 $ 66,060 $ 3,468 $ 37,324 $ 10,671 $ 15,284 $ 70,126 =========== ========= ======== ========== ========= ========= ========== =========== ========= ======== DECEMBER 31, 2006 Property and casualty ... $ 845 $ 83,253 $ 53,217 $ 7,663 $ 65,704 $ 10,593 $ 45,473 $ 11,666 $ 15,159 $ 64,789 =========== ========= ======== ========== ========= ========= ========== =========== ========= ======== DECEMBER 31, 2007 Property and casualty ... $ 1,118 $ 100,590 $ 46,389 $ 7,947 $ 66,185 $ 369 $ 41,393 $ 12,547 $ 15,493 $ 64,432 =========== ========= ======== ========== ========= ========= ========== =========== ========= ========
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-33 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, 2005 Property and casualty ........ $ 119,051 $ (50,218) $ 1,293 $ 70,126 1.84% ============ ============ ============ ============ ============ Year ended December 31, 2006 Property and casualty ........ $ 104,037 $ (48,254) $ 9,006 $ 64,789 13.90% ============ ============ ============ ============ ============ Year ended December 31, 2007 Property and casualty ........ $ 85,836 $ (35,649) $ 14,245 $ 64,432 22.11% ============ ============ ============ ============ ============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-34 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: 2005 ........................... $ 119 $ 176 $ (72) $ 223 ================ ================ ================ =============== 2006 ........................... $ 223 $ 73 $ (126) $ 170 ================ ================ ================ =============== 2007 ........................... $ 170 $ 19 $ (55) $ 134 ================ ================ ================ =============== Allowance for non-collection of reinsurance recoverables on paid and unpaid losses: 2005 ........................... $ 3,272 $ 108 $ (3,206) $ 174 ================ ================ ================ =============== 2006 ........................... $ 174 $ 97 $ (141) $ 130 ================ ================ ================ =============== 2007 ........................... $ 130 $ 356 $ (247) $ 239 ================ ================ ================ ===============
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-35 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, 2005 Property-casualty ................... $ - $ 41,470 =============== ================= Year ended December 31, 2006 Property-casualty ................... $ - $ 43,941 =============== ================= Year ended December 31, 2007 Property-casualty ................... $ - $ 37,608 =============== =================
SEE REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM. PAGE F-36 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.