-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, EkkdHzCYrRoFhfwQWdLzgtkJM/tYcn0X9TxHCXJAeDwAXTlmhQhAWxacydRva6ux fc5eh1ztr5sW/17N1zyDiQ== 0000792854-00-000002.txt : 20000323 0000792854-00-000002.hdr.sgml : 20000323 ACCESSION NUMBER: 0000792854-00-000002 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000322 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CHANDLER INSURANCE CO LTD CENTRAL INDEX KEY: 0000792854 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 000000000 FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-15286 FILM NUMBER: 575040 BUSINESS ADDRESS: STREET 1: 5TH FLR ANDERSON SQUARE STREET 2: PO BOX 1854 CITY: GRAND CAYMAN CAYMAN STATE: E9 ZIP: 00000 BUSINESS PHONE: 3459498177 MAIL ADDRESS: STREET 1: 5TH FLOOR ANDERSON SQUARE STREET 2: P O BOX 1854 CITY: GRAND CAYMAN STATE: E9 10-K405 1 ================================================================================ 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, 1999 COMMISSION FILE NUMBER: 0-15286 CHANDLER INSURANCE COMPANY, LTD. (Exact name of registrant as specified in its charter) CAYMAN ISLANDS NONE (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 5th FLOOR ANDERSON SQUARE P.O. BOX 1854 GRAND CAYMAN, CAYMAN ISLANDS B.W.I. N/A (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 345-949-8177 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON SHARES, $1.67 PAR VALUE 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 ----- The aggregate market value of the voting stock held by non-affiliates of the registrant on February 29, 2000 was $29,855,638 (all currency is expressed in U.S. dollars). See "Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" regarding registrant's assumptions about affiliates and possible changes in control. The number of common shares, $1.67 par value, of the registrant outstanding on February 29, 2000 was 4,428,033, which includes 1,142,625 common shares which were rescinded through litigation and are held by a court. See "Item 3. LEGAL PROCEEDINGS." 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 Insurance Company, Ltd. (the "Company") in periodic press releases, oral statements made by the Company's officials to analysts and shareholders in the course of presentations about the Company and conference calls following earnings releases, 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 the Company 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 the Company operates; (iv) claims frequency; (v) claims severity; (vi) the number of new and renewal policy applications submitted by the Company's agents; (vii) the ability of the Company to obtain adequate reinsurance in amounts and at rates that will not adversely affect its competitive position; (viii) the ability of National American Insurance Company ("NAICO") to maintain favorable insurance company ratings; (ix) the ability of the Company and its third party providers, agents and reinsurers to adequately address year 2000 issues; and (x) other factors including the ongoing litigation matters involving a significant concentration of ownership of the Company's common stock. ITEM 1. BUSINESS GENERAL The Company is an insurance company organized and domiciled in the Cayman Islands. Through its wholly owned subsidiaries, the Company operates in two lines of business: property and casualty insurance and insurance agency operations. NAICO is one of the leading commercial business insurance writers in Oklahoma, providing property and casualty coverage for businesses in various industries. NAICO has a network of independent agents, totaling approximately 230 at December 31, 1999, 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. Currently, NAICO is rated as "A- (Excellent)" by A.M. Best Company, an insurance rating agency. NAICO is also rated "A (Strong)" by Standard & Poor's rating agency. These ratings are independent opinions of a company's financial strength, operating performance and ability to meet its obligations to policyholders. Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") is a Barbados company and a wholly owned subsidiary of the Company that principally reinsures risks underwritten by NAICO. NAICO retains a portion of each risk, then transfers the balance to other reinsurance companies including Chandler Barbados. The Company reinsures Chandler Barbados for a portion of the risk that it assumes from NAICO. LaGere & Walkingstick Insurance Agency, Inc. ("L&W") is an independent insurance agency that represents various insurance companies providing a variety of property and casualty, individual and group life, medical and disability income coverages. L&W also acts as a surplus lines broker specializing in risk management and brokering insurance primarily for commercial enterprises. Chandler (U.S.A.), Inc. ("Chandler USA") is an Oklahoma corporation which is wholly owned by Chandler Barbados. Chandler USA is headquartered in Chandler, Oklahoma, in facilities also occupied by its wholly owned subsidiaries NAICO and L&W. Chandler USA provides administrative services for NAICO and L&W. The Company conducts its business from the Cayman Islands in the British West Indies and is not subject to regulation as an insurance company in any jurisdiction within the United States of America. The Company is, however, subject to certain regulations of the Cayman Islands Monetary Authority (the "Monetary Authority"). Chandler Barbados is subject to similar Barbados regulations. See "Regulation." Although Chandler Barbados is not subject to the minimum capital, audit, reporting and other requirements imposed by regulation upon United States reinsurance companies, as a foreign reinsurer it is required by the United States companies it reinsures to secure its reinsurance obligations by depositing acceptable securities in a trust for the benefit of the company ceding such obligations or by letters of credit in favor of the ceding company. See "Trust Arrangements and Special Deposits." NAICO is subject to minimum capital, audit, reporting, dividend and other requirements imposed by regulation upon United States insurance companies. See "Regulation." PAGE 2 INSURANCE PROGRAMS NAICO writes various property and casualty insurance products through four primary marketing programs. The programs are standard property and casualty, political subdivisions, surety bonds and group accident and health. STANDARD PROPERTY AND CASUALTY PROGRAM NAICO offers workers compensation, automobile liability and physical damage, general and umbrella liability and property coverages under its standard property and casualty program. In marketing these products, NAICO targets companies in the construction, manufacturing, wholesale, service, oil and gas, and retail industries. NAICO writes this business principally in Oklahoma and Texas. POLITICAL SUBDIVISIONS PROGRAM Under the political subdivisions program, NAICO writes insurance policies for school districts, counties and municipalities. As of December 31, 1999, NAICO insured 526 school districts in Oklahoma and 153 school districts in Texas. The coverages offered include workers compensation, automobile liability, automobile physical damage, general liability, property and school board legal liability. NAICO also writes property and casualty insurance for municipalities and counties in Oklahoma, Texas and Missouri. The coverages offered include workers compensation, automobile and general liability, automobile physical damage, property and public officials liability insurance. As of December 31, 1999, NAICO insured 270 municipalities and counties in Oklahoma, Texas and Missouri. SURETY BOND PROGRAM NAICO writes surety bonds, commonly referred to as contract performance bonds, to secure the performance of contractors and suppliers on construction projects. Individual bonds generally do not exceed $5 million, and an individual contractor generally does not have "work in progress" for both bonded and unbonded jobs in excess of $10 million. A substantial portion of this business is written in Oklahoma, Texas and California. NAICO also writes bail bonds, which guarantee that the principal will discharge obligations set by the court, as well as other types of miscellaneous bonds. GROUP ACCIDENT AND HEALTH PROGRAM In 1996, NAICO began offering excess accident and health coverage for small to medium sized employers that self-insure a portion of their company medical plans. In January 1999, NAICO began a new program covering primarily Oklahoma employers on a fully insured basis. NAICO discontinued writing new policies for excess accident and health coverage effective April 1, 1999. NAICO is currently evaluating the fully insured program and may modify or discontinue the program during 2000. The following table shows gross premiums earned and net premiums earned by insurance program for the years 1997, 1998 and 1999. 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.
GROSS PREMIUMS EARNED NET PREMIUMS EARNED -------------------------- -------------------------- INSURANCE PROGRAMS 1997 1998 1999 1997 1998 1999 - ---------------------------------------------- -------- -------- -------- -------- -------- -------- (In thousands) Standard property and casualty................ $ 62,841 $ 76,458 $ 99,512 $ 55,527 $ 41,662 $ 71,676 Political subdivisions........................ 21,503 25,091 29,994 14,945 13,073 17,415 Surety bonds.................................. 12,320 11,915 13,660 11,117 9,938 10,896 Group accident and health..................... 3,379 6,104 9,164 2,303 4,646 8,261 Nonstandard private-passenger automobile (1).. 14,303 6,016 118 8,841 482 4 Other (2)..................................... 2,363 487 65 1,946 263 75 -------- -------- -------- -------- -------- -------- TOTAL......................................... $116,709 $126,071 $152,513 $ 94,679 $ 70,064 $108,327 ======== ======== ======== ======== ======== ======== - -------------------------- (1) The nonstandard private-passenger automobile program was discontinued in 1997. (2) This category is comprised primarily of the run-off of other discontinued programs and NAICO's participation in various mandatory workers compensation pools and assigned risks.
PAGE 3 LINES OF INSURANCE The lines of insurance written by NAICO through its programs are workers compensation, automobile liability, surety, accident and health, automobile physical damage, property, inland marine and other liability lines, which include general and professional liability lines. The following table shows net premiums earned as a percentage of total net premiums earned by each line of insurance written by the Company during the period indicated. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
YEAR ENDED DECEMBER 31, ------------------------------------------------ 1995 1996 1997 1998 1999 -------- -------- -------- -------- -------- Workers compensation............... 46% 48% 47% 28% 36% Other liability.................... 8% 10% 13% 20% 18% Automobile liability............... 19% 20% 16% 20% 18% Surety............................. 18% 11% 12% 14% 10% Accident and health................ -% -% 3% 7% 8% Automobile physical damage......... 7% 8% 6% 7% 6% Property........................... 2% 2% 2% 3% 3% Inland marine...................... -% 1% 1% 1% 1% -------- -------- -------- -------- -------- Total......................... 100% 100% 100% 100% 100% ======== ======== ======== ======== ========
AGENCY AND BROKERAGE L&W is appointed by insurers to solicit applications for insurance policies, primarily in Oklahoma. L&W represents various personal and commercial lines insurance companies in marketing property and casualty insurance. L&W also markets individual and group life, medical and disability income coverage. Major target classes of business include political subdivisions, health care facilities, transportation companies, manufacturers, contractors, energy businesses, retailers, wholesalers and service organizations. L&W places a large portion of its property and casualty business with NAICO. It also acts as a surplus lines broker specializing in risk management and brokering insurance for commercial enterprises. L&W places direct agency business as well as business from other agents with specialty insurance companies. L&W acts as a broker for NAICO, accepting applications for insurance and surety bonds from independent agents who, in many instances, are not agents appointed directly by NAICO. L&W also acts as an underwriter for a significant portion of NAICO's surety bond program. UNDERWRITING AND CLAIMS Independent insurance agents submit applications for insurance coverage for prospective customers to NAICO. NAICO reviews a prospective risk in accordance with its specific underwriting guidelines. If the risk is approved and coverage is accepted by the insured, NAICO issues an insurance policy. NAICO has maintained a continuous contractual relationship with an underwriting manager for its bail bond program. During 1997, 1998 and 1999, the gross written premiums in this program were $2.6 million, $2.8 million and $2.8 million, respectively. This underwriting manager operates through a network of bail bond agents who submit applications to the underwriting manager. If the application meets the specific guidelines set by the underwriting manager, a bail bond is issued. This underwriting manager is an independent contractor and is responsible for collection of all premiums and payment of all commissions to bail bond agents. Additionally, it is responsible for all claims and recoveries and is required to maintain collateral security for each bond. NAICO's claim department reviews and administers all claims. When a claim is received, it is reviewed and assigned to an in-house claim adjuster based on the type and geographic location of the claim, its severity and its class of business. NAICO's claim department is responsible for reviewing each claim, obtaining necessary documentation and establishing loss and loss adjustment expense reserves. NAICO's in-house claims staff handles and supervises the claims, coordinates with outside legal counsel and independent claims adjusters if necessary, and processes the claims to conclusion. 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 or proportional basis (where the reinsurer shares proportionately in premiums and losses) and an excess of loss basis (where only losses above a specific amount are reinsured). The availability, costs and limits of reinsurance purchased varies from year to year based upon prevailing market conditions, reinsurers' underwriting results and NAICO's desired risk retention levels. A majority of NAICO's reinsurance programs renew on January 1, April 1 or July 1 of each year. NAICO renewed all January 1, 2000 reinsurance programs. At the present time, NAICO expects to renew the reinsurance programs that renew on April 1 or July 1, 2000 as applicable. NAICO has structured separate reinsurance programs for construction surety bonds, property (including inland marine), workers compensation, casualty (including automobile liability, general liability, umbrella liability and related professional liability), automobile physical damage and group accident and health. Chandler Barbados reinsures NAICO for a portion of the risk on NAICO's construction surety bonds, workers compensation and casualty reinsurance programs. A portion of the risk that Chandler Barbados assumes from NAICO is reinsured by the Company. Under the 1997 workers compensation reinsurance program, the combined net retention for NAICO and Chandler Barbados was $1,000,000 of loss per occurrence. During 1998, the combined net retention was reduced to 70% of the first $10,000 of loss per occurrence. During the fourth quarter of 1999, NAICO agreed to rescind reinsurance treaties which covered 15% of the first $10,000 of loss per occurrence and 75% of $490,000 excess of $10,000 of loss per occurrence for its workers compensation business and which had been in effect since January 1, 1999. NAICO received a fee of $10.0 million as compensation for agreeing to rescind the reinsurance treaties and to assume the additional risk. Effective January 1, 2000, the combined net retention was reduced to 85% of the first $10,000 of loss per occurrence plus 75% of $90,000 excess of $10,000 of loss per occurrence. Under the 1997 casualty reinsurance program, the combined net retention was $500,000 of loss per occurrence. During 1998, the combined net retention was reduced to $250,000 of loss per occurrence. Effective January 1, 2000, the combined net retention was reduced to $100,000 of loss per occurrence. Under the 1997 construction surety bond reinsurance program, the combined net retention was $500,000 per bond or per principal (e.g., contractor). During 1998, the combined net retention was reduced to $250,000 per bond or per principal. Under the property reinsurance program, NAICO retains 30% of the first $500,000 of risk for each loss per location. Under the group accident and health program, NAICO retains the first $50,000 in excess of the self-insured retention for each insured person, each policy, and the first $100,000 (or the first $250,000 for cases exceeding 400 covered employees) of losses in excess of the self-insured aggregate retention. NAICO retains the first $100,000 of risk for each insured person for fully insured cases under its group accident and health program. NAICO purchases catastrophe protection for its automobile physical damage and certain property coverages to limit its retention for single loss occurrences involving multiple policies and/or policyholders resulting from perils such as floods, winds and severe storms. This catastrophe protection is purchased primarily from Lloyd's of London. Under its automobile physical damage reinsurance program, NAICO retains the first $250,000 of loss per occurrence, plus 5% of amounts exceeding $250,000 of loss per occurrence up to $1 million of loss per occurrence. NAICO has also purchased reinsurance which limits its net retained loss for both automobile physical damage and property losses to $1,000,000 for each loss occurrence. NAICO also purchases facultative reinsurance when it writes a risk with limits of liability exceeding the maximum limits of its treaties or when it otherwise considers such action appropriate. PAGE 5 The following table sets forth certain information related to NAICO's five largest reinsurers (excluding Chandler Barbados) determined on the basis of net reinsurance recoverables as of December 31, 1999.
CEDED REINSURANCE NET PREMIUMS FOR A.M. REINSURANCE THE YEAR ENDED BEST CO. NAME OF REINSURER RECOVERABLE (1) DECEMBER 31, 1999 RATING - --------------------------------------------------------- --------------- ------------------ ---------- (Dollars in thousands) First Excess and Reinsurance Corporation................. $ 16,528 $ 10,709 A Swiss Reinsurance America Corporation.................... 10,801 12,909 A+ SCOR Reinsurance Company................................. 8,544 9,479 A+ Reliance Insurance Company (2)........................... 5,253 (5,484) A- Red River Reinsurance, Ltd............................... 2,193 3,629 -(3) --------------- ------------------ Top five reinsurers................................. $ 43,319 $ 31,242 =============== ================== All reinsurers...................................... $ 60,780 $ 41,698 =============== ================== Percentage of total represented by top five reinsurers... 71% 75% - --------------------------------------------------------- (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, 1999. (2) Excludes premiums receivable of $12.9 million as of December 31, 1999 related to the rescission of two reinsurance treaties. NAICO collected this amount during January 2000. (3) Red River Reinsurance, Ltd. ("Red River") is required to secure its reinsurance obligations by depositing acceptable securities in trust for NAICO's benefit. At December 31, 1999, Red River's reinsurance recoverables were collateralized by cash and investments with a fair value of $1.9 million deposited in a trust account for the benefit of NAICO and premiums payable to Red River of approximately $400,000.
Transamerica Occidental Life Insurance Company ("Transamerica") reinsured NAICO for certain workers compensation risks during 1989, 1990 and 1991. Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed under the reinsurance treaties. Transamerica owed NAICO approximately $1.3 million for reinsurance recoverables on paid losses and loss adjustment expenses as of December 31, 1999. NAICO is seeking arbitration in order to enforce the terms of the reinsurance treaties. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. During 1997 and 1998, NAICO incurred charges of $527,000 and $50,000, respectively, in uncollectible reinsurance recoverables from unaffiliated reinsurers. NAICO did not incur any charges for uncollectible reinsurance recoverables from unaffiliated reinsurers in 1999. PAGE 6 LOSS AND UNDERWRITING EXPENSE RATIOS The combined loss and underwriting expense ratio ("Combined Ratio") is the traditional measure of underwriting experience for property and casualty insurance companies. It is the sum of the ratios of (i) incurred losses and loss adjustment expenses to net premiums earned ("loss ratio") and (ii) underwriting expenses to net premiums written and assumed ("underwriting expense ratio"). The following table shows the underwriting experience of the Company for the periods indicated by line of insurance written. Adjustments to reserves made in subsequent periods are reflected in the year of adjustment. In the following table, incurred losses include paid losses and loss adjustment expenses, net changes in case reserves for losses and loss adjustment expenses and net changes in reserves for incurred but not reported losses and loss adjustment expenses. See also "Reserves" and "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
YEAR ENDED DECEMBER 31, ------------------------------------------------------------ 1995 1996 1997 1998 1999 ---------- ---------- ---------- ---------- ------------ (Dollars in thousands) Workers compensation: Net premiums earned.............$ 37,066 $ 42,813 $ 44,954 $ 19,651 $ 39,329 (2) Loss ratio...................... 62% 53% 66% 71% 69% (2) Other liability: Net premiums earned.............$ 6,579 $ 8,656 $ 12,209 $ 14,045 $ 19,799 Loss ratio...................... 43% 60% 49% 70% 67% Automobile liability: Net premiums earned.............$ 15,498 $ 17,581 $ 15,593 $ 14,139 $ 19,030 Loss ratio...................... 74% 98% 89% 75% 82% Surety: Net premiums earned.............$ 14,237 $ 10,123 $ 11,256 $ 10,101 $ 11,122 Loss ratio...................... 56% -1% 9% 16% 8% Automobile physical damage: Net premiums earned.............$ 5,881 $ 6,788 $ 5,726 $ 4,702 $ 7,039 Loss ratio...................... 68% 74% 60% 85% 104% Accident and health: Net premiums earned.............$ 230 $ 564 $ 2,529 $ 4,646 $ 8,261 Loss ratio...................... -49% 56% 43% 91% 103% Property: Net premiums earned.............$ 1,369 $ 1,467 $ 1,912 $ 2,332 $ 2,972 Loss ratio...................... 73% 114% 74% 136% 203% Inland marine: Net premiums earned.............$ 227 $ 1,294 $ 500 $ 448 $ 775 Loss ratio...................... 84% 115% 195% 123% 138% Total: Net premiums earned.............$ 81,087 $ 89,286 $ 94,679 $ 70,064 $108,327 (2) Loss ratio...................... 62% 60% 61% 68% 74% (2) Underwriting expense ratio (1).. 39% 46% 39% 37% 33% ---------- ---------- ---------- ---------- ------------ Combined ratio (1).............. 101% 106% 100% 105% 107% (2) ========== ========== ========== ========== ============ - ------------------------------------- (1) Interest expense and litigation expenses are not considered underwriting expenses; therefore, such costs have been excluded from these ratios. The 1996 underwriting expense ratio was increased by 4 percentage points by a reinsurance arbitration adjustment and the termination of relations with the Company's former surety bond underwriting manager. (2) The rescission of two reinsurance treaties during 1999 increased net premiums earned for workers compensation by $19.6 million and increased the workers compensation loss ratio by 17 percentage points. The rescission of the reinsurance treaties also increased the total 1999 loss ratio and combined ratio by 3 percentage points.
PAGE 7 RESERVES Insurance companies provide in their financial statements reserves for unpaid losses and loss adjustment expenses which are estimates of the expense of investigation and settlement of all reported and incurred but not reported losses under their previously issued insurance policies and/or reinsurance contracts. In estimating reserves, insurance companies use various standardized methods based on historical experience and payment and reporting patterns for the type of risk involved. The application of these methods involves subjective determinations by the personnel of the insurance company. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount of and uncertainty in the estimates is affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs, such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that expand insurance coverage after the insurance policy was priced and sold. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims. NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO, Chandler Barbados and the Company and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Any changes in the estimates are reflected in current operating results. Salvage and subrogation recoverables are accrued using the "case basis" method for large recoverables and statistical estimates based on historical experience for smaller recoverables. Recoverable amounts deducted from the Company's net liability for losses and loss adjustment expenses were approximately $5.3 million and $4.4 million at December 31, 1998 and 1999, respectively. The Company and Chandler Barbados report their reserves on the basis of United States generally accepted accounting principles ("U.S. GAAP"), which do not differ from the manner in which they are reported to the Monetary Authority and the Supervisor of Insurance of Barbados. NAICO's statutory-based reserves (reserves calculated in accordance with an insurer's domiciliary state insurance regulatory authorities) do not differ from its U.S. GAAP reserves. The Company and its subsidiaries do not discount their reserves for unpaid losses or loss adjustment expenses. NAICO participates in various pools covering workers compensation risks for insureds who were unable to purchase this coverage from an insurance company on a voluntary basis. In addition, NAICO receives direct assignments to write workers compensation for such insureds in lieu of participating in the pools. The consolidated financial statements reflect the reserves for unpaid losses and loss adjustment expenses and net premiums earned from its participation in the pools and from these direct assignments. There may be significant reporting lags between the occurrence of the insured loss and the time it is actually reported to the insurer. The inherent uncertainties in estimating insurance reserves are generally greater for casualty coverages, such as workers compensation, general and automobile liability, than for property coverages primarily due to the longer period of time that typically elapses before a definitive determination of ultimate loss can be made, which is also affected by changing theories of legal liability and changing political climates. There are significant additional uncertainties in estimating the amount of reserves required for environmental, asbestos-related and other latent exposure claims, including a lack of historical data, long reporting delays and complex unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different and frequently inconsistent conclusions as to when the loss occurred, what claims are covered, under what circumstances the insurer has an obligation to defend, how policy limits are determined and how policy exclusions are applied and interpreted. The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury and workers compensation claims have a much longer loss settlement period and may be paid out over several years. It is often necessary to adjust estimates of liability on a loss either upward or downward from the time a claim arises to the time of payment. Workers compensation indemnity benefit reserves are determined based on statutory benefits described by state law and are estimated based on the same factors generally discussed above which may include, where state law permits, inflation adjustments for rising benefits over time. Generally, the more costly automobile liability claims involve one or more severe bodily injuries or deaths. The ultimate cost of these types of claims is dependent on various factors including the relative liability of the parties involved, the number and severity of injuries and the legal jurisdiction where the incident occurred. PAGE 8 The following table sets forth a reconciliation of the beginning and ending reserves for losses and loss adjustment expenses which are net of reinsurance deductions for the years indicated.
YEAR ENDED DECEMBER 31, ------------------------------------------------------- 1995 1996 1997 1998 1999 ---------- ---------- ---------- ---------- ----------- (In thousands) Net balance before provision for uncollectible reinsurance at beginning of year............ $ 97,894 $ 81,388 $ 64,430 $ 62,890 $ 51,194 Net losses and loss adjustment expenses incurred related to: Current year........................... 50,975 53,314 53,704 42,724 74,997 Prior years............................ (432) 77 3,808 5,155 4,819 ---------- ---------- ---------- ---------- ----------- Total............................. 50,543 53,391 57,512 47,879 79,816 ---------- ---------- ---------- ---------- ----------- Net paid losses and loss adjustment expenses related to: Current year........................... (21,106) (23,836) (22,214) (23,152) (37,806) Prior years............................ (45,943) (46,513) (36,838) (36,423) (32,877) ---------- ---------- ---------- ---------- ----------- Total............................. (67,049) (70,349) (59,052) (59,575) (70,683) ---------- ---------- ---------- ---------- ----------- Net balance before provision for uncollectible reinsurance at end of year.................. 81,388 64,430 62,890 51,194 60,327 Adjustments to reinsurance recoverables on unpaid losses for uncollectible reinsurance.. 629 777 1,163 745 594 --------- ---------- ---------- ---------- ----------- Net balance at end of year........................ $ 82,017 $ 65,207 $ 64,053 $ 51,939 $ 60,921 ========= ========== ========== ========== ===========
The following table represents the development of net balance sheet reserves for 1990 through 1999. 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" 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 for the last eight years presented. 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 1993 for claims that occurred in 1990 will be included in the cumulative deficiency amount for years 1990, 1991, 1992 and 1993. 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 9
DEVELOPMENT OF RESERVES AS OF DECEMBER 31, --------------------------------------------------------------------------------------------------- 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- (In thousands) Net reserve for unpaid losses and loss adjustment expenses (1)..$125,348 $144,430 $119,963 $ 99,685 $ 98,592 $ 82,017 $ 65,207 $ 64,053 $ 51,939 $ 60,921 Net paid (cumulative) as of One year later................ 67,898 78,323 61,417 49,798 45,943 46,513 36,837 36,423 32,876 Two years later............... 114,793 120,319 94,047 73,225 72,718 65,754 52,078 54,753 Three years later............. 136,134 144,900 109,885 90,909 85,006 72,206 60,858 Four years later.............. 150,709 155,816 122,757 98,193 88,986 76,633 Five years later.............. 155,589 165,357 127,725 100,117 92,128 Six years later............... 159,396 168,509 129,070 102,055 Seven years later............. 160,358 169,494 130,633 Eight years later............. 160,771 170,745 Nine years later.............. 161,307 Net liability re-estimated as of (1) One year later................ 144,798 160,938 125,202 100,804 98,160 82,094 69,015 69,208 56,758 Two years later............... 156,986 163,100 127,557 101,467 96,279 84,023 71,183 70,877 Three years later............. 157,264 166,807 129,449 101,539 98,549 84,277 70,962 Four years later.............. 160,961 167,935 129,958 102,626 98,750 84,137 Five years later.............. 160,481 169,143 131,109 103,275 99,165 Six years later............... 160,736 170,077 131,522 104,110 Seven years later............. 161,117 170,403 132,444 Eight years later............. 161,395 171,137 Nine years later.............. 161,583 Net cumulative deficiency........$(36,235) $(26,707) $(12,481) $ (4,425) $ (573) $ (2,120) $ (5,755) $ (6,824) $ (4,819) $ - Supplemental gross data: Gross liability after reclassification of pools- end of year....................................$225,610 $179,815 $156,060 $128,794 $ 79,639 $ 74,929 $ 80,909 $ 98,460 Reclassification of pool liabilities (1)..........(18,875) (15,694) - - - - - - --------- --------- --------- --------- --------- --------- --------- --------- Gross liability before reclassification of pools- end of year (1)................................$206,735 $164,121 $156,060 $128,794 $ 79,639 $ 74,929 $ 80,909 $ 98,460 Reinsurance recoverable........................... 86,772 64,436 57,468 46,777 14,432 10,876 28,970 37,539 --------- --------- --------- --------- --------- --------- --------- --------- Net liability - end of year (1)...................$119,963 $ 99,685 $ 98,592 $ 82,017 $ 65,207 $ 64,053 $ 51,939 $ 60,921 ========= ========= ========= ========= ========= ========= ========= ========= Gross re-estimated liability - latest (1).........$211,063 $163,348 $156,254 $132,874 $ 93,777 $ 87,645 $ 96,241 Re-estimated recoverable - latest................. 78,619 59,238 57,089 48,737 22,815 16,768 39,483 --------- --------- --------- --------- --------- --------- --------- Net re-estimated liability - latest (1)...........$132,444 $104,110 $ 99,165 $ 84,137 $ 70,962 $ 70,877 $ 56,758 ========= ========= ========= ========= ========= ========= ========= Gross cumulative (deficiency) redundancy..........$ (4,328) $ 773 $ (194) $ (4,080) $(14,138) $(12,716) $(15,332) ========= ========= ========= ========= ========= ========= ========= - ----------------------------------------------------- (1) The December 31, 1993 and prior amounts do not include the reclassification of pool liabilities.
TRUST ARRANGEMENTS AND SPECIAL DEPOSITS Under the reinsurance arrangements with NAICO, Chandler Barbados has entered into a trust arrangement and established a trust account in favor of NAICO into which investments are deposited. The amount required in the trust account is adjusted periodically to secure losses and loss adjustment expenses paid and outstanding, unpaid losses and loss adjustment expenses and unearned premium reserves after giving effect for any reinsurance premiums receivable from NAICO. NAICO requires substantially the same trust arrangements or irrevocable letters of credit from all of its non-admitted reinsurers. This not only provides security to NAICO concerning such reinsurance obligations but also enables NAICO to take credit on its statutory financial statements for such reinsurance pursuant to state laws and regulations. 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. For additional information see Notes to Consolidated Financial Statements. PAGE 10 INVESTMENTS Funds available for investment include the Company's present capital as well as premiums received and retained under insurance policies and reinsurance agreements issued by its subsidiaries. Until these funds are required to be used for the settlement of claims and the payment of operating expenses of the Company's subsidiaries, they are invested with the objective of generating income, preserving principal and maintaining liquidity. Fixed-maturity investments are purchased to support the investment strategies of the Company 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 the Company 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. The Company has not classified any investments as trading account assets. Securities not classified as held to maturity or trading are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of income tax as a separate component of shareholders' equity until realized. Realized gains and losses on sales of securities are based on the specific identification method. Declines in the fair value of investment securities below their carrying value that are other than temporary are recognized in earnings. As of December 31, 1999, all of the investments of Chandler Barbados and of NAICO were in fixed-maturity investments (rated Aa3 or AA- or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), interest-bearing money market accounts, a collateralized repurchase agreement and common stock received in connection with two unaffiliated entities' conversion to for-profit corporations. Madison Scottsdale, L.C. is responsible for managing $21.5 million of Chandler Barbados' portfolio at December 31, 1999. The remainder is managed by the Investment Committee of the Company's Board of Directors. Approximately $80.4 million of NAICO's investment portfolio at December 31, 1999 is managed by Madison Scottsdale, L.C. The remainder is managed by the Investment Committee of its Board of Directors. For additional information, see "Trust Arrangements and Special Deposits" and Notes to Consolidated Financial Statements. DEBENTURE OFFERING On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior debentures with a maturity date of July 16, 2014. The debentures were priced at $1,000 each with an interest rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium. The proceeds to Chandler USA before expenses but after the underwriter's discount were $23.16 million. The proceeds of the offering were used to repay existing bank debt, to repay amounts owed by Chandler USA to Chandler Barbados, and for general corporate purposes. Chandler USA's subsidiaries and affiliates are not obligated by the debentures. Accordingly, the debentures are effectively subordinated to all existing and future liabilities and obligations of Chandler USA's existing and future subsidiaries. EMPLOYEES AND ADMINISTRATION The Company and Chandler Barbados have no employees. Day-to-day management of the Company's operations and administrative affairs is performed in the Cayman Islands by Chandler Insurance Management, Ltd. ("CIM"), a wholly owned subsidiary of the Company. Day-to-day management of Chandler Barbados' operations and administrative affairs is performed in Barbados by Chandler Insurance Management (Barbados), Ltd. ("CIM Barbados"), a wholly owned subsidiary of the Company. Steven R. Butler, the Vice President-Administration of the Company and the President of Chandler Barbados, is the Financial Director of CIM and the Treasurer and a director of CIM Barbados. At December 31, 1999, the subsidiaries of the Company organized under the laws of the United States had approximately 390 full-time employees. The subsidiaries generally have enjoyed good relations with their employees. COMPETITION NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO. A company's capacity to write insurance policies is dependent on a variety of factors including its net worth or "surplus," the lines of business written, the types of risk insured and its profitability. Since the late 1980's, the industry has generally had excess underwriting capacity. This condition has resulted in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO continues to experience pricing competition as the conditions of heightened price competition and impaired underwriting performance continue in the industry as a whole. PAGE 11 REGULATION REGULATION IN GENERAL The Company's insurance subsidiaries are subject to regulation by government agencies in the jurisdictions in which they do 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 the Company's insurance subsidiaries, the Company is also subject to regulation under the laws of the Cayman Islands and the Company and all of its affiliates are subject to regulation under the Nebraska Insurance Holding Company System Act (the "Holding Company Act"). The Holding Company Act contains certain reporting requirements including those requiring the Company, 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 Holding Company Act 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. The activities of L&W related to insurance brokerage and agency services and claims administration services are subject to licensing and regulation by the jurisdictions in which it conducts such activities. In addition, most jurisdictions require that certain individuals engaging in brokerage and agency activities be personally licensed. As a result, a number of L&W's employees are so licensed. The Company and NAICO Indemnity (Cayman), Ltd. ("NAICO Indemnity"), a wholly owned subsidiary of the Company, hold Unrestricted Class "B" Insurer's Licenses under provisions of the Insurance Law (1998 Revision) as amended of the Cayman Islands (the "Cayman Insurance Law"). An insurance company that is issued a Class "B" Insurer's License in the Cayman Islands is limited to writing insurance risks in jurisdictions other than the Cayman Islands. The Company, NAICO Indemnity and CIM are regulated by the Monetary Authority and must comply with the Cayman Insurance Law. The Monetary Authority has broad discretionary powers to regulate the operations of insurance companies in the Cayman Islands, including among other things the approval of shareholders that may own shares in such companies and the establishment of insurance ratio guidelines such as the ratio of net premium income to shareholders' equity. Such regulation is generally less restrictive than that of state insurance regulatory agencies in the United States. The Cayman Insurance Law requires a licensed insurer to provide annual audited financial statements. The Company, NAICO Indemnity and CIM prepare their financial statements in accordance with U.S. GAAP. The Monetary Authority is charged with the responsibility of ensuring that licensed insurers comply with the provisions of the law, are in a sound financial position and are carrying on business in a satisfactory manner. The Cayman Islands currently does not have restrictions or exchange controls applicable to the Company or NAICO Indemnity concerning the transfer of any funds into or out of the Cayman Islands. Under the Cayman Insurance Law, any change in the information supplied on the application for the license must receive the prior approval of the Monetary Authority. Therefore, licensed insurers must generally obtain prior approval of the Monetary Authority of changes in their shareholders or their shareholdings. The Company has, however, obtained an exemption from such approval for shareholders owning 5% or less of the issued common shares of the Company. PAGE 12 Chandler Barbados is licensed as an "exempt insurance company" by the Barbados Minister of Finance pursuant to the Barbados Exempt Insurance Act, Chapter 308A. That statute requires the maintenance of a minimum level of capital, payment of applicable annual taxes, annual preparation and filing of audited financial statements, and establishes standards of solvency that must be maintained. Exempt insurance companies are exempted from the provisions of the Barbados Exchange Control Act. Chandler Barbados and CIM Barbados are subject to regulation by the Supervisor of Insurance in Barbados. INSURANCE REGULATION CONCERNING CHANGE OR ACQUISITION OF CONTROL NAICO is a domestic property and casualty insurance company organized under the insurance laws of Nebraska (the "Insurance Code"). The 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 Nebraska 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 Nebraska, 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 the Company would also generally require prior approval by the Nebraska 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 the Company. RESTRICTIONS ON SHAREHOLDER DIVIDENDS A significant portion of the Company's consolidated assets represents assets of the Company's insurance subsidiaries that may not be immediately transferable to the holding company in the form of shareholder dividends, loans, advances or other payments. Statutes and regulations governing NAICO and other insurance companies domiciled in Nebraska regulate the payment of shareholder dividends and other payments by NAICO to Chandler USA. Under applicable Nebraska 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 Nebraska 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 plus statutory net income, excluding realized capital gains, from the second and third preceding calendar years, that was not paid in dividends or other distributions; 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, 1999, NAICO had statutory earned surplus of $11.9 million. Applying the Nebraska statutory limits described above, the maximum shareholder dividend NAICO may pay in 2000 without the approval of the Nebraska Department of Insurance is $4.9 million. In January 2000, NAICO paid a shareholder dividend of $1,250,000 to Chandler USA. NAICO paid a shareholder dividend of $6.0 million to Chandler USA during 1998. 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. PAGE 13 The payment of cash dividends by Chandler Barbados is limited to its realized earned surplus and margin of solvency requirements. Chandler Barbados has not paid any cash shareholder dividends. 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).
The ratios of total adjusted capital to authorized control level RBC for NAICO were 7.5:1 and 4.4:1 at December 31, 1998 and 1999, respectively. Therefore, NAICO's 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 11 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. Although NAICO has not received the official IRIS test results for 1999, management believes that NAICO had four 1999 ratios that would have been outside of the "usual values." PAGE 14 In 1999, NAICO experienced a "change in net writings" of 124% compared to a usual value of plus or minus 33%. NAICO experienced an increase in gross premiums written of 26% during 1999, and changes in NAICO's reinsurance programs which reduced NAICO's net retention in 1998, as well as the rescission of two reinsurance treaties during 1999 (which increased this ratio by 59 percentage points) were all contributing factors in the increase in this ratio in 1999. NAICO's "investment yield" as calculated using the IRIS formula was 3.4% during 1999 compared to a usual value of 4.5% to 10%. NAICO maintains a high-quality investment portfolio, approximately 10% of which was invested in tax-exempt bonds as of December 31, 1999. Tax-exempt bonds generally have a lower pre-tax yield than taxable bonds. During 1999, NAICO incurred $851,000 in investment expenses to subsidize a premium finance program for certain insureds of NAICO. While such expenses reduced NAICO's investment yield, the premium finance program enhances cash flow by providing cash which is available for investment earlier than conventional deferred payment plans. The ratio of "agents' balances to surplus" was 47% at December 31, 1999 compared to a usual value of 40% or less. The increase in gross premiums written during 1999, particularly during the fourth quarter of 1999, was the primary factor for the increase in this ratio. NAICO's "estimated current reserve deficiency to surplus" was 34% at December 31, 1999 compared to a usual value of 25% or less. The primary factors that affect this ratio were the significant increase in NAICO's net premiums earned in 1999 and the changes in NAICO's net retention during 1997, 1998 and 1999. The calculation of this ratio assumes that factors that led to past under reserving will cause current under reserving without regard to changes in premium volume, product mix, the amount of risk retained by NAICO and current reserving practices. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and "Reinsurance." CODIFICATION In 1998, the National Association of Insurance Commissioners adopted codified statutory accounting principles ("Codification"). Codification will change, to some extent, prescribed statutory accounting practices and will result in changes to the accounting practices that NAICO uses to prepare its statutory financial statements. The state of Nebraska has adopted Codification to be effective January 1, 2001. Management believes the most significant changes would be the elimination of the statutory liability for the "excess of statutory reserves over statement reserves" and the recognition of a deferred tax asset subject to an admissibility test. If Codification had been in effect at December 31, 1999, NAICO's statutory surplus would have increased approximately $7.6 million as a result of these items. 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, 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. TAXATION The following summary of certain United States and foreign taxes is based upon the Company's understanding of applicable tax law. The tax treatment of an investment in the Company's common shares may vary depending upon a shareholder's individual circumstances. Certain shareholders, such as foreign corporations, may be subject to special rules not discussed below. FOREIGN TAXES. The Company, Chandler Barbados and NAICO Indemnity are not obligated to pay any income or capital gains taxes in the Cayman Islands or Barbados. The Company is required to pay an annual fee based on its authorized capital, plus an annual license fee. Chandler Barbados is required to pay an annual license fee. The Company, NAICO Indemnity and Chandler Barbados have received tax concession guarantees from the Cayman Islands or Barbados, as applicable, for all taxes levied upon profits, income, gains and appreciation that are valid through September 30, 2003, March 10, 2012 and May 19, 2003, respectively. UNITED STATES EXCISE TAXES. Foreign insurance and reinsurance companies such as the Company, NAICO Indemnity and Chandler Barbados are subject to a 1% United States excise tax on reinsurance premiums received with respect to reinsured risks located in the United States and a 4% United States excise tax on direct premiums written and received with respect to insured risks located in the United States. PAGE 15 UNITED STATES TAXATION OF SHAREHOLDERS. Under Section 951(b) of the Internal Revenue Code of 1986 as amended (the "Code"), any United States corporation, citizen, resident or other United States person who owns, directly or indirectly, or is considered to own (by application of the rules of constructive ownership set forth in Code Section 958(b), generally applying to family members, partnerships, estates, trusts or controlled corporations) 10% or more of the total combined voting power of all classes of voting stock of the Company will be considered a "United States shareholder" for United States income tax purposes. If such "United States shareholders" collectively own more than 25% of the value or combined voting power of all classes of the Company's stock for an uninterrupted period of 30 days or more during any taxable year, each "United States shareholder" will be required to include in his gross income his share of the Company's "subpart F insurance income," whether or not this income is distributed to him. The Company's "subpart F insurance income" would include, among other items, income (including premium and investment income) derived from the reinsurance of risks located outside the Company's country of incorporation. In addition, if such "United States shareholders" collectively own more than 50% of the Company's stock for an uninterrupted period of 30 days or more during any taxable year, each "United States shareholder" will be required to include in gross income the Company's "other subpart F income" and amounts under Section 956, whether or not such income and amounts are distributed to him. The Company's Section 956 amounts would include certain amounts invested by the Company in U.S. property. The Company's "other subpart F income" would include most interest and other investment income and gains. See "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - Possible Change in Control." As of December 31, 1999, M. J. Moroun, individually and through CenTra, Inc. ("CenTra") and their affiliates (the "Moroun Group"), beneficially owned approximately 26% of the outstanding voting stock of the Company. See "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - Other Matters Regarding Beneficial Ownership." The Company is not aware of any other U.S. shareholders who currently own (directly or indirectly) 10% or more of the Company's stock, after giving effect to the tax rules concerning the constructive ownership of certain shares of the Company's stock. Assuming that the Moroun Group is considered to own the value and voting power of shares that it owns directly or indirectly, notwithstanding certain temporary restraints on its right to vote such stock, the Company and Chandler Barbados will each be treated as a controlled foreign corporation ("CFC"), at least with respect to its "subpart F insurance income," and possibly with respect to its "other subpart F income" and Section 956 amounts, and the Moroun Group and any other "United States shareholders" may be subject to tax on the Company's and Chandler Barbados' "subpart F insurance income" and possibly also its "other subpart F income" and Section 956 amounts. Under Section 953(c) of the Code, if U.S. persons indirectly own (i.e., through ownership of the Company) 25% or more of the total combined voting power of all classes of Chandler Barbados' stock entitled to vote or 25% or more of the total value of Chandler Barbados' stock, then each such person is required to include in his gross income a portion of any insurance income of the Company and Chandler Barbados attributable to a policy of insurance or reinsurance with respect to which the person insured (directly or indirectly) is related to a United States person who is a shareholder in the Company or Chandler Barbados ("related person insurance income" or "RPII"). Under these rules, all U.S. persons who own stock in the Company would generally be required, subject to the exception discussed hereinafter, to include in their gross incomes a portion of the RPII received by Chandler Barbados from NAICO. However, related person insurance income of Chandler Barbados need not be included in the income of a U.S. person who is not a "United States shareholder," as defined above, if, at all times during Chandler Barbados' taxable year, less than 20% of the total combined voting power of all classes of stock of Chandler Barbados and less than 20% of the total value of Chandler Barbados is owned (directly or indirectly) by persons who are (directly or indirectly) insured under any policy of insurance or reinsurance issued by Chandler Barbados, or who are related persons to any such person. Under Section 552 of the Code, the Company or any foreign subsidiary may be classified as a foreign personal holding company ("FPHC") if (i) at least 60% (or in the case of any corporation that has been classified as an FPHC in a previous year, 50%) of its gross income for the taxable year is FPHC income and (ii) at any time during the taxable year more than 50% of the total voting power or the total value of the stock of such company is owned (directly or indirectly) by or for not more than five individuals who are citizens or residents of the United States. FPHC income generally includes interest, royalties, annuities, gains from the sale or exchange of stock or securities and dividends, other than the non-FPHC portion of dividends. For purposes of determining a person's stock ownership, stock owned by a corporation will be considered to be owned proportionately by its shareholders. Hence, each ultimate individual owner of the Company will be treated as owning a portion of the stock of the Company determined by looking through all intermediate ownership entities. If the Company or any foreign subsidiary is classified as an FPHC by application of the above-stated rules, then each U.S. person owning stock in the Company or such foreign subsidiary will be required to include in his gross income, as a dividend, for the taxable year an amount equal to his share of the undistributed FPHC income of such corporation. Although management has concluded that the Company and its foreign subsidiaries satisfy the 50% ownership test, none of the foreign subsidiaries satisfies the 60% gross income test, and the Company did not receive any material FPHC income for its taxable years ending in 1997, 1998 and 1999. PAGE 16 Under Section 542 of the Code, the Company and each of its subsidiaries may be classified as a personal holding company ("PHC"). A corporation will be classified as a PHC if (i) it is not an FPHC or a passive foreign investment company ("PFIC"); (ii) at least 60% of its adjusted ordinary gross income (as defined in Section 543) for the taxable year is PHC income; (e.g., dividends, interest, annuities, royalties and rents) and (iii) at any time during the last half of the taxable year more than 50% in value of its outstanding stock is owned (directly or indirectly) by or for not more than five individuals. In the case of an affiliated group filing or required to file a consolidated U.S. income tax return, the 60% test is generally applied to the affiliated group as a whole and no members of the affiliated group will be considered to satisfy the 60% test unless the affiliated group meets the 60% test. If either the Company or any of its subsidiaries are classified as a PHC, such PHC will be subject to a PHC tax equal to 39.6% of the undistributed PHC income. Based on the proportion of the gross income of the Company and each of its subsidiaries that consisted of PHC income, the Company's management believes that neither the Company nor any of its subsidiaries constituted a PHC for its taxable years ending in 1997, 1998 and 1999. UNITED STATES INCOME TAXATION OF THE COMPANY AND ITS SUBSIDIARIES. Chandler Barbados is organized and endeavors to conduct its business from Barbados and not within the United States. Accordingly, Chandler Barbados does not presently file United States income tax returns. Pursuant to United States Treasury Regulations, Chandler Barbados has filed, and will continue to file, protective returns for its taxable years ending after July 31, 1990 indicating that it is not engaged in business in the United States and that even if it is so engaged it does not conduct such business through a permanent establishment in the United States so that, under the U.S.-Barbados Income Tax Treaty it is not subject to United States Federal income tax on its insurance income. However, since neither the Code, court decisions nor regulations definitively describe activities that constitute being engaged in a trade or business in the United States, there can be no assurance that the IRS will not successfully contend that Chandler Barbados is engaged in a trade or business in the United States through a permanent establishment on the basis that the Company's affiliates or its shareholders, employees, officers or directors are agents of Chandler Barbados in the United States. If Chandler Barbados is deemed to be so engaged, it will be subject to United States Federal income tax on its income that is effectively connected with the conduct of that trade or business. Such income tax, if imposed, would be computed on the effectively connected income in a manner comparable to the computation of income of a domestic insurance corporation, except that (i) Chandler Barbados may be subject to an additional "branch profits tax" on deemed dividend equivalents and interest payments, and (ii) Chandler Barbados' applicable deductions and credits will be disallowed if it fails to file a return for its taxable years ended prior to July 31, 1990 or to timely file the protective United States income tax return described above for taxable years ended after July 31, 1990. Chandler Barbados has not filed a return for the taxable years ended prior to July 31, 1990. Regardless of whether Chandler Barbados is considered to be engaged in a trade or business in the United States, it is subject to United States income tax on certain "fixed or determinable annual or periodic gains, profits and income" derived from sources within the United States as enumerated in Section 881(a) of the Code, including dividends and related party interest but generally excluding interest from unrelated parties. This tax is imposed on the gross amount of such income, generally at a fixed 30% rate but, in the case of dividends from Chandler USA to Chandler Barbados, at a 5% rate. The United States person responsible for payment of such items of income to Chandler Barbados is obligated to withhold this tax before payment is made to Chandler Barbados. NAICO is subject to tax on its taxable income under subchapter L of the Code. Reinsurance premiums paid by NAICO are generally deductible for this purpose. The IRS in Revenue Ruling 77-316 has taken the position that where a United States parent corporation and its domestic subsidiaries insure their risks with an offshore subsidiary, the premiums paid to the offshore corporation are not deductible by the United States corporation and, if paid by the United States subsidiaries, are constructive distributions to the United States parent. Certain court cases have supported the IRS's position that premiums paid by a parent to its subsidiary are not deductible. The IRS could argue that premiums paid to Chandler Barbados should not be deductible and that instead, to the extent of Chandler USA's earnings and profits, they should be characterized as dividends subject to a 5% withholding tax. The IRS has the authority under Section 482 of the Code to reallocate income, deductions and credits among related taxpayers. If the IRS were successfully to contend that a portion of the premiums paid by NAICO to Chandler Barbados exceeded an arm's length premium, such excess amount would probably be characterized as a distribution by Chandler USA to Chandler Barbados with the result that the United States consolidated group would not be permitted a deduction, and Chandler Barbados would be subject to a 5% withholding tax with respect to such excess amount. Any determination that Chandler Barbados was engaged in business in the United States, any disallowance of deductions for most or all of the reinsurance premiums paid by NAICO to Chandler Barbados or any substantial reallocation of income from Chandler Barbados to NAICO would cause substantially all of the Company's consolidated net income before income taxes to be subject to United States income tax with credit given for income and excise taxes previously paid. PAGE 17 DISPOSITIONS OF COMMON SHARES. Subject to the discussion below relating to the potential application of Section 1248 of the Code, a United States shareholder will generally, upon the sale or exchange of any common shares of the Company, recognize a gain or loss for United States Federal income tax purposes equal to the difference between the amount realized upon such sale or exchange and the shareholder's basis in the common shares of the Company. If the shareholder's holding period for such common shares of the Company is more than 12 months, any gain will be subject to tax at a current maximum marginal tax rate of 20% for individuals and 35% for corporations. Section 1248 of the Code provides that if a United States person disposes of stock in a foreign corporation and such person owned directly, indirectly or constructively 10% or more of the voting shares of the corporation at any time during the five-year period ending on the date of disposition when the corporation was a CFC, any gain from the sale or exchange of the shares may be treated as ordinary income to the extent of the CFC's previously untaxed earnings and profits during the period that the shareholder held the shares (with certain adjustments). A 10% United States shareholder may in certain circumstances be required to report a disposition of shares of a CFC by attaching IRS Form 5471 to the United States income tax or information return that the shareholder would normally file for the taxable year in which the disposition occurs. Section 953(c)(7) of the Code generally provides that Section 1248 will also apply to any sale or exchange of shares in a foreign corporation that earns RPII if the foreign corporation would be taxed as an insurance company if it were a domestic corporation, regardless of whether the selling shareholder is or was a 10% shareholder or whether RPII constitutes 20% or more of the corporation's gross insurance income. Existing treasury regulations do not address whether Section 1248 of the Code and the requirement to file Form 5471 would apply if the foreign corporation is not a CFC but the foreign corporation has a subsidiary that is a CFC or that would be taxed as an insurance company if it were a domestic corporation (although, as discussed above, shareholders of 10% or more of the common shares of the Company may have an independent obligation to file Form 5471). The foregoing discussion is based upon current law. The tax treatment of a shareholder of common shares of the Company, or a person treated as a shareholder of common shares of the Company for United States Federal income, state, local or non-United States tax purposes, may vary depending on the owner's particular tax situation. Legislative, judicial or administrative changes or interpretations may be forthcoming that could be retroactive and could affect the tax consequences to owners of common shares of the Company. SHAREHOLDERS SHOULD CONSULT THEIR OWN TAX ADVISORS CONCERNING THE UNITED STATES FEDERAL, STATE, LOCAL AND NON-UNITED STATES TAX CONSEQUENCES OF OWNERSHIP AND DISPOSITION OF THE COMMON SHARES OF THE COMPANY. During 1998, the IRS conducted an examination of the 1995 United States Federal income tax return of Chandler Barbados. The IRS completed the examination in the third quarter of 1998 and there were no proposed adjustments to tax liabilities. ITEM 2. PROPERTIES The Company's principal office is located on the 5th Floor, Anderson Square in Grand Cayman, Cayman Islands, B.W.I. Chandler Barbados' principal office is located in the Stevmar House, Rockley, Christ Church, Barbados. The Company and Chandler Barbados have no offices in the United States. The Company's United States-based subsidiaries own and occupy three office buildings with approximately 81,000 square feet of usable space in Chandler, Oklahoma, and an additional office building with approximately 46,000 square feet of usable space is being constructed in Chandler, Oklahoma. The Company's subsidiaries also lease approximately 10,000 square feet in the aggregate for its branch offices. The Company believes such space is sufficient for its operations for the foreseeable future. ITEM 3. LEGAL PROCEEDINGS CENTRA LITIGATION The Company and certain of its subsidiaries and affiliates have been involved in litigation with CenTra and certain of its affiliates, officers and directors (the "CenTra Group") since July 1992. See Note 11 to Consolidated Financial Statements for a detailed discussion. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CenTra Litigation." OTHER LITIGATION The Company and its subsidiaries are not parties to any other material litigation other than as is routinely encountered in their respective business activities. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during 1999. PAGE 18 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS MARKET The common shares of the Company trade on The Nasdaq Stock Market under the symbol: CHANF. The following table sets forth the quarterly high and low closing sales prices of the Company's common shares, as reported by The Nasdaq Stock Market, since January 1, 1998.
1999 HIGH LOW 1998 HIGH LOW ------------------ -------- ------- ------------------ -------- ------- First Quarter..... $ 10.00 $ 7.25 First Quarter..... $ 8.38 $ 5.13 Second Quarter.... 8.94 7.50 Second Quarter.... 8.00 7.19 Third Quarter..... 8.13 7.25 Third Quarter..... 8.13 6.75 Fourth Quarter.... 8.63 7.25 Fourth Quarter.... 7.88 7.00
The closing market price of the common shares on The Nasdaq Stock Market on March 20, 2000 was $7.81 per share. SHAREHOLDERS As of February 29, 2000, there were 138 shareholders of record and approximately 431 beneficial holders of the Company's common shares, and the number of common shares issued was 4,428,033 shares, which includes 1,142,625 common shares which were rescinded through litigation and are held by a court. See "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT." The provisions of Article XI of the Company's Articles of Association, which was adopted by the shareholders in 1988, prohibits business combinations lacking approval of the Continuing Directors (those not affiliated with a 20% or more shareholder) or 80% of the shareholders and may result in a prohibition against voting such shares held by a shareholder acquiring 20% or more of the common shares (and its affiliates and associates) if the Continuing Directors deny approval. In addition to the regulatory oversight of NAICO by the Nebraska Department of Insurance, the Company is also subject to regulation under the Nebraska Insurance Holding Company Systems Act (the "Holding Company Act"). In addition to various reporting requirements imposed on the Company, the Holding Company Act requires any person who seeks to acquire or exercise control over NAICO (which is presumed as to any person who owns 10% or more of the Company's outstanding voting stock) to file and obtain approval of certain applications with the Nebraska Department of Insurance regarding their current or proposed ownership of such shares. Noncompliance with the Holding Company Act may result in certain civil and criminal penalties or a requirement that the non-approved owner divest itself of such shares. DIVIDENDS The Company has never paid cash dividends on its common shares, and its current policy is to retain earnings to support its insurance operations. As a holding company, the Company depends primarily on share issuances, borrowings and dividends from its subsidiaries for its cash flow requirements. Any payment of future dividends will be dependent upon earnings of the Company's subsidiaries and their ability to pay shareholder dividends therefrom, financial requirements of the Company and its subsidiaries, business outlook, and other relevant factors. See "BUSINESS - Regulation - Restrictions on Shareholder Dividends." PAGE 19 FOREIGN ISSUER The Cayman Islands currently does not have any restrictions or exchange controls on the transfer of funds into and out of the Cayman Islands. Chandler Barbados is licensed as an "exempt insurance company," and Barbados currently does not have any restrictions or exchange controls for exempt insurance companies on the transfer of funds out of Barbados. If in the future the Company's assets are invested in foreign securities or held in currencies other than United States dollars, the Company will be subject to a risk of currency fluctuations and devaluations. See "BUSINESS-Regulation." All or a substantial portion of the Company's assets are or may be located outside the United States. As a result, it may be difficult to obtain jurisdiction over or to enforce judgments against the Company in any legal proceeding by the Company's shareholders. Certain remedies available under United States securities laws may not be allowed in a Cayman Islands or Barbados court as a violation of their public policy. The operations of the Company and Chandler Barbados will be conducted in the Cayman Islands and Barbados, respectively, and may, therefore, be affected by changes in those governments and other economic and political conditions. ITEM 6. SELECTED FINANCIAL DATA The selected financial data has been derived from the consolidated financial statements of the Company and its subsidiaries, which appear in Item 14(a). The consolidated balance sheets of the Company and its subsidiaries as of December 31, 1998 and 1999, and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1999, have been audited by Deloitte & Touche, independent auditors whose independent auditors report expresses an unqualified opinion and includes an explanatory paragraph relating to litigation. The selected financial data should be read in conjunction with "LEGAL PROCEEDINGS," "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and the consolidated financial statements of the Company and the notes thereto appearing in Item 14(a). See Notes to Consolidated Financial Statements for various litigation and contingency matters. PAGE 20 ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)
YEAR ENDED DECEMBER 31, -------------------------------------------------------------- 1995 1996 1997 1998 1999 ---------- ---------- ---------- ---------- ---------- (Amounts in thousands except per share data and percentages) OPERATING DATA Revenues Direct premiums written and assumed.............. $ 98,768 $ 107,943 $ 123,088 $ 134,329 $ 169,635 ========== ========== ========== ========== ========== Net premiums earned (1).......................... $ 81,087 $ 89,286 $ 94,679 $ 70,064 $ 108,327 Interest income, net............................. 7,641 7,199 7,253 6,467 5,594 Realized investment gains, net................... 412 140 764 1,163 55 Fee for rescinded reinsurance treaties........... - - - - 10,000 Commissions, fees and other income............... 3,095 3,620 2,528 1,952 1,730 ---------- ---------- ---------- ---------- ---------- Total revenues...................................... 92,235 100,245 105,224 79,646 125,706 ---------- ---------- ---------- ---------- ---------- Operating expenses Losses and loss adjustment expenses.............. 50,543 53,391 57,512 47,879 79,816 Policy acquisition costs......................... 23,995 32,123 28,145 17,033 28,681 General and administrative expenses.............. 12,770 14,038 13,116 12,710 12,029 Interest expense................................. 52 146 463 936 1,531 Litigation expenses, net......................... 285 (108) 4,772 (2,707) 1,133 ---------- ---------- ---------- ---------- ---------- Total operating expenses............................ 87,645 99,590 104,008 75,851 123,190 ---------- ---------- ---------- ---------- ---------- Income before income taxes.......................... 4,590 655 1,216 3,795 2,516 Federal income tax benefit (provision) of consolidated U.S. subsidiaries................... (812) 317 (2,281) (353) (365) ---------- ---------- ---------- ---------- ---------- Net income (loss)................................... $ 3,778 $ 972 $ (1,065) $ 3,442 $ 2,151 ========== ========== ========== ========== ========== Diluted earnings (loss) per common share............ $ 0.54 $ 0.14 $ (0.16) $ 0.53 $ 0.34 Diluted weighted average common shares outstanding.. 6,942 6,942 6,687 6,438 6,347 Combined loss and underwriting expense ratio (2).... 101% 106% 100% 105% 107% BALANCE SHEET DATA Cash and investments................................ $ 122,561 $ 119,136 $ 125,063 $ 120,812 $ 118,455 Total assets........................................ 246,949 206,827 210,790 236,025 269,120 Unpaid losses and loss adjustment expenses.......... 128,794 79,639 74,929 80,909 98,460 Notes payable....................................... 300 4,391 2,796 9,410 - Litigation liabilities.............................. - - 16,618 13,228 8,905 Debentures.......................................... - - - - 24,000 Total liabilities................................... 173,499 134,280 152,455 173,960 218,377 Stock held by subsidiary, at cost................... (2,148) - (2,487) (2,905) - Stock rescinded through litigation.................. - - (11,799) (11,799) (6,883) Shareholders' equity................................ 73,450 72,547 58,335 62,065 50,743 Book value per share (3)............................ 10.58 10.45 12.19 13.05 15.45 (1) During 1997 and 1998, the Company purchased additional reinsurance coverages which resulted in significantly lower net premiums earned in 1998. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." (2) Interest expense and litigation expenses are not considered underwriting expenses; therefore, such expenses have been excluded from this ratio. The 1996 combined loss and underwriting expense ratio was increased by four percentage points by a reinsurance arbitration adjustment and the termination of relations with the Company's former surety bond underwriting manager. The rescission of two reinsurance treaties during 1999 increased the 1999 combined loss and underwriting expense ratio by three percentage points. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." (3) Based on total common shares outstanding and common stock to be issued, less stock held by subsidiary and stock rescinded through litigation. See Note 11 to Consolidated Financial Statements.
PAGE 21 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL References to the "Company" which follow within this Item 7 refer to the Company and its subsidiaries on a consolidated basis unless otherwise indicated. The Company is engaged in various property and casualty insurance operations through its wholly owned subsidiaries, NAICO and L&W. NAICO writes various property and casualty insurance products through four separate marketing programs: standard property and casualty, political subdivisions, surety bonds (including both bail bonds and construction bonds) and group accident and health. The lines of insurance written by NAICO are commercial coverages consisting of automobile liability, workers compensation, surety, automobile physical damage, accident and health, property, inland marine and other liability lines, which include general and professional liability lines. L&W represents various personal and commercial lines insurance companies in marketing property and casualty insurance. L&W also markets individual and group life, medical and disability income coverage. L&W places the majority of its business with NAICO. Business produced by L&W and placed with NAICO constituted approximately 23% of NAICO's direct premiums written and assumed in 1999. 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. CLAIM COSTS AND LOSS 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 reinsurance contracts. In estimating reserves, insurance companies use various standardized methods based on historical experience and payment and reporting patterns for the type of risk involved. The application of these methods necessarily involves subjective determinations by the personnel of the insurance company. Inherent in the estimates of the ultimate liability for unpaid claims are expected trends in claim severity, claim frequency and other factors that may vary as claims are settled. The amount of and uncertainty in the estimates is affected by such factors as the amount of historical claims experience relative to the development period for the type of risk, knowledge of the actual facts and circumstances, and the amount of insurance risk retained. The ultimate cost of insurance claims can be adversely affected by increased costs, such as medical expenses, repair expenses, costs of providing legal defense for policyholders, increased jury awards and court decisions and legislation that expand insurance coverage after the insurance policy was priced and sold. Accordingly, the loss and loss adjustment expense reserves may not accurately predict an insurance company's ultimate liability for unpaid claims. NAICO periodically reviews the reserve estimates relating to insurance business written or assumed by NAICO, Chandler Barbados and the Company and the methods used to arrive at such reserve estimates. NAICO also retains independent professional actuaries who review such reserve estimates and methods. Any changes in the estimates are reflected in current operating results. See Notes to Consolidated Financial Statements. The loss settlement period on insurance claims for property damage is relatively short. The more severe losses for bodily injury and workers compensation claims have a much longer loss settlement period and may be paid out over several years. It is often necessary to adjust estimates of liability on a loss either upward or downward between the time a claim arises and the time of payment. Workers compensation indemnity benefit reserves are determined based on statutory benefits prescribed by state law and are estimated based on the same factors generally discussed above which may include, where state law permits, inflation adjustments for rising benefits over time. Generally, the more costly automobile liability claims involve one or more severe bodily injuries or deaths. The ultimate cost of these types of claims is dependent on various factors including the relative liability of the parties involved, the number and severity of injuries and the legal jurisdiction where the incident occurred. 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. PAGE 22 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 the Company. The Company and its subsidiaries report their reserves on the basis of U.S. GAAP. 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 U.S. GAAP. The Company and its subsidiaries do not discount their reserves for unpaid losses and loss adjustment expenses. See Notes to Consolidated Financial Statements. ECONOMIC CONDITIONS The impact of a recession on the Company 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 $145 million, or 86%, of NAICO's direct written premiums in 1999 were in the states of Oklahoma and Texas. An economic downturn in these states could have a significant adverse impact on the Company. A recession might also cause defaults on fixed-income securities owned by NAICO or Chandler Barbados. 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 the Company 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. During 1999, the market value of the Company's available for sale investments declined by $4.6 million due primarily to higher interest rates experienced during this time. Premium rates and commissions, however, are not significantly affected by inflation since competitive forces generally control such rates. NAICO's underwriting philosophy is to forego underwriting risks from which it is unable to obtain what it believes to be adequate premium rates. REGULATION The Company's insurance subsidiaries are subject to regulation by government agencies in the jurisdictions in which they do 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. In addition to the regulatory oversight of the Company's insurance subsidiaries, the Company is also subject to regulation under the laws of the Cayman Islands and the Nebraska Insurance Holding Company System Act (the "Holding Company Act"). The Holding Company Act contains certain reporting requirements including those requiring the Company, 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 Holding Company Act contains special reporting and prior approval requirements with respect to transactions among affiliates. The Holding Company Act also imposes certain requirements upon any person controlling or seeking to control an insurance company domiciled in Nebraska. 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 the Company must comply with the Holding Company Act. See "BUSINESS - Regulation." PAGE 23 Insurance companies are also affected by a variety of state and federal legislative and regulatory measures and judicial decisions that define and extend the risks and benefits for which insurance is sought and provided. These include the redefinition of risk exposure in areas such as product liability, environmental damage and workers compensation. In addition, individual state insurance departments may prevent premium rates for some classes of insureds from reflecting the level of risk assumed by the insurer for those classes. Such developments may adversely affect the profitability of various lines of insurance. In some cases, these adverse effects on profitability can be minimized through coverage repricing, if permitted by applicable regulations, or limitations or cessation of the affected business. COMPETITION NAICO operates in a highly competitive industry and faces competition from domestic and foreign insurers, many of which are larger, have greater financial, marketing and management resources, have more favorable ratings by ratings agencies and offer more diversified insurance coverages than NAICO. A company's capacity to write insurance policies is dependent on a variety of factors including its net worth or "surplus," the lines of business written, the types of risk insured and its profitability. Since the late 1980's, the industry has generally had excess underwriting capacity. This condition has resulted in depressed premium rates and expanded policy terms, which generally occur when excess underwriting capacity exists. NAICO continues to experience pricing competition as the conditions of heightened price competition and impaired underwriting performance continue in the industry as a whole. PAGE 24 ANALYSIS OF INSURANCE PROGRAM RESULTS OF OPERATIONS The following tables summarize the net premiums earned and the financial year (losses incurred and recognized by the Company regardless of the year in which the claim occurred) and accident year (losses incurred by the Company for a particular year regardless of the period in which the Company recognizes the costs) loss ratios (computed by dividing losses and loss adjustment expenses by net premiums earned) in each of the years presented. The first table is summarized by major insurance program and includes all lines of insurance written in each program. The second table is summarized by line of insurance written and includes all net premiums earned and net losses and loss adjustment expenses incurred from all insurance programs for that particular line:
YEAR ENDED DECEMBER 31, ----------------------------------------- 1997 1998 1999 ----------- ----------- ----------- (Dollars in thousands) INSURANCE PROGRAMS - ----------------------------------------------- STANDARD PROPERTY AND CASUALTY Net premiums earned......................... $ 55,527 $ 41,662 $ 71,676 Financial year loss ratio................... 67.1% 75.4% 75.2% Accident year loss ratio.................... 69.8% 68.4% 72.8% POLITICAL SUBDIVISIONS Net premiums earned......................... $ 14,945 $ 13,073 $ 17,415 Financial year loss ratio................... 56.8% 80.3% 97.0% Accident year loss ratio.................... 65.4% 81.1% 85.4% SURETY BONDS Net premiums earned......................... $ 11,117 $ 9,938 $ 10,896 Financial year loss ratio................... 8.6% 15.8% 6.6% Accident year loss ratio.................... 11.2% 17.1% 9.3% GROUP ACCIDENT AND HEALTH Net premiums earned......................... $ 2,303 $ 4,646 $ 8,261 Financial year loss ratio................... 43.3% 89.3% 104.0% Accident year loss ratio.................... 84.5% 103.2% 82.4% NONSTANDARD PRIVATE-PASSENGER AUTOMOBILE Net premiums earned......................... $ 8,841 $ 482 $ 4 Financial year loss ratio................... 72.2% (37.8)% (9,325.2)% Accident year loss ratio.................... 61.4% 18.2% -% OTHER Net premiums earned......................... $ 1,946 $ 263 $ 75 Financial year loss ratio................... 176.4% 161.3% 140.1% Accident year loss ratio.................... 73.4% 73.0% 132.9% TOTAL Net premiums earned......................... $ 94,679 $ 70,064 $ 108,327 Financial year loss ratio................... 60.7% 68.3% 73.7% Accident year loss ratio.................... 61.9% 65.5% 69.2%
PAGE 25
YEAR ENDED DECEMBER 31, ----------------------------------------- 1997 1998 1999 ----------- ----------- ----------- (Dollars in thousands) LINES OF INSURANCE - ----------------------------------------------- WORKERS COMPENSATION Net premiums earned......................... $ 44,954 $ 19,651 $ 39,329 Financial year loss ratio................... 66.3% 70.6% 69.4% Accident year loss ratio.................... 71.7% 57.3% 72.5% OTHER LIABILITY Net premiums earned......................... $ 12,209 $ 14,045 $ 19,799 Financial year loss ratio................... 48.5% 70.1% 66.7% Accident year loss ratio.................... 51.5% 63.4% 53.6% AUTOMOBILE LIABILITY Net premiums earned......................... $ 15,593 $ 14,139 $ 19,030 Financial year loss ratio................... 89.1% 75.0% 81.5% Accident year loss ratio.................... 72.2% 77.4% 74.6% SURETY Net premiums earned......................... $ 11,256 $ 10,101 $ 11,122 Financial year loss ratio................... 8.7% 15.9% 7.9% Accident year loss ratio.................... 11.2% 18.6% 9.6% AUTOMOBILE PHYSICAL DAMAGE Net premiums earned......................... $ 5,726 $ 4,702 $ 7,039 Financial year loss ratio................... 59.8% 85.3% 104.0% Accident year loss ratio.................... 59.7% 87.6% 103.3% ACCIDENT AND HEALTH Net premiums earned......................... $ 2,529 $ 4,646 $ 8,261 Financial year loss ratio................... 43.1% 90.9% 103.2% Accident year loss ratio.................... 82.1% 103.2% 82.4% PROPERTY Net premiums earned......................... $ 1,912 $ 2,332 $ 2,972 Financial year loss ratio................... 74.1% 135.8% 202.7% Accident year loss ratio.................... 75.8% 148.4% 187.7% INLAND MARINE Net premiums earned......................... $ 500 $ 448 $ 775 Financial year loss ratio................... 194.6% 122.8% 138.1% Accident year loss ratio.................... 118.9% 114.6% 126.9% TOTAL Net premiums earned......................... $ 94,679 $ 70,064 $ 108,327 Financial year loss ratio................... 60.7% 68.3% 73.7% Accident year loss ratio.................... 61.9% 65.5% 69.2%
PAGE 26 PURCHASE OF ADDITIONAL REINSURANCE During the second quarter of 1997, management concluded that it would be in NAICO's best interest to substantially reduce its underwriting risk in the California portion of the nonstandard private-passenger automobile program. In July 1997, NAICO purchased additional reinsurance for this portion of the program. In 1998, NAICO believed that reinsurance market conditions were conducive to the purchase of additional reinsurance. During the first quarter of 1998, NAICO purchased additional reinsurance under its workers compensation and casualty reinsurance programs. During the second quarter of 1998, NAICO purchased additional reinsurance for its construction surety bond reinsurance program. The purchase of the additional reinsurance coverages in 1997 and 1998 substantially reduced the per occurrence retention for NAICO's workers compensation, casualty, surety bond and nonstandard private-passenger automobile lines of business, but resulted in significantly lower net premiums earned, losses and loss adjustment expenses and policy acquisition costs. The purchase of additional reinsurance also resulted in an increase in reinsurance recoverables on unpaid losses, prepaid reinsurance premiums and premiums payable and a decrease in deferred policy acquisition costs. See "Premiums Earned" and "Policy Acquisition Costs." During the fourth quarter of 1999, NAICO agreed to rescind two reinsurance treaties which covered a portion of its workers compensation business and which had been in effect since January 1, 1999. The reinsurer agreed to return the reinsurance premiums that had been paid by NAICO during 1999, less losses and ceding commissions that had been paid by the reinsurer. The reinsurer also agreed to pay NAICO a fee of $10.0 million as additional compensation for entering into the agreement. In January 2000, NAICO received payment in the amount of $12.9 million relating to the transaction. 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 as of December 31 for each year presented:
INSURANCE PROGRAMS GROSS PREMIUMS EARNED NET PREMIUMS EARNED - ------------------------------------------ ----------------------------- ----------------------------- 1997 1998 1999 1997 1998 1999 --------- --------- --------- --------- --------- --------- (In thousands) Standard property and casualty............. $ 62,841 $ 76,458 $ 99,512 $ 55,527 $ 41,662 $ 71,676 Political subdivisions..................... 21,503 25,091 29,994 14,945 13,073 17,415 Surety bonds............................... 12,320 11,915 13,660 11,117 9,938 10,896 Group accident and health.................. 3,379 6,104 9,164 2,303 4,646 8,261 Nonstandard private-passenger automobile... 14,303 6,016 118 8,841 482 4 Other...................................... 2,363 487 65 1,946 263 75 --------- --------- --------- --------- --------- --------- TOTAL...................................... $116,709 $126,071 $152,513 $ 94,679 $ 70,064 $108,327 ========= ========= ========= ========= ========= ========= LINES OF INSURANCE GROSS PREMIUMS EARNED NET PREMIUMS EARNED - ------------------------------------------ ----------------------------- ----------------------------- 1997 1998 1999 1997 1998 1999 --------- --------- --------- --------- --------- --------- (In thousands) Workers compensation...................... $ 47,198 $ 48,699 $ 51,106 $ 44,954 $ 19,651 $ 39,329 Other liability........................... 13,593 17,593 26,260 12,209 14,045 19,799 Automobile liability...................... 20,672 20,005 22,701 15,593 14,139 19,030 Surety.................................... 12,459 12,078 13,886 11,256 10,101 11,122 Automobile physical damage................ 7,072 6,307 8,081 5,726 4,702 7,039 Accident and health....................... 3,697 6,111 9,164 2,529 4,646 8,261 Property.................................. 10,331 12,916 17,196 1,912 2,332 2,972 Inland marine............................. 1,687 2,362 4,119 500 448 775 --------- --------- --------- --------- --------- --------- TOTAL..................................... $116,709 $126,071 $152,513 $ 94,679 $ 70,064 $108,327 ========= ========= ========= ========= ========= =========
PAGE 27 Gross premiums earned, before reductions for premiums ceded to reinsurers, increased 13%, 8% and 21% in 1997, 1998 and 1999, respectively. The increases are primarily attributable to an increase in written premium production in Texas and Oklahoma, which we believe resulted from increased marketing efforts in these states and new insurance programs in Texas. Net premiums earned, after such reductions, increased 6% in 1997, decreased 26% in 1998 and increased 55% in 1999. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance for NAICO's workers compensation, casualty and nonstandard private-passenger automobile insurance programs described previously. The rescission of two reinsurance treaties increased net premiums earned in 1999 by $19.6 million. See "Purchase of Additional Reinsurance." Gross premiums earned in the standard property and casualty program increased 39%, 22% and 30% in 1997, 1998 and 1999, respectively. The increases are primarily attributable to increased written premium production in Texas. Net premiums earned increased 45% in 1997, decreased 25% in 1998 and increased 72% in 1999. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance in 1998 as previously described. The rescission of the reinsurance treaties increased net premiums earned in 1999 by $17.3 million in this program. Gross premiums earned in the political subdivisions program increased 11%, 17% and 20% in 1997, 1998 and 1999, respectively, due primarily to expansion of the school districts portion of the program in Texas and Missouri and increased written premium production in Oklahoma. Net premiums earned increased 7% in 1997, decreased 13% in 1998 and increased 33% in 1999. The reduction in net premiums earned in 1998 was due primarily to the purchase of additional reinsurance in 1998 as previously described. The rescission of the reinsurance treaties increased net premiums earned in 1999 by $2.3 million in this program. Gross premiums earned in the surety bond program increased 8% in 1997, decreased 3% in 1998 and increased 15% in 1999. The increase in 1999 was due primarily to increased written premium production in California. Net premiums earned in the surety bond program increased 11% in 1997, decreased 11% in 1998 and increased 10% in 1999. Increased competition, higher reinsurance costs and/or changes in risk retained contributed to the decline in 1998. Gross premiums earned in the group accident and health program increased 560%, 81% and 50% in 1997, 1998 and 1999, respectively, and net premiums earned increased 629%, 102% and 78% in 1997, 1998 and 1999, respectively. The significant increases in premiums in 1997 and 1998 are primarily the result of the growth expected in start-up programs. In January 1999, NAICO began a new program covering primarily Oklahoma employers on a fully insured basis. Gross and net premiums earned for this program were $6.0 million and $5.6 million, respectively, during 1999. NAICO discontinued writing new policies for the excess portion of its group accident and health program effective April 1, 1999. NAICO expects that premiums in its fully insured program will decline during 2000 due to the effect of rate increases and other changes in the program which were put in effect in late 1999. NAICO is currently evaluating the fully insured program and may modify or discontinue it during 2000. Nonstandard private-passenger automobile gross premiums earned decreased 14%, 58% and 98% in 1997, 1998 and 1999, respectively. Net premiums earned in the nonstandard private-passenger automobile premiums decreased 47%, 95% and 99% in 1997, 1998 and 1999, respectively. During 1997, NAICO discontinued the Oklahoma and Arizona portions of its nonstandard private-passenger automobile program. Effective July 1, 1997, NAICO entered into a 100% quota share reinsurance agreement to fully reinsure the risk in the California portion of the program. NAICO has discontinued the California program. Other programs in the preceding table include premiums from NAICO's participation in various mandatory pools covering workers compensation for insureds that were unable to purchase this coverage from an insurance company on a voluntary basis, and direct assignments to write workers compensation for such insureds in certain states in lieu of participating in related pools, in addition to the runoff of various programs which are no longer offered by NAICO. The majority of the decrease in net premiums earned during the periods is attributable to participation in the pools covering workers compensation and from direct assignments. The declines were attributable to decreased activity from the pools and fewer assignments in certain states. Both the size of the involuntary market and NAICO's relative participation in states having a mandatory pool mechanism declined in these years. NET INTEREST INCOME AND NET REALIZED INVESTMENT GAINS At December 31, 1999, the Company's investment portfolio consisted primarily of fixed income U.S. Government, high-quality corporate and tax exempt bonds, with approximately 7% invested in cash and money market instruments. Income generated from this portfolio is largely dependent upon prevailing levels of interest rates. The Company's portfolio contains no non-investment grade bonds or real estate investments. PAGE 28 Net interest income increased 1% in 1997 and decreased 11% and 13% in 1998 and 1999, respectively. The decrease in 1998 was due primarily to lower interest rates in 1998 and a reduction in invested assets due to the purchase of additional reinsurance in 1998. In addition, during the fourth quarter of 1997, NAICO shifted a portion of its fixed maturities portfolio from taxable to tax exempt bonds (which generally have a lower before-tax yield). In late 1998 and the first quarter of 1999, NAICO shifted approximately half of its investment in tax exempt bonds to taxable bonds. Net income from tax exempt securities was $112,000, $1.0 million and $483,000 in 1997, 1998 and 1999, respectively. The decrease in net interest income in 1999 was due primarily to a reduction in invested assets due to the purchase of additional reinsurance. Net realized investment gains were $764,000, $1,163,000 and $55,000 in 1997, 1998 and 1999, respectively. The average net yield on the portfolio, including net realized investment gains, was 6.6%, 6.1% and 4.7% in 1997, 1998 and 1999, respectively. The average net yield on the portfolio, excluding net realized investment gains, was 5.9%, 5.2% and 4.7% for 1997, 1998 and 1999, respectively. The decrease in the average net yield in 1999 was due primarily to an increase in investment expenses to subsidize a premium finance program for certain insureds of NAICO. While such expenses reduce the Company'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, 1999 was approximately $14 million. The average yield on the portfolio before deducting investment expenses was 6.3%, 5.8% and 5.7% in 1997, 1998 and 1999, respectively, excluding capital gains. FEE FOR RESCINDED REINSURANCE TREATIES During the fourth quarter of 1999, NAICO agreed to rescind two reinsurance treaties which covered a portion of its workers compensation business and which had been in effect since January 1, 1999. The reinsurer agreed to return the reinsurance premiums that had been paid by NAICO during 1999, less losses and ceding commissions that had been paid by the reinsurer. The reinsurer also agreed to pay NAICO a fee of $10.0 million as additional compensation for entering into the agreement. COMMISSIONS, FEES AND OTHER INCOME The Company's income from commissions, fees and other income decreased 30%, 23% and 11% for 1997, 1998 and 1999, respectively. The majority of the Company's income from commissions, fees and other income are from L&W's brokerage commissions and fees. L&W's brokerage commissions and fees before intercompany eliminations were $9.0 million in 1997, $8.5 million in 1998 and $9.6 million in 1999. A large portion of the brokerage commissions and fees for L&W is incurred by NAICO and thus eliminated in the consolidation of the Company's subsidiaries. L&W disposed of certain equipment in 1998 that resulted in a gain of approximately $145,000 which was included in other income. Fees generated by Network Administrators, Inc. ("Network"), a wholly owned subsidiary of the Company, were $435,000 in 1997. Network no longer functions as a third-party administrator. LOSSES AND LOSS ADJUSTMENT EXPENSES The Company 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 60.7%, 68.3% and 73.7% in 1997, 1998 and 1999, respectively. The rescission of the reinsurance treaties increased losses and loss adjustment expenses in 1999 by $17.0 million. Excluding the effect of the reinsurance rescission, the loss ratio was 70.9% in 1999. Weather-related losses (net of applicable reinsurance) from wind and hail were $459,000, $1.4 million and $4.3 million 1997, 1998 and 1999, respectively, and increased the respective loss ratios by 0.5, 2.0 and 4.9 percentage points (excluding the effect of the reinsurance rescission in 1999). PAGE 29 NAICO is a major insurer of property owned by businesses, cities, towns and school districts in Oklahoma. As a result, NAICO incurs weather-related losses. On May 3, 1999, tornadoes, hail and strong winds caused severe damage to property owned or used by NAICO insureds. NAICO estimates total insured damages from the storms at approximately $26.4 million. Giving effect to NAICO's applicable reinsurance, all of which is with unaffiliated reinsurers, NAICO estimates its net loss before income tax benefit resulting from the May 3, 1999 storms at $1.8 million which was recorded in the second quarter of 1999. 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. Recoverability of such deferred costs is dependent on the related unearned premiums on the policies being more than expected claim losses. The Company considers anticipated interest income in determining if a premium deficiency exists. The following table sets forth the Company's policy acquisition costs for each of the three years ended December 31, 1997, 1998 and 1999:
YEAR ENDED DECEMBER 31, ----------------------------------- 1997 1998 1999 ---------- ---------- ----------- (In thousands) Commissions expense......................... $ 15,860 $ 15,478 $ 20,542 Other premium related assessments........... 744 928 1,214 Premium taxes............................... 3,400 3,144 3,179 Excise taxes................................ 153 161 237 Dividends to policyholders.................. 1,155 242 324 Other expense............................... 146 151 205 ---------- ---------- ----------- Total direct expenses....................... 21,458 20,104 25,701 Indirect underwriting expenses.............. 13,464 13,858 16,354 Commissions received from reinsurers........ (6,458) (19,860) (9,267) Adjustment for deferred acquisition costs... (319) 2,931 (4,107) ---------- ---------- ----------- Net policy acquisition costs................ $ 28,145 $ 17,033 $ 28,681 ========== ========== ===========
Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 28.4%, 25.3% and 24.8% in 1997, 1998 and 1999, respectively. For these periods, commission expense as a percentage of gross written and assumed premiums was 12.9%, 11.5% and 12.1%. Indirect underwriting expenses were 10.9%, 10.3% and 9.6% of total direct written and assumed premiums in 1997, 1998 and 1999, respectively. Indirect expenses include general overhead and administrative costs associated with the acquisition of new and renewal business, some of which is relatively fixed in nature, thus, the percentage of such expenses to direct written and assumed premiums will vary depending on the Company's overall premium volume. NAICO received commissions totaling approximately $1.9 million and $909,000 during 1997 and 1998, respectively, under the quota-share reinsurance arrangement for the California portion of the nonstandard private-passenger automobile program which was effective July 1, 1997. During 1998 and 1999, NAICO received commissions from reinsurers totaling approximately $13.8 million and $4.6 million, respectively, related to the purchase of additional reinsurance under its workers compensation and casualty reinsurance programs. Commissions received from reinsurers included the return of $9.7 million in ceding commissions during the fourth quarter of 1999 related to the rescission of the reinsurance treaties discussed previously. Net policy acquisition costs increased $7.0 million in 1999 due to the rescission of the reinsurance treaties, net of the adjustment for deferred acquisition costs. See "Purchase of Additional Reinsurance." PAGE 30 GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses were 11.0%, 9.9% and 7.8% of gross premiums earned and commissions, fees and other income (excluding the fee related to the rescission of the reinsurance treaties) in 1997, 1998 and 1999, respectively. General and administrative expenses have historically not varied in direct proportion to the Company'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 the Company's revenues. General and administrative expenses decreased 3.1% in 1998, due primarily to a reduction in costs attributable to Network. Network ceased functioning as a third party administrator during 1997. General and administrative expenses decreased 5.4% in 1999. In 1998, the Company adopted a stock option and stock grant plan for certain non-employee directors of the Company. Compensation expense related to the plan in the amount of $272,000 is included in general and administrative expenses in 1998. Excluding the expense related to the plan, general and administrative expenses declined $678,000 or 5.2% in 1998 compared to 1997 and declined $409,000 or 3.3% in 1999 compared to 1998. INTEREST EXPENSE Interest expense increased 217%, 102% and 64% in 1997, 1998 and 1999, respectively. The increase in 1997 and 1998 were due primarily to increased levels of bank debt. The increase in 1999 was due primarily to interest expense on the $24 million debenture offering which was completed on July 16, 1999 by Chandler USA. See "Liquidity and Capital Resources." LITIGATION EXPENSES Litigation expenses reflect expenses related to the ongoing legal proceedings involving the CenTra Group. Litigation expenses were $4.8 million in 1997 compared to a credit of approximately $2.7 million in 1998, and were an expense of approximately $1.1 million in 1999. During the second quarter of 1998, the U.S. District Court in Oklahoma City, Oklahoma ("Oklahoma Court") in which the CenTra litigation is pending ordered all parties to pay their own costs and attorney's fees in the case thus denying the CenTra Group's request of approximately $4.7 million for those expenses. CenTra did not initially appeal this decision. Accordingly, the Company reduced the previous first quarter of 1997 net charge for CenTra litigation matters by approximately $3.8 million during the second quarter of 1998. In later papers filed with the appellate court, CenTra has attempted to appeal this decision. The Company believes CenTra's appeal of the decision is barred. Increased or renewed activity could result in greater litigation expenses in 2000 or future years. Certain litigation expenses may be recovered from the Company's directors and officers liability insurer ("D&O Insurer"). As a result of various events in 1995, the Company recorded an $818,000 estimated recovery of costs from the D&O Insurer related to a $1 million claim for reimbursable amounts previously paid that relate to allowable defense and litigation costs for such parties. In 1996, the Company recorded an additional estimated recovery of $982,000. The Company received a payment for the 1995 claim during 1996 in the amount of $795,000. In connection with the Oklahoma Court judgments, the Company recorded an additional estimated recovery of $2.7 million from the D&O Insurer. The Company is entitled to a total of $5 million under the applicable insurance policy to the extent it has advanced reimbursable expenses. Some amounts have been previously paid without dispute and the Company is negotiating with the D&O Insurer for payment of the policy balance. The Company could recover the remaining policy limits or could compromise its claim, and could incur significant costs in either case. The estimated insurance recovery is based upon these variable factors. See "CenTra Litigation" and Note 11 to Consolidated Financial Statements. INCOME TAX PROVISION The provision for or benefit from federal income taxes of the consolidated U.S. subsidiaries varies with the level of income or loss before income taxes of such subsidiaries. The provision or benefit relative to the consolidated income before income taxes will also vary dependent on the contribution to income before income taxes by the consolidated U.S. subsidiaries. PAGE 31 NET INCOME (LOSS) As a result of the factors described above, the Company reported net income of $2,151,000 in 1999 compared to $3,442,000 in 1998 and a net loss of $1,065,000 in 1997. Net litigation expenses related to legal proceedings involving the CenTra Group reduced net income by $1.1 million in 1999 compared to an increase of $2.9 million in 1998 and a reduction of $4.5 million in 1997. The rescission of the reinsurance treaties resulted in a net after tax gain of $3.8 million during 1999. The rescission of the reinsurance treaties increased net premiums earned by $19.6 million in the fourth quarter of 1999. The rescission also increased losses and loss adjustment expenses by $17.0 million, and increased expenses for policy acquisition costs by $7.0 million. NAICO received a fee of $10.0 million as additional compensation for entering into the agreement. The provision for federal income taxes increased by $1.9 million in 1999 due to the rescission of the reinsurance treaties. LIQUIDITY AND CAPITAL RESOURCES The Company is a reinsurance company and a holding company receiving cash principally through equity sales, borrowings and subsidiary dividends, subject to various regulatory restrictions described in "Regulation" and the Notes to Consolidated Financial Statements. The capacity of insurance and reinsurance companies to underwrite insurance and reinsurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for the Company's subsidiaries are funds generated from insurance and reinsurance premiums, investment income, capital contributions from the Company 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. All significant Company subsidiaries maintain liquid operating positions and follow 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 and assume reinsurance. Fixed-maturity investments are purchased to support the investment strategies of the Company 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 the Company 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. The Company has not classified any investments as trading account assets. Securities not classified as held to maturity or trading are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of income tax as a separate component of shareholders' equity until realized. In 1997, the Company provided $3.9 million in cash from operations. During 1998, the Company used $8.8 million in cash from operations due primarily to the purchase of additional reinsurance described previously. During 1999, the Company provided $8.7 million in cash from operations. Cash flows from investing activities were primarily the result of normal purchases and sales of investment securities, and in 1997 NAICO sold the common stock of Century Business Services, Inc. for a total of approximately $2.5 million. The Century Business Services common stock was received as a part of NAICO's 1996 settlement with a former underwriting manager. Net realized investment gains before income taxes were $764,000, $1,163,000 and $55,000 during 1997, 1998 and 1999, respectively, from the sale of investments. In addition, the Company received proceeds of $48.0 million and $4.2 million during 1998 and 1999, respectively, from the sale of available for sale fixed-income securities prior to their maturity. In 1998, to augment maturities and reposition their portfolios, Chandler Barbados and NAICO chose to liquidate certain fixed maturity securities that were available for sale prior to their maturities. The average maturity of the Company's investments was 4.0 years and 3.9 years at December 31, 1998 and 1999, respectively. PAGE 32 Chandler Barbados is required as a foreign reinsurer to secure reserves for unpaid losses and loss adjustment expenses and unearned premiums for the benefit of the primary insurer ceding such amounts. Chandler Barbados secures such amounts by trust arrangements whereby securities are deposited into a trust account for the benefit of the primary insurer. 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, 1999, the total amount of cash and investments restricted for Chandler Barbados and NAICO as a result of these arrangements was $24.1 million and $7.2 million, respectively. Cash flows from financing activities include bank borrowings and repayments, the sale of debentures and purchases of the Company's common stock in accordance with the divestiture of stock owned by the CenTra Group. In February 1998, Chandler USA entered into a five-year loan agreement with a bank having a principal amount of $2.3 million. The loan was collateralized by certain equipment which was purchased with the proceeds of the loan. The equipment had previously been leased by Chandler USA. In March 1998, Chandler USA borrowed an additional $6.2 million under an existing loan agreement with a bank and the proceeds were used to repay amounts due to Chandler Barbados. The bank note was collateralized by shares of NAICO stock owned by Chandler USA. In July 1999, both bank notes were repaid from the proceeds of the debenture offering. On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior debentures with a maturity date of July 16, 2014. The debentures were priced at $1,000 each with an interest rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium. The proceeds to Chandler USA before expenses but after the underwriter's discount were $23.16 million. The proceeds of the offering were used to repay existing bank debt, to repay amounts owed by Chandler USA to its parent Chandler Barbados, and for general corporate purposes. In April 1998, CIM acquired 69,858 shares of the Company's common stock from an agent for approximately $524,000. These shares had previously been pledged to NAICO to secure certain obligations resulting from insurance balances produced by another agent. In December 1999, these shares were transferred to the Company and canceled. In December 1999, the Company made payments totaling approximately $15.2 million to acquire 1,989,200 shares of its own stock previously owned by CenTra and certain of its affiliates. The shares have been formally canceled. The acquisitions were made in accordance with a divestiture plan which had been proposed by NAICO and adopted by a U.S. District Court in Nebraska ("Nebraska Court"). CENTRA LITIGATION In 1992, the Company became involved in certain legal proceedings beyond the ordinary course of business. Note 11 to Consolidated Financial Statements describes the extensive CenTra litigation related to the Company and its affiliates and the CenTra Group. During December 1999, the Company acquired 1,989,200 shares of its own stock in exchange for payment of $15,204,758 to CenTra and its affiliates pursuant to a divestiture plan proposed by NAICO and approved by the Nebraska Court. All shares were canceled upon their return to the Company. Based on an April 22, 1997 judgement by the Oklahoma Court, the Company had previously recorded the return of 517,500 of the 1,989,200 shares as a decrease to shareholders' equity during 1997. The Nebraska Court had ordered CenTra to divest all shares of Chandler owned or controlled by it or its affiliates. An additional share block owned by CenTra and affiliates consists of 1,142,625 shares which will be divested following a ruling on CenTra's appeal of a judgment entered by an Oklahoma Court in April 1997. That judgment requires CenTra to transfer the shares to the Company in exchange for payment of $6,882,500. Based on the April 22, 1997 judgement and subsequent actions by the Oklahoma Court, the Company previously recorded the return of the 1,142,625 shares as a decrease to shareholders' equity during 1997. Following the conclusion of the appeal, the Nebraska Court will determine the method of divestiture of these shares. The appellate court heard oral arguments on November 15, 1999. The Company cannot predict when the appellate court will rule on the appeal. While the Company believes that it is likely that the Company and its affiliates will ultimately prevail as to all material claims asserted in the CenTra litigation, should the CenTra litigation be modified, reversed or decided adversely to the Company, such event could have a material adverse effect on the Company. PAGE 33 YEAR 2000 READINESS DISCLOSURES YEAR 2000 UPDATE Through the first two months of the year 2000, the Company had not experienced any significant problems or disruptions related to Year 2000 Problems (as described below). The Company is currently not aware of any significant disruptions experienced by its customers, vendors and service providers that would materially affect their ability to do business with the Company. While it is possible that certain Year 2000 Problems may exist but have not yet materialized, the Company does not currently expect any Year 2000 Problems to be encountered for the remainder of the year 2000 that would have a material adverse effect on the operating results of the Company. YEAR 2000 READINESS OVERVIEW Computer software, hardware, microprocessor chips and other computer equipment use two digits to identify a particular year, and therefore may not recognize the number "00" or may recognize it as a year prior to 1999. Unless computer equipment and software programs are modified to correct these data recognition problems (the "Year 2000 Problems"), errors could result. These errors could cause damage to personal property and disrupt business practices and functions. In addition to potential problems from computer systems, potential problems could arise from equipment with embedded chips, such as vaults, elevators, aircraft and other systems not generally classified as information technology systems. The Company is heavily dependent upon complex information technology computer systems for its operations. The Company has taken action to attempt to identify the nature and extent of the work required to assess and remediate Year 2000 Problems with respect to its systems, products and infrastructures, including non-information technology systems, none of which are considered critical to operations. The Company began work in 1995 to prepare its financial, information and other computer-based systems for the year 2000, including updating existing legacy systems, and such work is complete at this time. The Company estimates that it has spent $350,000 updating these systems to address Year 2000 Problems, and such costs were expensed as they were incurred, primarily in 1996 and 1997. During the fourth quarter of 1998, the Company retained an independent consultant to prepare a plan for testing its information technology systems. In late 1998, the Company determined that the testing would be performed by its employees, and this testing was completed during the first half of 1999. During the fourth quarter of 1998, the Company incurred approximately $150,000 in additional expenses to evaluate its information systems and in preparation of plans to test its information systems. The Company incurred additional costs of approximately $125,000 to complete its testing during the first six months of 1999. These costs included the use of internal employees, cost of external software to enhance testing efforts and computer rental costs. These costs were expensed during 1999 as incurred. The Company could incur costs in the future if additional efforts are needed to perform modifications to the Company's information technology systems. The Company has established a contingency plan for all critical business operations. The contingency plan includes possible manual operations and the implementation of alternative information processing procedures. The Company believes, based on the information currently available, that the most reasonably likely worst case scenarios resulting from Year 2000 Problems include: - Legal risks arising from failure of NAICO or L&W to provide contracted services, deal with claims on a timely basis, provide pertinent data to those dependent upon the data and similar risks; - Increased operational costs due to manual processing, data corruption or disaster recovery; - Inability to bill or invoice; - Lost revenue resulting from the inability to render accurate billings and from the inability to efficiently market insurance products; - Increased legal and accounting expenses; - Fines and associated expenses resulting from inability to comply with regulatory requirements; and - Failure of management controls. Any previously mentioned Year 2000 Problems could have a material adverse effect on the Company, including the financial condition of the Company's subsidiaries and their ability to pay dividends or other payments to the Company and its subsidiaries. PAGE 34 It is possible that the credit or operating ability of agents, reinsurers and others with whom the Company maintains commercial relationships may be adversely affected by one or more unforeseen circumstances caused by Year 2000 Problems. However, the Company does not have control over these third parties and, as a result, it cannot currently determine to what extent future operating results may be adversely affected by the failure of these third parties to successfully address their Year 2000 Problems. However, the Company has developed plans to attempt to minimize identified third-party exposures. The Company has requested information from its major vendors and service providers to assess their year 2000 readiness. The Company cannot predict the adverse impact, if any, of Year 2000 Problems upon parties with whom it does business. The Company continues to study the complex issues related to insurance coverage for losses arising from the myriad potential fact situations connected with Year 2000 Problems and NAICO's liability to its insureds. The Company believes that the coverages NAICO provides do not extend to the types of losses which are most likely to occur as a result of Year 2000 Problems, and NAICO has made no provisions for loss reserves based on potential Year 2000 Problems. NAICO expects to utilize coverage exclusion endorsements based on the individual underwriting of commercial accounts, and it has adopted endorsements to its policies based on forms provided and filed for approval with various regulatory authorities by Insurance Services Office, Inc., an insurance services company which provides regulatory research and filing support to insurance companies. Use of these special endorsements is governed by the law and regulatory policies of states in which NAICO is authorized to do business. It is possible that future court interpretations of policy language based on specific facts, or legislation mandating coverage, could result in coverage for losses attributable to Year 2000 Problems. Such decisions or legislation could have a material adverse impact on the Company. It is also possible that NAICO may incur expenses defending claims for which it is ultimately determined there is no insurance coverage. CERTAIN TAX MATTERS During 1998, the IRS conducted an examination of the 1995 U.S. Federal income tax return of Chandler Barbados. The IRS completed the examination in the third quarter of 1998, and there were no proposed adjustments to tax liabilities. ACCOUNTING STANDARD ISSUED BUT NOT YET ADOPTED In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that the Company recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company will adopt SFAS No. 133 when required. The Company's management does not expect that adoption of SFAS No. 133 will have a material impact on the Company's consolidated financial condition or results of operations. FORWARD-LOOKING STATEMENTS Some of the statements made in this Form 10-K report, as well as statements made by the Company in periodic press releases, oral statements made by the Company's officials to analysts and shareholders in the course of presentations about the Company and conference calls following earnings releases, 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 the Company 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 the Company operates; (iv) claims frequency; (v) claims severity; (vi) the number of new and renewal policy applications submitted by the Company's agents; (vii) the ability of the Company to obtain adequate reinsurance in amounts and at rates that will not adversely affect its competitive position; (viii) the ability of NAICO to maintain favorable insurance company ratings; (ix) the ability of the Company and its third party providers, agents and reinsurers to adequately address year 2000 issues; and (x) other factors including the ongoing litigation matters involving a significant concentration of ownership of the Company's common stock. PAGE 35 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's consolidated balance sheets include a certain amount of assets and liabilities whose fair values are subject to market risk. Due to the Company's significant investment in fixed-maturity investments, interest rate risk represents the largest market risk factor affecting the Company'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 31,1999, substantially all of the investments of Chandler Barbados and NAICO were in fixed-maturity investments (rated Aa3 or AA- or better by Moody's Investors Service, Inc. or Standard & Poor's, respectively), interest-bearing money market accounts and a collateralized repurchase agreement. The Company 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 the Company'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 Hypothetical fair value after change in hypothetical Fair value at interest rate change in December 31, (bp=basis points) interest rate --------------------- ---------------------- --------------------- 1998 1999 (Dollars in thousands) 1998 1999 ---------- ---------- ---------- ---------- Fixed-maturity investments (1)... $ 97,074 $ 109,748 100 bp increase....... $ 93,731 $ 106,457 200 bp increase....... 90,581 103,340 100 bp decrease....... 100,627 113,228 200 bp decrease....... 104,406 116,910 - --------------------------------- (1) The fair value at December 31, 1998 excludes short-term investments with a fair value of $13.3 million as management does not feel that these investments are exposed to significant interest rate risk due to their maturity dates. The Company did not hold any short-term investments at December 31, 1999.
The table above illustrates, for example, that an instantaneous 200 basis point increase in market interest rates at December 31, 1999 would reduce the estimated fair value of the Company's fixed-maturity investments by approximately $6.4 million at that date. The Company is obligated for senior debentures that have a maturity date of July 16, 2014. The debentures have a fixed interest rate of 8.75% and are redeemable on or after July 16, 2009 without penalty or premium. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14 (a) 1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PAGE 36 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS AND EXECUTIVE OFFICERS A brief description of each director and executive officer of the Company 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 the Company are as follows:
NAME AGE POSITION - ---------------- --- ------------------------------------------------------- W. Brent LaGere 54 Chairman of the Board, Chief Executive Officer, President, Executive Committee Chairman, Investment Committee Member and Director. Mark T. Paden 43 Executive Vice President, Chief Financial Officer, Executive Committee Member, Investment Committee Member and Director. Brenda B. Watson 59 Executive Vice President, Executive Committee Member and Director. Richard L. Evans 53 Vice President and Director. Steven R. Butler 42 Vice President - Administration. Mark C. Hart 44 Vice President - Accounting and Treasurer. James M. Jacoby 65 Audit Committee Member, Option and Compensation Committee Chairman and Director. Paul A. Maestri 69 Executive Committee Member, Audit Committee Member, Option and Compensation Committee Member and Director. Robert L. Rice 65 Audit Committee Chairman, Executive Committee Member, Investment Committee Member, Option and Compensation Committee Member and Director. Larry A. Davis 58 Director. W. Scott Martin 49 Director.
W. BRENT LAGERE has been Chairman of the Board of the Company since September 1983, Chief Executive Officer since March 1986 and President since May 1997. Since October 1988 he has served in officer and director capacities for various subsidiaries of the Company pursuant to an employment contract with Chandler USA. Since 1971 he has served in various capacities with L&W. MARK T. PADEN has served as Executive Vice President of the Company since May 1998, was Vice President - Finance of the Company from August 1987 through May 1998 and has been a director since May 1992. Since February 1987, Mr. Paden has been an employee of L&W and/or Chandler USA. In May 1998, Mr. Paden was elected Executive Vice President and Chief Operating Officer for Chandler USA, NAICO and L&W. Mr. Paden has served as Chief Financial Officer of NAICO since January 1988 and of L&W since May 1987, and also served as Vice President - Finance of NAICO from January 1988 through May 1998 and of L&W from May 1987 through May 1998. Mr. Paden has also been a director of Chandler USA since July 1988, NAICO since November 1992 and L&W since October 1992. BRENDA B. WATSON has been Executive Vice President of the Company since October 1988, was a Vice President of the Company for three years prior thereto, and has been a director of the Company since September 1985. Since October 1988, she has served in officer and director capacities for various subsidiaries of the Company pursuant to an employment contract with Chandler USA. PAGE 37 RICHARD L. EVANS has been a director of the Company since September 1983. He has been a Vice President of the Company since August 1986, and since May 1989, he has been an employee of Chandler USA. Mr. Evans has served L&W since 1979 in various capacities. Mr. Evans has also been a director of Chandler USA since May 1990. STEVEN R. BUTLER has served as Vice President-Administration of the Company since January 1987, and also serves as a director, the President and Treasurer of CIM Barbados. He is also a director and the Financial Director of CIM, and is a director and serves as President of Chandler Barbados. The Company began handling its own and Chandler Barbados' operations and administrative affairs through CIM and CIM Barbados, respectively, in 1990. From 1984 through 1989, Mr. Butler served as Financial Director of Insurance Management Services, Ltd. and, beginning in 1988, of its affiliate Insurance Risk Management Services, Ltd., which performed substantially all of the administrative management functions of the Company and Chandler Barbados, respectively, through March 1990. MARK C. HART has served as Vice President - Accounting and Treasurer of the Company since May 1998. Since May 1988, Mr. Hart has been an employee of NAICO and/or Chandler USA. In May 1998, Mr. Hart was elected Vice President - Finance and Treasurer of Chandler USA, NAICO and L&W. Mr. Hart has been a Vice President of Chandler USA since March 1994. JAMES M. JACOBY has been a director since October 1993. He has been a director of NAICO since August 1990. He has been an insurance agent for more than five years and was formerly employed by NAICO from June 1990 to March 1991. Mr. Jacoby retired in September 1994 from Alexander and Alexander, Inc. where he was a Vice President with the Omaha, Nebraska office, and is currently employed by Constructor's Bonding & Insurance in Omaha, Nebraska where he is involved in servicing insurance accounts. PAUL A. MAESTRI has been a director of the Company since October 1985. Since February 1990 Mr. Maestri has engaged in personal investment activities. From 1980 to February 1990 Mr. Maestri was a director and the President and Chief Executive Officer of P.A.M. Transport, Inc. He has also been a director of L&W since December 1993, NAICO since May 1997 and CIM since May 1998. ROBERT L. RICE has been in private practice as a certified public accountant for more than five years and a director of the Company since May 1987. Mr. Rice has also been a director of Chandler USA since June 1993, L&W since May 1997 and CIM since May 1998. LARRY A. DAVIS has been a director of the Company since August 1997. Mr. Davis has also been a director of Chandler Barbados and CIM Barbados since December 1992. Since July 1998, Mr. Davis has been Manager of Neweol Investments Limited, Luxembourg Branch, a Canadian corporation wholly owned by The Loewen Group of Burnaby, British Columbia, Canada. From September 1996 to July 1998, Mr. Davis was Vice President with Loewen Financial Corporation, a Barbados corporation wholly owned by The Loewen Group. From September 1993 to September 1996, Mr. Davis provided business consulting services and served as a director for several Barbados corporations. Mr. Davis was Chairman and Chief Executive Officer of Caribbean Commercial Bank, a Barbados corporation, from September 1988 to September 1993. W. SCOTT MARTIN was appointed to serve as a director at the Company's November 10, 1999 board meeting, subject to his qualification and acceptance by the Cayman Islands Monetary Authority which was received on January 17, 2000. Mr. Martin has been President of the Tulsa Loan Production Office with First Bank & Trust Company in Wagoner, Oklahoma since 1994. Mr. Martin also serves as a director of First Bank & Trust in Wagoner, Oklahoma, First Bank of Chandler in Chandler, Oklahoma, First National Bank in Burkburnett, Texas and The Bank of Union in Union City, Oklahoma. The Company learned on November 9, 1999, that M.J. Moroun, Norman E. Harned and Ronald W. Lech had resigned as directors of the Company. Messrs. Moroun and Harned resigned effective November 2, 1999 and Mr. Lech resigned effective November 8, 1999. All three resignations were formally accepted by the Company's board of directors on November 10, 1999. Messrs. Moroun, Harned and Lech are current or former directors and officers of CenTra, Inc. At its November 10, 1999 meeting, the Company's board of directors voted to reduce its total membership from 11 to 9 and appointed W. Scott Martin to serve as a director, subject to his qualification and acceptance by the Cayman Islands Monetary Authority. PAGE 38 In the civil proceeding CenTra, Inc. v. Chandler Insurance Company, Ltd., et. al, Case No. CIV-92-1301-M, in the U.S. District Court for the Western District of Oklahoma, judgment was entered in favor of CenTra and against Messrs. LaGere, Paden, Evans, Rice, Ms. Watson and two former directors in the amount of $1.00 each, finding a violation of Section 10(b) of the Securities Exchange Act of 1934 and a violation of Section 11(a) of the Securities Act of 1933 based upon a failure by the Company and certain of its officers and directors to disclose the applicability of the Nebraska Insurance Holding Company Act to purchasers of stock of the Company in a public offering. The judgments are currently being appealed. See Note 11 to Consolidated Financial Statements. COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934 Based solely upon a review of Forms 3, 4 and 5, any amendments thereto furnished to the Company pursuant to the rules of the Securities and Exchange Commission, or written representations from certain reporting persons presented to the Company, all such reports required to be filed by reporting persons have been filed in a timely fashion during the fiscal year ended December 31, 1999. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth the compensation paid or to be paid by the Company or any of its subsidiaries as well as certain other compensation paid or accrued, during the years indicated, to the Chairman and Chief Executive Officer and the four other highest paid executive officers of the Company (the "Named Executives") for such period in all capacities in which they served.
SUMMARY COMPENSATION TABLE ANNUAL COMPENSATION (1) -------------------------------------------------------------- OTHER ANNUAL ALL OTHER SALARY BONUS COMPENSATION COMPENSATION NAME AND PRINCIPAL POSITION YEAR ($) ($)(2) ($)(3) ($)(4) - ----------------------------------------------- -------- ------------ ---------- ------------ ------------- W. Brent LaGere 1999 $ 404,228 $ - N/A $ 38,349 Chairman of the Board, CEO and President 1998 397,361 - N/A 36,596 of Chandler USA, NAICO and L&W 1997 389,340 - N/A 37,471 Mark T. Paden 1999 231,188 - N/A 5,000 Executive Vice President, COO & CFO 1998 209,300 - N/A 4,900 of Chandler USA, NAICO and L&W 1997 178,637 - N/A 4,975 Brenda B. Watson 1999 225,437 112,500 N/A 8,600 Executive Vice President of NAICO 1998 221,607 - N/A 8,100 and L&W 1997 216,882 - N/A 8,475 Richard L. Evans 1999 224,735 - N/A 6,400 Vice President - Claims of Chandler USA, 1998 218,190 - N/A 6,200 NAICO and L&W 1997 211,873 - N/A 6,275 Steven R. Butler 1999 137,252 16,419 N/A - President of CIM and CIM Barbados 1998 133,252 16,272 N/A - 1997 127,514 12,850 N/A - - ------------------------------------------------ (1) Amounts shown include cash and non-cash compensation earned and received by the Named Executives as well as amounts earned but deferred at their election. (2) All Named Executives are eligible to participate in bonus plans based upon premium production and/or profitability. (3) The Company provides various perquisites to certain employees including the Named Executives. In each case, the value of the perquisites provided to each Named Executive did not exceed ten percent of such Named Executive's annual salary and bonus. (4) The amounts shown under this column represent contributions by the Company's U.S. subsidiaries to a 401(k) plan ($3,475 for each of the Named Executives in 1997 and $3,600 in 1998 and 1999), and the premiums paid or to be paid by the Company's U.S. subsidiaries under life insurance arrangements with the Named Executives. A portion of the premiums ($24,300, $23,400 and $25,700 in 1997, 1998 and 1999, respectively) were paid under split dollar life insurance plans. Under these plans, the Company's U.S. subsidiaries pay the premiums for life insurance issued to the Named Executive. Repayment of the premiums is secured by the death benefit or the cash surrender value of the policy, if any, if the Named Executive cancels and surrenders the policy.
PAGE 39 OPTIONS EXERCISED AND HOLDINGS No options were granted to or exercised by the Named Executives during 1999 and there were no unexercised options held by the Named Executives as of December 31, 1999. DIRECTOR COMPENSATION Messrs. Jacoby, Maestri, Rice, Davis and Martin -- the Company's outside directors -- receive an annual retainer of $6,000 and $1,000 for each meeting. These outside directors are compensated at the rate of $1,000 per day for time spent on board-related activities. During 1999, Messrs. Maestri, Jacoby and Davis received total director compensation from the Company and its subsidiaries of $30,750, $29,500 and $25,500, respectively, including compensation for time spent in connection with certain litigation. See Note 11 to Consolidated Financial Statements. During the second quarter of 1998, the Company's directors approved the Directors' Stock Option and Stock Grant Plan (the "Directors' Plan"). The Directors' Plan provides that the non-employee directors of the Company, other than Norman Harned, Ronald Lech and M.J. Moroun, are eligible for grants of stock options and stock grants in accordance with the terms of the Directors' Plan. Messrs. Harned, Lech and Moroun resigned as directors of the Company during November 1999. Options and stock grants may not be granted under the plan for more than 260,000 shares of common stock of the Company, but this number may be adjusted to reflect, if deemed appropriate by the board of directors, any stock dividend, stock split, share combination, recapitalization or the like, of or by the Company. The exercise price of the stock options shall generally be equal to the average closing price of common stock of the Company for the 30 calendar days preceding the date the options are granted. The option period begins on the effective date of the option grant and terminates on the tenth anniversary of that date. The aggregate number of shares of stock awarded to an eligible director as a stock grant shall total 20,000 shares of common stock of the Company. The award shall be divided into two equal installments. The first installment of 10,000 shares shall automatically be awarded as of the first regular board meeting after an eligible director completes ten continuous years of service on the board. The second installment of 10,000 shares will automatically be awarded as of the first anniversary of the initial stock grant, regardless of whether the director is still a member of the board. During the second quarter of 1998, a total of 40,000 shares valued at $250,000 were awarded to two directors, and this amount is included in general and administrative expenses in the Company's consolidated statements of operations. During the third quarter of 1998, the Company issued 20,000 of the 40,000 shares to the two directors as required under the plan from the Company's stock held by subsidiary. During the second quarter of 1999, the Company issued the remaining 20,000 shares to the two directors from the Company's stock held by subsidiary. The difference between the average reacquisition cost of the shares issued and the share price at the date of the stock grant was credited to paid-in surplus. Each eligible director shall automatically be granted options to purchase 1,500 shares of common stock of the Company as of the first regular board meeting in each year the director serves on the board. Each eligible director shall also automatically be granted options to purchase 30,000 shares of common stock of the Company effective as of the first regular board meeting after the director completes ten continuous years of service on the board. During the second quarter of 1998, options for 66,000 shares were awarded with an exercise price of $5.92 per share, which resulted in approximately $22,000 of compensation expense which is included in general and administrative expenses in the Company's consolidated statements of operations. During the first quarter of 1999, options for 6,000 shares were awarded with an exercise price of $8.06 per share. As the exercise price of the options exceeded the market value at the date of grant, the Company did not recognize any compensation expense for the options issued in 1999. As of December 31, 1999, options for 72,000 shares were outstanding. The options require shareholder approval prior to being exercised. EMPLOYMENT AGREEMENTS Chandler USA has an employment agreement with W. Brent LaGere, Chairman of the Board and Chief Executive Officer of the Company 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 to participate in certain incentive bonus plans offered by Chandler USA and its subsidiaries. PAGE 40 Chandler USA has an employment agreement with Brenda B. Watson, a director and executive officer of the Company and L&W, and an executive officer of NAICO. Under this agreement, Ms. Watson's base compensation is established at not less than $125,000 per year. The agreement terminates on December 31, 2003, unless earlier terminated by Chandler USA for cause, as defined in the agreement. In the event that Ms. Watson is terminated without cause, she is entitled to receive her base compensation through the termination date. In addition to her base compensation, Ms. Watson is eligible to receive certain benefits and to participate in certain incentive bonus plans offered by Chandler USA and its subsidiaries. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table lists the directors and executive officers of the Company and provides information on their ownership of the Company's common shares at February 29, 2000:
BENEFICIAL OWNERSHIP --------------------------------------- NAME OF DIRECTOR OF EXECUTIVE OFFICER NUMBER OF SHARES (1) PERCENT (2) - ---------------------------------------------------- ---------------------- --------------- W. Brent LaGere..................................... 476,965 (3) 10.8% Brenda B. Watson.................................... 53,566 1.2% Richard L. Evans.................................... 59,522 1.3% Paul A. Maestri..................................... 20,000 (4) * James M. Jacoby..................................... - (5) - Robert L. Rice...................................... 20,000 (4) * Mark T. Paden....................................... 28,810 * Larry A. Davis...................................... - (5) - Mark C. Hart........................................ 2,515 * W. Scott Martin..................................... 31,500 * Steven R. Butler.................................... 3,200 * All directors and officers as a group (11 persons) 696,078 15.7% - ---------------------------------------------------- * Less than 1% (1) Except as otherwise indicated, each person has the sole power to vote and dispose of all shares, and the sole power to exercise any options listed opposite his or her name. (2) These percentages are computed based on 4,428,033 shares of common stock outstanding including 1,142,625 common shares rescinded through litigation. Elsewhere in this Form 10-K, references to the number or percentage of the Company's common shares that a person owns do not reflect common shares issuable under outstanding options, if any. (3) Includes (i) 348,390 common shares owned by the W. Brent LaGere Irrevocable Trust and (ii) 45,000 common shares owned by W&L Holding Corp. ("W&L Holding"), a corporation 49% of which is owned by the W. Brent LaGere Irrevocable Trust. Mr. LaGere disclaims beneficial ownership of the shares held by W&L Holding and the trust. The power to vote and dispose of the shares held by W&L Holding is shared with Benjamin T. Walkingstick, who also owns 49% of W&L Holding. The business address of Mr. LaGere is 1010 Manvel Avenue, Chandler, Oklahoma, 74834. (4) These totals do not include 33,000 common shares issuable under outstanding options the exercisability of which is subject to approval by the Company's shareholders. (5) These totals do not include 3,000 shares issuable under outstanding options the exercisability of which is subject to approval by the Company's shareholders.
PAGE 41 SHAREHOLDERS HOLDING OVER FIVE PERCENT Listed below are persons, other than those listed previously, who are known by the Company to own beneficially more than 5% of the Company's common shares as of February 29, 2000. 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) - ---------------------------------------------------- --------------------- ----------------- CenTra Group (CenTra, Ammex, and Messrs. M.J. Moroun, Lech and Harned, Agnes A. Moroun and Matthew T. Moroun) 12225 Stephens Road, Warren, Michigan 48089....... 1,144,700 (3) 25.9% Benjamin T. Walkingstick 1001 Manvel Avenue, Chandler, Oklahoma 74834...... 400,029 (4) 9.0% Marvel List, Trustee of the W. Brent LaGere Irrevocable Trust 420 Bennett Boulevard, Chandler, Oklahoma 74834... 398,077 9.0% - ----------------------------------------------------- (1) Except as otherwise indicated, each person or group has the sole power to vote and dispose of all shares and the sole power to exercise any options listed opposite his or her name. (2) These percentages are computed based on 4,428,033 shares of common stock outstanding including 1,142,625 common shares rescinded through litigation. (3) The CenTra Group has filed a Schedule 13D with the Securities and Exchange Commission reporting collective beneficial ownership of 49.2% of the Company's common shares as of July 1992. This percentage included certain common shares the CenTra Group contracted to acquire subject to regulatory approval and was calculated based on total outstanding shares of 7,509,058. The beneficial ownership set forth above includes: (i) 842,625 common shares owned by CenTra; (ii) 275,000 common shares owned by Ammex, Inc. ("Ammex"); (iii) 25,000 common shares owned by DuraRock Underwriters, Ltd. ("DuraRock"), which is owned by Matthew T. Moroun, M.J. Moroun's son; (iv) 250 common shares held by Mr. Harned; (v) 200 common shares held by Mr. Lech; and (vi) 1,625 common shares owned by Agnes A. Moroun, M.J. Moroun's sister. The Company includes the ownership of Messrs. Harned and Lech and Agnes A. Moroun in the beneficial ownership of the CenTra Group because of their present or former employment and other relationships with CenTra and M.J. Moroun and their involvement in CenTra's attempts to take control of the Company. See "Possible Change of Control" and "Other Matters Regarding Beneficial Ownership" regarding the Company's assumptions about beneficial ownership and the presence of certain restrictions on the voting and disposition of the common shares beneficially owned by Messrs. M.J. Moroun, Harned, Lech, Agnes A. Moroun and Matthew T. Moroun. The business address of CenTra and Messrs. Moroun and Harned is 12225 Stephens Road, Warren, Michigan 48089. The business address of Mr. Lech is 5301 Lauren Court, Bloomfield Hills, Michigan 48302-2941. (4) Includes 45,000 common shares owned by W&L Holding, a corporation 49% of which is owned by Mr. Walkingstick. The power to vote and dispose of the shares held by W&L Holding is shared with the W. Brent LaGere Irrevocable Trust, which also owns 49% of W&L Holding.
OTHER MATTERS REGARDING BENEFICIAL OWNERSHIP For purposes of this report, unless otherwise indicated, the Company 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 the Company's Articles of Association or applicable insurance holding company laws may be at variance with the above stated percentages. PAGE 42 As to the beneficial ownership of its common shares, the Company has assumed that beneficial ownership (voting and investment power) is shared among CenTra, Can-Am Investments, Ltd. ("Can-Am"), Ammex, and Messrs. M.J. Moroun, Harned, Lech, Agnes A. Moroun and Matthew T. Moroun. CenTra, Can-Am, Ammex and M.J. Moroun have filed a Schedule 13D acknowledging that they compose a group formed to affect the management practices and policies of the Company. M.J. Moroun has represented that he is the controlling shareholder, Chairman and President of CenTra and Ammex. Mr. Lech was, until June 2, 1995, a director and executive officer of CenTra and continues to receive regular periodic payments from CenTra. Mr. Harned is an executive officer of CenTra. Messrs. Harned and Lech are executive officers and directors of Can-Am. Correspondence provided to the Company and an amendment to the Schedule 13D described above indicate that M.J. Moroun is the owner of all of the outstanding voting stock of Can-Am. The Company includes the ownership of Messrs. Harned, Lech, Agnes A. Moroun and Matthew T. Moroun in the beneficial ownership of the CenTra Group because of their present or former employment and other relationships with CenTra and M.J. Moroun and their involvement in CenTra's attempts to take control of the Company. Each member of the group disclaims beneficial ownership or control of the common shares held by any other group member. They presumably would disclaim shared beneficial ownership with either Messrs. Harned or Lech. CenTra and its affiliates face certain restrictions in the voting or disposition of their common shares. By resolution dated August 19, 1992, the Company restricted the voting of common shares held by CenTra and its affiliates, including Can-Am. In addition, voting of these shares in a manner which would constitute a direct or indirect exercise of control over NAICO is restricted by Nebraska law. The United States District Court for the District of Nebraska ("Nebraska Court") has assumed jurisdiction over all shares owned or controlled by M.J. Moroun and/or his affiliates. During December 1999, the Company acquired 1,989,200 shares of its own stock in exchange for payment of $15,204,758 to CenTra and its affiliates pursuant to a divestiture plan proposed by NAICO and approved by the Nebraska Court. All shares were canceled upon their return to the Company. The Nebraska Court had ordered CenTra to divest all shares of Chandler owned or controlled by it or its affiliates. An additional share block owned by CenTra and affiliates consists of 1,142,625 shares which will be divested following a ruling on CenTra's appeal of a judgment entered by an Oklahoma Federal Court in April 1997. That judgment requires CenTra to transfer the shares to the Company in exchange for payment of $6,882,500. Following the conclusion of the appeal, the Nebraska Court will determine the method of divestiture of these shares. The appellate court heard oral arguments on November 15, 1999. The Company cannot predict when the appellate court will rule on the appeal. See Note 11 to Consolidated Financial Statements. During December 1999, CIM transferred the 524,475 shares of the Company's common stock that it owned to the Company. The shares were canceled by the Company. POSSIBLE CHANGE IN CONTROL Until July 1992, CenTra and its affiliates held 22.7% of the Company's common shares. In July 1992, M.J. Moroun attempted to obtain control of the Company and acquired or contracted to acquire in open market and private purchases 26.5% of the Company's common stock (which was later transferred to Can-Am), bringing the total beneficial stock ownership of CenTra and its affiliates to 49.2% as of July 1992. To further their purposes, CenTra or its affiliates or both initiated litigation in Oklahoma, Arkansas, Michigan, and an administrative proceeding in Nebraska, the domicile of NAICO. See Note 11 to Consolidated Financial Statements and "BUSINESS--Taxation--United States Taxation of Shareholders." In response to the threats posed by CenTra and its affiliates, the Company and its subsidiaries vigorously asserted defenses and counterclaims where appropriate in the litigation and successfully opposed the Form A application of CenTra and its affiliates in the administrative hearings before the Nebraska Department of Insurance (the "Department"). The Form A application sought the Department's approval of M.J. Moroun's share purchases and attempted assertion of control. The ruling of the Department and a state district court were affirmed by the Nebraska Supreme Court on December 1, 1995. By resolution dated August 19, 1992, the Company has restricted the voting of common shares held by CenTra and its affiliates. A U.S. District Court Judge for the Nebraska Court ordered the divestiture of all CenTra shares and CenTra delivered the shares to the registry of the Court. The Nebraska Court adopted a divestiture plan proposed by NAICO ("NAICO Plan"). The NAICO Plan includes a proposal whereby the Company would acquire and cancel the shares of Chandler Stock owned or acquired by the CenTra Group. The NAICO plan has been partially implemented resulting in the Company acquiring 1,989,200 shares of its own stock in exchange for payment of $15,204,758. 1,142,625 shares remain with the Nebraska Court subject to divestiture following the conclusion of an appeal of a judgment regarding those shares in another court. See Note 11 to Consolidated Financial Statements. PAGE 43 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In June and November 1998, W. Brent LaGere purchased, on behalf of and for the benefit of the Chandler (U.S.A.), Inc. 401(k) Thrift Plan (the "Plan") 52,000 and 80,000 shares, respectively, of the Company's common stock. On November 19, 1998, the Plan acquired these and other shares of the Company's common stock at no profit to Mr. LaGere. Chandler USA leases a rural property from Davenport Farms, Inc. ("Davenport Farms"), a corporation owned by Messrs. LaGere, Evans and Paden. Chandler USA has placed three mobile homes on the property, drilled a water well connected to the mobile homes and made other smaller improvements to the property. Its personnel maintains these improvements. These mobile homes and the property provide hunting, fishing, lodging, dining and other outdoor recreational activities for the entertainment of customers and business associates of Chandler USA and/or its subsidiaries. Chandler USA pays no rent to Davenport Farms but reimburses it for one-half of the utilities and for hunting supplies. Chandler USA has also agreed to indemnify Davenport Farms for claims arising out of its use of the property. Chandler USA retains the right to remove all structures located upon the property when the lease terminates. In 1997, 1998 and 1999, Chandler USA incurred approximately $159,000, $217,000 and $202,000, respectively, in expenses associated with its use of this property, including $9,000, $7,000 and $8,000 paid to Davenport Farms for reimbursement of certain expenses, such as utility and similar expenses, for the years 1997, 1998 and 1999, respectively. Prior to May 1, 1997, Benjamin T. Walkingstick was an employee of Chandler USA pursuant to an employment agreement dated October 28, 1988 (the "Employment Agreement") and served as an executive officer and director of the Company and certain of it subsidiaries. Effective May 1, 1997, Mr. Walkingstick resigned these positions and ceased to be an employee of Chandler USA. He continues to be a consultant to Chandler USA and its subsidiaries pursuant to the Employment Agreement and continues to receive compensation based on an annual rate of $323,291 under the Employment Agreement through October 2000 at which time he reaches age 70. On September 18, 1997, Mr. Walkingstick and L&W entered into an agreement providing that Mr. Walkingstick will produce insurance business only through L&W as an independent contractor (the "Insurance Agreement"). Mr. Walkingstick will receive one-half of all commissions upon any business he produces which was not previously written by L&W and is liable for payment of all premiums due upon such business. The Insurance Agreement may be terminated by either party at any time upon thirty days written notice. Upon termination, the insurance policy expirations or renewal rights (ownership) of the insurance business produced by Mr. Walkingstick shall remain the property of L&W. Mr. Walkingstick is required to maintain his own support staff. Commissions paid to Mr. Walkingstick under this arrangement were $10,832, $10,603 and $12,979 during 1997, 1998 and 1999, respectively. During 1997, L&W acquired 494,617 shares of the Company's common stock from two former agents of NAICO and L&W as payment for debts owed to L&W and NAICO. L&W transferred those shares during 1997 to CIM. During 1999, these shares were transferred to the Company and were canceled. Chandler USA and its subsidiaries paid $66,130, $142,694 and $248,188 in 1997, 1998 and 1999, respectively, for services rendered by Gardere & Wynne, L.L.P. David G. McLane, a partner of Gardere & Wynne, L.L.P., served as Secretary of NAICO during 1997 and 1998, and as Assistant Secretary during 1999. Approximately $35,323 and $227,545 of the 1998 and 1999 amounts related to the issuance of debentures by Chandler USA during 1999. PAGE 44 NAICO and Chandler Barbados engage in various reinsurance arrangements from time to time. The current financial effect of those arrangements is described in Notes 12 and 13 to the Consolidated Financial Statements. Chandler USA anticipates that NAICO and Chandler Barbados will in the future continue to engage in similar reinsurance arrangements. ADVANCEMENT OF LITIGATION EXPENSES. In the CenTra litigation, certain officers of the Company and the Company's directors other than Messrs. M.J. Moroun, Harned, Lech and Maestri were named as defendants. In accordance with its Articles of Association, the Company has advanced the litigation expenses of these persons in exchange for undertakings to repay such expenses if those persons are later determined to have breached the standard of conduct provided in the Articles of Association. The Company has paid expenses totaling approximately $2.3 million as of December 31, 1999. A portion of these expenses relate to claims which have been dismissed or which were decided in favor of the officers and directors. In addition, certain expenses may be recovered from the Company's directors and officers liability insurer. As a result of various events in 1995, the Company recorded an $818,000 estimated recovery of costs from its directors and officers liability insurer related to a $1 million claim for reimbursable amounts previously paid that relate to allowable defense and litigation costs for such parties. In 1996, the Company recorded an additional estimated recovery of $982,000. The Company received a payment for the 1995 claim during 1996 in the amount of $795,000. In connection with the Oklahoma Federal Court judgments, the Company recorded an additional estimated recovery of $2.7 million from the Company's directors and officers liability insurer. The Company is entitled to a total of $5 million under the applicable insurance policy. Some amounts have been previously paid without dispute and the Company is negotiating with the insurer for payment of the policy balance. The Company could recover the remaining policy limits or could compromise its claim, and could incur significant costs in either case. The estimated insurance recovery is based upon these variable factors. Except for the recovery of a portion of the litigation costs from the Company's directors and officers liability insurer, no provision has been made in the accompanying consolidated financial statements related to the advancement of litigation expenses to certain defendants. The special litigation committee's of the Company and Chandler USA were delegated the authority of the board's of directors to deal with all issues arising from the Oklahoma litigation including the issue of officer and director indemnification. The Company believes that all transactions, including loans, with directors, officers, or shareholders of the Company are and will continue to be on terms no less favorable to the Company than could be obtained from unaffiliated parties. PAGE 45 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS. The consolidated balance sheets of the Company and its subsidiaries as of December 31, 1998 and 1999, and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1999, together with the related notes thereto and the report of Deloitte & Touche, independent auditors on such financial statements as of December 31, 1999 and for the three years then ended 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 Memorandum of Association of the Company. (2) 3.2 Articles of Association of the Company and amendments thereto. (2) (1) 4.1 Specimen Certificate for common shares of the Company. (4) 10.1 Non-Qualified Stock Option Plan, as amended, adopted at the Shareholder's Annual Meeting on January 19, 1987. (3) 10.2 Form of Non-Qualified Stock Option Agreement. (1) 10.3 Agreement for Placement of Insurance Business. (5) 10.4 Directors' Stock Option and Stock Grant Plan. (6) 21.1 Subsidiaries of the registrant. 23.1 Deloitte & Touche consent. 27.1 Financial Data Schedule (EDGAR version only) - ---------------------------- (1) Previously filed as an exhibit to Registration No. 33-21381 on Form S-1 and incorporated herein by reference. (2) Previously filed as an exhibit to Registration No. 33-5168 on Form S-1 and incorporated herein by reference. (3) Previously filed as an exhibit to registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 and incorporated herein by reference. (4) Previously filed as an exhibit to Registration No. 33-33540 on Form S-2 and incorporated herein by reference. (5) Previously filed as an exhibit to registrant's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1997 and incorporated herein by reference. (6) Previously filed as an exhibit to registrant's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1998 and incorporated herein by reference. Copies of the foregoing exhibits filed with this Form 10-K or incorporated by reference are available from the Company upon written request and payment of a reasonable copying fee. (b) Reports on Form 8-K. The Company filed two current reports on Form 8-K dated December 10, 1999 and December 17, 1999 responding to Item 5 of Form 8-K. PAGE 46 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 INSURANCE COMPANY, LTD. Date: March 20, 2000 By:/s/ W. Brent LaGere ------------------------------------------------- W. Brent LaGere Chairman of the Board, President 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 DATE INDICATED. Date: March 20, 2000 /s/ W. Brent LaGere ------------------------------------------------- W. Brent LaGere, Chairman of the Board, Chief Executive Officer, President and Director (Principal Executive Officer) Date: March 20, 2000 /s/ Mark T. Paden ------------------------------------------------- Mark T. Paden, Executive Vice President, Chief Financial Officer and Director (Principal Financial Officer) Date: March 20, 2000 /s/ Mark C. Hart ------------------------------------------------- Mark C. Hart, Vice President - Accounting and Treasurer (Principal Accounting Officer) Date: March 20, 2000 /s/ Brenda B. Watson ------------------------------------------------- Brenda B. Watson, Executive Vice President and Director Date: March 20, 2000 /s/ Richard L. Evans ------------------------------------------------- Richard L. Evans, Vice President and Director Date: March 20, 2000 /s/ James M. Jacoby ------------------------------------------------- James M. Jacoby, Director Date: March 20, 2000 /s/ Robert L. Rice ------------------------------------------------- Robert L. Rice, Director PAGE 47 Date: March 20, 2000 /s/ Paul A. Maestri ------------------------------------------------ Paul A. Maestri, Director Date: March 20, 2000 /s/ Larry A. Davis ------------------------------------------------ Larry A. Davis, Director Date: March 20, 2000 /s/ W. Scott Martin ------------------------------------------------ W. Scott Martin, Director PAGE F-1 CHANDLER INSURANCE COMPANY, LTD. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
PAGES ------------------ FINANCIAL STATEMENTS Consolidated Balance Sheets as of December 31, 1998 and 1999................... F-2 Consolidated Statements of Operations for the years ended December 31, 1997, 1998 and 1999............................................ F-3 Consolidated Statements of Comprehensive Income for the years ended December 31, 1997, 1998 and 1999............................................ F-4 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1998 and 1999............................................ F-5 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1997, 1998 and 1999............................................ F-6 Notes to Consolidated Financial Statements..................................... F-7 through F-27 Independent Auditors' Report on Consolidated Financial Statements and Financial Statement Schedules........................................... F-28 SCHEDULES I Summary of Investments - Other Than Investments in Related Parties....... F-29 II Condensed Financial Information of Registrant............................ F-30 through F-32 III Supplementary Insurance Information...................................... F-33 IV Reinsurance.............................................................. F-34 V Valuation and Qualifying Accounts........................................ F-35 VI Supplemental Information (for property-casualty insurance underwriters).. F-36
PAGE F-2 CHANDLER INSURANCE COMPANY, LTD. CONSOLIDATED BALANCE SHEETS (Amounts in thousands except share amounts)
DECEMBER 31, ------------------------ 1998 1999 ---------- ---------- ASSETS Investments Fixed maturities available for sale, at fair value......................... $ 109,055 $ 108,709 Fixed maturities held to maturity, at amortized cost (fair value $1,332 and $1,039 in 1998 and 1999, respectively)....................... 1,183 984 Equity securities available for sale, at fair value........................ 191 306 ---------- ---------- Total investments....................................................... 110,429 109,999 Cash and cash equivalents..................................................... 10,383 8,456 Premiums receivable, less allowance for non-collection of $200 and $263 at 1998 and 1999, respectively............................ 28,479 47,721 Reinsurance recoverable on paid losses, less allowance for non-collection of $275 at 1998 and 1999.................................... 2,760 3,281 Reinsurance recoverable on unpaid losses, less allowance for non-collection of $330 and $302 at 1998 and 1999, respectively............. 28,970 37,539 Prepaid reinsurance premiums.................................................. 22,448 19,960 Deferred policy acquisition costs............................................. 2,381 6,488 Property and equipment, net................................................... 8,124 10,765 Licenses, net................................................................. 4,194 4,044 Excess of cost over net assets acquired, net.................................. 4,604 3,955 Other assets.................................................................. 13,253 16,912 ---------- ---------- Total assets.................................................................. $ 236,025 $ 269,120 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities Unpaid losses and loss adjustment expenses................................. $ 80,909 $ 98,460 Unearned premiums.......................................................... 50,647 67,769 Policyholder deposits...................................................... 4,936 5,135 Notes payable.............................................................. 9,410 - Accrued taxes and other payables........................................... 3,869 6,796 Premiums payable........................................................... 10,961 7,312 Litigation liabilities..................................................... 13,228 8,905 Debentures................................................................. - 24,000 ---------- ---------- Total liabilities....................................................... 173,960 218,377 ---------- ---------- Shareholders' equity Common stock, $1.67 par value, 10,000,000 shares authorized, 6,941,708 and 4,428,033 shares issued and outstanding in 1998 and 1999, respectively.. 11,593 7,395 Paid-in surplus............................................................ 34,983 21,380 Common stock to be issued (20,000 shares in 1998).......................... 125 - Capital redemption reserve................................................. 947 947 Retained earnings.......................................................... 28,328 30,479 Less: Stock held by subsidiary, at cost (544,475 shares in 1998)........... (2,905) - Less: Stock rescinded through litigation (1,660,125 and 1,142,625 shares in 1998 and 1999, respectively)......................................... (11,799) (6,883) Accumulated other comprehensive income (loss): Unrealized gain (loss) on investments available for sale, net of deferred income taxes......................................... 793 (2,575) ---------- ---------- Total shareholders' equity.............................................. 62,065 50,743 ---------- ---------- Total liabilities and shareholders' equity.................................... $ 236,025 $ 269,120 ========== ==========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-3 CHANDLER INSURANCE COMPANY, LTD. CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands except per share data)
YEAR ENDED DECEMBER 31, ------------------------------------- 1997 1998 1999 ---------- ---------- ---------- Premiums and other revenues Direct premiums written and assumed........................................ $ 123,088 $ 134,329 $ 169,635 Reinsurance premiums ceded................................................. (26,222) (68,793) (41,698) ---------- ---------- ---------- Net premiums written and assumed........................................ 96,866 65,536 127,937 Decrease (increase) in unearned premiums................................... (2,187) 4,528 (19,610) ---------- ---------- ---------- Net premiums earned..................................................... 94,679 70,064 108,327 Interest income, net.......................................................... 7,253 6,467 5,594 Realized investment gains, net................................................ 764 1,163 55 Fee for rescinded reinsurance treaties........................................ - - 10,000 Commissions, fees and other income............................................ 2,528 1,952 1,730 ---------- ---------- ---------- Total premiums and other revenues....................................... 105,224 79,646 125,706 ---------- ---------- ---------- Operating costs and expenses Losses and loss adjustment expenses........................................ 57,512 47,879 79,816 Policy acquisition costs................................................... 28,145 17,033 28,681 General and administrative expenses........................................ 13,116 12,710 12,029 Interest expenses.......................................................... 463 936 1,531 Litigation expenses, net................................................... 4,772 (2,707) 1,133 ---------- ---------- ---------- Total operating costs and expenses...................................... 104,008 75,851 123,190 ---------- ---------- ---------- Income before income taxes.................................................... 1,216 3,795 2,516 Federal income tax provision of consolidated U.S. subsidiaries.......................................... (2,281) (353) (365) ---------- ---------- ---------- Net income (loss).......................................................... $ (1,065) $ 3,442 $ 2,151 ========== ========== ========== Basic earnings (loss) per common share........................................ $ (0.16) $ 0.54 $ 0.34 Diluted earnings (loss) per common share...................................... $ (0.16) $ 0.53 $ 0.34 Basic weighted average common shares outstanding.............................. 6,687 6,429 6,330 Diluted weighted average common shares outstanding............................ 6,687 6,438 6,347
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-4 CHANDLER INSURANCE COMPANY, LTD. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in thousands)
YEAR ENDED DECEMBER 31, ------------------------------------ 1997 1998 1999 ---------- ---------- ---------- Net income (loss)......................................................... $ (1,065) $ 3,442 $ 2,151 ---------- ---------- ---------- Other comprehensive income (loss), before income tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period............. 2,369 1,905 (4,568) Less: Reclassification adjustment for gains included in net income (loss)................................................ (764) (1,163) (55) ---------- ---------- ---------- Other comprehensive income (loss), before income tax...................... 1,605 742 (4,623) Income tax benefit (provision) related to items of other comprehensive income (loss)............................................ (466) (202) 1,255 ---------- ---------- ---------- Other comprehensive income (loss), net of income tax...................... 1,139 540 (3,368) ---------- ---------- ---------- Comprehensive income (loss)............................................... $ 74 $ 3,982 $ (1,217) ========== ========== ==========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PAGE F-5 CHANDLER INSURANCE COMPANY, LTD. CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands)
YEAR ENDED DECEMBER 31, ------------------------------------ 1997 1998 1999 ---------- ---------- ---------- OPERATING ACTIVITIES Net income (loss)...................................................... $ (1,065) $ 3,442 $ 2,151 Add (deduct): Adjustments to reconcile net income to cash provided by (applied to) operating activities: Realized investment gains, net................................... (764) (1,163) (55) Net (gains) losses on sale of equipment.......................... 3 (146) 69 Amortization and depreciation.................................... 2,214 2,458 2,361 Provision for non-collection of premiums......................... 52 152 210 Provision for non-collection of reinsurance recoverables......... 527 50 - Earned compensation - non-employee director stock option and stock-grant plan.......................................... - 272 - Net change in non-cash balances relating to operating activities: Premiums receivable.............................................. (1,794) (552) (19,452) Reinsurance recoverable on paid losses........................... 596 (160) (671) Reinsurance recoverable on unpaid losses......................... 3,169 (17,676) (8,419) Prepaid reinsurance premiums..................................... (4,192) (12,786) 2,488 Deferred policy acquisition costs................................ (319) 2,931 (4,107) Other assets..................................................... (2,456) (562) (767) Unpaid losses and loss adjustment expenses....................... (4,710) 5,980 17,551 Unearned premiums................................................ 6,379 8,259 17,122 Policyholder deposits............................................ 814 106 199 Accrued taxes and other payables................................. (1,437) (2,471) 2,927 Premiums payable................................................. 2,106 6,407 (3,649) Litigation liabilities........................................... 4,819 (3,390) 776 ---------- ---------- ---------- Cash provided by (applied to) operating activities.................. 3,942 (8,849) 8,734 ---------- ---------- ---------- INVESTING ACTIVITIES Fixed maturities available for sale: Purchases........................................................... (35,001) (71,195) (30,931) Sales............................................................... 22,232 47,957 4,159 Maturities.......................................................... 12,541 27,413 21,948 Fixed maturities held to maturity: Maturities.......................................................... 380 100 265 Equity securities available for sale: Maturities.......................................................... 2,459 - - Cost of property and equipment purchased............................... (893) (3,470) (3,920) Proceeds from sale of property and equipment........................... 45 337 121 ---------- ---------- ---------- Cash provided by (applied to) investing activities............... 1,763 1,142 (8,358) ---------- ---------- ---------- FINANCING ACTIVITIES Cost of common stock purchased by subsidiary........................... - (524) - Payments to acquire stock under divestiture plan....................... - - (15,204) Proceeds from notes payable & debentures............................... - 8,548 24,000 Payments on notes payable.............................................. (1,595) (1,933) (9,410) Debt issue costs....................................................... - - (1,689) ---------- ---------- ---------- Cash provided by (applied to) financing activities.................. (1,595) 6,091 (2,303) ---------- ---------- ---------- Increase (decrease) in cash and cash equivalents during the period..... 4,110 (1,616) (1,927) Cash and cash equivalents at beginning of period....................... 7,889 11,999 10,383 ---------- ---------- ---------- Cash and cash equivalents at end of period............................. $ 11,999 $ 10,383 $ 8,456 ========== ========== ==========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-6 CHANDLER INSURANCE COMPANY, LTD. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (Amounts in thousands except share amounts)
Stock Accumulated Common Capital Stock rescinded other Total Common Paid-in stock to be redemption Retained held by through comprehensive shareholders' stock surplus issued reserve earnings subsidiary litigation income (loss) equity -------- -------- ------------ ---------- -------- ---------- ---------- ------------- ------------- Balance, January 1, 1997..... $11,593 $34,942 $ - $ 947 $25,951 $ - $ - $ (886) $ 72,547 Net loss..................... - - - - (1,065) - - - (1,065) Stock acquired by subsidiary at cost (494,617 shares)... - - - - - (2,487) - - (2,487) Stock rescinded through liti- gation (1,660,125 shares).. - - - - - - (11,799) - (11,799) Change in unrealized gain on investments available for sale, net of income tax.... - - - - - - - 1,139 1,139 -------- -------- ------------ ---------- -------- ---------- ---------- ------------- ------------ Balance, December 31, 1997... 11,593 34,942 - 947 24,886 (2,487) (11,799) 253 58,335 Net income................... - - - - 3,442 - - - 3,442 Stock acquired by subsidiary at cost (69,858 shares).... - - - - - (524) - - (524) Stock issued or to be issued for non-employee director stock option and stock grant plan (40,000 shares)....... - 41 125 - - 106 - - 272 Change in unrealized gain on investments available for sale, net of income tax.... - - - - - - - 540 540 -------- -------- ------------ ---------- -------- ---------- ---------- ------------- ------------ Balance, December 31, 1998... 11,593 34,983 125 947 28,328 (2,905) (11,799) 793 62,065 Net income................... - - - - 2,151 - - - 2,151 Stock issued for non-employee director stock grant plan (20,000 shares)............ - 18 (125) - - 107 - - - Stock acquired from subsidiary and retired (524,475 shares).................... (876) (1,922) - - - 2,798 - - - Stock acquired pursuant to divestiture order and retired.................... (3,322) (11,699) - - - - 4,916 - (10,105) Change in unrealized loss on investments available for sale, net of income tax.... - - - - - - - (3,368) (3,368) -------- -------- ------------ ---------- -------- ---------- ---------- ------------- ------------ Balance, December 31, 1999... $ 7,395 $21,380 $ - $ 947 $30,479 $ - $ (6,883) $ (2,575) $ 50,743 ======== ======== ============ ========== ======== ========== ========== ============= ============
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PAGE F-7 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1997, 1998 AND 1999 NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES (A) BASIS OF PRESENTATION Chandler Insurance Company, Ltd. ("Chandler" or the "Company") is an insurance company organized and domiciled in the Cayman Islands. Operating revenues, expenses and identifiable assets are primarily from operations outside the Cayman Islands. The Company's wholly owned subsidiaries are engaged in various property and casualty insurance and reinsurance operations. The insurance products offered by the Company through its subsidiary, National American Insurance Company, include property and casualty insurance coverage primarily for businesses in various industries, political subdivisions, surety bonds for small contractors and group accident and health insurance in the United States of America ("U.S."). A substantial part of the business is conducted through individual independent insurance agencies and underwriting managers, primarily in the Southwest and Midwest areas of the U.S. One of the Company's subsidiaries, Chandler Insurance (Barbados), Ltd., principally reinsures risks underwritten by National American Insurance Company. In addition, one of the Company's subsidiaries, LaGere and Walkingstick Insurance Agency, Inc., operates as an independent insurance agency based in Chandler, Oklahoma, and represents various insurance companies that provide a variety of property and casualty, life and accident and health coverages, and acts as a surplus lines broker specializing in risk management and brokering insurance for commercial enterprises. The consolidated financial statements have been prepared in accordance with United States of America generally accepted accounting principles ("U.S. GAAP") and are expressed in U.S. dollars. 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 the Company and all wholly owned subsidiaries. The following represents the significant subsidiaries: - Chandler Insurance (Barbados), Ltd. ("Chandler Barbados") and NAICO Indemnity (Cayman), Ltd. ("NAICO Indemnity"), wholly owned subsidiaries of the Company. - Chandler (U.S.A.), Inc. ("Chandler USA"), a wholly owned subsidiary of Chandler Barbados. - National American Insurance Company ("NAICO") and LaGere and Walkingstick Insurance Agency, Inc. ("L&W"), wholly owned subsidiaries of Chandler USA. All significant intercompany accounts and transactions have been eliminated in consolidation. (C) IMPAIRMENT OF LONG-LIVED ASSETS The Company periodically evaluates the carrying value of long-lived assets to be held and used when changes in events and circumstances warrant such a review. The carrying value of a long-lived asset is considered impaired when the separately identifiable anticipated undiscounted cash flow from such asset is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the long-lived asset. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that fair values are reduced for disposal costs. (D) REVENUE RECOGNITION Premiums are generally recognized as earned on a pro rata basis over the policy period, which is in proportion to the insurance protection provided. The portion of premiums that will be earned in the future are deferred and reported as unearned premiums. Amounts recorded for ceded reinsurance premiums are reported as prepaid reinsurance premiums and amortized over the remaining contract period in proportion to the amount of the insurance protection provided. Commission revenues are generally recognized when coverage is effective and premiums are billed. PAGE F-8 (E) 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. (F) EARNINGS PER COMMON SHARE Basic earnings (loss) per common share is computed based upon net income (loss) divided by the weighted average number of common shares outstanding during each period. Diluted earnings (loss) per common share is computed based upon net income (loss) divided by the weighted average number of common shares outstanding during each period adjusted for the effect of dilutive potential common shares calculated using the treasury stock method. Weighted average shares include 1,660,125 common shares which were rescinded through litigation during 1997 but were outstanding at December 31, 1997 and 1998 (1,142,625 were outstanding at December 31, 1999), and exclude 494,617 and 544,475 shares held by a subsidiary of the Company at December 31, 1997 and 1998, respectively. The numerator for basic and diluted earnings per share is equal to the net income (loss) for the respective period. The following table sets forth the computation of the denominator for basic and diluted earnings per share:
YEAR ENDED DECEMBER 31, -------------------------------- 1997 1998 1999 ---------- ---------- ---------- (In thousands) Denominator for basic earnings (loss) per common share - weighted average shares......... 6,687 6,429 6,330 Effect of dilutive securities- non-employee director stock options............ - 9 17 ---------- ---------- ---------- Denominator for dilutive earnings (loss) per common share - adjusted weighted average shares and assumed conversions................. 6,687 6,438 6,347 ========== ========== ==========
(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. Recoverability of such deferred costs is dependent on the related unearned premiums on the policies being more than expected claim losses. The Company considers anticipated interest income in determining if a premium deficiency exists. Certain policy acquisition costs, such as policyholder dividends, are expensed directly. NAICO expensed $1.2 million, $242,000 and $324,000 during 1997, 1998 and 1999, respectively, for dividends to policyholders primarily on participating workers compensation policies. Gross written premiums for participating policies were $3.6 million, $2.3 million and $1.9 million in 1997, 1998 and 1999, respectively. (H) PROPERTY AND EQUIPMENT Real estate and improvements and other property and equipment are stated at cost and depreciated using the straight-line method over their useful lives which range from 3 to 31 years. Property and equipment consisted of the following at December 31:
1998 1999 ---------- ---------- (In thousands) Real estate and improvements............ $ 5,765 $ 8,157 Other property and equipment............ 10,257 11,353 --------- ---------- 16,022 19,510 Accumulated depreciation................ (7,898) (8,745) --------- ---------- $ 8,124 $ 10,765 ========= ==========
PAGE F-9 Depreciation expense was approximately $872,000, $1,062,000 and $1,090,000 for 1997, 1998 and 1999, respectively. (I) INTANGIBLE ASSETS The cost of insurance licenses acquired is amortized over 40 years using the straight-line method. The excess of cost over net assets acquired is amortized by the straight-line method over 15-17 years. Intangible assets included the following at December 31:
1998 1999 ---------- ---------- (In thousands) Licenses................................... $ 5,991 $ 5,991 Excess of cost over net assets acquired.... 10,748 10,748 ---------- ---------- 16,739 16,739 Accumulated amortization................... (7,941) (8,740) ---------- ---------- $ 8,798 $ 7,999 ========== ==========
(J) POLICYHOLDER DEPOSITS NAICO requires certain policyholders to pay a deposit at inception of coverage to secure payment of future premiums and deductibles on claims incurred. It is expressly agreed between NAICO and the policyholder that the funds will be used by NAICO only in the event the policyholder fails to pay any premiums, deductibles or other charges when due. NAICO has established a liability for these deposits in an amount equal to that due the policyholders based on insurance premiums reported as of the balance sheet date. (K) INVESTMENTS At the time of purchase, investments in debt securities that the Company 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. The Company has not classified any investments as trading account assets. Securities not classified as held to maturity or trading are classified as available for sale, with the related unrealized gains and losses excluded from earnings and reported net of income tax as a component of other comprehensive income until realized. Realized gains and losses on sales of securities are based on the specific identification method. Declines in the fair value of investment securities below their carrying value that are other than temporary are recognized in earnings. (L) INCOME TAXES The Company 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, the Company considers all highly liquid investments with original maturities of 14 days or less to be cash equivalents. For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value. PAGE F-10 (N) SUPPLEMENTAL CASH FLOW INFORMATION Cash payments for interest and income taxes, and noncash investing activities were as follows:
YEAR ENDED DECEMBER 31, -------------------------------- 1997 1998 1999 ---------- ---------- ---------- (In thousands) Cash payments during the year for: Interest................................. $ 818 $ 1,307 $ 549 Income taxes............................. 1,855 170 857
In January 1997, NAICO received publicly traded common stock valued at approximately $2.2 million at the settlement date as a result of settling certain legal disputes with a former underwriting manager for a portion of the surety bond program. During 1997, NAICO received shares of common stock with a fair value of approximately $124,000 in connection with an unaffiliated entity's conversion to a for-profit corporation. During 1997, L&W acquired 494,617 shares of the Company's common stock from two former agents of NAICO and L&W as payment for debts owed to NAICO and L&W. L&W transferred those shares during 1997 to Chandler Insurance Management, Ltd. ("CIM"), a wholly owned subsidiary of the Company who, in turn assumed debt of L&W to Chandler Barbados in the amount of approximately $2.5 million, the fair value of the shares. As a result of a jury verdict in April 1997, the Company recorded the rescission of certain common stock of the Company that it sold in 1990 in return for a future payment of $5,099,133. The rescission was recorded as a decrease to shareholders' equity in the amount of approximately $4,916,000 with the remaining amount included in litigation expense. In December 1999, the Company paid the $5,099,133 in exchange for the stock which was then canceled. In the fourth quarter of 1997, the Company recorded the rescission of certain additional common stock of the Company pursuant to an order issued on March 10, 1998 in the amount of $6,882,500. This amount is included in "Litigation liabilities" on the Company's consolidated balance sheets. See Note 11 for additional information. (O) REINSURANCE Management believes all of the Company's reinsurance contracts with reinsurers meet the criteria for risk transfer and the revenue and cost recognition provisions in order to be accounted for as reinsurance. As more fully explained in Note 12, reinsurance contracts do not relieve the Company from its obligation to policyholders. In addition, failure of reinsurers to honor their obligations could result in losses to the Company. (P) ACCOUNTING STANDARD ISSUED BUT NOT YET ADOPTED In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that the Company recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company will adopt SFAS No. 133 when required. Management of the Company does not expect that adoption of SFAS No. 133 will have a material impact on the Company's consolidated financial condition or results of operations. PAGE F-11 NOTE 2. INVESTMENTS AND INTEREST INCOME Net interest income and realized investment gains are summarized in the following table. These amounts are net of investment expenses.
YEAR ENDED DECEMBER 31, -------------------------------- 1997 1998 1999 ---------- ---------- ---------- (In thousands) Interest on fixed-maturity investments............. $ 6,967 $ 6,236 $ 5,908 Interest on cash equivalents....................... 677 953 907 Investment expenses................................ (391) (722) (1,221) ---------- ---------- ---------- Interest income, net............................ 7,253 6,467 5,594 ---------- ---------- ---------- Realized gains - fixed-maturity investments, net... 508 1,163 55 Realized gains - equities, net..................... 256 - - ---------- ---------- ---------- Realized investment gains, net.................. 764 1,163 55 ---------- ---------- ---------- $ 8,017 $ 7,630 $ 5,649 ========== ========== ==========
Investment expenses include $72,000, $399,000 and $851,000 for the years ended December 31, 1997, 1998 and 1999, respectively, in expense to subsidize a premium finance program for certain insureds of NAICO with an unaffiliated premium finance company. The amortized cost of fixed maturities or cost of equity securities, gross unrealized gains or losses, fair value and carrying value of investments are as follows:
GROSS GROSS UNREALIZED UNREALIZED FAIR CARRYING DECEMBER 31, 1998 COST GAINS LOSSES VALUE VALUE - ----------------------------------------- ---------- ---------- ---------- ---------- ---------- (In thousands) FIXED MATURITIES AVAILABLE FOR SALE: U.S. Treasury securities and obligations of U.S. government corporations and agencies.......................... $ 55,018 $ 273 $ (67) $ 55,224 $ 55,224 Debt securities issued by foreign governments................... 1,510 9 - 1,519 1,519 Obligations of states and political subdivisions.......................... 12,178 318 - 12,496 12,496 Corporate obligations.................... 31,333 348 (58) 31,623 31,623 Public utilities......................... 7,321 141 (18) 7,444 7,444 Mortgage-backed securities............... 725 24 - 749 749 ---------- ---------- ---------- ---------- ---------- $ 108,085 $ 1,113 $ (143) $ 109,055 $ 109,055 ========== ========== ========== ========== ========== FIXED MATURITIES HELD TO MATURITY: U.S. Treasury securities and obligations of U.S. government corporations and agencies.......................... $ 1,183 $ 149 $ - $ 1,332 $ 1,183 ========== ========== ========== ========== ========== EQUITY SECURITIES AVAILABLE FOR SALE: Corporate stock.......................... $ - $ 191 $ - $ 191 $ 191 ========== ========== ========== ========== ==========
PAGE F-12
GROSS GROSS UNREALIZED UNREALIZED FAIR CARRYING DECEMBER 31, 1999 COST GAINS LOSSES VALUE VALUE - ----------------------------------------- ---------- ---------- ---------- ---------- ---------- (In thousands) FIXED MATURITIES AVIALABLE FOR SALE: U.S. Treasury securities and obligations of U.S. government corporations and agencies.......................... $ 55,818 $ 7 $ (1,681) $ 54,144 $ 54,144 Debt securities issued by foreign governments................... 1,503 - (5) 1,498 1,498 Obligations of states and political subdivisions.......................... 10,188 - (274) 9,914 9,914 Corporate obligations.................... 37,063 - (1,342) 35,721 35,721 Public utilities......................... 7,280 - (482) 6,798 6,798 Mortgage-backed securities............... 624 12 (2) 634 634 ---------- ---------- ---------- ---------- ---------- $ 112,476 $ 19 $ (3,786) $ 108,709 $ 108,709 ========== ========== ========== ========== ========== FIXED MATURITIES HELD TO MATURITY: U.S. Treasury securities and obligations of U.S. government corporations and agencies.......................... $ 984 $ 55 $ - $ 1,039 $ 984 ========== ========== ========== ========== ========== EQUITY SECURITIES AVAILABLE FOR SALE: Corporate stock.......................... $ - $ 306 $ - $ 306 $ 306 ========== ========== ========== ========== ==========
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, 1999 are shown below:
AVAILABLE FOR SALE HELD TO MATURITY --------------------- --------------------- AMORTIZED AMORTIZED COST FAIR VALUE COST FAIR VALUE ---------- ---------- ---------- ---------- (In thousands) Due in one year or less.................... $ 28,723 $ 28,580 $ - $ - Due after one year through five years...... 41,352 40,443 984 1,039 Due after five years through ten years..... 41,777 39,052 - - Due after ten years........................ - - - - ---------- ---------- ---------- ---------- 111,852 108,075 984 1,039 Mortgage-backed securities................. 624 634 - - ---------- ---------- ---------- ---------- $ 112,476 $ 108,709 $ 984 $ 1,039 ========== ========== ========== ==========
Realized gains and losses from sales of fixed maturities and equity securities are shown below:
GROSS REALIZED GAINS GROSS REALIZED LOSSES -------------------- --------------------- (In thousands) 1997.............................. $ 803 $ 39 1998.............................. 1,224 61 1999.............................. 67 12
Chandler Barbados is required as a foreign reinsurer to secure reserves for unpaid losses and loss adjustment expenses and unearned premiums for NAICO's benefit. Chandler Barbados secures such amounts with a trust arrangement whereby securities are deposited into a trust account for NAICO's benefit. At December 31, 1998 and 1999, Chandler Barbados had cash and investments with a carrying value of approximately $25.3 million and $24.1 million, respectively, deposited in a trust account for NAICO's benefit. 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, 1998 and 1999, the carrying value of these deposits totaled approximately $8.2 million and $7.2 million, respectively. At December 31, 1999, the total amount of cash and investments restricted as a result of these arrangements was approximately $31.3 million. PAGE F-13 NOTE 3. UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES The Company 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 the Company's net liability for unpaid losses and loss adjustment expenses were approximately $5.3 million and $4.4 million at December 31, 1998 and 1999, respectively. Although such estimates are management's best estimates of the expected values, the ultimate liability for unpaid claims may vary from these values. The Company 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, -------------------------------- 1997 1998 1999 ---------- ---------- ---------- (In thousands) Net balance before provision for uncollectible reinsurance at beginning of year................................................ $ 64,430 $ 62,890 $ 51,194 ---------- ---------- ---------- Net losses and loss adjustment expenses incurred related to: Current year........................................................ 53,704 42,724 74,997 Prior years......................................................... 3,808 5,155 4,819 ---------- ---------- ---------- Total............................................................ 57,512 47,879 79,816 ---------- ---------- ---------- Net paid losses and loss adjustment expenses related to: Current year........................................................ (22,214) (23,152) (37,806) Prior years......................................................... (36,838) (36,423) (32,877) ---------- ---------- ---------- Total............................................................ (59,052) (59,575) (70,683) ---------- ---------- ---------- Balance before provision for uncollectible reinsurance at end of year.. 62,890 51,194 60,327 Adjustments to reinsurance recoverables on unpaid losses for uncollectible reinsurance......................... 1,163 745 594 ---------- ---------- ---------- Net balance at end of year............................................. $ 64,053 $ 51,939 $ 60,921 ========== ========== ==========
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 the Company. PAGE F-14 NOTE 4. NOTES PAYABLE During 1996, Chandler USA borrowed $4.5 million from a bank for a three year term. During the fourth quarter of 1997, the related loan agreement was amended to provide for additional borrowings up to $8.5 million and to revise the term to five years with interest payable at a floating rate equal to 1% over the prime rate published in the Wall Street Journal. The principal balance of the note was approximately $7,397,000 at December 31, 1998. Proceeds from the note were used to repay amounts due to Chandler Barbados. The bank note was collateralized by the shares of NAICO stock owned by Chandler USA. In July 1999, the note was repaid from the proceeds of a debenture offering. See Note 5. At December 31, 1998, Chandler USA had a note payable related to the acquisition of Network Administrators, Inc., an inactive subsidiary of Chandler USA, with a balance of $75,000. The note had an interest rate of 7% per annum and was repaid during 1999. In February 1998, Chandler USA entered into a five year loan agreement with a bank having a principal amount of $2.3 million and an interest rate of 7.75% per annum. Effective September 28, 1998, the interest rate was reduced to 7.5% per annum. The outstanding balance of the note was approximately $1,938,000 at December 31, 1998. The loan was collateralized by certain equipment which was purchased with the proceeds of the loan. The equipment had previously been leased by Chandler USA. In July, 1999, the note was repaid from the proceeds of a debenture offering. See Note 5. NOTE 5. DEBENTURE OFFERING On July 16, 1999, Chandler USA completed a public offering of $24 million principal amount of senior debentures with a maturity date of July 16, 2014. The debentures were priced at $1,000 each with an interest rate of 8.75% and are redeemable by Chandler USA on or after July 16, 2009 without penalty or premium. The proceeds to Chandler USA before expenses but after the underwriter's discount were $23.16 million. The proceeds of the offering were used to repay existing bank debt, to repay amounts owed by Chandler USA to its parent, Chandler Barbados, and for general corporate purposes. Chandler USA has capitalized $1.7 million related to debt issuance costs for the debentures. These costs are being amortized as interest expense over the term of the debentures. Chandler USA's subsidiaries and affiliates are not obligated by the debentures. Accordingly, the debentures are effectively subordinated to all existing and future liabilities and obligations of Chandler USA's existing and future subsidiaries. The indenture governing the debentures contains certain restrictive covenants, including covenants that limit subsidiary debt, issuance or sale of subsidiary stock, incurring of liens, sale-leaseback transactions, mergers, consolidations and sales of assets. At December 31, 1999, Chandler USA was in compliance with all covenants. NOTE 6. SHAREHOLDERS' EQUITY CAPITAL STOCK On May 7, 1988, the Company's shareholders authorized the issuance of up to 3,000,000 preferred shares with a par value of $1.00. No preferred shares have been issued as of December 31, 1999. The provisions of Article XI of the Company's Articles of Association, which was adopted by the shareholders in 1988, prohibits business combinations lacking approval of the Continuing Directors (those not affiliated with a 20% or more shareholder) or 80% of the shareholders and may result in a prohibition against voting such shares held by a shareholder acquiring 20% or more of the common shares (and its affiliates and associates) if the Continuing Directors deny approval. In addition to the regulatory oversight of NAICO by the Nebraska Department of Insurance, the Company is also subject to regulation under the Nebraska Insurance Holding Company Systems Act (the "Holding Company Act"). In addition to various reporting requirements imposed on the Company, the Holding Company Act 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 the Company's outstanding voting stock) to file and obtain approval of certain applications with the Nebraska Department of Insurance regarding their proposed ownership of such shares. In 1996, the Company acquired 567,350 shares of its stock previously held by Chandler USA and retired the shares. In accordance with the Companies Law (1995 Revision) of the Cayman Islands, the Company established the capital redemption reserve in the amount of $947,475 which is reflected as a separate component of shareholders' equity in the consolidated balance sheets as of December 31, 1998 and 1999. The Companies Law no longer requires a capital redemption reserve to be established when shares are retired. PAGE F-15 During December 1999, the Company acquired 1,989,200 shares of its own stock in exchange for payment of $15,204,758 to CenTra and its affiliates pursuant to a divestiture plan proposed by NAICO and approved by the Nebraska Court. All shares were canceled upon their return to the Company. The Nebraska Court had ordered CenTra to divest all shares of Chandler owned or controlled by it or its affiliates. An additional share block owned by CenTra and affiliates consists of 1,142,625 shares which will be divested following a ruling on CenTra's appeal of a judgment entered by an Oklahoma Federal Court in April 1997. That judgment requires CenTra to transfer the shares to the Company in exchange for payment of $6,882,500. Following the conclusion of the appeal, the Nebraska Court will determine the method of divestiture of these shares. The appellate court heard oral argument on November 15, 1999. The Company cannot predict when the appellate court will rule on the appeal. During December 1999, CIM transferred the 524,475 shares of the Company's common stock that it owned to the Company. The shares were canceled by the Company. See Note 8 regarding possible taxation of certain income of the Company to U.S. shareholders with certain ownership percentages. STATUTORY FINANCIAL INFORMATION AND MINIMUM CAPITAL REQUIREMENTS Chandler, Chandler Barbados, NAICO Indemnity and NAICO are required to file financial statements with insurance regulatory authorities. Chandler and NAICO Indemnity file financial statements with the Cayman Islands Monetary Authority and Chandler Barbados files financial statements with the Supervisor of Insurance in Barbados. NAICO is required to file financial statements with state regulatory authorities prepared on a statutory basis which differs from U.S. GAAP. Statutory net income (loss) and statutory capital and surplus of NAICO are as follows:
1997 1998 1999 ---------- ---------- ---------- (In thousands) Statutory net income (loss)..... $ 6,737 $ 6,877 $ (1,455) Statutory capital and surplus... $ 45,283 $ 45,327 $ 44,638
Chandler, NAICO Indemnity and Chandler Barbados are also required to maintain net worth subject to minimum requirements imposed by the applicable regulatory authorities. Chandler and NAICO Indemnity are required to maintain a net worth of the greater of (i) $120,000, or (ii) an amount equal to 20% of their net premiums earned. Chandler Barbados must have assets exceeding liabilities by (i) $125,000 where the premium income in the previous year did not exceed $750,000; or (ii) 20% of the premium income for the preceding year where the premium income exceeded $750,000 but did not exceed $5,000,000; or (iii) the aggregate of $1,000,000 and 10% of the amount by which the premium income in that fiscal year exceeded $5,000,000. The National Association of Insurance Commissioners 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, 1998 and 1999. 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 As a holding company, the Company may receive cash through equity sales, borrowings and dividends from its subsidiaries. Chandler Barbados and NAICO are subject to regulations which restrict their ability to pay shareholder dividends. The payment of cash shareholder dividends by Chandler Barbados to the Company is limited to its earned surplus (approximately $40.6 million at December 31, 1999) and margin of solvency requirements. The amount of cash shareholder dividends that NAICO can pay to Chandler USA within any one year without the approval of the Nebraska Department of Insurance is generally limited to the greater of (i) statutory net income excluding realized capital gains for the preceding year (statutory net income excluding realized capital gains from the second and third preceding years, less any dividends paid, may be carried forward), 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 2000 without the approval of the Nebraska Department of Insurance is approximately $4.9 million. Prior to 1998, NAICO (during the ownership by the Company) had not paid any cash shareholder dividends. During 1998, NAICO paid a cash shareholder dividend of $6.0 million to Chandler USA. In January 2000, NAICO paid a cash shareholder dividend of $1,250,000 to Chandler USA. PAGE F-16 The future payment of shareholder dividends also depends upon the earnings, financial position and cash requirements of the Company, as well as regulatory limitations and such other factors as the board of directors may deem relevant. Chandler Barbados has not paid any cash shareholder dividends. NAICO is subject to regulations which restrict its ability to pay dividends to policyholders. The maximum amount of available policyholder dividends is limited to statutory earned surplus (approximately $11.9 million as of December 31, 1999). NAICO paid approximately $423,000, $561,000 and $465,000 in policyholder dividends during 1997, 1998 and 1999, respectively. NOTE 7. STOCK OPTIONS AND WARRANTS The Company has a non-qualified stock option plan (the "Officers' Plan") for which the Company has reserved an aggregate of 968,750 shares of its common stock subject to adjustment for reorganizations, recapitalizations, stock splits or similar events, for issuance upon exercise of options to be granted under the Officers' Plan. Options are granted at a purchase price of the fair market value as of the grant date. Shares of common stock subject to the unexercised portions of any options granted under the Officers' Plan which terminate or are canceled may again be subject to reissuance under the Officers' Plan. Officers of the Company and its subsidiaries are eligible to receive options under the Officers' Plan. The Officers' Plan is administered by a committee of the Company's outside directors appointed by the board of directors of the Company. No stock options were outstanding under the Officers' Plan from January 1, 1997 through December 31, 1999. During the second quarter of 1998 the Company's directors approved the Directors' Stock Option and Stock Grant Plan (the "Directors' Plan"). The Directors' Plan provides that the non-employee directors of the Company, other than Norman Harned, Ronald Lech and M.J. Moroun, are eligible for grants of stock options and stock grants in accordance with the terms of the Directors' Plan. Messrs. Harned, Lech and Moroun resigned as directors of the Company during November 1999. Options and stock grants may not be granted under the Directors' Plan for more than 260,000 shares of common stock of the Company, but this number may be adjusted to reflect, if deemed appropriate by the board of directors, any stock dividend, stock split, share combination, recapitalization or the like, of or by the Company. The exercise price of the stock options shall generally be equal to the average closing price of common stock of the Company for the 30 calendar days preceding the date the options are granted. The option period begins on the effective date of the option grant and terminates on the tenth anniversary of that date. The aggregate number of shares of stock awarded to an eligible director as a stock grant shall total 20,000 shares of common stock of the Company. The award shall be divided into two equal installments. The first installment of 10,000 shares shall automatically be awarded as of the first regular board meeting after an eligible director completes ten continuous years of service on the board. The second installment of 10,000 shares shall automatically be awarded as of the first anniversary of the initial stock grant, regardless of whether the director is still a member of the board. During the second quarter of 1998, a total of 40,000 shares valued at $250,000, based upon a weighted average grant-date fair value of $6.25 per share, were awarded to two directors, and this amount is included in general and administrative expenses in the Company's consolidated statements of operations. During the third quarter of 1998, the Company issued 20,000 of the 40,000 shares to the two directors as required under the Directors' Plan from the Company's stock held by subsidiary. During the second quarter of 1999, the Company issued the remaining 20,000 shares to the two directors from the Company's stock held by subsidiary. The difference between the average reacquisition cost of the shares issued and the share price at the date of the stock grant was credited to paid-in surplus. Each eligible director shall automatically be granted options to purchase 1,500 shares of common stock of the Company as of the first regular board meeting in each year the director serves on the board. Each eligible director shall also automatically be granted options to purchase 30,000 shares of common stock of the Company effective as of the first regular board meeting after the director completes ten continuous years of service on the board. The options require shareholder approval prior to being exercised. During the second quarter of 1998, options for 66,000 shares were granted with an exercise price of $5.92 per share, which resulted in approximately $22,000 of compensation expense which is included in general and administrative expenses in the Company's consolidated statements of operations. During the first quarter of 1999, options for 6,000 shares were awarded with an exercise price of $8.06 per share. As the exercise price of the options exceeded the market value at the date of grant, the Company did not recognize any compensation expense for the options issued in 1999. As of December 31, 1999, options for 72,000 shares were outstanding, none of which were exercisable. The Company applies Accounting Principles Board Opinion 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations in accounting for its stock option plans, as permitted by SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION. SFAS No. 123 requires disclosure of pro forma net income and basic and diluted earnings per share as if the Company had adopted the fair value provisions of SFAS No. 123. Had compensation cost been determined based on the fair value at the grant date of the stock options granted to the directors in accordance with SFAS No. 123, the Company's pro forma net income for 1998 and 1999 would have been approximately $3,278,000 and $2,131,000, respectively, and pro forma basic and diluted earnings per share for 1998 and 1999 would have been $0.51 and $0.34, respectively. PAGE F-17 The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted average grant-date fair value per option granted during 1998 and 1999 under the Directors' Plan was $2.81 and $3.32, respectively. The following weighted-average assumptions were used in the Black-Scholes option pricing model for the options granted in 1998 and 1999.
1998 1999 ---------- ---------- Dividend yield................ -% -% Volatility.................... 39% 38% Risk-free interest rate....... 5.62% 5.30%
NOTE 8. INCOME TAXES Chandler, Chandler Barbados and NAICO Indemnity have received tax concessions from the respective Cayman Islands and Barbados governments for all taxes levied on profits, income, gains and appreciation that are valid through September 30, 2003, May 19, 2003 and March 10, 2012, respectively. Accordingly, no income taxes have been provided. The companies do not consider themselves engaged in a trade or business within the United States and therefore are not subject to United States Federal income taxes. Should the Internal Revenue Service ("IRS") determine that any of the companies are engaged in a trade or business within the United States and has not filed a federal income tax return, such company may be subject to federal income taxes and may not be allowed any deductions or credits in determining its tax liability. Under Section 953(c) of the Internal Revenue Code of 1986 as amended (the "Code"), if U.S. persons indirectly own (i.e., through ownership of the Company) 25% or more of the total combined voting power of all classes of Chandler Barbados' stock entitled to vote or 25% or more of the total value of Chandler Barbados' stock, then each such person is required to include in his gross income a portion of any insurance income of Chandler Barbados attributable to a policy of insurance or reinsurance with respect to which the person (directly or indirectly) insured is a related person to a shareholder in Chandler Barbados ("related person insurance income" or "RPII"). Under these rules, all U.S. persons who own stock in the Company would generally be required, subject to the exception discussed hereinafter, to include in their gross incomes a portion of the RPII received by Chandler Barbados from NAICO. However, related person insurance income of Chandler Barbados need not be included in the income of a U.S. person who is not a "United States shareholder," as defined in Section 951(b) of the Code, if, at all times during Chandler Barbados' taxable year, less than 20% of the total combined voting power of all classes of stock of Chandler Barbados and less than 20% of the total value of Chandler Barbados is owned (directly or indirectly) by persons who are (directly or indirectly) insured under any policy of insurance or reinsurance issued by Chandler Barbados, or who are related persons to any such person. During 1994, the IRS contended that Chandler Barbados did not qualify for the exception to the inclusion of RPII for all U.S. persons who hold the Company's stock, because the Company owns more than 20% of the voting power and value of Chandler Barbados, and the Company is a related party to NAICO, which purchases reinsurance from Chandler Barbados. However, the Company believes, and asserted to the IRS that U.S. persons who hold less than 5.5% of the stock of the Company should not be required to include any RPII of Chandler Barbados in their income. The IRS has agreed with the Company's position on this issue, and a formal closing agreement was executed in 1996. PAGE F-18 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:
1997 1998 1999 ------------ ------------- ------------ (In thousands) Computed income tax provision at 34%................. $ 413 $ 1,290 $ 855 Increase (decrease) in income taxes resulting from: Expense (benefit) from income or loss not subject to U.S. Federal income tax..................... 1,384 (1,023) (760) Amortization of licenses and other intangibles.... 380 362 271 Interest income on tax exempt securities.......... (32) (298) (140) Other, net........................................ 136 22 139 ------------ ------------- ------------ Federal income tax provision......................... $ 2,281 $ 353 $ 365 ============ ============= ============
U.S. Federal income tax provision (benefit) consists of:
CURRENT DEFERRED TOTAL ------------ -------------- ------------ (In thousands) 1997................................................. $ 2,389 $ (108) $ 2,281 1998................................................. 52 301 353 1999................................................. 1,127 (762) 365
Deferred income tax provision (benefit) relating to temporary differences includes the following components:
1997 1998 1999 ---------- ---------- ---------- (In thousands) Loss reserve discounts...................................... $ (97) $ 921 $ (500) Unearned premiums........................................... (58) 395 (1,168) Deferred policy acquisition costs........................... 1 (1,209) 1,093 Reserve for uncollectible premiums receivable and reinsurance recoverables............................. 188 (9) (63) Depreciation and lease expense.............................. (164) (60) (46) Other....................................................... 22 263 (78) ---------- ---------- ---------- $ (108) $ 301 $ (762) ========== ========== ==========
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:
1998 1999 ---------- ---------- (In thousands) Deferred tax assets: Loss reserve discounts...................................................... $ 2,832 $ 3,410 Unearned premiums........................................................... 1,430 2,598 Reserve for uncollectible premiums receivable and reinsurance recoverables.. 180 243 Unrealized loss on investments available for sale........................... - 886 Net operating loss carryforwards - state.................................... 1,670 1,774 Other....................................................................... 253 263 Valuation allowance......................................................... (1,670) (1,774) ---------- ---------- Total deferred tax assets...................................................... 4,695 7,400 ---------- ---------- Deferred tax liabilities: Deferred policy acquisition costs........................................... (27) 1,066 Depreciation and lease expense.............................................. 693 646 Unrealized gain on investments available for sale........................... 368 - Other....................................................................... 590 601 ---------- ---------- Total deferred tax liabilities................................................. 1,624 2,313 ---------- ---------- Net deferred tax assets........................................................ $ 3,071 $ 5,087 ========== ==========
At December 31, 1999, Chandler USA had net operating loss carryforwards available for Oklahoma state tax purposes totaling approximately $29.6 million which expire in the years 2006 through 2015. A valuation allowance has been provided for the tax effect of the state net operating loss carryforwards since realization of such amounts is not considered more likely than not. PAGE F-19 NOTE 9. EMPLOYEE BENEFITS Chandler USA and its subsidiaries participate in a defined contribution retirement plan established under Section 401(k) of the Code. All full time employees who have completed one year of service and attained age 21 may elect to participate in the 401(k) plan. Participants may contribute up to 15% of compensation, not to exceed the statutory limitations which for 1999 was $10,000. 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 $3,600 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 $254,000, $259,000 and $276,000 for 1997, 1998 and 1999, respectively. NOTE 10. FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS 107, Disclosures About Fair Value of Financial Instruments. The estimated fair value amounts have been determined by the Company, 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 the Company 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 the Company's significant assets (including deferred policy acquisition costs, property and equipment, reinsurance recoverables, prepaid reinsurance premiums, licenses and excess of cost over net assets acquired) 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, the Company 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, notes payable and premiums payable, approximates their fair value as of December 31, 1998 and 1999. The estimated fair values of the Company's fixed-maturity and equity security investments are disclosed at Note 2. At December 31, 1999, the Company maintained custody of letters of credit from policyholders totaling $12.3 million, which is a reasonable estimate of their fair value. NOTE 11. LITIGATION The Company and certain of its subsidiaries and affiliates have been involved in various matters of litigation with CenTra, Inc. ("CenTra") and certain of its affiliates, officers and directors (the "CenTra Group") since 1992. The CenTra Group has been a significant shareholder in the Company owning 49.2% of the Company's stock in July 1992. Three present or former executive officers of CenTra, Norman E. Harned, Ronald W. Lech and M. J. Moroun were directors of the Company until November 1999. On March 25, 1997, the U.S. District Court for the District of Nebraska ("Nebraska Court") ordered CenTra and certain of its affiliates to divest all Chandler shares owned by them. The CenTra defendants owned or controlled 3,133,450 Chandler shares. The Nebraska Court approved a divestiture plan submitted by NAICO (the "NAICO Plan") which called for the Company to acquire and cancel the shares of Chandler stock owned by the CenTra Group. During December 1999, the Company acquired 1,989,200 shares of its stock in exchange for payment of $15,204,758. These shares were canceled upon acquisition by the Company. The Nebraska Court continues to hold 1,142,625 shares pending the outcome of CenTra's appeal of a judgment by the U.S. District Court in Oklahoma City, Oklahoma ("Oklahoma Court") regarding these shares. Following the conclusion of the appeal, the Nebraska Court will determine the method of divestiture of these shares. The Company cannot predict when the appellate court will rule on the appeal. On April 1, 1997, the Oklahoma Court entered judgment in favor of NAICO on CenTra's claims for alleged wrongful cancellation of CenTra's insurance with NAICO and NAICO Indemnity in 1992. The remaining issues were submitted to a jury. On April 22, 1997, the Oklahoma Court entered judgments on the jury verdicts. One judgment against the Company required the CenTra Group to return stock it purchased in 1990 to the Company in return for a payment of $5,099,133 from the Company. Payment was made and the stock was returned to the Company and canceled in December 1999 as a part of the acquisition of shares described previously. Another judgment was against both the Company and Chandler Barbados. CenTra and an affiliate, Ammex, Inc., were awarded $6,882,500 in connection with a 1988 stock purchase agreement. On March 10, 1998, the Oklahoma Court modified its judgment to require CenTra and its affiliates to deliver 1,142,625 shares of Chandler stock they owned upon payment of the $6,882,500 judgment which was entered in April 1997. Both of these judgments related to an alleged failure by the Company to adequately disclose the fact that ownership of the Company's stock may be subject to regulation by the Nebraska Department of Insurance under certain circumstances. Judgment was also entered in favor of CenTra and against certain officers and/or directors of the Company on the securities claims relating to CenTra's 1990 stock purchases and the failure to disclose the application of Nebraska insurance law, but the judgments were $1 against each individual defendant on those claims. On ten derivative claims brought by CenTra, the jury found in CenTra's favor on three. Certain officers were directed to repay to Chandler USA bonuses received for the years 1988 and 1989 totaling $711,629 and a total of $25,000 for personal use of corporate aircraft. These amounts are included in other assets in the accompanying consolidated balance sheets. On the remaining claim relating to the acquisition of certain insurance agencies in 1988, the jury awarded $1 each against six officers and/or directors. PAGE F-20 Judgment was also entered in favor of NAICO and NAICO Indemnity on counterclaims against CenTra for CenTra's failure to pay insurance premiums. Judgment was for the amount of $788,625. During 1998, the judgment was paid by funds held by the Oklahoma Court aggregating, with interest, $820,185. DuraRock Underwriters, Ltd. ("DuraRock"), an affiliate of CenTra, claimed $725,000 was owed to it under certain reinsurance treaties. That claim was settled in January 2000 with NAICO and NAICO Indemnity paying $137,500 to DuraRock. The Oklahoma Court's judgment also upheld a resolution adopted by the Company's Board of Directors in August 1992 pursuant to Article XI of the Company's Articles of Association preventing CenTra and its affiliates from voting their Chandler stock. As a result of the Oklahoma Court judgments and subsequent decisions, the Company recorded a net charge for the litigation matters during 1997 totaling approximately $1.4 million ($1.6 million including provision for federal income tax). The Company recorded the return of 1,660,125 shares of the Company's stock in connection with the rescission judgments as a decrease to shareholders' equity in the amount of approximately $12.0 million. On April 21, 1998, the Oklahoma Court denied the CenTra Group's request for costs and attorney fees. The CenTra Group did not appeal this decision within the time permitted by applicable law. Accordingly, the Company reduced the previous 1997 net charge for litigation matters by $3.8 million during the second quarter of 1998. On March 23, 1998, the CenTra Group filed a formal notice of intent to appeal certain orders of the Oklahoma Court, and filed the initial appellate brief on September 9, 1998. The appeals are being considered by the U.S. Court of Appeals for the 10th Circuit. The CenTra Group's appeals are based upon the Oklahoma Court's failure to award prejudgment interest, the Oklahoma Court's refusal to permit the CenTra Group to amend certain pleadings to assert new claims, the Oklahoma Court's modification of the judgment for $6,882,500 to require CenTra to return shares of the Company's stock upon payment of the judgment, and the Oklahoma Court's denial of attorney fees. The Company believes the appeal of this issue is untimely and therefore barred by law. The Company elected not to appeal any of the judgments. The individual officers and directors against whom judgments were entered have all filed appeals. The Company's board of directors appointed a committee of the board (the "Committee") to deal with all matters arising from the Oklahoma litigation. The members of the Committee are Messrs. Jacoby, Maestri and Davis, all of whom are non-parties to the CenTra litigation. The Committee is empowered by the board to make decisions on behalf of the Company regarding issues relating to litigation strategy, officer and director indemnification and claims made under the Company's director and officer liability insurance policy (the "D&O Insurer"). A similar committee composed of Chandler USA directors is authorized to deal with those same issues regarding Chandler USA. In 1997, NAICO learned that several CenTra affiliates had filed two lawsuits against NAICO, NAICO Indemnity and certain NAICO officers asserting some of the same claims made and tried in the Oklahoma lawsuit described previously. Those claims were purportedly prosecuted by CenTra on its own behalf and on behalf of its subsidiaries and were based upon alleged wrongful cancellation of their insurance policies by NAICO and NAICO Indemnity. The Oklahoma Court entered a judgment against CenTra on these claims. NAICO and NAICO Indemnity contend that the Oklahoma Court's adjudication is conclusive as to all claims. The lawsuits have been consolidated and have been assigned to the same judge who presided over the action in the Oklahoma Court. Dispositive motions filed by NAICO, NAICO Indemnity and the other defendants are currently under consideration by the Oklahoma Court. In the CenTra litigation, certain officers and directors of the Company were named as defendants. In accordance with its Articles of Association, the Company has advanced the litigation expenses of these persons in exchange for undertakings to repay such expenses if those persons are later determined to have breached the standard of conduct provided in the Articles of Association. The Company has paid expenses on behalf of these officers and directors totaling approximately $2.3 million as of December 31, 1999. A portion of these expenses relate to claims which have been dismissed or which were decided in favor of the officers and directors. These expenses together with certain other expenses may be recovered from the D&O Insurer. As a result of various events in 1995, 1996 and 1997, the Company recorded estimated recoveries of costs from its D&O Insurer totaling $4,500,000 for reimbursable amounts previously paid that relate to allowable defense and litigation costs for such parties. The Company received payment for a 1995 claim during 1996 in the amount of $795,000. The balance is included in other assets in the Company's consolidated balance sheets. The Company is entitled to a total of $5 million under the applicable insurance policy to the extent it has advanced reimbursable expenses. The Company is negotiating with the insurer for payment of the policy balance. The Company could recover the remaining policy limits or could compromise its claim, and could incur significant costs in either case. The ultimate outcome of the appeals of the various parties as described above could have a material adverse effect on the Company and could negatively impact future earnings. The Company's management believes that adequate financial resources are available to pay the judgments as they currently exist or as they may be modified on appeal. As a holding company, the Company may receive cash through equity sales, borrowings and dividends from its subsidiaries. Chandler Barbados and NAICO are subject to various regulations which restrict their ability to pay shareholder dividends. A reduction in the amount of invested assets, or an increase in borrowings resulting from potential payments of these judgments would reduce investment earnings or increase operating expenses in future periods. PAGE F-21 At the present time the Company is actively participating in court proceedings and rights of appeal concerning these legal proceedings; therefore, the Company is unable to predict the outcome of such litigation with certainty or the effect of such ongoing litigation on future operations. The Company is also unable to predict the effect of the remaining divestiture order on the rights, limitations or other regulation of ownership of the stock of any existing or prospective holders of the Company's common stock, or the effect on the market price of the Company's stock. OTHER LITIGATION The Company and its subsidiaries are not parties to any other material litigation other than as is routinely encountered in their respective business activities. NOTE 12. COMMITMENTS AND CONTINGENCIES REINSURANCE In the ordinary course of business, NAICO and NAICO Indemnity cede 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 and NAICO Indemnity'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 policy. NAICO has structured separate reinsurance programs for construction surety bonds, property, workers compensation, casualty (including automobile liability and physical damage, general liability, umbrella liability and related professional liability) and group accident and health. Chandler Barbados reinsures NAICO for a portion of the risk on the construction surety bonds, workers compensation and casualty reinsurance programs. Effective October 1, 1999, the Company began reinsuring Chandler Barbados for a portion of the risk that it assumes from NAICO. In July 1997, NAICO purchased additional reinsurance for the California portion of the nonstandard private-passenger automobile program. During the first quarter of 1998, NAICO purchased additional reinsurance under its workers compensation and casualty reinsurance programs that substantially reduced the combined net retentions in these lines of business. During the second quarter of 1998, NAICO purchased additional reinsurance under its construction surety bond reinsurance program. The purchase of the additional reinsurance coverages in 1997 and 1998 substantially reduced the per occurrence retention for NAICO's workers compensation, casualty, surety bond and private-passenger automobile lines of business, but resulted in significantly lower net premiums earned, losses and loss adjustment expenses and policy acquisition costs. The purchase of additional reinsurance also resulted in an increase in reinsurance recoverables on unpaid losses, prepaid reinsurance premiums and premiums payable and a decrease in deferred policy acquisition costs. During the fourth quarter of 1999, NAICO agreed to rescind reinsurance treaties which covered a portion of its workers compensation business and which had been in effect since January 1, 1999. In addition, NAICO purchases catastrophe protection to limit its retention for single loss occurrences involving multiple policies and/or policyholders, such as floods, winds and severe storms. NAICO also purchases facultative reinsurance when it writes a risk with limits of liability exceeding the maximum limits of its treaties or when it otherwise considers such action appropriate. Treaty reinsurance may be ceded under treaties on both a pro rata or proportional basis (where the reinsurer shares proportionately in premiums and losses) and an excess of loss basis (where only losses above a specific amount are reinsured). The availability, costs and limits of reinsurance purchased can vary from year to year based upon prevailing market conditions, reinsurers underwriting results and NAICO's desired retention levels. A majority of NAICO's reinsurance programs renew on January 1, April 1 or July 1 of each year. NAICO renewed all January 1, 2000 reinsurance programs. At the present time, NAICO expects to renew the reinsurance programs that renew on April 1 and July 1, 2000. In formulating its reinsurance programs, NAICO considers numerous factors, the most important of which are the financial stability of the reinsurer, including its ability to provide sufficient collateral if required, reinsurance coverage offered and price. NAICO periodically reviews certain prospective single year reinsurance treaties, subject to commutation provisions therein, to determine if it is advantageous to assume the estimated loss exposure on expired insurance policies covered by such treaties in exchange for return premiums. Commutation of such reinsurance treaties will be determined in future periods based on timely review of all available data. NAICO reviews the historical results for reinsurance contracts with similar commutation provisions and accrues for such commutations where a commutation election is considered probable, which resulted in an increase in net premiums earned of $918,000 and $931,000 in 1997 and 1998, respectively, and a decrease in net premiums earned of $877,000 in 1999. PAGE F-22 Transamerica Occidental Life Insurance Company ("Transamerica") reinsured NAICO for certain workers compensation risks during 1989, 1990 and 1991. Beginning in 1996, Transamerica refused to pay NAICO for balances that it owed under the reinsurance treaties. Transamerica owed NAICO approximately $1.3 million for reinsurance recoverables on paid losses and loss adjustment expenses as of December 31, 1999. NAICO is seeking arbitration in order to enforce the terms of the reinsurance treaties. Reinsurance contracts do not relieve an insurer from its obligation to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. NAICO charged $527,000 and $50,000 to policy acquisition costs during 1997 and 1998, respectively, for estimated uncollectible reinsurance recoverables from certain unaffiliated reinsurers. NAICO did not incur any charges for uncollectible reinsurance recoverables from unaffiliated reinsurers in 1999. The effect of reinsurance on premiums written and earned was as follows:
1997 1998 1999 -------------------- -------------------- -------------------- WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED --------- --------- --------- --------- --------- --------- (In thousands) Direct........................... $123,014 $116,101 $134,436 $126,017 $169,449 $152,314 Assumed.......................... 74 608 (107) 54 186 199 Ceded............................ (26,222) (22,030) (68,793) (56,007) (41,698) (44,186) --------- --------- --------- --------- --------- --------- Net premiums..................... $ 96,866 $ 94,679 $ 65,536 $ 70,064 $127,937 $108,327 ========= ========= ========= ========= ========= =========
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 $10.6 million, $42.6 million and $59.0 million for 1997, 1998 and 1999, respectively. SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK NAICO conducts its business through individual independent insurance agencies and underwriting managers. Certain of these underwriting managers have provided collateral to NAICO to secure a portion of the premiums receivable. Substantially all of the principal shareholders of the independent agencies and underwriting managers have provided personal guarantees for payment of premiums to NAICO. NAICO also requires certain policyholders to pay a deposit at the time of inception of coverage to secure payment of future premiums or other policy related obligations. Receivables under installment plans do not exceed the corresponding liability for unearned premiums. Total consolidated premiums receivable at December 31, 1998 and 1999 were $28.5 million and $47.7 million, respectively. The 1999 amount includes $12.9 million related to the rescission of the reinsurance treaties. This amount was collected in January 2000. Receivables for deductibles, in most cases, are secured by cash deposits and letters of credit. At December 31, 1999, the Company maintained custody of such letters of credit securing these and other transactions totaling approximately $12.3 million, which is a reasonable estimate of their fair value. These letters of credit are not reflected in the accompanying consolidated financial statements. There were no unaffiliated independent insurance agents that produced 10% or more of NAICO's direct written and assumed premiums during 1997, 1998 or 1999. NAICO's largest underwriting manager was responsible for underwriting $12.3 million and $4.0 million of NAICO's direct written and assumed premiums for the California and Arizona portions of the nonstandard private-passenger automobile program in 1997 and 1998, respectively. The program underwritten by this underwriting manager was discontinued in 1998. NAICO's bail bond underwriting manager was responsible for gross written premiums of $2.6 million, $2.8 million and $2.8 million during 1997, 1998 and 1999, respectively. Approximately $8.7 million, or 14% of the Company's reinsurance recoverables and prepaid reinsurance premiums at December 31, 1999 are collateralized by premiums payable to the reinsurers, securities pledged in trust or letters of credit for the benefit of NAICO. The Company 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. PAGE F-23 The following table sets forth certain information related to NAICO's five largest reinsurers (excluding Chandler Barbados) determined on the basis of net reinsurance recoverables as of December 31, 1999.
CEDED NET REINSURANCE REINSURANCE PREMIUMS FOR A.M. RECOVERABLE THE YEAR ENDED BEST CO. NAME OF REINSURER (1) DECEMBER 31, 1999 RATING - -------------------------------------------------------- ----------- ----------------- -------- (Dollars in thousands) First Excess and Reinsurance Corporation................ $ 16,528 $ 10,709 A Swiss Reinsurance America Corporation................... 10,801 12,909 A+ SCOR Reinsurance Company................................ 8,544 9,479 A+ Reliance Insurance Company (2).......................... 5,253 (5,484) A- Red River Reinsurance, Ltd.............................. 2,193 3,629 -(3) ----------- ----------------- Top five reinsurers..................................... $ 43,319 $ 31,242 =========== ================= All reinsurers..................................... $ 60,780 $ 41,698 =========== ================= Percentage of total represented by top five reinsurers.. 71% 75% - -------------------------------------------------------- (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, 1999. (2) Excludes premiums receivable of $12.9 million as of December 31, 1999 related to the rescission of two reinsurance treaties. NAICO collected this amount during January 2000. (3) Red River Reinsurance, Ltd. ("Red River") is required to secure its reinsurance obligations by depositing acceptable securities in trust for NAICO's benefit. At December 31, 1999, Red River's reinsurance recoverables were collateralized by cash and investments with a fair value of $1.9 million deposited in a trust account for the benefit of NAICO and premiums payable to Red River of approximately $400,000.
NAICO loaned funds to certain agents which are secured by the agent's stock in Red River. The outstanding loan balances at December 31, 1999 consist of 21 individual loans totaling approximately $650,000 ($977,000 at December 31, 1998) and are included in other assets in the accompanying consolidated balance sheets. OTHER See Note 11 regarding contingencies relating to litigation matters. Chandler USA has an employment agreement with W. Brent LaGere, Chairman of the Board and Chief Executive Officer of the Company 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 to participate in certain incentive bonus plans offered by Chandler USA and its subsidiaries. Chandler USA has an employment agreement with Brenda B. Watson, a director and executive officer of the Company and L&W, and an executive officer of NAICO. Under this agreement, Ms. Watson's base compensation is established at not less than $125,000 per year. The agreement terminates on December 31, 2003, unless earlier terminated by Chandler USA for cause, as defined in the agreement. In the event that Ms. Watson is terminated without cause, she is entitled to receive her base compensation through the termination date. In addition to her base compensation, Ms. Watson is eligible to receive certain benefits and to participate in certain incentive bonus plans offered by Chandler USA and its subsidiaries. In addition, certain executives are eligible to participate in bonus plans based upon premium production and/or profitability. NAICO is subject to a variety of assessments related to insurance activities, including those by state guaranty funds and workers compensation second-injury funds. The amounts and timing of such assessments are beyond the control of NAICO. NAICO provides for these charges on a current basis by applying historical factors to premiums earned. Actual results may vary from these values and adjustments therefrom are necessary to maintain an adequate reserve for these assessments. The reserve for unpaid assessments was approximately $851,000 and $667,000 at December 31, 1998 and 1999, respectively. In certain cases, NAICO is permitted to recover a portion of its assessments generally as a reduction to premium taxes paid to certain states. NAICO has recorded receivables in the amount that it expects to recover of approximately $54,000 and $67,000 at December 31, 1998 and 1999, respectively. PAGE F-24 At December 31, 1999, the Company's subsidiaries were committed under noncancellable operating leases for certain equipment and office space. Rental payments under these leases were $1.1 million, $535,000 and $487,000 in 1997, 1998 and 1999, respectively. Future minimum lease payments are as follows:
(In thousands) 2000.............. $ 384 2001.............. 266 2002.............. 143 2003.............. 91 2004.............. - -------------- $ 884 ==============
NOTE 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS NAICO and NAICO Indemnity provided insurance coverage and risk management services for CenTra and certain of its affiliates (see Note 11). All such policies were canceled effective September 5, 1992 or expired as of September 30, 1992. As of December 31, 1997, the unpaid premiums and other amounts due from CenTra to the Company's subsidiaries were $788,625, as reflected by the April 22, 1997 jury verdicts. During 1998, the judgment was paid by funds held by the Oklahoma Court aggregating, with interest, $820,185. DuraRock, a CenTra affiliate, claimed $725,000 was owed to it by NAICO and NAICO Indemnity under certain reinsurance treaties. In January 2000, the parties agreed to settle the matter and NAICO and NAICO Indemnity agreed to pay DuraRock a total of $137,500, which was recorded in the fourth quarter of 1999. Liberty Bell Agency, Inc. ("Liberty Bell"), an affiliate of CenTra, has administered claims under the CenTra insurance program. NAICO and NAICO Indemnity reimburse Liberty Bell for their share of claim payments, but are not obligated for DuraRock's share. DuraRock reinsured NAICO and NAICO Indemnity for substantially all CenTra risks underwritten by them. As a part of a settlement of certain related litigation, National Union Fire Insurance Company of Pittsburgh ("National Union") agreed to assume the reinsurance obligations of DuraRock effective March 31, 1993. Reinsurance recoverables from National Union totaled approximately $1.5 million and $755,000 as of December 31, 1998 and 1999, respectively. The reduction in reinsurance recoverables as well as to the corresponding liabilities for unpaid losses and loss adjustment expenses is based upon information provided by Liberty Bell and National Union. Although NAICO's and NAICO Indemnity's risks are fully reinsured, they are ultimately liable as the policy-issuing company. If National Union does not meet its obligations, such failure could adversely affect NAICO and the Company (see Notes 11 and 12). OTHER See Note 11 regarding advancement of litigation expenses to certain officers and directors of the Company in the CenTra litigation. Chandler USA leases and has made certain improvements to a rural property in which certain directors and/or officers of the Company own interests. Under the lease, no cash rental is paid, but a subsidiary of Chandler USA drilled a water well on the property and maintains certain structures it regularly uses. This property provides recreational activities for the entertainment of customers and business associates of the Company's U.S. subsidiaries. Chandler USA incurred approximately $159,000, $217,000 and $202,000 in expenses associated with its use of this property during 1997, 1998 and 1999, respectively, including $9,000, $7,000 and $8,000 paid to Davenport Farms for reimbursement of certain expenses, such as utility and similar expenses, for the years 1997, 1998 and 1999, respectively. The Company believes that all transactions, including loans with directors, officers, or shareholders of the Company, are and will continue to be on terms no less favorable to the Company than could be obtained from unaffiliated parties. NOTE 14. SEGMENT INFORMATION The Company 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. PAGE F-25 The property and casualty segment accounted for 91.6%, 89.6% and 92.4% of 1997, 1998 and 1999 consolidated revenues before intersegment eliminations, respectively. The insurance products are underwritten by NAICO and are marketed through independent insurance agencies, including L&W. NAICO underwrites various lines of property and casualty insurance, including surety bonds and workers compensation insurance. NAICO's main areas of concentration include the construction, manufacturing, oil and gas, wholesale, service and retail industries along with political subdivisions. The property and casualty segment operates primarily in Oklahoma and Texas, and other surrounding states. Oklahoma accounted for approximately 55%, 55% and 48% of gross written premiums in 1997, 1998 and 1999, respectively, while Texas accounted for approximately 18%, 28% and 37% of gross written premiums during the same years. Management evaluates the property and casualty segment's performance on the basis of growth in gross written premiums and income before income taxes. The agency segment accounted for 8.1%, 10.0% and 7.2% of 1997, 1998 and 1999 consolidated revenues before intersegment eliminations, respectively. L&W is appointed by insurers to solicit applications for policies of insurance, primarily in Oklahoma. L&W represents personal and commercial lines insurance companies, and markets property and casualty, individual and group life, medical and disability income coverages. Major target classes of business are political subdivisions, healthcare facilities, transportation companies, manufacturers, contractors, oil & gas, retailers, wholesalers and service organizations. A large portion of certain classes of business produced by L&W is placed with NAICO. L&W also acts as a surplus lines broker specializing in risk management and brokering insurance for commercial enterprises. L&W acts as the underwriter for a significant portion of NAICO's construction surety bond program. L&W places direct agency business as well as business from other agents with specialty insurance companies. Management evaluates the agency segment's performance on the basis of commission income generated and income before income taxes. The Company 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 nonaffiliate. There can be no assurance the rates charged reflect those that would have been agreed upon following an arm's length negotiation. The following table presents a summary of the Company's operating segments for the years ended December 31:
PROPERTY AND ALL INTERSEGMENT REPORTED AGENCY CASUALTY OTHER ELIMINATIONS BALANCES ------------ ------------ ----------- ------------ ------------ (In thousands) 1997 Revenues from external customers......................... $ 1,763 $ 95,224 $ 220 $ - $ 97,207 Intersegment revenues.................................... 7,277 201 138 (7,616) - Interest income, net..................................... 56 7,186 11 - 7,253 Interest expense......................................... 1 462 - - 463 Segment profit (loss) before income taxes (1)............ 167 6,874 (5,778) (47) 1,216 Segment assets........................................... 6,177 217,092 2,656 (15,135) 210,790 Depreciation and amortization............................ 121 1,031 1,062 - 2,214 1998 Revenues from external customers......................... $ 1,561 $ 70,223 $ 232 $ - $ 72,016 Intersegment revenues.................................... 7,088 197 150 (7,435) - Interest income, net..................................... 55 6,412 - - 6,467 Interest expense......................................... 2 934 - - 936 Segment profit (loss) before income taxes (1)............ 227 2,075 1,510 (17) 3,795 Segment assets........................................... 5,323 243,180 4,227 (16,705) 236,025 Depreciation and amortization............................ 107 1,355 996 - 2,458 1999 Revenues from external customers......................... $ 1,495 $ 118,288 $ 274 $ - $ 120,057 Intersegment revenues.................................... 8,171 178 163 (8,512) - Interest income, net..................................... 32 5,561 1 - 5,594 Interest expense......................................... 2 1,529 - - 1,531 Segment profit (loss) before income taxes (1)............ 119 4,138 (1,725) (16) 2,516 Segment assets........................................... 4,604 273,584 468 (9,536) 269,120 Depreciation and amortization............................ 83 1,614 664 - 2,361 - -------------------------------------------------- (1) Includes net realized investment gains.
PAGE F-26 Net premiums earned and losses and loss adjustment expenses within the property and casualty segment can be identified to Company designated insurance programs. The Company'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, the Company's chief operating decision makers consider many other factors such as the lines of business offered within an insurance program and the states in which the insurance programs are offered. Certain discrete financial information is not readily available by insurance program, including assets, interest income, and investment gains or losses, allocated to each insurance program. The Company 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 1997 1998 1999 - --------------------------------------------------------------------- -------------- -------------- -------------- (In thousands) NET PREMIUMS EARNED Standard property and casualty....................................... $ 55,527 $ 41,662 $ 71,676 Political subdivisions............................................... 14,945 13,073 17,415 Surety bonds......................................................... 11,117 9,938 10,896 Group accident and health............................................ 2,303 4,646 8,261 Nonstandard private-passenger automobile............................. 8,841 482 4 Other................................................................ 1,946 263 75 -------------- -------------- -------------- $ 94,679 $ 70,064 $ 108,327 ============== ============== ============== LOSSES AND LOSS ADJUSTMENT EXPENSES Standard property and casualty....................................... $ 37,253 $ 31,419 $ 53,916 Political subdivisions............................................... 8,490 10,502 16,893 Surety bonds......................................................... 952 1,569 721 Group accident and health............................................ 998 4,149 8,589 Nonstandard private-passenger automobile............................. 6,386 (182) (408) Other................................................................ 3,433 422 105 -------------- -------------- -------------- $ 57,512 $ 47,879 $ 79,816 ============== ============== ==============
The following table shows the detail of intersegment eliminations for segment assets shown in the previous table:
1997 1998 1999 -------------- -------------- -------------- (In thousands) Segment asset eliminations Investment in subsidiaries......................................... $ 475 $ 475 $ 5,675 Other consolidating adjustments.................................... 14,660 16,230 3,861 -------------- -------------- -------------- $ 15,135 $ 16,705 $ 9,536 ============== ============== ==============
PAGE F-27 NOTE 15. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The Company's quarterly results of operations (unaudited) for 1998 and 1999 are as follows:
BASIC AND NET DILUTED EARNINGS TOTAL INCOME (LOSS) PER REVENUES (LOSS) COMMON SHARE ---------------- ------------------ ---------------- (In thousands except per share amounts) 1998 - ---------------------------------------------------------------------- First quarter.................................................... $ 18,550 $ 974 $ 0.15 Second quarter................................................... 19,853 1,031 0.16 Third quarter.................................................... 20,248 605 0.09 Fourth quarter................................................... 20,995 832 0.13 1999 - ---------------------------------------------------------------------- First quarter.................................................... $ 22,918 $ 525 $ 0.08 Second quarter................................................... 22,387 (1,155) (0.18) Third quarter.................................................... 24,242 (323) (0.05) Fourth quarter................................................... 56,159 3,104 0.51
In the second quarter of 1998, the Company reduced the previous 1997 net charge for litigation matters by $3.8 million due to the Oklahoma Court's denial of the CenTra Group's request for costs and attorney fees. During the second quarter of 1999, the Company experienced significant weather-related losses totaling $2.8 million before income taxes (or $1.8 million after income taxes). The tornadoes, strong winds and hail that caused significant damage in Oklahoma on May 3, 1999 accounted for approximately $1.8 million or 66% of the weather-related losses in the second quarter. Weather-related losses also increased during the third quarter of 1999, totaling $803,000 before income taxes (or $530,000 after income taxes). During the fourth quarter of 1999, NAICO agreed to rescind certain reinsurance treaties under its workers compensation reinsurance program effective January 1, 1999. The rescission of the reinsurance treaties increased total revenues by $29.6 million during the fourth quarter, and increased net income after income taxes by approximately $3.8 million during the fourth quarter. * * * * * * * PAGE F-28 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Chandler Insurance Company, Ltd.: We have audited the accompanying consolidated balance sheets of Chandler Insurance Company, Ltd. and subsidiaries (the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1999 (all expressed in United States dollars). Our audits also included the financial statement schedules listed in the Index at Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Chandler Insurance Company, Ltd. and subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 11 to the consolidated financial statements, the Company is involved in various legal proceedings, the outcome of which is uncertain. /s/ Deloitte & Touche DELOITTE & TOUCHE Grand Cayman, Cayman Islands February 11, 2000 PAGE F-29 SCHEDULE I CHANDLER INSURANCE COMPANY, LTD. AND SUBSIDIARIES SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES AS OF DECEMBER 31, 1999 (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............................... $ 55,818 $ 54,144 $ 54,144 Debt securities issued by foreign governments......................... 1,503 1,498 1,498 Obligations of states and political subdivisions...................... 10,188 9,914 9,914 Corporate obligations................................................. 37,063 35,721 35,721 Public utilities...................................................... 7,280 6,798 6,798 Mortgage-backed securities............................................ 624 634 634 ------------------ -------------- --------------- 112,476 108,709 108,709 FIXED MATURITIES HELD TO MATURITY: U.S. Treasury securities and obligations of U.S. government corporations and agencies............................... 984 1,039 984 EQUITY SECURITIES AVAILABLE FOR SALE: Corporate stock....................................................... - 306 306 ------------------ -------------- --------------- Total investments.................................................. $ 113,460 $ 110,054 $ 109,999 ================== ============== ===============
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-30 SCHEDULE II CHANDLER INSURANCE COMPANY, LTD. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER INSURANCE COMPANY, LTD. (PARENT COMPANY ONLY) BALANCE SHEETS (In thousands except share amounts)
DECEMBER 31, --------------------------------- 1998 1999 ---------------- ---------------- ASSETS Cash and cash equivalents ........................................................... $ 15 $ 73 Premiums receivable.................................................................. 10 2,476 Deferred policy acquisition costs.................................................... - 838 Investment in subsidiaries, net...................................................... 75,268 59,223 ---------------- ---------------- Total assets......................................................................... $ 75,293 $ 62,610 ================ ================ LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities Unpaid losses and loss adjustment expenses........................................ $ - $ 561 Unearned premiums................................................................. - 2,401 Litigation liabilities............................................................ 13,228 8,905 ---------------- ---------------- Total liabilities.................................................................... 13,228 11,867 ---------------- ---------------- Shareholders' equity Common stock, $1.67 par value, 10,000,000 shares authorized; 6,941,708 and 4,428,033 shares issued and outstanding in 1998 and 1999, respectively...................................................... 11,593 7,395 Paid-in surplus................................................................... 34,983 21,380 Common stock to be issued (20,000 shares in 1998)................................. 125 - Capital redemption reserve........................................................ 947 947 Retained earnings................................................................. 28,328 30,479 Less: Stock held by subsidiary, at cost (544,475 shares in 1998).................. (2,905) - Less: Stock rescinded through litigation (1,660,125 and 1,142,625 shares in 1998 and 1999, respectively)................................................ (11,799) (6,883) Accumulated other comprehensive income (loss): Unrealized gain (loss) on investments available for sale, net of deferred income taxes....................................................... 793 (2,575) ---------------- ---------------- Total shareholders' equity........................................................... 62,065 50,743 ---------------- ---------------- Total liabilities and shareholders' equity........................................... $ 75,293 $ 62,610 ================ ================
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-31 SCHEDULE II CHANDLER INSURANCE COMPANY, LTD. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER INSURANCE COMPANY, LTD. (PARENT COMPANY ONLY) STATEMENTS OF OPERATIONS (In thousands)
YEAR ENDED DECEMBER 31, -------------------------------------------- 1997 1998 1999 -------------- -------------- -------------- Premiums and other revenues Net premiums earned............................................... $ - $ 37 $ 1,655 Interest income, net.............................................. - - 1 -------------- -------------- -------------- Total premiums and other revenues.............................. - 37 1,656 -------------- -------------- -------------- Operating costs and expenses Losses and loss adjustment expenses............................... - 22 671 Policy acquisition costs.......................................... - 6 584 General and administrative expenses............................... - 272 - Litigation expenses, net.......................................... 4,819 (3,390) 777 -------------- -------------- -------------- Total operating costs and expenses............................. 4,819 (3,090) 2,032 -------------- -------------- -------------- Income (loss) before equity in net income of subsidiaries............ (4,819) 3,127 (376) Equity in net income of subsidiaries................................. 3,754 315 2,527 -------------- -------------- -------------- Net income (loss).................................................... $ (1,065) $ 3,442 $ 2,151 ============== ============== ==============
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-32 SCHEDULE II CHANDLER INSURANCE COMPANY, LTD. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CHANDLER INSURANCE COMPANY, LTD. (PARENT COMPANY ONLY) STATEMENTS OF CASH FLOWS (In thousands)
YEAR ENDED DECEMBER 31, -------------------------------------------- 1997 1998 1999 -------------- -------------- -------------- OPERATING ACTIVITIES Net income (loss)................................................. $ (1,065) $ 3,442 $ 2,151 Adjustments to reconcile net income (loss) to cash provided by (applied to) operating activities: Earned compensation: non-employee director stock option and stock grant plan........................................ - 272 - Net income of subsidiaries not distributed to parent........... (3,754) (315) (2,527) Net change in non-cash balances relating to operating activities: Premiums receivable............................................ - (10) (2,466) Deferred acquisition costs..................................... - - (838) Unpaid losses and loss adjustment expenses..................... - - 561 Unearned premiums.............................................. - - 2,401 Litigation liabilities......................................... 4,819 (3,390) 776 -------------- -------------- -------------- Cash provided by (applied to) operating activities............. - (1) 58 -------------- -------------- -------------- FINANCING ACTIVITIES Proceeds from borrowing from subsidiary........................... - - 15,204 Payments to acquire stock under divestiture plan.................. - - (15,204) -------------- -------------- -------------- Cash provided by financing activities.......................... - - - -------------- -------------- -------------- Increase (decrease) in cash and cash equivalents..................... - (1) 58 Cash and cash equivalents at beginning of year....................... 16 16 15 -------------- -------------- -------------- Cash and cash equivalents at end of year............................. $ 16 $ 15 $ 73 ============== ============== ==============
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-33 SCHEDULE III CHANDLER INSURANCE COMPANY, LTD. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands)
FUTURE POLICY AMORTI- BENEFITS, OTHER ZATION OF NET DEFERRED LOSSES, POLICY CLAIMS, DEFERRED PREMIUMS POLICY CLAIMS CLAIMS AND NET LOSSES AND POLICY OTHER WRITTEN ACQUISITION AND LOSS UNEARNED BENEFITS PREMIUM INTEREST SETTLEMENT ACQUISITION OPERATING AND COSTS EXPENSES PREMIUMS PAYABLE REVENUE INCOME EXPENSES COSTS EXPENSES ASSUMED ----------- -------- -------- ---------- --------- --------- ---------- ----------- --------- --------- YEAR ENDED DECEMBER 31, 1997 Property and casualty.. $ 5,312 $74,929 $42,388 $ 4,830 $ 94,679 $ 7,186 $ 57,512 $ 21,064 $ 10,309 $ 96,866 Agency................. - - - - - 56 - 7,081 1,896 - Other.................. - - - - - 11 - - 6,146 - ----------- -------- -------- ---------- --------- --------- ---------- ----------- --------- --------- Total.................. $ 5,312 $74,929 $42,388 $ 4,830 $ 94,679 $ 7,253 $ 57,512 $ 28,145 $ 18,351 $ 96,866 =========== ======== ======== ========== ========= ========= ========== =========== ========= ========= YEAR ENDED DECEMBER 31, 1998 Property and casualty.. $ 2,381 $80,909 $50,647 $ 4,936 $ 70,064 $ 6,411 $ 47,879 $ 10,099 $ 10,510 $ 65,536 Agency................. - - - - - 55 - 6,934 1,540 - Other.................. - - - - - 1 - - (1,111) - ----------- -------- -------- ---------- --------- --------- ---------- ----------- --------- --------- Total.................. $ 2,381 $80,909 $50,647 $ 4,936 $ 70,064 $ 6,467 $ 47,879 $ 17,033 $ 10,939 $ 65,536 =========== ======== ======== ========== ========= ========= ========== =========== ========= ========= YEAR ENDED DECEMBER 31, 1999 Property and casualty.. $ 6,488 $98,460 $67,769 $ 5,135 $108,327 $ 5,561 $ 79,816 $ 20,617 $ 11,000 $127,937 Agency................. - - - - - 32 - 8,064 1,514 - Other.................. - - - - - 1 - - 2,179 - ----------- -------- -------- ---------- --------- --------- ---------- ----------- --------- --------- Total.................. $ 6,488 $98,460 $67,769 $ 5,135 $108,327 $ 5,594 $ 79,816 $ 28,681 $ 14,693 $127,937 =========== ======== ======== ========== ========= ========= ========== =========== ========= =========
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-34 SCHEDULE IV CHANDLER INSURANCE COMPANY, LTD. 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, 1997 Property and casualty...................................... $ 123,014 $ (26,222) $ 74 $ 96,866 0.08 % =========== ============ ============ ============ =========== Year ended December 31, 1998 Property and casualty...................................... $ 134,436 $ (68,793) $ (107) $ 65,536 (0.16)% =========== ============ ============ ============ =========== Year ended December 31, 1999 Property and casualty...................................... $ 169,449 $ (41,698) $ 186 $ 127,937 0.15 % =========== ============ ============ ============ ===========
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-35 SCHEDULE V CHANDLER INSURANCE COMPANY, LTD. 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: 1997........................................... $ 177 $ 52 $ (114) $ 115 ================ ================ ================ ================ 1998........................................... $ 115 $ 152 $ (67) $ 200 ================ ================ ================ ================ 1999........................................... $ 200 $ 210 $ (147) $ 263 ================ ================ ================ ================ Allowance for non-collection of reinsurance recoverables on paid and unpaid losses: 1997........................................... $ 491 $ 527 $ (353) $ 665 ================ ================ ================ ================ 1998........................................... $ 665 $ 50 $ (110) $ 605 ================ ================ ================ ================ 1999........................................... $ 605 $ - $ (28) $ 577 ================ ================ ================ ================
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-36 SCHEDULE VI CHANDLER INSURANCE COMPANY, LTD. 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, 1997 Property-casualty........................................ $ - $ 59,052 =============== =============== Year ended December 31, 1998 Property-casualty........................................ $ - $ 59,575 =============== =============== Year ended December 31, 1999 Property-casualty........................................ $ - $ 70,683 =============== ===============
SEE INDEPENDENT AUDITORS' REPORT. PAGE F-37 EXHIBIT 21.1 CHANDLER INSURANCE COMPANY, LTD. AND SUBSIDIARIES SUBSIDIARIES OF THE REGISTRANT 1. Chandler Insurance (Barbados), Ltd., a Barbados company ("Chandler Barbados") that is a wholly owned subsidiary of the Company. 2. Chandler (U.S.A.), Inc., an Oklahoma corporation ("Chandler USA") that is a wholly owned subsidiary of Chandler Barbados. 3. LaGere & Walkingstick Insurance Agency, Inc., an Oklahoma corporation ("L&W") that is a wholly owned subsidiary of Chandler USA. 4. National American Insurance Company, a Nebraska corporation ("NAICO") that is a wholly owned subsidiary of Chandler USA. 5. Network Administrators, Inc., a Texas corporation ("Network") that is a wholly owned subsidiary of Chandler USA. 6. NAICO Indemnity (Cayman), Ltd., a Cayman Islands company ("NAICO Indemnity") that is a wholly owned subsidiary of the Company. 7. Chandler Insurance Management, Ltd., a Cayman Islands company ("CIM") that is a wholly owned subsidiary of the Company. 8. Chandler Insurance Management (Barbados), Ltd., a Barbados company ("CIM Barbados") that is a wholly owned subsidiary of the Company. 9. Windsor Acquisition Corporation, an Oklahoma corporation ("Windsor") that is a wholly owned subsidiary of Chandler Barbados. PAGE F-38 EXHIBIT 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Post-Effective Amendment No. 3 to Form S-2 on Form S-8 Registration Statement No. 33-28436 of Chandler Insurance Company, Ltd. of our report dated February 11, 2000 (which expresses an unqualified opinion and includes an explanatory paragraph relating to litigation discussed in Note 11) appearing in the Annual Report on Form 10-K of Chandler Insurance Company, Ltd. for the year ended December 31, 1999. /s/ Deloitte & Touche DELOITTE & TOUCHE Grand Cayman, Cayman Islands March 20, 2000 EX-27 2
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CHANDLER INSURANCE COMPANY, LTD.'S DECEMBER 31, 1999 FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS DEC-31-1999 DEC-31-1999 108,709 984 1,039 306 0 0 109,999 8,456 3,281 6,488 269,120 98,460 67,769 5,135 0 0 0 0 7,395 43,348 269,120 108,327 5,594 55 11,730 79,816 28,681 14,693 2,516 365 2,151 0 0 0 2,151 0.34 0.34 51,939 74,997 4,819 37,806 32,877 60,921 4,819
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