The Company leases office space at 1099 North Meridian Street, Indianapolis, Indiana in the Landmark Building. This building is located approximately one mile from downtown Indianapolis. The lease covers approximately 65,000 square feet and expires in August, 2003, with an option to renew for an additional ten years. The Company's entire operations, with the exception of Baldwin & Lyons, California, are conducted from these leased facilities.
Baldwin & Lyons, California leases approximately 2,700 square feet of office space in a suburb of Los Angeles, California. The lease expires in August, 1998 with a three year renewal option which the company intends to exercise. All west coast operations are conducted from these facilities.
Shareholders' equity increased to $294.0 million at December 31, 1997, from $273.1 million at December 31, 1996. In addition to current year earnings, this increase includes a $7.1 million increase in unrealized net gains on the Company's investment portfolio from $38.5 million at December 31, 1996 to $45.6 million at December 31, 1997. The increase in shareholders' equity is net of $5.1 million in treasury share purchases and $5.5 million of dividends to shareholders. Book value per common share outstanding increased 9% to $21.23 at December 31, 1997 from $19.46 per share at December 31, 1996.
Premium writings from reinsurance assumed increased by $1.8 million (18.7%) to $11.7 million during 1997. This increase is due principally to $3.9 million relating to the Company's participation in a new excess facultative program, partially offset by lower premiums assumed from voluntary property catastrophe retrocession pools during 1997. The decreased catastrophe assumed premium is attributable to reductions in the Company's shares in these pools during 1997 as well as decreases in gross pool revenues.
Net investment income decreased by $1.1 million (5.8%) during 1997 due to across - -the-board declines in the pre-tax yields on invested assets. The average pre- tax yield on invested assets for 1997 was 5.0% compared to 5.3% for 1996 while the after-tax yield for 1997 was 3.5% compared to 3.7% for 1996. Investment expenses, which are netted directly against income, were relatively unchanged from 1997 and were 6.2% of gross investment income compared to 5.6% for 1996.
Other operating expenses for 1997, before credits for allowances from reinsurers, increased $1.9 million (8.4%) to $24.4 million. Personnel related expenses, including amounts allocated to loss expenses and investment income, decreased $.4 million (2.7%) despite a net 22% increase in the number of employees during the year, attributable to the expansion of the Company's new products. Salary expense during 1996 was increased, as compared to 1997, by larger accruals for equity appreciation rights which are tied to book value and by the issuance of discounted stock options to employees. Direct commission expense increased $2.4 million (71.6%) as the result of increases in premiums from Sagamore's personal automobile product and voluntary reinsurance assumed from catastrophe pools. Allowances from reinsurers decreased $.2 million (21.2%) as the result of the termination of the quota share reinsurance treaty covering the Company's "work accident" program partially offset by an increase in facultative placements. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 33.3% during 1997 compared to 29.2% for 1996. Including the agency operations, which absorbed a portion of the development costs for the Company's new products, the ratio of other operating expenses to total revenue, adjusted to remove net realized gains, was 28.9% for 1997 compared with 27.1% for 1996.
As a result of the factors mentioned above, income from consolidated continuing operations for 1997 was $24.4 million compared to $21.3 million for 1996 and net income for 1997 totaled $24.4 million compared to $21.7 million reported during 1996. Diluted earnings per share increased to $1.75 in 1997 from $1.51 in 1996 due primarily to the increase in realized gains on investments.
1996 COMPARED TO 1995 Direct premiums written for 1996 totaled $63.4 million, a decrease of $4.0 million (6.0%) from 1995. This decrease is primarily attributable to decreases in the majority of the Company's trucking-related products. Large fleet and medium fleet trucking premium writings decreased $9.9 million (29.1%) and $.8 million (20.7%), respectively, reflecting the continued intense competition in these markets which resulted in the non-renewal of several accounts and rate reductions on those accounts renewed. Premium writings for Protective's "work accident" program also decreased by $2.1 million (13.8%) from 1995, reflecting rate reductions on renewed accounts. Decreases in premium writings were also derived from Sagamore's program for small trucking fleet risks and surety premiums related to large fleet risks of $.7 million each. The above decreases were partially offset by an increase in Sagamore's nonstandard private passenger automobile business of $8.8 million (181.6%) from 1995. In addition, premiums for retrospectively rated workers' compensation policies increased $1.3 million reflecting loss development on prior year policies.
After giving effect to changes in unearned premiums, net premiums earned were $58.7 million for 1996, nearly unchanged from 1995. Net premiums earned from all trucking liability insurance products, including small fleet trucking, decreased by $5.7 million (12.8%). Premiums earned from voluntary reinsurance assumed decreased by $1.8 million. The above decreases were offset by a $7.6 million increase in Sagamore's nonstandard private passenger automobile program during 1996.
Net investment income decreased by $.6 million (2.9%) during 1996 due to $.9 million in non-recurring income from the liquidation of a limited partnership during 1995. The average pre-tax yield on invested assets for 1996 was 5.3% compared to 5.9% for 1995 while the after-tax yield for 1996 was 3.7% compared to 4.1% for 1995. Investment expenses, which are netted directly against income, were relatively unchanged from 1995 and were 5.6% of gross investment income compared to 5.3% for 1995.
The Company's net income for 1996 totaled $21.7 million compared to a record $29.4 million reported during 1995, which included a $7.6 million gain on the sale of Hoosier Insurance Company. Earnings per share decreased to $1.51 in 1996 from a record $1.96 in 1995.
The liability method is used in accounting for federal income taxes. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The provision for deferred federal income tax was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. Net deferred tax liabilities of $16.2 million and $10.7 million were recorded at December 31, 1997 and 1996, respectively. The net deferred tax liability at December 31, 1997 included $6.2 million in special tax deposits covered under Section 847 of the Internal Revenue Code, as explained in the following paragraph, which compares to $7.0 million in special tax deposits at December 31, 1996. Adjusted for the special deposits, a net deferred tax liability of $22.4 million was recorded at December 31, 1997 compared to a net deferred tax liability of $17.7 million at December 31, 1996. The increase in deferred federal taxes payable is primarily attributable to changes in unrealized capital gains in the investment portfolio.
A provision in the Technical and Miscellaneous Revenue Act of 1988 created a mechanism which would allow for a recognizable deferred tax asset specifically for property and casualty loss reserves discounted for tax purposes. Adopted as Section 847 of the Internal Revenue Code, this provision allows an insurer to take a special tax deduction equal to the discount on post 1986 accident year loss and loss expense reserves while making "special estimated tax payments" equal to the amount of the tax benefit derived from the special deduction. The "special estimated tax payments" can be carried forward for fifteen years to offset taxes arising from decreases in the special deduction and can be treated as regular estimated payments or refunded at the end of the carryforward period. Based upon the concerns regarding the recognition of deferred tax assets, the Company adopted the provisions of Section 847 for all tax years 1987 and subsequent and has taken deductions for the entire amount of discount on post- 1986 loss reserves. As mentioned above, special Section 847 estimated tax deposits totaling $6.2 million have been paid in connection with this election.
The Company will communicate with its significant suppliers and large customers to determine the extent to which the Company's interface systems are vulnerable to third party failures to remediate Year 2000 system deficiencies. It is believed that the Company's total Year 2000 project costs will not be significantly impacted by third party Year 2000 Issues based on presently available information. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be converted on a timely basis and would not have an adverse effect on the Company's systems. The Company has determined it has no exposure to contingencies related to the Year 2000 Issue for the products it has sold.
The Company will utilize existing staff and other internal resources to reprogram and test its internally developed software, and to test its purchased software, for Year 2000 compliance. Any internally developed software that is deemed unworthy of Year 2000 conversion will be replaced with new internally developed or purchased software that is Year 2000 compliant. Any currently owned purchased software for which Year 2000 upgrades are unavailable will also be replaced with purchased software that is Year 2000 compliant. The Company anticipates completing the Year 2000 project by the first quarter of 1999. The majority of the past and future costs associated with the Year 2000 project can be attributed to internal staffing requirements associated with the development of new product software and would have largely been incurred regardless of the Year 2000 Issue. These costs, and the costs associated with the acquisition of Year 2000 compliant software from outside vendors, are not material with respect to the Company's operations or financial position.
COMPREHENSIVE INCOME During 1997, the Company adopted Financial Accounting Standards Board Statement No. 130, REPORTING COMPREHENSIVE INCOME. Statement No. 130 requires companies to report certain unrealized potential income or loss items, previously recognized only in separate components of shareholders' equity, as "other comprehensive income". Companies are also required to report "comprehensive income" that is comprised of net income and such other comprehensive income items. The Company's only material item of other comprehensive income is the unrealized gain or loss associated with its investment portfolio.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income and retained earnings, changes in equity other than capital, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedules listed in the index at item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
NOTE A - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) RECOGNITION OF REVENUE AND COSTS: Premiums are earned over the period for which insurance protection is provided. A reserve for unearned premiums, computed by the daily pro-rata method, is established to reflect amounts applicable to subsequent accounting periods. Commissions to unaffiliated companies and other acquisition costs applicable to unearned premiums are deferred and expensed as the related premiums are earned. Anticipated investment income is considered in determining recoverability of deferred acquisition costs.
The fair values and the cost or amortized cost of fixed maturity investments at December 31, 1997, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers have, in some cases, the right to call or prepay obligations with or without call or prepayment penalties. Maturities for mortgage-backed securities are determined on a specific identification basis.
Approximately 38% of purchases and 53% of sales of investments during the three years ended December 31, 1997 were made through securities broker-dealers in which certain directors of the Company were officers, directors or owners. Fees earned by affiliated investment advisors were $604, $932 and $965 in 1997, 1996 and 1995, respectively.
The reserves for losses and loss expenses, net of related reinsurance recoverables, at December 31, 1996, 1995 and 1994 were decreased by $7,838, $12,245 and $5,484, respectively, for claims that had occurred on or prior to those dates. These decreases are the result of the settlement of claims at amounts lower than previously reserved and changes in estimates of losses incurred but not reported as part of the normal reserving process. Development during 1997 and 1996, on reserves outstanding at December 31, 1996 and 1995 included $8 and $2,395, respectively, of incurred losses and loss expenses related to environmental damage claims. Reported cases relate primarily to policies issued in the 1970's to one account which was involved in the business of hauling and disposing of hazardous waste. Included in the above amounts are reserves for incurred but not reported environmental losses of $5,000 at both December 31, 1997 and 1996. Adjusted for environmental claims, management believes that the more favorable than anticipated experience may be attributable, at least in part, to changes in trucking safety in general resulting from the implementation of the national commercial driver license, mandatory drug testing and an increased awareness by trucking companies of the cost of unsafe operations. It is further believed that the Company's selection techniques, minimum safety standards and claims handling have also contributed to the current favorable loss experience. These trends were considered in the establishment of the Company's reserves at December 31, 1997.
NOTE C - LOSS AND LOSS EXPENSE RESERVES (CONTINUED) The Company participates in mandatory residual market pools in various states. The Company records the results from participation in these pools as reported and records an additional provision in the financial statements for operating periods unreported by the pools.
NOTE D - INCOME TAXES (CONTINUED) A summary of the difference between federal income tax expense computed at the statutory rate and that reported in the consolidated financial statements is as follows:
NOTE F - OTHER OPERATING EXPENSES Details of other operating expenses are as follows:
The Company records accumulated other comprehensive income from unrealized gains and losses on available-for-sale securities as a separate component of shareholders' equity. Foreign exchange adjustments are immaterial and the Company has no pension plan.
NOTE J - STOCK PURCHASE AND OPTION PLANS In accordance with the terms of the 1981 Stock Purchase Plan (1981 Plan), the Company is obligated to repurchase shares issued under the 1981 Plan, at a price equal to 90% of the book value of the shares at the end of the quarter immediately preceding the date of repurchase. No shares were repurchased during 1997, 1996 or 1995. At December 31, 1997 there were 156,854 shares (Class A) and 398,641 shares (Class B) outstanding which are eligible for repurchase by the Company.
NOTE J - STOCK PURCHASE AND OPTION PLANS (CONTINUED) A summary of the Company's stock option activity and related information for the years ended December 31 follows:
NOTE K - INDUSTRY SEGMENTS The Company and its consolidated subsidiaries operate within the property/casualty insurance industry in two identifiable segments: the insurance brokerage/agency segment and the insurance underwriting segment. The insurance brokerage/agency segment obtains property and casualty insurance coverage for its customers from the insurance underwriting segment and other non-affiliated insurance companies and provides other insurance-related services. The insurance underwriting segment provides multiple line property and casualty insurance coverage for its insureds, primarily for coverage of motor vehicle liability and physical damage and workers' compensation risks. The insurance brokerage/agency segment specializes exclusively in insurance for the trucking industry. The insurance underwriting segment's fleet trucking business is produced by the insurance brokerage/agency segment on a direct basis. Premiums from the private passenger automobile, small fleet trucking and small business workers' compensation markets are produced through an extensive network of independent agents. The insurance underwriting segment also serves as assuming reinsurer on numerous retrocessions from other reinsurers covering both individual property and liability risks and high limit catastrophe pools.
The brokerage/agency segment received essentially all of its commission income from the insurance underwriting segment in 1997, 1996 and 1995. Intersegment commission rates are generally comparable to the average commission rates paid by unaffiliated insurance companies. The insurance underwriting segment received approximately 59% of its direct premium revenue by providing insurance coverage to customers of the brokerage/agency segment (74% and 86%, respectively, in 1996 and 1995). Premiums charged by the insurance underwriting segment to customers of the brokerage/agency segment are comparable to premiums charged to other insureds for similar insurance coverages. Intersegment reimbursements for certain expenses (office space, equipment costs, salaries, etc.) are based upon actual usage and other predetermined allocation methods. Underwriting expenses of the insurance underwriting segment include approximately $10,562 in 1997, $8,303 in 1996 and $7,418 in 1995 representing allocations of general operating expenses from the brokerage/agency segment, which records these reimbursements as reductions in its operating expenses.
Net premium earned by the insurance underwriting segment is produced in all states and all Canadian provinces. The following products accounted for more than 10% of net premium earned by this segment for the years ended December 31, as follows: