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 46,000 square feet and expires in August, 1998, with an option to renew for an additional three years. The Company's entire operations, with the exception of Baldwin & Lyons, California, are conducted from these leased facilities.
Net premiums written by the Company's U.S. insurance subsidiaries for 1996 were approximately 24% of the combined statutory surplus of these subsidiaries. Premium writings of 200% to 300% of surplus are generally considered acceptable by regulatory authorities. Accordingly, the Company has the ability to significantly increase its business without seeking additional capital to meet statutory guidelines.
Consolidated shareholders' equity increased to $273.1 million at December 31, 1996, from $247.0 million at December 31, 1995. In addition to current year earnings, this increase includes a $19.2 million increase in unrealized net gains on the Company's investment portfolio from $19.3 million at December 31, 1995 to $38.5 million at December 31, 1996. The increase in shareholders' equity is net of $10.2 million in treasury share purchases and $5.1 million of dividends to shareholders. Book value per common share outstanding increased 16% to $19.46 at December 31, 1996 from $16.78 per share at December 31, 1995.
As more fully discussed in Note H to the consolidated financial statements, at December 31, 1996, $20.5 million, or 7.5% of consolidated 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 due to statutory restrictions on the allowable transfers. However, management believes that these restrictions pose no material liquidity concerns for the Company. The financial strength and stability of the subsidiaries permit ready access by the parent company to short-term and long- term sources of credit. The parent company had cash and marketable investments of approximately $49.7 million at December 31, 1996.
NOTE: ALL COMPARATIVE AMOUNTS IN THE FOLLOWING DISCUSSION, FOR THE YEAR 1994, HAVE BEEN ADJUSTED TO REFLECT THE SALE OF HOOSIER INSURANCE COMPANY DURING 1995. SEE NOTE A FOR MORE INFORMATION WITH RESPECT TO THIS SALE.
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 non-standard private passenger automobile program during 1996.
Net investment income decreased by $.6 million (2.9%) during 1996 due to $.9 million 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.
Losses and loss expenses during 1996 decreased $5.0 million (12.9%) to $33.8 million. The 1996 consolidated loss and loss expense ratio was 57.5% compared to 65.9% for 1995. Losses and loss expenses incurred for 1996 and 1995 included adverse development on environmental liability claims of $2.4 million and $7.6 million, respectively, relating to policies written in the 1970's. Adjusted for the development on environmental liability claims, the consolidated loss and loss expense ratios for 1996 and 1995 were 53.4% and 53.0%, respectively. The consolidated savings on all prior year losses was $12.2 million for 1996 compared to $5.5 million for 1995. Adjusted for the development on environmental liability claims, savings on prior accident year losses were $14.6 million and $13.1 million during 1996 and 1995, respectively. These savings related predominantly to the Company's trucking and trucking-related business. Because of the high limits provided by the Company to its insureds, the length of time required to settle larger, more complex claims and the volatility of the trucking liability insurance business, the Company believes it is important to have a high degree of comfort in its reserving process. As claims are settled in years subsequent to their occurrence, the Company's claim handling process has, in recent years, tended to produce savings from the reserves provided. The Company believes that the favorable loss development 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. The Company has established provisions for incurred but not reported environmental losses at December 31, 1996 which are believed to be sufficient to cover all anticipated exposure.
Other operating expenses for 1996, before credits for allowances from reinsurers, increased $3.3 million (17.2%) to $22.5 million. Salary related expenses increased $2.1 million (18.7%) due primarily to a 16% increase in the number of employees, as the Company's new products continue to expand, and equity appreciation rights accruals which are tied to the Company's book value. Direct commission expense increased $.9 million (34.5%) as the result of increases in premiums from Sagamore's personal automobile product. Allowances from reinsurers decreased $.7 million (42.7%) as the result of the termination of the quota share reinsurance treaty covering the Company's "work accident" program. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 29.2% during 1996 compared to 28.0% for 1995. Including the agency operations, which absorbed much of the development costs for the Company's new products, the ratio of other operating expenses to total revenue, adjusted for net realized gains, was 27.1% for 1996 compared with 21.9% for 1995.
As a result of the factors mentioned above, income from consolidated continuing operations for 1996 was $21.3 million compared to $20.6 million for 1995.
Net investment income increased by $5.4 million (36.8%) during 1995. Income for 1995 includes $.9 million representing income derived from a limited partnership investment which was liquidated effective December 31, 1995. The average pre- tax yield on invested assets for 1995 was 5.9% compared to 4.6% for 1994 while the after-tax yield for 1995 was 4.1% compared to 3.3% for 1994. Investment expenses, which are netted directly against income, increased approximately $.2 million and were 5.3% of gross investment income in 1995 compared to 6.1% for 1994.
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 $7.0 million have been paid in connection with this election.
To the extent inflation influences yields on investments, the Company is also affected. The Company maintains a sizable portion of its investment portfolio in short-term instruments and changes in current market interest rates correspondingly affect yields on these investments. Further, as inflation affects current market rates of return, previously committed investments may rise or decline in value depending on the type and maturity of investment.
Inflation must also be considered by the Company in the creation and review of loss and loss adjustment expense reserves since portions of these reserves are expected to be paid over extended periods of time. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and loss adjustment expenses. The importance of continually adjusting reserves is even more pronounced in a period of extreme inflationary pressure.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Baldwin & Lyons, Inc. and subsidiaries at December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: The consolidated financial statements include the accounts of Baldwin & Lyons, Inc. and its wholly owned subsidiaries (the Company). All significant intercompany transactions and accounts have been eliminated in consolidation.
USE OF ESTIMATES: Preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
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
Stock-based Compensation: Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations is used in accounting for stock options, stock purchases and equity appreciation rights which are, from time to time, granted to employees and outside directors. Application of Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, would yield results no different from those reported.
EARNINGS PER SHARE: Earnings per share of common stock are based on the average number of shares of Class A and Class B common stock outstanding during the year, adjusted for the effect, if any, of options outstanding.
RECLASSIFICATION: Certain prior year balances have been reclassified to conform to the current year presentation.
NOTE B - INVESTMENTS (CONTINUED) Realized and unrealized gains (losses) on investments for the years ended December 31 are summarized below:
Sales of fixed maturity investments during 1996, 1995 and 1994 produced gross gains of $622, $351 and $494, respectively, and gross losses of $230, $69 and $471, respectively. Sales of equity securities during 1996, 1995 and 1994 produced gross gains of $9,204, $11,170 and $5,346, respectively, and gross losses of $2,717, $4,438 and $4,103, respectively.
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. Management relies on the reserve data provided by the pools and performs no additional actuarial tests on such data.
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:
Cash flows related to federal income taxes paid, net of refunds received, for 1996, 1995 and 1994 were $11,805, $13,600 and $13,355, respectively, including Section 847 special tax deposits. Future tax benefits on approximately $7,031 of deferred tax assets at December 31, 1996 arising from loss reserve discounting is assured based on Section 847 of the Internal Revenue Code.
NOTE F - REINSURANCE The insurance subsidiaries cede portions of their gross premiums written to certain other insurers under excess and quota share treaties and by facultative placements. Risks are reinsured with other companies to permit the recovery of a portion of related direct losses. The insurance subsidiaries also assume voluntary reinsurance from various property catastrophe retrocession pools. The occurrence of a major catastrophic event could have a significant impact on the Company's financial statements. 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.
Net premiums earned for 1996, 1995 and 1994 have been reduced by reinsurance ceded premiums of approximately $11,698, $16,340 and $18,477, respectively. Net losses and loss expenses incurred for 1996, 1995 and 1994 have been reduced by reinsurance recoveries of approximately $991, $26,554 and $20,955, 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 1996, 1995 and 1994 include approximately $10,220, $12,322 and $13,679, respectively, relating to the assumption of reinsurance from other companies and from reinsurance pools.
NOTE G - 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 1996, 1995 and 1994 were $499, $465 and $472, respectively.
Consolidated shareholders' equity at December 31, 1996 includes $242,622 representing GAAP shareholder's equity of insurance subsidiaries, of which $35,203 may be transferred by dividend or loan to the parent company without approval by, or notification to, regulatory authorities. An additional $186,898 of shareholder's equity of such insurance subsidiaries may be advanced or loaned to the Company with prior notification to regulatory authorities.
NOTE J - STOCK PURCHASE AND OPTION PLANS In accordance with the terms of the 1981 Stock Purchase Plan (1981 Plan), the Company reserved 300,000 shares (Class A) and 1,200,000 shares (Class B) of its authorized but unissued common stock for issuance to certain of its employees and directors. There are no shares of either Class A or Class B common stock available for issuance at December 31, 1996. The 1981 Plan provides for the repurchase of shares issued by the Company, based on circumstances, 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 1996, 1995 or 1994. At December 31, 1996 there were 157,179 shares (Class A) and 398,641 shares (Class B) outstanding which are eligible for repurchase by the Company.
During 1985, in accordance with the terms of the 1984 Stock Option and Stock Appreciation Plan (1984 Plan, amended during 1991), the Company granted options to purchase 30,000 shares (Class A) and 120,000 shares (Class B) of common stock at the then book value $3.22 per share. These options were exercised during 1995 and no further shares are available for issuance. The exercise of these options is included in the option table below.
The Company maintains Discounted Stock Option Plans and has reserved an aggregate of 1,050,000 shares of Class B common stock for the granting of discounted stock options to employees and directors. Options granted to employees are generally exercisable immediately while options granted to directors are generally not exercisable for one year from the date of grant. All options expire ten years after the date of grant.
A summary of the Company's stock option activity, and related information for the years ended December 31 follows:
Exercise prices for options outstanding as of December 31, 1996 were either $.33 or $1.00. The weighted-average remaining contractual life of those options is 5.5 years. The compensation cost that has been charged against income for all stock-based compensation plans was $.5 million, $.5 million and $.1 million for 1996, 1995 and 1994, respectively.
NOTE L - 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 various 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. Both segments specialize primarily in insurance for the trucking industry.
NOTE L - INDUSTRY SEGMENTS (CONTINUED) Intersegment commissions, which are eliminated in the consolidated statements of income, are included in revenue and income for the insurance brokerage/agency segment.
NOTE M - DISCONTINUED OPERATIONS On November 9, 1996, Amli Realty Co. (Amli) closed an agreement with UICI, a publicly traded financial services and insurance company, which resulted in UICI acquiring 100% of Amli's outstanding stock. The Company received 617,278 shares of UICI common stock, with a market value at December 31, 1996 of approximately $20 million, in a non-monetary, tax-free exchange for its 38% stake in Amli. The Company accounted for its minority investment in Amli by the equity method. The book value of the Company's investment in Amli at the date of the exchange was $7.5 million.