The Company owns a small building and the adjacent real estate approximately two miles from its main office. This building contains approximately 3,300 square feet of usable space, and is used primarily as storage facilities and as a contingent back up and disaster recovery site for computer operations.
For several years, the Company's investment philosophy has emphasized the purchase of short-term instruments with maximum quality and liquidity. As interest rates have remained relatively low and yield curves have been essentially flat in recent years, the Company has not committed funds to longer term fixed maturity investments. Recently, however, the Company has extended into slightly longer maturity investments in an effort to increase the yield on its portfolio. As a result, the average life of the Company's bond and short- term investment portfolio was 4.6 years compared to 3.6 years for 1997. The Company also remains an active participant in the equity securities market. Investments made by the Company's domestic insurance subsidiaries are regulated by guidelines promulgated by the National Association of Insurance Commissioners that are designed to provide protection for both policyholders and shareholders.
The effective federal tax rate for consolidated operations for 1998 was 28.7%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.
As a result of the factors mentioned above, net income from consolidated operations for 1998 was $16.9 million compared to $24.4 million for 1997. Diluted earnings per share decreased to $1.22 in 1998 from $1.75 in 1997 due primarily to the decrease in realized gains on investments. Diluted earnings per share from operations before realized gains on investments was $1.09 in 1998 compared to $.94 in 1997.
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.
The effective federal tax rate for consolidated operations for 1997 was 31.4%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.
NOTE: ANTICIPATED COSTS OF THE COMPANY'S YEAR 2000 PROJECT, AS PROVIDED IN THE FOLLOWING DISCUSSION, ARE BASED ON MANAGEMENT'S ESTIMATES OF ULTIMATE TOTAL COSTS AND PERCENTAGES OF COMPLETION WITH RESPECT TO EACH PHASE OF THE PROJECT. THESE ANTICIPATED COSTS HAVE NOT BEEN AUDITED BY OUR INDEPENDENT AUDITORS.
The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs or hardware that have date-sensitive features may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in normal business activities. The insurance industry is especially aware of the Year 2000 concern given that the majority of its products and services are time and date sensitive (e.g., policy effective periods and loss occurrence dates).
The Company has been in the process of developing software for its new and rapidly expanding products since 1995. All internally developed new product software is Year 2000 compliant, with minor exceptions, and currently handles approximately 90% of the Company's processed transactions. The Company is also engaged in an ongoing analysis of its remaining systems to determine the nature and extent of existing deficiencies and the appropriate corrective solutions. The Company believes that with modifications to existing software and conversions to new software, the Year 2000 Issue will not pose significant operational problems for its computer systems. However, if such modifications and conversions are not completed on a timely basis, the Year 2000 Issue could have a significant impact on the operations of the Company.
The Company's plan to resolve the Year 2000 Issue involves the following four phases: assessment, remediation, testing and implementation. To date, the Company has completed is assessment of all mission critical systems and continues to evaluate the needs to repair or replace non mission critical systems. The
completed assessment indicated that most of the Company's significant information technology systems could be affected, particularly with respect to policy and claim processing, billing, general ledger and cash receipts and disbursements systems. To date, the Company's general ledger system and the portions of the remaining systems that handle approximately 90% of the Company's transactions are fully Year 2000 ready.
The Company will continue to 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 June 30, 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. The costs associated with the Year 2000 project can be categorized into three basic areas: 1) Internal resources, mainly programming and technical personnel, used to correct internally developed software. The estimated total cost of this area is anticipated to be approximately $2.5 million with 20% of this amount relating to future costs. 2) Replacement or upgrade of purchased software. The estimated total cost of this area is anticipated to be approximately $1.0 million with 25% of this amount relating to future costs. 3) Upgrading equipment. Most of the hardware replacements and upgrades to date have not been due to the Year 2000 Issue. More than 80% of the Company's network equipment has been replaced over the last eighteen months and all mainframe hardware is less than three years old. Future hardware costs should not exceed $.3 million.
Management believes it has an effective program in place to resolve all Year 2000 issues in a timely manner. As noted above, the Company has not yet completed all necessary phases of the Year 2000 project. In the unlikely event that the Company does not complete all additional phases of this project, the Company may be unable to process policy and claim transactions on certain of its less transaction-volume-intensive products. Currently, the Company has no contingency plans in place in the event this occurs. However, the Company will evaluate the status of completion of its Year 2000 project by June 30, 1999 and determine whether such a contingency plan is necessary.
The costs of the project and the date on which the Company believes it will complete its Year 2000 effort are based on management's best estimates, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ
"management approach" in disclosing information about its industry segments. In compliance with the new standard, the Company has defined its reportable industry segments to be 1) Fleet trucking 2) Non-standard private passenger automobile and 3) Voluntary reinsurance assumed. The Company also offers products for small trucking fleets and workers' compensation to small business. However, premiums generated by these products are not material for purposes of Statement No. 131 and they are included in the "all other" category in Note J to the consolidated financial statements. The Company has restated all prior year data included in Note J in accordance with Statement No. 131.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc. and subsidiaries as of December 31, 1998 and 1997, 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, 1998. 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.
CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS Baldwin & Lyons, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS Baldwin & Lyons, Inc. and Subsidiaries
DISCONTINUED OPERATIONS: The Company sold its interest in Amli Realty, Inc. ("Amli") in 1996. No gain or loss was realized on the Amli sale which was treated as a non-monetary, tax-free exchange. The consolidated statement of cash flows for 1996 includes changes in certain assets and liabilities which are presented without the effects of the sale of Amli.
Certain loss reserves related to permanent total disability claims under workers' compensation coverages are discounted to present value using tables provided by the National Council on Compensation Insurance which are based upon a pretax interest rate of 3.5 percent, and adjusted for losses retained by the insured.
STOCK-BASED COMPENSATION: Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations are used in accounting for stock options, stock purchases and equity appreciation rights which are, from time to time, granted to employees and outside directors.
FEDERAL INCOME TAXES: A consolidated federal income tax return is filed by the Company and includes all wholly owned subsidiaries.
The reserves for losses and loss expenses, net of related reinsurance recoverables, at December 31, 1997, 1996 and 1995 were decreased by $10,741, $7,838 and $12,245, 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 1998 and 1997, on reserves outstanding at December 31, 1997 and 1996 included $1,070 and $8, 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, 1998 and 1997. 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, 1998.
Loss reserves have been reduced by estimated salvage and subrogation recoverable of approximately $1,700 and $1,725 at December 31, 1998 and 1997, respectively.
NOTE D - EMPLOYEE BENEFIT PLANS The Company maintains a defined contribution 401(k) Employee Savings and Profit Sharing Plan ("the Plan") which covers all employees who have completed one year of service. The Company's contributions to the Plan for 1998, 1997 and 1996 were $615, $585 and $499, respectively.
NOTE E - INCOME TAXES (CONTINUED) The components of the provision for deferred federal income taxes (credits) are as follows:
Net premiums earned for 1998, 1997 and 1996 have been reduced by reinsurance ceded premiums of approximately $12,337, $8,091 and $11,698, respectively. Net losses and loss expenses incurred for 1998, 1997 and 1996 have been reduced by reinsurance recoveries of approximately $10,255, $11,155 and $991, respectively. Ceded reinsurance premiums and loss recoveries for catastrophe reinsurance contracts were not material. The Company remains liable to the extent the reinsuring companies are unable to meet their obligations under reinsurance contracts. Net premiums earned for 1998, 1997 and 1996 include approximately $8,338, $10,609 and $10,220, respectively, relating to the assumption of reinsurance from other companies and from reinsurance pools.
Shareholders' equity at December 31, 1998 includes $277,355 representing GAAP shareholder's equity of insurance subsidiaries, of which $39,055 may be transferred by dividend or loan to the parent company without approval by, or notification to, regulatory authorities. An additional $170,724 of shareholder's equity of such insurance subsidiaries may be advanced or loaned to the Company with prior notification to regulatory authorities.
No effect on net income was considered to result from the presumed exercise of the options used in calculating diluted earnings per share. Options to purchase 497,000 shares of common stock at $25.75 per share were issued in December, 1997 and were outstanding at December 31, 1998 and 1997. These options were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the Company's stock.
NOTE J - REPORTABLE SEGMENTS (CONTINUED) The following tables are reconciliations of reportable segment revenues and profits to the Company's consolidated revenue and income from continuing operations before federal income taxes, respectively.
One customer of the fleet trucking segment represents approximately $18,436 of the Company's 1998 consolidated revenue. This same customer provided revenues to the fleet trucking segment of approximately $19,278 and $19,152 in 1997 and 1996, respectively.
The Company maintains stock option plans and has reserved an aggregate of 1,050,000 shares of Class B common stock for the granting of stock options to employees and directors. Discounted options granted to employees are generally exercisable immediately while discounted options granted to directors are generally not exercisable for one year from the date of grant. During 1997, the Company issued 497,000 market value options which become exercisable in one- third increments on the first, second and third anniversary of the date of grant, assuming continued employment with the Company of the optionee. All options expire ten years after the date of grant.
NOTE K - 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: