MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ----------------------------------------------------
For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds with maximum quality and liquidity. As interest rates and yield curves have not provided a strong incentive to lengthen maturities in recent years, the Company has maintained and, during 2005, increased its short-term position with respect to the vast majority of its fixed maturity investments in anticipation of interest rate increases, such as those that occurred in 2005. The average contractual life of the Company's bond and short-term investment portfolio has remained just above two years and the average duration has remained slightly below two years. The Company also remains an active participant in the equity securities market using capital which is in excess of amounts considered necessary to fund current operations. The long-term horizon for the Company's equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuation, is the primary focus. Investments made by the Company's domestic insurance subsidiaries are regulated by guidelines promulgated by the National Association of Insurance Commissioners which are designed to provide protection for both policyholders and shareholders.
As more fully discussed in Note G to the consolidated financial statements, at December 31, 2005, $73.8 million, or 21% of shareholders' equity, represented net assets of the Company's insurance subsidiaries which, at that time, could not be transferred in the form of dividends, loans or advances to the parent company because
Premiums ceded to reinsurers decreased $38.9 million (50%) during 2005 to $39.7 million as the consolidated percentage of premiums ceded to direct premiums written decreased to 19% for 2005 from 33% for 2004. This decrease is reflective of the Company's increased retention under reinsurance treaties effective in 2004 and 2005 covering large fleet trucking risks. The Company's maximum retained loss under these treaties has increased over the last two years and, as a result, a lower percentage of the direct premiums are ceded to reinsurers. There were no other significant changes to reinsurance treaties during 2005.
The Company has maintained its portfolio of fixed income securities at an increasingly short-term level during the past several years as long-term interest rates were not considered to be sufficiently attractive to commit funds for extended periods. Even as the Federal Reserve discount rate and short-term rates increased dramatically during the past eighteen months, medium and long-term rates continue to lag and the yield curve remains flat. In fact, during much of 2005 yields on 30 day securities were providing yields essentially equal to five and ten year obligations given the same quality considerations. Since most of the Company's investments fell into the short end of the range, the increase in rates was instantly accretive, with pre-tax net investment income increasing $2.6 million (21%) during 2005. The impact on the fourth quarter was even more
Net gains on investments, referred to in prior year financial statements as "realized net gains on investments", totaled $23.0 million in 2005 compared to only $9.8 million last year. The increase is attributable to equity in the earnings of limited partnership investments which have increased in significance during 2005. For several years, the Company had invested in various limited partnership ventures, consisting of real estate development, small venture capital and securities trading activities, with a cost basis of $7.8 million as of October 31, 2004. Between November 1, 2004 and December 31, 2005, the cost basis of limited partnership investments increased to $30.9 million, net of distributions received, with the majority of the increase allocated to securities trading activities, including $15 million committed to trading in the India stock market. Each of these new investments experienced very favorable earnings during 2005, with the aggregate of the Company's share of such earnings totaling approximately $14.8 million, compared to only $.6 million during 2004. The Company follows the equity method of accounting for its investments in limited partnerships. To the extent that the limited partnerships include both realized and unrealized gains or losses in their net income, the Company's proportionate share of net income will include unrealized as well as realized gains or losses. The current year limited partnership total is composed of estimated realized income of $5.1 million and estimated unrealized income of $9.7 million, as reported to the Company by the general partners. The other component of this total, gains from direct trading of securities, was $8.2 million in 2005 compared to $9.2 million in 2004, including adjustments attributable to "other-than-temporary impairment", as more fully explained in Note B.
The loss and loss expense ratio for fleet trucking products for 2005 reflects a decrease in severity of accidents, particularly in the large fleet excess product. While overall frequency in the trucking lines has not changed significantly, the frequency of severe losses was lower in 2005. The Company's higher retention under recent reinsurance treaty renewals allows for more net volatility in this line of business.
Reinsurance ceded credits were $12.7 million (62%) lower in 2005, resulting from the Company retaining a greater percentage of the gross premium for its own account under recent reinsurance treaties. The loss of ceding commission resulted in an $8.5 million increase in net operating expenses for the year.
As a result of the factors mentioned above, net income for 2005 was $34.2 million compared to $30.3 million for 2004. Diluted earnings per share increased to $2.30 in 2005 from $2.05 in 2004. Earnings per share from operations, before gains on investments, was $1.30 in 2005 compared to $1.62 in 2004 with the hurricane losses reducing operating income by $.68 per share in 2005 versus only $.22 in the prior year.
the addition of contractors by existing accounts. Increased competitive pressures are responsible for the decline in premium volume from the Sagamore personal automobile and small fleet trucking programs. The decline in small business workers' compensation premium resulted from management's decision to discontinue marketing this business during the fourth quarter of 2004.
Net investment income decreased $.6 million (5%) during 2004 reflecting lower overall pre-tax yields while average invested assets increased 11%. The average pre-tax yield on invested assets dropped to 2.9% this year from 3.3% during 2003 (13%). The decline in yields occurred entirely within the bond portfolio which averaged 3.2% during 2004 compared to 3.9% last year. A portion of this decline in pre-tax yield is attributable to the increased use of tax-exempt bonds during 2004. Yields on equity securities and short-term investments increased to 3.3% and 1.2%, respectively, from 3.1% and 1.0%, respectively, during 2003, partially offsetting the decline in bond yields. After-tax yields were 2.2% and 2.4% for 2004 and 2003, respectively.
The Company produced an overall savings on the handling of prior year claims during 2004 of $15.0 million, including $5.4 million attributable to retrospectively-rated policies. Approximately $6.7 million of the remainder is attributable to the Company's direct business, principally large fleet trucking products. See comments regarding prior year savings in the comparison of 2005 to 2004.
The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 24.0% during 2004 compared to 26.5% for 2003. Including the agency operations, and after elimination of inter-company commissions, the ratio of other operating expenses to operating revenue (defined as total revenue less gains on investments) was 16.2% for 2004 compared with 18.4% for 2003, and reflects the fixed nature of certain of the Company's expenses, as discussed above.
The effective federal tax rate for consolidated operations for 2004 was 31.1%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.
$14.3 million of fixed maturity investments (2% of total invested assets) consists of bonds rated as less than investment grade at year end. The majority of this total is composed of shares in a widely diversified high yield municipal bond fund where exposure to default by any single issuer is extremely limited. Further, the average bond quality of assets held in this fund at year end was BBB, which would be considered investment grade. We have included the investment in this fund in the total of non-investment grade bonds since, under the terms of the fund, the average bond quality could fall below BBB.
It is important to note that all investments included in the Company's financial statements are valued at current fair market values. The evaluation process for determination of other than temporary decline in value of investments does not change these valuations but, rather, determines when the decline in value will be recognized in the income statement (other than temporary decline) as opposed to a charge to shareholders' equity (temporary decline). Subsequent recoveries in value of investments which have incurred an other than temporary impairment adjustment are accounted for as unrealized gains until the security is actually disposed of or sold. At December 31, 2005, unrealized gains include $6.0 million of appreciation on investments previously adjusted for other than temporary impairment, compared to a $5.1 million of impairment write-downs at that date. See Note B to the consolidated financial statements for additional detail with respect to this process. This evaluation process is subject to risks and uncertainties since it is not always clear what has caused a decline in value of an individual security or since some declines may be associated with general market conditions or economic factors which relate to an industry, in general, but not necessarily to an individual issue. The Company has attempted to minimize many of these uncertainties by adopting a largely objective evaluation process which results in automatic income statement recognition of any investment which, over a six month period, is unable to recover from a 20% decline in value from our cost basis. However, to the extent that certain declines in value are reported as unrealized at December 31, 2005, it is possible that future earnings charges will result should the declines in value increase or persist or should the security actually be disposed of while market values are less than cost. At December 31, 2005, the total gross unrealized loss included in the Company's investment portfolio was less than $4.5 million. No individual issue constituted a material amount of this total. Had this entire amount been considered other than temporary at December 31, 2005, investment gains would have decreased by $.19 per share for the year. There would, however, have been no impact on total shareholders equity or book value per share since the decline in value of these securities was already recognized as a reduction to shareholders equity at December 31, 2005.
Amounts recoverable under the terms of reinsurance contracts comprise approximately 22% of total Company assets as of December 31, 2005. In order to be able to provide the high limits required by the Company's trucking company insureds, we share a significant amount of the insurance risk of the underlying contracts with various insurance entities through the use of reinsurance contracts. Some reinsurance contracts provide that a loss be shared among the Company and its reinsurers on a predetermined pro-rata basis ("quota-share") while other contracts provide that the Company keep a fixed amount of the loss, similar to a deductible, with reinsurers taking all losses above this fixed amount ("excess of loss"). Some risks are covered by a
As with any receivable, credit risk exists in the recoverability of reinsurance. This is even more pronounced than in normal receivable situations since recoverable amounts are not generally due until the loss is settled which, in some cases, may be many years after the contract was written. If a reinsurer is unable, in the future, to meet its financial commitments under the terms of the contracts, the Company would be responsible for the reinsurer's portion of the loss. The financial condition of each of the Company's reinsurers is initially determined upon the execution of a given treaty and only reinsurers with the highest credit ratings available are utilized. However, as noted above, reinsurers are often not called upon to satisfy their obligations for several years and changes in credit worthiness can occur in the interim period. Reviews of the current financial strength of each reinsurer are made continually and, should impairment in the ability of a reinsurer be determined to exist, current year operations would be charged in amounts sufficient to provide for the Company's additional liability. Such charges are included in other operating expenses, rather than losses and loss expenses incurred, since the inability of the Company to collect from reinsurers is a credit risk rather than a deficiency associated with the loss reserving process. See Notes F and M to the consolidated financial statements, on pages 46 and 52, for further discussion of reinsurance and concentrations of credit risk with respect to reinsurance recoverable.
The Company's reserves for losses and loss expenses ("reserves") are determined based on complex estimation processes using historical experience, current economic information and, when necessary, available industry statistics. Reserves are evaluated in three basic categories (1) "case basis", (2) "incurred but not reported" and (3) "loss adjustment expense" reserves. Case basis reserves are established for specific known loss occurrences at amounts dependent upon various criteria such as type of coverage, severity and the underlying policy limits, as examples. Case basis reserves are generally estimated by experienced claims adjusters using established Company guidelines and are subject to review by claims management. Incurred but not reported reserves, which are established for those losses which have occurred, but have not yet been reported to the Company, are not linked to specific claims but are computed on a "bulk" basis. Common actuarial methods are employed in the establishment of incurred but not reported loss reserves using company historical loss data, consideration of changes in the Company's business and study of current economic trends affecting ultimate claims costs. Loss adjustment expense reserves, or reserves for the costs associated with the investigation and settlement of a claim, are also bulk reserves representing the Company's estimate of the costs associated with the claims handling process. Loss adjustment expense reserves include amounts ultimately allocable to individual claims as well as amounts required for the general overhead of the claims handling operation that are not specifically allocable to individual claims. Historical analyses of the ratio of loss adjusting expenses to losses paid on prior closed claims and study of current economic trends affecting loss settlement costs are used to estimate the loss adjustment reserve needs related to the established loss reserves. Each of these reserve categories contain elements of uncertainty which assure variability when compared to the ultimate costs to settle the underlying claims for which the reserves are established.
The reserving process requires management to continuously monitor and evaluate the life cycle of claims based on the class of business and the nature of claims. Our claims range from the very routine private passenger automobile "fender bender" to the highly complex and costly third party bodily injury claim involving large
Any forward-looking statements in this report including, without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties including, without limitation, the following: (i) the Company's plans, strategies, objectives, expectations and intentions are subject to change at any time at the discretion of the Company; (ii) the Company's business is highly competitive and the entrance of new competitors into or the expansion of the operations by existing competitors in the Company's markets and other changes in the market for insurance products could adversely affect the Company's plans and results of operations; and (iii) other risks and uncertainties indicated from time to time in the Company's filings with the Securities and Exchange Commission.
The most significant of the three identified market risks relates to prices in the equities market. Though not the largest category of the Company's invested assets, equity securities have the greatest potential for short-term price fluctuation. The market value of the Company's equity positions at December 31, 2005 was $130.8 million or approximately 21% of invested assets. This market valuation includes $66.7 million of appreciation over the cost basis of the equity security investments. Funds invested in the equities market are not considered to be assets necessary for the Company to conduct its daily operations and, therefore, can be committed for extended periods of time. The long-term nature of the Company's equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuations, is the primary focus.
Reference is made to the discussion of limited partnership investments in the Critical Accounting Policies portion of this report. All of the market risks attendant to equity securities apply to the underlying assets in these partnerships, and to a greater degree because of the generally more aggressive investment philosophies utilized by the partnerships. In addition, these investments are illiquid. There is no primary or secondary market on which these limited partnerships trade and, in most cases, the Company is prohibited from disposing of its limited partnership interests for some period of time and must seek approval from the general partner for any such disposal. Distributions of earnings from these partnerships are largely at the sole discretion of the
general partners and distributions are generally not received by the Company for many years after the earnings have been reported. Finally, through the application of the equity method of accounting, the Company's share of net income reported by the limited partnerships may include significant amounts of unrealized appreciation on the underlying investments. As such, the likelihood that reported income from limited partnership investments will be ultimately returned to the Company in the form of cash is markedly lower than the Company's other investments, where income is reported only when a security is actually sold.
The table below sets forth the amounts of the Company's contractual obligations at December 31, 2005.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Baldwin & Lyons, Inc.'s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2006 expressed an unqualified opinion thereon.
RESERVES FOR LOSSES AND LOSS EXPENSES: The reserves for losses and loss expenses, minor portions of which are discounted, are determined using case basis evaluations and statistical analyses and represent estimates of the ultimate cost of all reported and unreported losses which are unpaid at year end. These reserves include estimates of future trends in claim severity and frequency and other factors which could vary as the losses are ultimately settled. Although it is not possible to measure the degree of variability inherent in such estimates, management believes that the reserves for losses and loss expenses are adequate. The estimates are continually reviewed and as adjustments to these reserves become necessary, such adjustments are reflected in current operations.
Should impairment in the ability of a reinsurer to satisfy its obligations to the Company be determined to exist, current year operations would be charged in amounts sufficient to provide for the Company's additional liability. Such charges, when incurred, are included in other operating expenses, rather than losses and loss expenses incurred, since the inability of the Company to collect from reinsurers is a credit risk rather than a deficiency associated with the loss reserving process.
STOCK-BASED COMPENSATION: The Company uses the "fair value method" to account for options granted to employees and non-employee directors in accordance with Statement of Financial Accounting Standards No. 123, Stock-Based Compensation, as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure.
The enclosed STATEMENT OF CHANGES IN EQUITY OTHER THAN CAPITAL refers to comprehensive income as TOTAL REALIZED AND UNREALIZED INCOME. Items of other comprehensive income included in this statement are referred to as CHANGE IN UNREALIZED GAINS (LOSSES) ON INVESTMENTS AND FOREIGN EXCHANGE ADJUSTMENT. A reclassification adjustment to other comprehensive income is made for GAINS DURING PERIOD INCLUDED IN NET INCOME.
There is no primary or secondary market for the Company's investments in limited partnerships and, in most cases, the Company is prohibited from disposing of its limited partnership interests for some period of time and must seek approval from the general partner for any such disposal. Distributions of earnings from these partnerships are largely at the sole discretion of the general partners and distributions are generally not received by the Company for many years after the earnings have been reported. The Company has commitments to contribute an additional $3.6 million to various limited partnerships as of December 31, 2005.
The 2005 net gains from limited partnerships, as shown in the above table, include approximately $9.7 million of unrealized gains as reported in the net income of the various partnerships. Shareholders' equity includes approximately $8.9 million, net of deferred federal income taxes, of earnings yet undistributed by limited partnerships as of December 31, 2005.
During the three years ended December 31, 2005, substantially all of the Company's fixed income portfolio was managed by ABN AMRO Asset Management (ABN). A director of the Company is an executive officer of ABN. Management fees paid to ABN were $232, $379 and $366 during 2005, 2004 and 2003, respectively. The agreement with ABN was terminated effective October 1, 2005 and management of this portion of the Company's investment portfolio was transferred to a new, non-affiliated, manager.
The Company utilized the services of a broker-dealer firm of which a director of the Company is an executive officer and owner. This broker-dealer serves as agent for purchases and sales of securities and manages an equity securities portfolio and fixed income portfolio with market values of approximately $4,092 and $16,455, respectively, at December 31, 2005. The Company has been informed that commission and management rates charged by this broker-dealer to the Company are commensurate with rates charged to non-affiliated customers for similar investments. Total commissions and fees earned by the broker-dealer and affiliates on these transactions and for advice and consulting were approximately $279, $151 and $151 during 2005, 2004 and 2003, respectively. The Company had previously entered into an agreement with an associate of this broker-dealer for management of a portion of its equity securities portfolio. That agreement was terminated during the third quarter of 2005. That associate earned performance-based compensation and management services fees and expense reimbursements totaling approximately $90, $307 and $2,333 during 2005, 2004 and 2003, respectively. The Company has been informed that the broker-dealer retained none of this compensation for its own account.
The fair value of regulatory deposits with various insurance departments in the United States and Canada totaled $22,317 at December 31, 2005.
Loss reserves on certain permanent total disability workers' compensation reserves have been discounted to present value at pre-tax rates not exceeding 3.5%. At December 31, 2005 and 2004, loss reserves have been reduced by approximately $4,476 and $3,932, respectively. Discounting is applied to these claims since the amount of periodic payments to be made during the lifetime of claimants is fixed and determinable.
Loss reserves have been reduced by estimated salvage and subrogation recoverable of approximately $3,374 and $3,462 at December 31, 2005 and 2004, respectively.
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 2005, 2004 and 2003 were $1,093, $1,053 and $978, respectively.
The Company is required to establish a valuation allowance for any portion of the gross deferred tax asset that management believes will not be realized. Management has determined that no such valuation allowance is necessary at December 31, 2005.
The Company also serves as an assuming reinsurer under retrocessions from certain other reinsurers. These retrocessions include individual risks but are comprised primarily of high layer catastrophe treaties. Accordingly, the occurrence of a major catastrophic event can have a significant impact on the Company's operations. In addition, the insurance subsidiaries participate in certain involuntary reinsurance pools which require insurance companies to provide coverages on assigned risks. The assigned risk pools allocate participation to all insurers based upon each insurer's portion of premium writings on a state or national level. Historically, the operation of these assigned risk pools have resulted in net losses allocated to the Company although such losses have generally not been material in relation to the Company's direct and voluntary assumed operations.
Net losses and loss expenses incurred for 2005, 2004 and 2003 include approximately $20,152, $6,349 and $5,732 relating to reinsurance assumed from non-affiliated insurance or reinsurance companies, including involuntary residual market pools. The assumed reinsurance losses in 2005 included $17,595 related to hurricanes Katrina and Wilma and 2004 assumed losses included $5,000 related to hurricanes, all before reinstatement premium.
Net income of the insurance subsidiaries, as determined in accordance with statutory accounting practices, was $18,221, $19,941 and $22,851 for 2005, 2004 and 2003, respectively. Consolidated statutory shareholder's equity for these subsidiaries was $331,738 and $319,436 at December 31, 2005 and 2004, respectively. Minimum statutory surplus necessary for the insurance subsidiaries to satisfy statutory risk based capital requirements was $65,691 at December 31, 2005.
The Company maintains stock option plans and has reserved an aggregate of 1,312,500 shares of Class B common stock for the granting of stock options to employees and directors. No options were granted to employees during the three year period ended December 31, 2005. All employee options outstanding at December 31, 2005 are exercisable. Options granted to directors are generally not exercisable for one year from the date of grant. All discounted options expire ten years after the date of grant. Market value options granted to directors as part of their regular annual directors' fees expire seven years after the date of grant. All of the Company's option plans have received shareholder approval. Approximately 283,000 of such options are available for future grants.
Prior to May, 2005, discounted options were granted to non-employee directors in lieu of cash directors' fees. In addition, during 2005, non-employee directors were each granted 1,500 options at market value on the date of grant as part of their regular annual directors' fees. The fair value of the market value options granted during 2005 and 2004 was determined using a Black-Scholes-Merton option pricing model with the following assumptions: risk-free interest rate of 3.0% and 1.0%, respectively; dividend yield of 1.6%; volatility factor of the expected market price of the Company's common stock of .30; and an expected life of the option of 7 years. During 2005 and 2004, the Company recorded expense, net of federal income tax, of $78 and $53, respectively, for these market value options using the straight-line method based upon a one-year vesting period for each grant. The compensation cost that has been charged against income for all stock-based compensation plans, consisting of directors' fees only, was $197, $256 and $143 for 2004, 2003 and 2002, respectively.
The Company evaluates performance and allocates resources based on gain or loss from insurance underwriting operations before income taxes. Underwriting gain or loss does not include net investment income or gains or losses on the Company's investment portfolio. All investment-related revenues are managed at the corporate level. Underwriting gain or loss for the fleet trucking segment includes revenue and expense from the Company's agency operations since the agency operations serve as an exclusive direct marketing facility for this segment. Underwriting gain or loss also includes fee income generated by each segment in the course of its underwriting operations. Management does not identify or allocate assets to reportable segments when evaluating segment performance and depreciation expense is not material for any of the reportable segments. The accounting policies of each reportable segment are the same as those described in the summary of significant accounting policies.
NOTE L - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Quarterly results of operations are as follows:
Acceptable collateral may be provided in the form of letters of credit on Company approved banks, Company approved marketable securities or cash. At December 31, 2005, the Company held collateral in the aggregate amount of $238,249. The amount of collateral required of an insured is determined by the financial condition of the insured, the type of obligations guaranteed by the Company, estimated reserves for incurred losses within the SIR or deductible that have been reported to the insured or the Company, estimated incurred but not reported losses, and estimates for losses that are expected to occur, within the SIR or deductible, prior to the next collateral adjustment date. In general, the Company attempts to hold collateral equal to 100% of the ultimate losses that would be paid by or due the Company in the event of the insured's default. Periodic audits are conducted by the Company to evaluate its exposure and the collateral required. If a deficiency in collateral is noted as the result of an audit, additional collateral is requested immediately. Because collateral amounts contain numerous estimates of the Company's exposure, are adjusted only periodically and are sometimes adjusted based on the financial condition of the insured, the amount of collateral held by the Company at a given point in time may not be sufficient to fully reimburse the Company for all of its guarantees or amounts due in the event of an insured's default. Further, the Company is not fully collateralized for the guarantees made for, or the deductible amounts that may be due from, the Company's largest customer, and in the event of that customer's default, such default may have a material adverse impact on the Company. The Company estimates its uncollateralized exposure related to this Fortune 500 company to be as much as 25% of shareholders' equity at December 31, 2005.
In addition, the Company has recorded paid and unpaid amounts recoverable from reinsurers under various agreements totaling $191,435 at December 31, 2005, as more fully discussed in Note F - Reinsurance. With minor exception, these recoverables are uncollateralized. Estimated amounts recoverable from three reinsurers in the group, each exceeding 10% of the total amount recoverable from all reinsurers, totaled $67,171 at December 31, 2005.
Included in the above recoverable amount are case basis and estimated IBNR losses of approximately $20.5 million due from Converium Insurance (North America) Inc., $5.5 million due from Quanta Re., $5.3 million due from PMA Re. and $.7 million due from Trenwick Re., each of which have reported substantial reserve strengthening and/or impairment of assets which have negatively affected their reported financial positions. All amounts due from these reinsurers on paid claims as of December 31, 2005 are current and the Company has no information at this time to indicate that all obligations of these reinsurers will not be met.
At its regular meeting in February, 2003, the Company's Board of Directors declared a 25% stock dividend in the form of a five-for-four stock split on the Company's Class A and Class B Common Stock. The additional shares were distributed on March 3, 2003 to shareholders of record on February 17, 2003. Fractional shares were settled in cash using the closing market value on February 17, 2003. All share and per share references within this report have been restated to reflect the stock split.
The company adopted the fair-value-based method of accounting for share-based payments effective with grants of market value options to non-employee directors during 2004 using the "modified prospective method" described in SFAS No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION--TRANSITION AND DISCLOSURE. Currently, the company uses a Black-Scholes-Merton model to estimate the value of stock options granted to non-employee directors and expects to continue to use this acceptable option valuation model upon the required adoption of SFAS No. 123R on January 1, 2006. The company does not anticipate that adoption of SFAS No. 123R will have a material impact on its results of operations or its financial position. However, SFAS No. 123R also requires that the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after the effective date. While the company cannot estimate what those amounts will be in the future (because they depend on, among other things, when option exercises occur), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $5, $226, and $147 in 2005, 2004 and 2003, respectively.