Baldwin & Lyons, California leases approximately 2,700 square feet of office space in a suburb of Los Angeles, California on a month-to-month basis. All West Coast operations are conducted from these facilities.
The primary sources of the Company's liquidity are (1) funds generated from insurance premiums, (2) net investment income and (3) maturing investments. The Company generally experiences positive cash flow resulting from the fact that premiums are collected on insurance policies in advance of the disbursement of funds in payment of claims. Operating costs of the insurance subsidiaries, other than loss and loss expense payments and commissions paid to the parent company, generally average between 25% and 35% of premiums earned on a consolidated basis and the remaining amount is available for investment for varying periods of time depending on the type of insurance coverage provided. During extended periods of declining net premium volume, however, operating cash flows may turn negative as loss settlements exceed net premium revenue and receipts of investment income.
For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds 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. The average life of the Company's bond and short-term investment portfolio was 4.0 years and 4.3 years for 2000 and 1999, respectively. 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 which are designed to provide protection for both policyholders and shareholders.
The Company's assets at December 31, 2000 included $59.1 million in short-term investments which are readily convertible to cash without market penalty and an additional $49.2 million of fixed maturity investments maturing in less than one year. The Company believes that these liquid investments, plus the expected cash flow from current operations, are more than sufficient to provide for projected claim payments and operating cost demands. In addition, the Company's reinsurance program is structured to avoid serious cash drains that might accompany catastrophic losses. In the event competitive conditions produce inadequate rates and the Company chooses to restrict volume, the Company believes that the liquidity of its investment portfolio would permit it to continue to pay claims as settlements are reached without requiring the disposal of investments at a loss, regardless of interest rates in effect at the time.
Net premiums written by the Company's U.S. insurance subsidiaries for 2000 equaled approximately 22% of the combined statutory surplus of these subsidiaries. Premium writings of 200% to 300% of surplus are generally considered acceptable by regulatory authorities. Further, the statutory capital of each of the insurance subsidiaries substantially exceeds minimum risk based capital requirements set by the National Association of Insurance Commissioners. Accordingly, the Company has the ability to significantly increase its business without seeking additional capital to meet statutory guidelines.
Shareholders' equity increased to $294.0 million at December 31, 2000, from $284.8 million at December 31, 1999, including an increase of $11.5 million in unrealized net gains on investments. The change in shareholders' equity also included $17.0 million in treasury share purchases and $5.0 million of cash dividends to shareholders. Book value per common share outstanding increased 12% to $24.01 at December 31, 2000 from $21.50 per share at December 31, 1999.
Net investment income increased by $.2 million (.8%) during 2000 reflecting higher overall pre-tax yields on slightly lower average invested assets. The average pre-tax yield on invested assets was 5.5% and 5.0% for 2000 and 1999, respectively. After-tax yields were 3.9% and 3.6% for 2000 and 1999, respectively.
Other operating expenses for 2000, before credits for allowances from reinsurers, increased $2.9 million (9.2%) to $34.7 million. Personnel related expenses, including amounts allocated to loss expenses and investment income, increased 6.9% and accounted for approximately 40% of the total operating expense increase, reflecting the fully-employed labor market from which the Company draws. Direct commission expense increased $.9 million (12.8%) as the result of higher direct premiums from all of the Company's products. Ceding commission allowances from reinsurers increased $1.9 million (27.7%), resulting from increased premium volume covered under the reinsurance agreements covering Protective's fleet trucking business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 28.0% during 2000 compared to 29.6% for 1999. Including the agency operations, the ratio of other operating expenses to total revenue, adjusted to remove net realized gains, was 26.0% for 2000 compared with 27.5% for 1999. Expenses for 1999 included expenditures in preparation for Year 2000 (Y2K) compliance that were not present in the year 2000.
Premiums ceded to reinsurers increased $5.7 million (44.9%) during 1999 to $18.3 million. The percentage of premiums ceded to direct premiums written increased to 21.3% for 1999 from 16.3% for 1998, as the
Company's new reinsurance agreements for its fleet trucking products, effective June 1, 1998, were inforce for the full year. The new treaties provide for the Company to cede larger portions of its premium as well as the underlying risk.
After giving effect to changes in unearned premiums, net premiums earned increased .4% to $69.1 million for 1999 from $68.9 million for 1998. Net premiums earned from all trucking-related insurance products increased by $2.5 million (8.5%), including $2.2 million (59.7%) for small fleet trucking. Premiums earned from private passenger automobile increased by $1.0 million. The above increases were offset by a $3.7 million decrease (43.8%) in voluntary reinsurance assumed premium during 1999.
Losses and loss expenses incurred during 1999 increased $2.4 million (5.6%) to $44.9 million. The 1999 consolidated loss and loss expense ratio was 65.0% compared to 61.8% for 1998. The increase in the loss and loss expense ratio is primarily attributable to incurred loss development on discontinued products and residual market participation along with growth in the Company's small trucking fleet program, all of which is measured against a relatively unchanged consolidated premium base. Changes in the Company's remaining products were individually insignificant.
Other operating expenses for 1999, before credits for allowances from reinsurers, increased $2.3 million (7.8%) to $31.8 million. Personnel related expenses, including amounts allocated to loss expenses and investment income, increased $2.4 million (16.1%) from 1998. Personnel expense for 1999 was higher primarily as the result of accruals for equity appreciation rights, which represent a broad-based employee incentive program which is tied to changes in the Company's book value, in addition to regular annual payroll increases. Direct commission expense decreased $.9 million (11.0%) as the result of the decline in premiums from voluntary reinsurance assumed, partially offset by increases in premiums from Sagamore's small fleet and small business workers' compensation products. Ceding commission allowances from reinsurers increased $3.7 million (115.7%) resulting from new reinsurance agreements covering Protective's fleet trucking business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 29.6% during 1999 compared to 32.0% for 1998. Including the agency operations, the ratio of other operating expenses to total revenue, adjusted to remove net realized gains, was 27.5% for 1999 compared with 29.4% for 1998. Expenses for 1999 and 1998 include expenditures for Year 2000 (Y2K) compliance. While it is not possible to precisely isolate Y2K expenditures from those for ongoing development of current product lines, management believes that amounts spent during 1999 for Y2K related issues were higher than expenditures during 1998.
As a result of the factors mentioned above, net income from consolidated operations for 1999 was $18.6 million compared to $16.9 million for 1998. Diluted earnings per share increased to $1.38 in 1999 from $1.22 in 1998 due primarily to the increase in realized gains on investments. Diluted earnings per share from operations before realized gains on investments was $1.11 in 1999 compared to $1.09 in 1998.
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 $12.5 million and $7.7 million were recorded at December 31, 2000 and 1999, respectively. The net deferred tax liability at December 31, 2000 included $4.2 million in special tax deposits covered under Section 847 of the Internal Revenue Code, as explained in the following paragraph, which compares to $5.0 million in special tax deposits at December 31, 1999. Adjusted for the special deposits, a net deferred tax liability of $16.7 million was recorded at December 31, 2000 compared to a net deferred tax liability of $12.7 million at December 31, 1999. The increase in deferred federal taxes payable is primarily attributable to changes in unrealized capital gains in the investment portfolio.
The Company operates solely within the property and casualty insurance industry and, accordingly, has significant invested assets which are exposed to various market risks. These market risks relate to interest rate fluctuations, foreign currency translation and equities market prices. All of the Company's invested assets are classified as available for sale and are listed as such in the enclosed consolidated financial statements in Note B.
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, 2000 was $158.0 million or approximately 36% of invested assets, including money market instruments classified as cash. 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, are the most important feature.
INVESTMENTS: Carrying amounts for fixed maturity securities (bonds, notes and redeemable preferred stocks) represent fair value and are based on quoted market prices, where available, or broker/dealer quotes for specific securities where quoted market prices are not available. Equity securities (nonredeemable preferred stocks and common stocks) are carried at quoted market prices (fair value). Other investments are carried at either market value, cost or cost adjusted for operations of limited partnerships, depending on the nature of the investment. All fixed maturity and equity securities are considered to be available for sale; the related unrealized net gains or losses (net of applicable tax effect) are reflected directly in shareholders' equity. Although the Company has classified fixed maturity investments as available for sale, it has the ability to hold its fixed maturity investments to maturity. Short-term investments are carried at cost which approximates their fair values. Realized gains and losses on disposals of investments are determined by specific identification of cost of investments sold and are included in income.
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.
EARNINGS PER SHARE: Diluted 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. Basic earnings per share are presented exclusive of the effect of options outstanding. See note I.
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 REALIZED DURING PERIOD INCLUDED IN NET INCOME.
The fair values and the cost or amortized cost of fixed maturity investments at December 31, 2000, 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 31% of purchases and 47% of sales of investments during the three years ended December 31, 2000 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 $1,499, $614 and $590 in 2000, 1999 and 1998, respectively.
The reserves for losses and loss expenses, net of related reinsurance recoverables, at December 31, 1999, 1998 and 1997 were decreased by $8,107, $10,609 and $10,741, 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 2000 and 1999, on reserves outstanding at December 31, 1999 and 1998 included increases of $15 and decreases of $1,082, respectively, for 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 $3,900 and $5,000 at December 31, 2000 and 1999, respectively. 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, 2000.
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 2000, 1999 and 1998 were $657, $620 and $615, respectively.
NOTE E - INCOME TAXES (CONTINUED) Cash flows related to federal income taxes paid, net of refunds received, for 2000, 1999 and 1998 were $8,807, $7,367 and $6,533, respectively, including Section 847 special tax deposits. Future tax benefits on approximately $4,154 of deferred tax assets at December 31, 2000 arising from loss reserve discounting is assured based on Section 847 of the Internal Revenue Code.
Net premiums earned for 2000, 1999 and 1998 have been reduced by reinsurance ceded premiums of approximately $23,943, $19,037 and $12,337, respectively. Net losses and loss expenses incurred for 2000 and 1998 have been reduced by reinsurance recoveries of approximately $40,586 and $10,255, respectively. Net losses and loss expenses incurred for 1999 have been increased by net savings on reinsured claims of $771. 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 2000, 1999 and 1998 include approximately $4,678, $4,981 and $8,338, respectively, relating to the assumption of reinsurance from other companies and from reinsurance pools.
The Company's Class A and Class B common stock has a stated value of approximately $.05.
NOTE H - OTHER OPERATING EXPENSES Details of other operating expenses are as follows:
NOTE J - REPORTABLE SEGMENTS The Company and its consolidated subsidiaries market and underwrite casualty insurance in three major specialty areas (reportable segments): (1) fleet trucking, (2) non-standard private passenger automobile and (3) the assumption of reinsurance. The fleet trucking segment provides multiple line insurance coverage to large trucking fleets which generally retain substantial amounts of self-insurance and to medium-sized trucking fleets on a first dollar or small deductible basis. The non-standard private passenger automobile segment provides motor vehicle liability and physical damage coverage to individuals. The reinsurance assumed segment accepts retrocessions from selected reinsurance companies, principally reinsuring against catastrophes.
NOTE K - 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 2000, 1999 or 1998. At December 31, 2000 there were 136,179 shares (Class A) and 375,766 shares (Class B) outstanding which are eligible for repurchase by the Company.
Exercise prices for options outstanding as of December 31, 2000 were $.33, $1.00 or $25.75. The weighted-average remaining contractual life of options exercisable at either $.33 or $1.00 is 5.3 years with a weighted-average exercise price of $.78. The remaining contractual life of options exercisable at $25.75 is 7 years. The compensation cost that has been charged against income for all stock-based compensation plans, consisting of directors' fees only, was $136, $140 and $135 for 2000, 1999 and 1998, respectively.
During 2000, the Company offered loans to certain key employees for the sole purpose of purchasing the Company's Class B common stock in the open market. $1,709 of such full-recourse loans were issued and outstanding at December 31, 2000 and carry an interest rate of 6%, payable annually on the loan anniversary date. The underlying securities serve as collateral for these loans, which must be repaid no later than 10 years from the date of issue.