The Company leases office space at 1099 North Meridian Street, Indianapolis, Indiana. This building is located approximately one mile from downtown Indianapolis. The lease covers approximately 72,000 square feet and expires in August, 2008, with an option to renew for an additional five years.
2 Includes extra dividends of $.65, $1.70, $.55, $1.65 and $.25 per share for 2007, 2006, 2005, 2004 and 2003, respectively.
4 Data is for all coverages combined, does not include fee income and is presented based upon generally accepted accounting principles.
The primary sources of the Company’s liquidity are (1) funds generated from insurance operations including net investment income, (2) proceeds from the sale of investments and (3) proceeds from maturing investments. The Company generally experiences positive cash flow from operations 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, generally average less than 30% 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. Because losses are often settled in periods subsequent to when they are incurred, operating cash flows may, at times, turn negative as loss settlements on claim reserves established in prior years exceed net premium revenue and receipts of investment income. During 2007, positive cash flow from operations totaled $27.3 million compared to $16.6 million in 2006. This comparative increase in operating cash flow resulted from non-recurring refunds of premium related to retrospectively rated policies during 2006 of approximately $11 million.
The Company’s assets at December 31, 2007 included $131 million in short-term and cash equivalent investments which are readily convertible to cash without market penalty and an additional $60.2 million of fixed maturity investments (at par) 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 the event competitive conditions produce inadequate premium rates and the Company chooses to further restrict volume, the liquidity of its investment portfolio would permit management 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. In addition, the Company’s reinsurance program is structured to avoid serious cash drains that accompany large losses.
Net premiums written by the Company’s U.S. insurance subsidiaries for 2007 equaled approximately 36% of the combined statutory surplus of these subsidiaries. Premium writings of 100% to 200% 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 regulatory guidelines.
Premiums assumed from other insurers and reinsurers totaled $26.4 million during 2007, an increase of $13.5 million (105%) from 2006. The reinsurance assumed increase resulted primarily from new business generated by the Company’s affiliation with Paladin Catastrophe Management. Protective is the exclusive market for property catastrophe business produced by Paladin which focuses on soliciting coverage from insurance companies with risks throughout the U.S. Midwest and limited coastal regions excluding Florida and California. This business complements other reinsurance assumed by Protective in different geographic regions. Premium volume from reinsurance assumed will often fluctuate depending on the favorability of pricing for the coverages provided. Further, premium volume for this segment is limited by the Company’s self-imposed limitation to loss from a single catastrophic event.
Premiums ceded to reinsurers on direct business increased $8.1 million (32.8%) during 2007 to $33.0 million as the consolidated percentage of premiums ceded to direct premiums written increased to 19% for 2007 from 14% for 2006. This increase is reflective of the Company’s decreased retention under reinsurance treaties effective June 2007 covering large fleet trucking risks, resulting in a higher percentage of the direct premiums ceded to reinsurers.
Losses and loss expenses incurred during 2007 decreased $4.8 million (4%) to $107.8 million. The decrease in losses incurred is due to increased savings on prior accident year losses, primarily from fleet trucking and reinsurance assumed, continued low frequency of large trucking claims, and premium volume declines in the Company’s private passenger automobile and small fleet products. The aforementioned decreases in loss and loss expenses were largely offset by $12.2 million in losses from the Company’s expansion of its property catastrophe business during 2007. The 2007 consolidated loss and loss expense ratio was 60.2% compared to 66.3% for 2006. The Company’s loss and loss expense ratios for individual product lines are summarized in the following table.
production of fleet trucking business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 30.9% during 2007 compared to 26.6% for 2006. 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 27.7% for 2007 compared with 24.2% for 2006, reflective of the increase in commission expense, as discussed above.
As a result of the factors mentioned above, net income for 2007 was $55.1 million compared to $38.2 million for 2006. Diluted earnings per share increased to $3.63 in 2007 from $2.54 in 2006. Earnings per share from operations, before gains on investments, was $1.91 compared to $1.80 in 2006.
Premiums ceded to reinsurers decreased $14.8 million (37%) during 2006 to $24.8 million as the consolidated percentage of premiums ceded to direct premiums written decreased to 14% for 2006 from 19% for 2005. This decrease is reflective of the Company’s increased retention under reinsurance treaties effective in 2004 through 2006 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 2006.
Losses and loss expenses incurred during 2006 decreased $28.0 million (20%) to $112.6 million. The decrease in losses incurred is due primarily to the lack of hurricane losses in 2006 and lower premium volume during 2006. 2006 loss and loss expenses included $1.5 million in hurricane losses, resulting from late reporting by ceding reinsurers of Hurricane Rita and Wilma losses, compared to $17.6 million during 2005. The 2006 consolidated loss and loss expense ratio was 66.3% compared to 75.5% for 2005. The Company’s loss and loss expense ratios for individual product lines are summarized in the following table.
Other operating expenses for 2006, before credits for allowances from reinsurers, increased $1.2 million (2.6%) to $48.7 million. This increase is due primarily to a $1.4 million increase in commission expense related to reinsurance assumed. A large portion of commission on reinsurance assumed is dependent on experience. During 2005, hurricane losses resulted in significant reductions to contingent commissions on this business. The favorable experience during 2006 returned commissions to normal levels in relation to premium volume. Offsetting much of the reinsurance assumed commission change was the recovery during 2006 of nearly $1 million previously written off related to bankrupt reinsurers. After consideration for these two items, expenses before ceding allowances increased $.7 million, or 1.7% from 2005. Because much of the Company’s expense structure is fixed, expenses do not vary directly with revenue, which consists principally of net premiums earned from the insurance subsidiaries. In general, only commissions to independent agents, premium taxes and other acquisition costs vary directly with premium volume.
As a result of the factors mentioned above, net income for 2006 was $38.2 million compared to $34.2 million for 2005. Diluted earnings per share increased to $2.54 in 2006 from $2.30 in 2005. Earnings per share from operations, before gains on investments, was $1.80 in 2006 compared to $1.30, including hurricane losses that reduced operating income by $.68 per share in 2005.
Approximately 77% of the Company’s assets are composed of investments at December 31, 2007. Approximately 88% of these investments are publicly-traded, owned directly and have readily-ascertainable market values. The remaining 12% of investments are composed of minority interests in several limited partnerships. These limited partnerships are engaged in the trading of public and non-public equity securities and debt, hedging transactions, real estate development and venture capital investment. These partnerships, themselves, do not have readily-determinable market values. Rather, the fair values recorded are those provided to the Company by the respective partnerships based on the underlying assets of the partnerships. While the majority of the underlying assets at December 31, 2007 are publicly-traded securities, some have been valued by the respective partnerships using their experience and judgment. In addition, approximately $15.7 million of fixed maturity investments (2.4% of total invested assets) consists of bonds rated as less than investment grade at year end. These investments are primarily composed of shares in three widely diversified high yield bond funds where exposure to default by any single issuer is likely to be limited. These funds carry a Morningstar rating of four and five stars. We have included the investments in these funds in the total of non-investment grade bonds since, under the investment guidelines of the funds, the average bond quality rating could fall below BBB. At December 31, 2007, the market value of these bond funds was 1.7% less than cost.
Amounts recoverable under the terms of reinsurance contracts comprise approximately 16% of total Company assets as of December 31, 2007. 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 combination of quota-share and excess of loss contracts. The computation of amounts due from reinsurers is based upon the terms of the various contracts and follows the underlying estimation process for loss and loss expense reserves, as described below. Accordingly, the uncertainties inherent in the loss and loss expense reserving process also affect the amounts recorded as recoverable from reinsurers. Estimation uncertainties are greatest for claims which have occurred but which have not yet been reported to the Company. Further, the high limits provided by the Company’s insurance policies for trucking liability and workers’ compensation, provide more variability in the estimation process than lines of business with lower coverage limits.
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 D and L to the consolidated financial statements, on pages 48 and 56, 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 tractor-trailer rigs. Reserving for each class of claims requires a set of assumptions based upon historical experience, knowledge of current industry trends and seasoned judgment. The high limits provided in the Company’s trucking liability policies provide for greater volatility in the reserving process for more serious claims. Court rulings, legislative actions and trends in jury awards also play a significant role in the estimation process of larger
claims. The Company continuously reviews and evaluates loss developments subsequent to each measurement date and adjusts its reserve estimation assumptions, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time. Changes to previously established reserve amounts are charged or credited to losses and loss expenses incurred in the accounting periods in which they are determined. Note C to the consolidated financial statements includes additional information relating to loss and loss adjustment expense reserve development.
• Expected loss ratios for the current book of business, particularly the Company’s large fleet excess product, where the number of accounts insured, selected self-insured
Under reasonably possible scenarios, it is conceivable that the Company’s selected loss reserve estimates could be 10%, or more, redundant or deficient. As shown in the table on page 29, the majority of the Company’s reserves for losses and loss expenses, on either a gross or a net of reinsurance basis, relates to the Fleet trucking product. Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company’s large fleet excess product for policies subject to certain recent major reinsurance treaties (approximately $77.9 million, or approximately 27% of, carried direct reserves for Fleet trucking). A 10 percentage point increase or decrease in the loss factors actually utilized in the Company’s reserve determination at December 31, 2007 would increase or decrease gross and net loss reserves by approximately $12.1 million and $5.9 million, respectively. Similarly, a 20 percentage point increase or decrease would increase or decrease gross and net loss reserves by $24.3 million and $11.8 million, respectively.
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 reported at December 31, 2007 and 2006 consisted of (dollars in thousands):
Deferred tax assets at December 31, 2007, include approximately $10,412 related to policy liability discounts required by the Internal Revenue Code which are perpetual in nature and, in the absence of the termination of business, will not reverse to a material degree in the foreseeable future. An additional $1.0 million relates to impairment adjustments made to investments, as required by accounting regulations. Deferred tax assets also incluse $7.8 million related to FIN 48 reclassification. See FIN 48 discussion below. The sizable unrealized gains in the Company’s investment portfolios would allow for the recovery of this deferred tax at any time. The balance of deferred tax assets, approximately $2.9 million, consists of various normal operating expense accruals and is not considered to be material. As a result of its analysis, management does not consider any of these assets to be impaired at December 31, 2007.
Financial Accounting Standards Board Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109, provides guidance for recognizing and measuring uncertain tax positions, as defined in SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Based on this guidance, we regularly analyze tax positions taken or expected to be taken in a tax return based on the threshold condition prescribed under FIN 48. Tax positions that do not meet or exceed this threshold condition are considered uncertain tax positions. We accrue interest related to these uncertain tax positions which is recognized in income tax expense. Penalties, if any, related to uncertain tax positions would be recorded in income tax expenses.
We estimate that a 100 basis point increase in market interest rates would have resulted in a pre-tax loss in the fair value of fixed maturity investments of approximately $5.6 million at December 31, 2007. Similarly, a 100 basis point decrease in market interest rates would have resulted in an estimated pre-tax gain in the fair value of these instruments of approximately $6.1 million at December 31, 2007. Note, however, that the hypothetical loss mentioned above would only be realized if the Company was obligated to sell bonds prior to maturity, which is extremely unlikely. The aggregate value of money
The table below sets forth the amounts of the Company’s contractual obligations at December 31, 2007.
The Company’s loss and loss expense reserves do not have contractual maturity dates and the exact timing of the payment of claims cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of when we might expect our direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid in the preceding table. Timing of the collection of the related reinsurance recoverable, estimated to be $132.8 million at December 31, 2007, would approximate that of the above projected direct reserve payout.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Baldwin & Lyons, Inc.’s internal control over financial reporting as of December 31, 2007, 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 12, 2008 expressed an unqualified opinion thereon.
Notes to Consolidated Financial Statements Baldwin & Lyons, Inc. and Subsidiaries
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.
Cash and cash equivalents: The Company considers investments in money market funds to be cash equivalents. Carrying amounts for these instruments approximate their fair values.
Property and Equipment: Property and equipment is carried at cost. Depreciation is computed principally by the straight-line method.
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.
Reinsurance: Reinsurance premiums, commissions, expense reimbursements and reserves related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded to other insurers have been reported as a reduction of premium earned. Amounts applicable to reinsurance ceded for unearned premium and claim loss reserves have been reported as reinsurance recoverable assets. Certain reinsurance contracts provide for additional or return premiums and commissions based upon profits or losses to the reinsurer over prescribed periods. Estimates of additional or return premiums and commissions are adjusted quarterly to recognize actual loss experience to date as well as projected loss experience applicable to the various contract periods. Estimates of reinstatement premiums on reinsurance assumed contracts covering catastrophic events are recorded concurrently with the related loss.
Share-Based Payments: The Company uses a “Black-Scholes-Merton” option pricing model to value options granted to employees and non-employee directors in accordance with Statement of Financial Accounting Standards No. 123R, Share-Based Payment, adopted January 1, 2006 with no material effect. Compensation costs for all share-based awards to employees and non-employee directors are measured based on the grant date fair value of the award and are recognized over the period(s) during which the employee or non-employee director is required to perform service in exchange for the award (the vesting period).
Comprehensive Income: 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 generally not material and the Company has no defined benefit pension plan.
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.
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 maturity portfolio with market values of approximately $2,349 and $16,862, respectively, at December 31, 2007. 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 $170, $148 and $279 during 2007, 2006 and 2005, 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 2005. That associate earned performance-based compensation and management services fees and expense reimbursements totaling approximately $90 during 2005. The Company has been informed that the broker-dealer retained none of this compensation for its own account.
Short-term investments at December 31, 2007 include $2,900 in foreign time certificates of deposit.
The table above shows that a savings of $21,284 was developed during 2007 in the settlement of claims occurring on or before December 31, 2006, with similar savings being developed during the prior two calendar years on losses occurring on or before years ended December 31, 2005 and 2004. These savings 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.
Loss reserves have been reduced by estimated salvage and subrogation recoverable of approximately $4,069 and $3,845 at December 31, 2007 and 2006, respectively.
Reinsurance assumed premiums for 2007, as shown in the table above, are presented net of a retrocession purchased to limit the Company’s probable maximum loss to amounts considered prudent by management. The cost of this retrocession was $4,800.
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, 2007. As of December 31, 2007, the Internal Revenue Service had completed examinations and settled all audits through the Company’s 2004 tax year.
The Company adopted FIN 48 on January 1, 2007 with no adjustment necessary to beginning retained earnings. The total amount of unrecognized tax benefits from uncertain tax positions at January 1, 2007 was $10,301. The tax positions are uncertain as to the timing of deductibility and therefore, if recognized would have no impact on the Company’s effective tax rate.
The Company’s Class A and Class B common stock has a stated value of approximately $.04 per share.
Shareholders’ equity at December 31, 2007 includes $371,712 representing GAAP shareholder’s equity of insurance subsidiaries, of which $55,363 may be transferred by dividend or loan to the parent company during calendar year 2008 with proper notification to, but without approval from, regulatory authorities. An additional $233,951 of shareholder’s equity of such insurance subsidiaries may be advanced or loaned to the parent company with prior notification to and approval from regulatory authorities.
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 2007, 2006 and 2005 were $1,132, $1,137, and $1,093, respectively.
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 have ever been repurchased under the 1981 Plan. At December 31, 2007 there were 158,503 shares (Class A) and 438,583 shares (Class B) outstanding which are eligible for repurchase by the Company.
The weighted-average grant-date fair value of options granted during 2005 at prices below market value was $25.10. The weighted-average grant-date fair value of options granted during 2005 at market was $5.33. The total intrinsic value of options exercised during 2007, 2006 and 2005 was $0, $484, and $27, respectively.
The total intrinsic value of options exercised during 2007, 2006 and 2005 was $722, $1,684, and $420, respectively.
Cash received from option exercise under all share-based payment arrangements for the years ended December 31, 2007, 2006, and 2005 was $2,211 , $6,804, and $1,618, respectively. The federal tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $253, $759, and $157, respectively, for the years ended December 31, 2007, 2006, and 2005. Under the terms of the Employee Plan, $253, $589, and $147, respectively, of tax benefits realized were passed on to employees in the form of cash for the years ended December 31, 2007, 2006 and 2005.
During 2002 and 2001, the Company offered loans to certain employees for the sole purpose of purchasing the Company’s Class B common stock in the open market. Principal and interest totaling $2,228 and $2,343 relating to such loans was outstanding at December 31, 2007 and 2006, respectively. Loans carry interest rates ranging from 4.75% to 6%, payable annually. The underlying securities, with value in excess of the related debt, serve as collateral for these full-recourse loans, which must be repaid no later than 10 years from the date of issue. This loan program was terminated in 2002.
The Company and its consolidated subsidiaries market and underwrite casualty insurance in four major specialty areas (reportable segments): (1) fleet trucking, (2) private passenger automobile, (3) small fleet trucking and (4) 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 private passenger automobile segment provides motor vehicle liability and physical damage coverages to individuals. The small fleet trucking segment provides commercial automobile coverages to small trucking fleets and owner/operators. The reinsurance assumed segment accepts cessions from other insurance companies as well as retrocessions from selected reinsurance companies, principally reinsuring against catastrophes.
The Company’s reportable segments are business units that operate in the property/casualty insurance industry and each offers products to different classes of customers. The reportable segments are managed separately due to the differences in underwriting criteria used to market products to each class of customer and the methods of distribution of the products each reportable segment provides. Segment information shown in the table below as “all other” includes products provided by the Company to assigned risks and residual markets as well as the runoff of discontinued product lines, including small business workers’ compensation discontinued in the fourth quarter of 2004.
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.
The following tables are reconciliations of reportable segment revenues and profits to the Company’s consolidated revenue and income before federal income taxes, respectively.
One customer of the fleet trucking segment represents approximately $93,852, $69,636 and $62,570 of the Company’s consolidated direct and assumed premium written in 2007, 2006 and 2005, respectively.
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 27% of shareholders’ equity at December 31, 2007.
In September 2006, the Financial Accounting Standards Board issued Statement No. 157, “Fair Value Measurements” (“SFAS No. 157”), which provides a common definition of fair value and establishes a framework to make the measurement of fair value more consistent and comparable. SFAS No. 157 also requires expanded disclosures about (1) the extent to which companies measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value and (3) the effect of fair value measures on earnings. SFAS 157 is effective for financial assets and liabilities on January 1, 2008. The FASB has deferred the implementation of the provisions of SFAS 157 relating to certain nonfinancial assets and liabilities until January 1, 2009. SFAS 157 is not expected to have a significant impact on the Company’s consolidated financial condition or results of operations.
In February 2007, the Financial Accounting Standards Board issued Statement No. 159, “The Fair Value Option for Financial Assets and Liabilities - Including an Amendment of FASB Statement No. 115,” to permit an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions in SFAS 159 are elective; however the amendment to SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” applies to all entities with available-for-sale and trading securities. The fair value option permits all entities to choose to measure eligible items at fair value at specified election dates. The fair value option may be applied on an instrument-by-instrument basis, is irrevocable and is to be applied to entire instruments and not portions thereof. SFAS 159 is not expected to have a significant impact on the Company’s consolidated financial condition or results of operations.