10-Q 1 edgusa6302010.txt CHANDLER (U.S.A.), INC. 6/30/10 10-Q ------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------------------------------- FORM 10-Q X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE --- SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2010 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE --- SECURITIES EXCHANGE ACT OF 1934 For the Transition Period from to --------- --------- COMMISSION FILE NUMBER: 1-15135 CHANDLER (U.S.A.), INC. (Exact name of registrant as specified in its charter) OKLAHOMA 73-1325906 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 1010 MANVEL AVENUE, CHANDLER, OKLAHOMA 74834 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (405) 258-0804 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO --- --- Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES NO --- --- Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer Accelerated filer -- -- Non-accelerated filer X (Do not check if a smaller reporting company) -- Smaller reporting company -- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES NO X --- --- The number of common shares, $1.00 par value, of the registrant outstanding on July 31, 2010 was 2,484, which are owned by Chandler Insurance Company, Ltd. ------------------------------------------------------------------------------- Page i CHANDLER (U.S.A.), INC. INDEX ----- PART I - FINANCIAL INFORMATION ------------------------------ ITEM 1. FINANCIAL STATEMENTS: -------------------------------- Consolidated Balance Sheets as of June 30, 2010 (unaudited) and December 31, 2009 ..................................................1 Consolidated Statements of Operations for the three months ended June 30, 2010 and 2009 (unaudited) ..............................2 Consolidated Statements of Operations for the six months ended June 30, 2010 and 2009 (unaudited) ..............................3 Consolidated Statements of Comprehensive Income for the three months ended June 30, 2010 and 2009 (unaudited) .......................4 Consolidated Statements of Comprehensive Income for the six months ended June 30, 2010 and 2009 (unaudited) .......................5 Consolidated Statements of Cash Flows for the six months ended June 30, 2010 and 2009 (unaudited) ..............................6 Notes to Interim Consolidated Financial Statements (unaudited) ..............7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND -------------------------------------------------------------------------- RESULTS OF OPERATIONS ............................................15 --------------------- ITEM 4. CONTROLS AND PROCEDURES .............................................21 -------------------------------- PART II - OTHER INFORMATION --------------------------- Item 1. Legal Proceedings ...............................................22 Item 1A. Risk Factors ...................................................22 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ....22 Item 3. Defaults Upon Senior Securities ................................22 Item 4. Reserved .......................................................22 Item 5. Other Information ..............................................22 Item 6. Exhibits .......................................................22 Signatures .................................................................23 PAGE 1 CHANDLER (U.S.A.), INC. CONSOLIDATED BALANCE SHEETS (Amounts in thousands except share amounts)

See accompanying Notes to Interim Consolidated Financial Statements. PAGE 2 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (Amounts in thousands)

See accompanying Notes to Interim Consolidated Financial Statements. PAGE 3 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (Amounts in thousands)

See accompanying Notes to Interim Consolidated Financial Statements. PAGE 4 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Amounts in thousands)

See accompanying Notes to Interim Consolidated Financial Statements. PAGE 5 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Amounts in thousands)

See accompanying Notes to Interim Consolidated Financial Statements. PAGE 6 CHANDLER (U.S.A.), INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Amounts in thousands)

See accompanying Notes to Interim Consolidated Financial Statements. PAGE 7 CHANDLER (U.S.A.), INC. NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED JUNE 30, 2010 AND 2009 (Unaudited) NOTE 1. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements of Chandler (U.S.A.), Inc. ("Chandler USA") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. They do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. However, except as disclosed herein, there have been no material changes in the information included in Chandler USA's Annual Report on Form 10-K for the year ended December 31, 2009. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for the interim periods ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year. The consolidated financial statements include the accounts of Chandler USA and all wholly owned subsidiaries that meet consolidation requirements including National American Insurance Company ("NAICO") and Chandler Insurance Managers, Inc. ("CIMI"). NOTE 2. SEGMENT INFORMATION Chandler USA has two reportable operating segments: property and casualty insurance and agency. The segments are managed separately due to the differences in the nature of the insurance products and services sold. The following table presents a summary of Chandler USA's operating segments for the periods indicated:

PAGE 8 Net premiums earned and losses and loss adjustment expenses within the property and casualty insurance segment can be identified to Chandler USA designated insurance programs and to each line of insurance. Chandler USA's chief operating decision makers review net premiums earned and losses and loss adjustment expenses in assessing the performance of the insurance programs and lines of business. In addition, Chandler USA's chief operating decision makers consider many other factors such as the lines of business offered within an insurance program and the states in which the insurance programs are offered. Certain discrete financial information is not readily available by insurance programs or lines of insurance, including assets, interest income, and investment gains or losses, allocated to each insurance program or line of insurance. Chandler USA does not consider its insurance programs or lines of insurance 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 by insurance program and line of insurance for the property and casualty insurance segment.

PAGE 9 NOTE 3. COMMITMENTS AND CONTINGENCIES During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for three years. During March 2004 and March 2007, the lease was extended for additional three year terms, and during March 2010, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $10,929 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime which was 4.25% at June 30, 2010. The interest rate is subject to a minimum rate of 5.5%. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.5 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.2 million. Chandler USA has guaranteed the obligations of Chandler Capital Trust I and Chandler Capital Trust II (the "Capital Trusts") with respect to the trust preferred securities they have outstanding. The Capital Trusts distribute the interest received from Chandler USA on the junior subordinated debentures to the holders of the trust preferred securities to fulfill their obligations with respect to such securities. The Capital Trusts are wholly owned non- consolidated subsidiaries of Chandler USA. Chandler USA guarantees payment of distributions and the redemption price of the trust preferred securities until the securities are redeemed in full. The total redemption price of the trust preferred securities is $20.0 million. NOTE 4. LITIGATION In October 1999, NAICO provided surety bonds for Gulsby Engineering, Inc. ("Gulsby") in connection with contracts between Gulf Liquids New River Project, LLC ("Gulf Liquids") and Gulsby for the construction of two gas processing plants in Louisiana. During 2001, Gulsby became unable to pay various vendors resulting in payments to vendors by NAICO totaling $20,182,499. In August 2001, NAICO filed suit in federal court in Louisiana alleging that Gulf Liquids had breached its obligations under the bonds by materially altering certain contracts and that, as a result, NAICO was exonerated on the bonds and should recover the amounts paid to vendors. In the fall of 2001, Gulsby and Bay Limited, another contractor with whom Gulsby had entered into a joint venture for the construction of other gas processing plants for Gulf Liquids, filed lawsuits relating to those plants in Houston, Texas. Gulf Liquids filed original actions and counterclaims. NAICO intervened in the Texas lawsuits and, in addition, sued Williams Energy Marketing and Trading (which later became Williams Power Company, Inc.) ("Williams") alleging fraud, breach of contract, tortious interference with contractual relations, conspiracy and alter ego. These claims were asserted against both Gulf Liquids and Williams. Gulf Liquids asserted counterclaims alleging breach of contract against NAICO and requesting contractual and statutory damages ranging from $40 million to $80 million. The cases were consolidated for trial in the 215th Judicial District Court in Harris County, Texas. The trial in the Harris County cases began in late April 2006, and concluded August 1, 2006. The jury found in favor of NAICO and Gulsby, Bay Limited and the joint venture between Gulsby and Bay Limited ("Gulsby-Bay Plant Partners") on all counts and fixed damages against Gulf Liquids and Williams totaling $402,568,089. The damages determined by the jury included a total of $325 million in punitive damages. Among other findings, the jury found: 1. Williams tortiously interfered with NAICO's contractual relationship with Gulsby and Gulf Liquids; and 2. Williams fraudulently induced NAICO to issue the surety bonds; and 3. Williams defrauded NAICO after the bonds were issued; and 4. Williams' actions were malicious; and 5. Gulf Liquids fraudulently induced NAICO to issue the surety bonds; and 6. Gulf Liquids breached its obligations to NAICO under the bonds; and 7. Williams is responsible for the claims against Gulf Liquids because Gulf Liquids is the alter ego of Williams; and 8. There were material alterations (cardinal changes) to the contracts NAICO bonded. The amounts the jury found owing to NAICO included $20,182,499 in actual damages, against both Gulf Liquids and Williams, $20 million in punitive damages against Gulf Liquids, and $50 million in punitive damages against Williams. The verdicts in favor of Gulsby included $20,941,436 in actual damages against both Gulf Liquids and Williams, $25 million in punitive damages against Gulf Liquids and $60 million in punitive damages against Williams. NAICO is subrogated to any recovery by Gulsby to the extent of NAICO's losses on the bonds including loss adjustment expenses with interest from the date the losses and loss expenses were paid. PAGE 10 A significant amount of NAICO's losses on the surety bonds were ceded to various reinsurers and NAICO will be required to reimburse these reinsurers in accordance with the agreements between NAICO and the reinsurers. On January 28, 2008, the court entered a final judgment denying Gulf Liquid's claims against NAICO and Gulsby, denying all of NAICO's claims against Gulf Liquids and Williams, and entering judgment for Gulsby against Gulf Liquids for $15,651,927 plus interest at 7.25% compounded annually from January 28, 2008 until paid. The court also ordered Gulf Liquids to pay Gulsby's taxable court costs, estimated at $100,000. Gulf Liquids has appealed the judgment entered in favor of Gulsby and the denial of its claims against NAICO and Gulsby. NAICO has appealed the trial court's denial of its claims against Gulf Liquids and Williams and seeks entry of judgment upon the jury verdicts for the amounts the jury found should be awarded to NAICO. Gulsby has also appealed the trial court's final judgment, contending that judgment should be entered in its favor against Gulf Liquids and Williams in accordance with the jury verdicts. The recoverable amounts deducted from Chandler USA's net liability for losses and loss adjustment expenses related to this litigation were approximately $10.1 million at June 30, 2010 and December 31, 2009. NOTE 5. NEW ACCOUNTING STANDARDS Chandler USA has reviewed the recently issued accounting pronouncements and concluded that the following new accounting standards and accounting standard updates are applicable to Chandler USA. In June 2009, the Financial Accounting Standards Board ("FASB") issued new guidance on the accounting for transfers of financial assets. The new guidance requires additional disclosures for transfers of financial assets, including securitization transactions, and any continuing exposure to the risks related to transferred financial assets. There is no longer a concept of a qualifying special-purpose entity, and the requirements for derecognizing financial assets have changed. Chandler USA has adopted this new guidance as of January 1, 2010. The adoption of this new guidance did not have any impact on its consolidated financial statements. In June 2009, the FASB issued new guidance on the accounting for variable interest entities. The new guidance requires an enterprise to perform an analysis to determine whether the enterprise's variable interest or interests give it a controlling financial interest in a variable interest entity; to require ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity; to eliminate the quantitative approach previously required for determining the primary beneficiary of a variable interest entity; to add an additional reconsideration event for determining whether an entity is a variable interest entity when any changes in facts and circumstances occur such that holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity's economic performance; and to require enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise's involvement in a variable interest entity. Chandler USA has adopted this new guidance as of January 1, 2010. The adoption of this new guidance did not have any impact on its consolidated financial statements. While the trusts that hold Chandler USA's junior subordinated debentures are variable interest entities, and Chandler USA has 100% ownership and has guaranteed the performance of the trusts, Chandler USA is not the primary beneficiary because its interest is not variable. Therefore, Chandler USA does not consolidate the trusts under this new guidance. In January 2010, the FASB issued new guidance on improving disclosures about fair value measurements. The new guidance does not change how fair values are measured. Chandler USA has adopted this new guidance as of January 1, 2010. The adoption of this new guidance did not have any impact on its consolidated financial statements. The disclosures required by this new guidance are included in Note 7. In July 2010, the FASB issued new guidance on disclosures about the credit quality of financing receivables and the allowance for credit losses. The new guidance is effective for interim and annual reporting periods ending after December 15, 2010. The new guidance requires additional disclosures about financing receivables and the allowances for credit losses. The new guidance does not change how financing receivables or allowances for credit losses are measured. Accordingly, except for the additional disclosures, Chandler USA does not anticipate that the initial application of the new guidance will have any impact on Chandler USA's consolidated financial statements. PAGE 11 NOTE 6. INVESTMENTS AND INVESTMENT INCOME Net investment income and realized investment gains are summarized in the following table. These amounts are net of investment expenses.

Investment expenses included $21,000 and $39,000 in the second quarter and first six months of 2010, and $26,000 and $54,000 in the second quarter and first six months of 2009, 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:

PAGE 12 Other than investments in bonds and notes of the U.S. Government and U.S. Government agencies and authorities, Chandler USA did not hold any fixed maturity investments that exceeded 10% of shareholder's equity at June 30, 2010 or December 31, 2009. The fair value of Chandler USA's investments with continuous gross unrealized losses at June 30, 2010 is presented below:

The unrealized losses of Chandler USA's fixed maturity investments were primarily caused by changes in market interest rates since the date of purchase, current conditions in the capital markets and the impact of those conditions on market prices. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Chandler USA regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Based on an evaluation of the issues, including, but not limited to, Chandler USA's intentions to sell or ability to hold the investments; the length of time and amount of the unrealized loss; and the credit ratings of the issuers of the investments, Chandler USA does not consider these investments to be other-than-temporarily impaired at June 30, 2010. 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 June 30, 2010 are shown below:

Realized gains and losses from sales of investments are shown below:

PAGE 13 The mortgage loan on real estate is recorded at carrying value, which is comprised of the original cost net of repayments. The mortgage loan has an interest rate of prime plus 1%, which was 4.25% at June 30, 2010. The mortgage loan contract requires monthly payments of both principal and interest. The mortgage loan contract is due upon demand, and has an amortization period of 10 years. NAICO is required to deposit cash and securities with regulatory agencies in which it is licensed as a condition of conducting operations in the state. In addition, NAICO has deposited cash and securities into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer. NAICO has also established a letter of credit in the amount of $500,000 and pledged cash and investments in this amount to secure reserves assumed under a reinsurance agreement. Certain insurance companies require CIMI to hold unremitted net insurance premiums in a fiduciary capacity until disbursed by CIMI. At June 30, 2010, the total amount of cash and securities restricted as a result of these arrangements was $34.3 million which was a decrease of $3.3 million from December 31, 2009. NOTE 7. FAIR VALUE MEASUREMENTS Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The quality and reliability of the information used to determine fair values is prioritized into three broad categories, with the highest priority given to Level 1 inputs and the lowest priority to Level 3 inputs. These levels are defined as follows: Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2 - Observable inputs other than quoted prices included within Level 1 for the asset or liability, either directly or indirectly. If an asset or liability has a specified term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 3 - Unobservable inputs for the asset or liability. The following table presents information about Chandler USA's assets measured at fair value on a recurring basis as of June 30, 2010 and December 31, 2009, and indicates the fair value hierarchy of the valuation techniques utilized to determine such values. Substantially all of the prices of fixed maturities, equity securities and short-term investments that are valued as Level 1 or Level 2 in the fair value hierarchy are received from independent pricing services utilized by our investment custodians. No liabilities were measured at fair value at June 30, 2010 or December 31, 2009.

PAGE 14

Prices for fixed maturities available for sale and short-term investments were provided by various custodians that hold such assets on behalf of Chandler USA. The custodians utilize independent pricing services to determine prices for these assets. Management reviews the prices provided but does not conduct an independent validation of the prices. Any fixed maturities that are not held by a custodian are priced using non-binding broker quotations. Total assets priced from broker quotations totaled $382,000 at June 30, 2010 and December 31, 2009, or 0.4% of total Level 2 assets in each period. There were no transfers into or out of Level 1 or Level 2 during the second quarter or six months ended June 30, 2010. At June 30, 2010, Chandler USA's equity securities which were measured at fair value using Level 3 inputs consisted of common stock received in connection with an unaffiliated entity's conversion to a for-profit corporation. The fair value of this stock was based upon an analytically determined valuation from an independent rating organization. The following table presents additional information about assets measured at fair value using Level 3 inputs for the three and six month periods ended June 30, 2010:

PAGE 15 NOTE 8. FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS Estimated fair value amounts have been determined by Chandler USA using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates of fair values presented herein are not necessarily indicative of the amounts that Chandler USA could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. A number of Chandler USA's significant assets (including deferred policy acquisition costs, property and equipment, reinsurance recoverables, prepaid reinsurance premiums and state insurance licenses) and liabilities (including unpaid losses and loss adjustment expenses and unearned premiums) are not considered financial instruments. Based on the short term nature or other relevant characteristics, Chandler USA has concluded that the carrying value of other assets and liabilities considered financial instruments, such as cash equivalents, mortgage loan on real estate, premiums receivable, policyholder deposits, accrued taxes and other payables, and premiums payable, approximates their fair value as of June 30, 2010 and December 31, 2009. The estimated fair values of Chandler USA's fixed-maturity and equity security investments are disclosed at Note 6. The fair value of Chandler USA's senior debentures was estimated to be $7.3 million as of June 30, 2010 and $7.1 million at December 31, 2009, based on an analytically determined valuation from an independent rating organization. Chandler USA's senior debentures have not historically traded regularly, and settlement at the reported fair value may not be possible. The senior debentures are redeemable by Chandler USA without penalty or premium and may be purchased and cancelled by Chandler USA at a price of less than the sum of the principal amount and accrued interest at any time. Chandler USA is obligated for $13.4 million principal amount of junior subordinated debentures that mature in 2033 with a fixed interest rate of 9.75%, and $7.2 million principal amount of junior subordinated debentures that mature in 2034 with a floating rate of 4.10% over LIBOR. The interest rate at June 30, 2010 was 4.40%. The fair value of Chandler USA's junior subordinated debentures was estimated to be $23.3 million and $22.0 million at June 30, 2010 and December 31, 2009, respectively. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS Some of the statements made in this Form 10-Q report, as well as statements made by Chandler (U.S.A.), Inc. ("Chandler USA") in periodic press releases and oral statements made by Chandler USA's officials constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of Chandler USA to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such factors include, among other things, (i) general economic and business conditions; (ii) interest rate changes; (iii) competition and regulatory environment in which Chandler USA and its subsidiaries operate, including the ability to implement price increases; (iv) claims frequency; (v) claims severity; (vi) catastrophic events of unanticipated frequency or severity; (vii) the number of new and renewal policy applications submitted to National American Insurance Company ("NAICO") by its agents; (viii) the ability of NAICO to obtain adequate reinsurance in amounts and at rates that will not adversely affect its competitive position; (ix) the ability of NAICO to collect reinsurance recoverables; (x) the ability of NAICO to maintain favorable insurance company ratings; and (xi) various other factors including ongoing litigation matters. PAGE 16 RESULTS OF OPERATIONS PREMIUMS EARNED The following table sets forth premiums earned on a gross basis (before reductions for premiums ceded to reinsurers) and on a net basis (after such reductions) for each insurance program as well as each line of insurance for the periods indicated:

Gross premiums earned decreased $732,000 or 3% and $2.8 million or 6% in the second quarter and first six months of 2010, respectively, compared to the 2009 periods. Net premiums earned decreased $323,000 or 2% and $1.9 million or 7% for the second quarter and first six months of 2010, respectively. Gross premiums earned in the standard lines program increased $105,000 or less than 1% and decreased $1.3 million or 3% in the second quarter and first six months of 2010, respectively, compared to the 2009 periods. Gross premiums earned from trucking accounts in this program decreased $23,000 and $1.2 million in the second quarter and first six months of 2010, respectively. Gross premiums earned in this program for other liability decreased $448,000 and $925,000 in the second quarter and first six months of 2010, respectively, and gross premiums earned in this program for automobile physical damage decreased $100,000 and $854,000 in the second quarter and first six months of 2010. Gross premiums earned in this program for automobile liability increased $33,000 and decreased $596,000 in the second quarter and first six months of 2010. These decreases were partially offset by increases in property, inland marine and workers compensation premiums. Net premiums earned in this program increased $273,000 or 2% and decreased $923,000 or 3% in the second quarter and first six months of 2010, respectively. PAGE 17 From January 2007 to the second quarter of 2009, the property and inland marine lines of insurance that were previously written by NAICO in the standard lines program were written by Praetorian Insurance Company ("Praetorian") through an arrangement between Praetorian and CIMI. Under this arrangement, CIMI received commission income for the business it produced for Praetorian. NAICO handles all claims for this business under a separate claims handling agreement with Praetorian. CIMI and Praetorian terminated this arrangement effective June 29, 2009, and NAICO resumed writing these lines of insurance in this program. Gross premiums earned in the political subdivisions program decreased $718,000 or 73% and $1.4 million or 69% in the second quarter and first six months of 2010, respectively, compared to the 2009 periods. Net premiums earned in this program decreased $476,000 or 75% and $895,000 or 70% in the second quarter and first six months of 2010, respectively. From January 2007 to the second quarter of 2009, the property and inland marine lines of insurance in the political subdivisions program that were previously written by NAICO were written by Praetorian through an arrangement between Praetorian and CIMI. CIMI and Praetorian terminated this arrangement effective June 29, 2009. Effective June 1, 2009, the property, inland marine, automobile liability, automobile physical damage and other liability lines of insurance in the political subdivisions program that were previously written by NAICO are being written by Greenwich Insurance Company ("Greenwich") through an arrangement with CIMI. Under this arrangement, CIMI receives commission income for the business it produces. CIMI is responsible for the payment of commissions to the producing agents, and is also responsible for providing underwriting and loss control services for this business. NAICO handles all claims for this business under a separate claims handling agreement with Greenwich. NAICO will continue to write workers compensation coverages for the political subdivisions program and reinsures on a quota share basis 35% of the first $1,000,000 of loss per occurrence of the other liability business in this program. During July 2010, Greenwich provided notice of termination of CIMI's underwriting authority for this business effective November 17, 2010. CIMI is currently evaluating other alternatives for placing this business. NET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS At June 30, 2010, Chandler USA's investment portfolio consisted primarily of fixed income U.S. Treasury and government agency bonds, high-quality corporate and tax exempt bonds, certificates of deposit insured by the FDIC and a real estate mortgage loan, with approximately 13% invested in cash and money market instruments. Income generated from this portfolio is largely dependent upon prevailing levels of interest rates. Chandler USA's portfolio contains no non-investment grade bonds or real estate investments. Chandler USA also receives interest income from related parties on intercompany loans. Net investment income, excluding interest income from related parties decreased $49,000 or 6% and decreased $77,000 or 5% in the second quarter and first six months of 2010, respectively. The decreases in 2010 were due primarily to lower interest rates. Cash and invested assets were $117.9 million at June 30, 2010 compared to $111.1 million at December 31, 2009 and $112.9 million at June 30, 2009. Net interest income from related parties decreased $5,000 and $1,000 in the second quarter and first six months of 2010, respectively. Net realized investment gains were $167,000 and $1.1 million during the second quarter and first six months of 2010, respectively. The realized gains resulted from sales of fixed maturities available for sale in the amount of $36.2 million. Net realized investment gains were $805,000 and $1.2 million during the second quarter and first six months of 2009. OTHER INCOME Other income was $436,000 and $928,000 in the second quarter and first six months of 2010, respectively, compared to $332,000 and $775,000 in the second quarter and first six months of 2009. The increases in the 2010 periods were due primarily to an increase in commission income related to business produced by CIMI for insurance companies other than NAICO. Other income included net commission income related to business produced by CIMI for insurance companies other than NAICO totaling $326,000 and $742,000 in the second quarter and first six months of 2010, respectively, compared to $222,000 and $520,000 in the second quarter and first six months of 2009. PAGE 18 LOSSES AND LOSS ADJUSTMENT EXPENSES Chandler USA estimates losses and loss adjustment expenses based on historical experience and payment and reporting patterns for the type of risk involved. These estimates are based on data available at the time of the estimate and are periodically reviewed by independent professional actuaries. Although such estimates are management's best estimates of the expected values, the ultimate liability for unpaid claims may vary from these values. The percentage of losses and loss adjustment expenses to net premiums earned ("loss ratio") was 59.3% and 60.7% for the second quarter and first six months of 2010, compared to 66.9% and 61.1% in the corresponding 2009 periods. During the second quarter of 2010, NAICO experienced an increase in losses incurred related to prior accident years totaling $148,000 which increased the loss ratio by 1.1 percentage points. Loss reserve development for the first six months of 2010 was redundant by $270,000 which decreased the loss ratio by 1.0 percentage points. In the second quarter of 2009, losses and loss adjustment expenses incurred related to prior accident years were $315,000 and increased the loss ratio by 2.2 percentage points. Loss reserve development for the first six months of 2009 was redundant by $15,000. Weather-related losses from wind and hail totaled $193,000 in the second quarter and first six months of 2010 and increased the respective loss ratios by 1.4 and 0.7 percentage points. Weather-related losses totaled $62,000 and $79,000 in the second quarter and first six months of 2009, and increased the respective 2009 loss ratios by 0.4 and 0.3 percentage points. POLICY ACQUISITION COSTS Policy acquisition costs consist of costs associated with the acquisition of new and renewal business and generally include direct costs such as premium taxes, commissions to agents and ceding companies and premium-related assessments and indirect costs such as salaries and expenses of personnel who perform and support underwriting activities. NAICO also receives ceding commissions from the reinsurers who assume premiums from NAICO under certain reinsurance contracts and the ceding commissions are accounted for as a reduction of policy acquisition costs. Direct policy acquisition costs and ceding commissions are deferred and amortized over the terms of the policies. When the sum of anticipated losses, loss adjustment expenses and unamortized policy acquisition costs exceeds the related unearned premiums, including anticipated investment income, a provision for the indicated deficiency is recorded. The following table sets forth Chandler USA's policy acquisition costs for each of the periods indicated:

Total gross direct and indirect expenses as a percentage of direct written and assumed premiums were 25.9% and 25.4% for the second quarter and first six months of 2010, compared to 25.3% and 24.7% in the corresponding year ago periods. Commissions expense as a percentage of gross written and assumed premiums was 14.7% in the second quarter and the first six months of 2010 compared to 14.0% and 14.4% in the corresponding 2009 periods. PAGE 19 Indirect underwriting expenses increased $10,000 and $53,000 in the second quarter and first six months of 2010, respectively, and were 6.7% of total direct written and assumed premiums in the second quarter and first six months of 2010, respectively, compared to 6.9% and 6.3% in the corresponding 2009 periods. Indirect expenses include general overhead and administrative costs associated with the acquisition of new and renewal business, some of which is relatively fixed in nature, thus, the percentage of such expenses to direct written and assumed premiums will vary depending on Chandler USA's overall premium volume. Commissions received from reinsurers as a percent of ceded reinsurance premiums were 25.7% and 25.9% in the second quarter and first six months of 2010, respectively, compared to 30.5% and 31.7% in the corresponding 2009 periods. Commissions received from reinsurers decreased $437,000 and $1.2 million in the second quarter and first six months of 2010 compared to the corresponding year-ago periods due to a reduction in the ceding commission rate on premiums ceded to related parties. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses increased $462,000 and $352,000 in the second quarter and first six months of 2010, respectively, and were 14.0% and 13.8% of gross premiums earned and other income in the second quarter and first six months of 2010, respectively, compared to 11.7% and 12.3% for the corresponding 2009 periods. General and administrative expenses have historically not varied in direct proportion to Chandler USA's revenues. A portion of such expenses is allocated to policy acquisition costs (indirect underwriting expenses) and loss and loss adjustment expenses based on various factors including employee counts, salaries, occupancy and specific identification. Because certain types of expenses are fixed in nature, the percentage of such expenses to revenues will vary depending on Chandler USA's overall premium volume. INTEREST EXPENSE Interest expense decreased $17,000 and $38,000 in the second quarter and first six months of 2010, respectively, compared to the 2009 periods. Substantially all of Chandler USA's interest expense is related to its outstanding senior debentures and junior subordinated debentures. The decrease in the 2010 periods was due to lower interest rates during 2010, as a portion of Chandler USA's junior subordinated debentures were issued with a floating interest rate. LIQUIDITY AND CAPITAL RESOURCES In the first six months of 2010, Chandler USA provided $2.7 million in cash from operations. Unpaid losses and loss adjustment expenses increased $2.2 million, premiums receivable decreased $3.7 million and accrued taxes and other payables increased $864,000 during the first six months of 2010. These were partially offset by an increase in reinsurance recoverable on unpaid losses of $2.4 million, an increase in deferred policy acquisition costs of $794,000 and a decrease in policyholder deposits of $694,000. In the first six months of 2009, Chandler USA provided $10.9 million in cash from operations. Unpaid losses and loss adjustment expenses increased $8.7 million, premiums receivable decreased $4.2 million and policyholder deposits increased $2.5 million during the first six months of 2009. These were partially offset by an increase in reinsurance recoverable on unpaid losses of $5.8 million. NAICO is required to deposit cash and securities with regulatory agencies in which it is licensed as a condition of conducting operations in the state. In addition, NAICO has deposited cash and securities into a trust account as collateral for a reinsurance agreement in which NAICO is the assuming reinsurer. NAICO has also established a letter of credit in the amount of $500,000 and pledged cash and investments in this amount to secure reserves assumed under a reinsurance agreement. Certain insurance companies require CIMI to hold unremitted net insurance premiums in a fiduciary capacity until disbursed by CIMI. At June 30, 2010, the total amount of cash and securities restricted as a result of these arrangements was $34.3 million which was a decrease of $3.3 million from December 31, 2009. At June 30, 2010, Chandler USA's parent company, Chandler Insurance Company, Ltd., owed approximately $11.7 million to Chandler USA versus $12.7 million at December 31, 2009 under an Intercompany Credit Agreement (the "Credit Agreement") covering intercompany loans between the parties. The Credit Agreement requires interest to be paid at the prime interest rate published in the Wall Street Journal each month, and balances owed by either party are payable at any time upon demand. PAGE 20 During March 2001, Chandler USA entered into a $3.8 million sale and leaseback transaction for certain owned equipment for three years. During March 2004 and March 2007, the lease was extended for three years and during March 2010, the lease was extended for an additional three years with monthly rental installments equal to the sum of (i) $10,929 plus (ii) interest on the unpaid lease balance at 1% over JP Morgan Chase Bank prime which was 4.25% at June 30, 2010. The interest rate is subject to a minimum rate of 5.5%. Chandler USA has the option to repurchase the equipment at the end of the lease for approximately $1.5 million (the "Balloon Payment"), or may elect to have the lessor sell the equipment. If the election to sell the equipment is made, Chandler USA would retain any proceeds exceeding the Balloon Payment. If the proceeds were less than the Balloon Payment, Chandler USA would be required to pay the difference between the proceeds and the Balloon Payment, not to exceed approximately $1.2 million. Chandler USA is a holding company receiving cash principally through borrowings, subsidiary dividends and other payments, subject to various regulatory restrictions. The capacity of insurance companies to write insurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for Chandler USA's subsidiaries are funds generated from insurance premiums, investment income, capital contributions from Chandler USA and proceeds from sales and maturities of portfolio investments. The principal expenditures are payment of losses and loss adjustment expenses, insurance operating expenses and commissions. A significant portion of Chandler USA's consolidated assets represents assets of NAICO that may not be immediately transferable to Chandler USA in the form of shareholder dividends, loans, advances or other payments. Statutes and regulations governing NAICO and other insurance companies domiciled in Oklahoma regulate the payment of shareholder dividends and other payments by NAICO to Chandler USA. Under applicable Oklahoma statutes and regulations, NAICO is permitted to pay shareholder dividends only out of statutory earned surplus. To the extent NAICO has statutory earned surplus, NAICO may pay shareholder dividends only to the extent that such dividends are not defined as extraordinary dividends or distributions. If the dividends are, under applicable statutes and regulations, extraordinary dividends or distributions, regulatory approval must be obtained. Under the applicable Oklahoma statute, and subject to the availability of statutory earned surplus, the maximum shareholder dividend that may be declared (or cash or property distribution that may be made) by NAICO in any one calendar year without regulatory approval is the greater of (i) NAICO's statutory net income, excluding realized capital gains, for the preceding calendar year; or (ii) 10% of NAICO's statutory policyholders' surplus as of the preceding calendar year end, not to exceed NAICO's statutory earned surplus. As of December 31, 2009, NAICO had statutory earned surplus of $15.5 million. Applying the Oklahoma statutory limits described above, the maximum shareholder dividend NAICO may pay in 2010 without the approval of the Oklahoma Department of Insurance is $5.4 million. NAICO paid cash shareholder dividends of $300,000 to Chandler USA in March 2010 and $1.1 million in June 2010. NAICO paid cash shareholder dividends of $500,000 to Chandler USA in March 2009 and $900,000 in June 2009. In addition to the statutory limits described above, the amount of shareholder dividends and other payments to affiliates can be further limited by contractual or regulatory restrictions or other agreements with regulatory authorities restricting dividends and other payments, including regulatory restrictions that are imposed as a matter of administrative policy. If insurance regulators determine that payment of a shareholder dividend or other payments to an affiliate (such as payments under a tax sharing agreement, payments for employee or other services, or payments pursuant to a surplus note) would be hazardous to such insurance company's policyholders or creditors, the regulators may block such payments that would otherwise be permitted without prior approval. Historically, NAICO has played a significant role in the servicing of debt and other obligations of Chandler USA through the payment of shareholder dividends. These obligations include $7.0 million of 8.75% senior debentures due in 2014, $13.4 million of 9.75% junior subordinated debentures due in 2033, $7.2 million of floating rate junior subordinated debentures due in 2034 and the obligations under the sale and leaseback transaction discussed previously. To the extent that the restrictions discussed previously limit NAICO's ability to pay shareholder dividends or other payments to Chandler USA, Chandler USA's ability to satisfy the debt obligations may also be limited. PAGE 21 LITIGATION In October 1999, NAICO provided surety bonds for Gulsby Engineering, Inc. ("Gulsby") in connection with contracts between Gulf Liquids New River Project, LLC ("Gulf Liquids") and Gulsby for the construction of two gas processing plants in Louisiana. During 2001, Gulsby became unable to pay various vendors resulting in payments to vendors by NAICO totaling $20,182,499. In August 2001, NAICO filed suit in federal court in Louisiana alleging that Gulf Liquids had breached its obligations under the bonds by materially altering certain contracts and that as a result, NAICO was exonerated on the bonds and should recover the amounts paid to vendors. In the fall of 2001, Gulsby and Bay Limited, another contractor with whom Gulsby had entered into a joint venture for the construction of other gas processing plants for Gulf Liquids, filed lawsuits relating to those plants in Houston, Texas. Gulf Liquids filed original actions and counterclaims. NAICO intervened in the Texas lawsuits and, in addition, sued Williams Energy Marketing and Trading (which later became Williams Power Company, Inc.) ("Williams") alleging fraud, breach of contract, tortious interference with contractual relations, conspiracy and alter ego. These claims were asserted against both Gulf Liquids and Williams. Gulf Liquids asserted counterclaims alleging breach of contract against NAICO and requesting contractual and statutory damages ranging from $40 million to $80 million. The cases were consolidated for trial in the 215th Judicial District Court in Harris County, Texas. On August 1, 2006, the jury trial concluded in Harris County, Texas, related to the construction of two gas processing plants in Louisiana. The amounts the jury found owing to NAICO included approximately $20.2 million in actual damages and $70.0 million in punitive damages. See Note 4 of Notes to Consolidated Financial Statements for a discussion of this jury verdict. On January 28, 2008, the court entered a final judgment denying Gulf Liquid's claims against NAICO and Gulsby, denying all of NAICO's claims against Gulf Liquids and Williams, and entering judgment for Gulsby against Gulf Liquids for $15,651,927 plus interest at 7.25% compounded annually from January 28, 2008 until paid. The court also ordered Gulf Liquids to pay Gulsby's taxable court costs, estimated at $100,000. Gulf Liquids has appealed the judgment entered in favor of Gulsby and the denial of its claims against NAICO and Gulsby. NAICO has appealed the trial court's denial of its claims against Gulf Liquids and Williams and seeks entry of judgment upon the jury verdicts for the amounts the jury found should be awarded to NAICO. Gulsby has also appealed the trial court's final judgment, contending that judgment should be entered in its favor against Gulf Liquids and Williams in accordance with the jury verdicts. The recoverable amounts deducted from Chandler USA's net liability for losses and loss adjustment expenses related to this litigation were approximately $10.1 million at June 30, 2010 and December 31, 2009. ITEM 4. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES As of the end of the period covered by this report and pursuant to Rule 13a-15 of the Securities Exchange Act of 1934 (the "Exchange Act"), Chandler USA's management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness and design of Chandler USA's disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act). Based upon that evaluation, Chandler USA's Chief Executive Officer and Chief Financial Officer concluded, as of the end of the period covered by this report, that Chandler USA's disclosure controls and procedures were effective in recording, processing, summarizing and reporting information required to be disclosed by Chandler USA, within the time periods specified in the Securities and Exchange Commission's rules and forms. CHANGES IN INTERNAL CONTROLS In addition and as of the end of the period covered by this report, there have been no changes in internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the quarter to which this report relates that have materially affected or are reasonably likely to materially affect, the internal control over financial reporting. PAGE 22 PART II. OTHER INFORMATION ----------------- Item 1. LEGAL PROCEEDINGS ----------------- Chandler USA and its subsidiaries are not parties to any material litigation other than as is routinely encountered in their respective business activities. While the outcome of these matters cannot be predicted with certainty, Chandler USA does not expect these matters to have a material adverse effect on its financial condition, results of operations or cash flows. See Note 4 of Notes to Interim Consolidated Financial Statements for a discussion of a favorable jury verdict in civil litigation regarding certain surety bond claims. Item 1A. RISK FACTORS ------------ There have been no material changes from risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009. Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS ----------------------------------------------------------- None. Item 3. DEFAULTS UPON SENIOR SECURITIES ------------------------------- None. Item 4. RESERVED -------- None. Item 5. OTHER INFORMATION ----------------- None. Item 6. EXHIBITS -------- 31.1 Rule 13a-14(a)/15d-14(a) Certifications. 32.1 Section 1350 Certifications. PAGE 23 SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: August 10, 2010 CHANDLER (U.S.A.), INC. By: /s/ W. Brent LaGere -------------------------------------- W. Brent LaGere Chairman of the Board and Chief Executive Officer (Principal Executive Officer) By: /s/ Mark C. Hart -------------------------------------- Mark C. Hart Senior Vice President - Finance, Chief Financial Officer and Treasurer (Principal Accounting Officer)

CHANDLER USA INC 10-Q