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 81,000 square feet and expires in August, 2013. In March, 2013, the Company purchased a building and the adjacent real estate in Carmel, Indiana, approximately 13 miles from its present leased premises, and will relocate all operations to this new building by the end of August, 2013. The new building contains a total of 184,000 usable square feet and the Company intends to occupy approximately 60% of this space with the remainder being leased to non-affiliated entities.
1 Earnings and book value per share are adjusted for the dilutive effect of stock options outstanding.
Includes money market instruments classified with cash in the Consolidated Balance Sheets.
Written premiums assumed from other insurers and reinsurers totaled $57.1 million during 2012, a decrease of $3.3 million (6%) from 2011. Premiums generated by property reinsurance products decreased $4.6 million (12%), reflective of management’s decision to terminate certain retrocessions effective January 1, 2012, with runoff through July 1, 2012. Partially offsetting the property decrease was an increase of $1.3 million (6%) in the Company’s growing book of professional liability reinsurance assumed.
After giving effect to changes in unearned premiums, consolidated net premiums earned totaled $237.5 million for 2012 compared to $244.6 million for 2011, a decrease of 2.9%. This decrease is in line with the commercial multi-peril, property assumed and personal automobile product reductions mentioned above which were largely offset by increased premium written in fleet transportation and professional liability.
A portion of the Company’s fleet transportation business is produced by the direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Rather, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. is included in operating expenses. In general, commissions paid by the Insurance Subsidiaries to the parent company exceed related acquisition costs incurred in the production of the property and casualty insurance business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 30.8% in 2012 and 30.2% in 2011. Including the agency operations and corporate expenses, and after elimination of inter-company commissions, the ratio of operating expenses to operating revenue (defined as total revenue less gains (losses) on investments) was 30.6% for 2012 compared with 28.1% for 2011 with the current year increase being attributable to higher salary expense as noted above.
Net income for 2012 of $31.9 million compares to a net loss of $28.2 million during catastrophe-plagued 2011. Diluted earnings per share of $2.15 were recorded in 2012 compared to per share loss of $1.90 in 2011.
Written premiums assumed from other insurers and reinsurers totaled $60.4 million during 2011, an increase of $14.3 million (31%) from 2010. The increase is related almost entirely to the expansion of the Company’s professional liability reinsurance business which was also launched in 2010. Premium ceded related to the reinsurance assumed business remained level with the 3% average rate from 2010.
Net losses on investments, before taxes, totaled $17.8 million in 2011 compared to net gains on investments of $16.5 million during 2010. The net losses in 2011 are attributable to $21.9 million in limited partnerships net losses partially offset by $4.1 million in fixed maturity and equity security net direct trading gains. The aggregate of the Company’s share of losses in these entities represented a 29% decline in value for 2011 compared to an appreciation in value of 12% for 2010. During 2011, approximately $20.6 million (94%) of the net loss was attributable to a reduction in unrealized gains and only 6% resulted from realized transactions. Recoveries of $1.3 million on previously impaired available-for-sale securities that were sold in 2011 are included in the fixed maturity and equity security net gains stated above. See additional comments related to limited partnerships included in the comparison of 2012 to 2011, above.
The effective federal tax rate on the consolidated pre-tax loss for 2011 was 37.8%. The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.
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 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 are publicly-traded securities, those which are not publically traded have been valued by the respective partnerships using their experience and judgment.
In determining if and when an equity security’s decline in market value below cost is other-than-temporary, we first make an objective analysis of each individual equity security where current market value is less than cost. For any equity security where the unrealized loss exceeds 20% of original or adjusted cost, and where that decline has existed for a period of at least six months, the decline is treated as an other-than-temporary impairment, without any subjective evaluation as to possible future recovery. For individual issues where the decline in value is less than 20% but the amount of the decline is considered significant, we will also evaluate the market conditions, trends of earnings, price multiples and other key measures for the securities to determine if it appears that the decline is other-than-temporary. In those instances, the Company also considers its intent and ability to hold equity investments until recovery can be reasonably expected. For any decline which is considered to be other-than-temporary, we recognize an impairment loss in the current period earnings as an investment loss. Declines which are considered to be temporary are recorded as a reduction in shareholders’ equity, net of related federal income tax credits.
It is important to note that all available for sale securities 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, as described above, does not change these valuations but, rather, determines when a decline in value will be recognized in the income statement (other-than-temporary decline) as opposed to a charge to shareholders’ equity (temporary decline). Another aspect of this accounting policy which is important to understand is that any subsequent recovery in value of investments which have incurred other-than-temporary impairment adjustments are accounted for as unrealized gains until the security is actually disposed of or sold. At December 31, 2012, unrealized gains include $8.3 million of appreciation on investments previously adjusted for other-than-temporary impairment, compared to $7.8 million of impairment write-downs at that date. 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 as described above. However, to the extent that certain declines in value are reported as unrealized at December 31, 2012, 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, 2012, the total gross unrealized loss included in the Company’s investment portfolio was approximately $2.9 million. No individual issue constituted a material amount of this total. Had this entire amount been considered other-than-temporary at December 31, 2012, there would have been no impact on total shareholders’ equity or book value since the decline in value of these securities was recognized as a reduction to shareholders’ equity.
A discussion of the Company’s reinsurance strategies is presented in Item 1, Business, on page 3.
The Company’s reserves for known claims are determined on an individual case basis and can range from the routine private passenger “fender bender” valued at a few hundred dollars to the very complex long-haul trucking claim involving multiple vehicles, severe injuries and extensive property damage costing several millions of dollars to settle. Each known claim, regardless of complexity, is handled by a claims adjuster experienced with claims of this nature and a “case” reserve, appropriate for the individual loss occurrence, is established. For very routine “short-tail” claims such as private passenger physical damage, the Company records an initial reserve that is based upon historical loss settlements adjusted for current trends. As information regarding the loss occurrence is gathered in the claim handling process, the initial reserve is adjusted to reflect the anticipated ultimate cost to settle the claim. For more complex claims which can tend toward being “long-tail” in nature, an experienced claims adjuster will review the facts and circumstances surrounding the loss occurrence to make a determination of the reserve to be established. Many of the more complex claims involve litigation and necessitate an evaluation of potential jury awards in addition to the factual information to determine the value of each claim. Each claim is frequently monitored and the recorded reserve is increased or decreased relative to information gathered during the settlement life cycle.
Deferred tax assets at December 31, 2012, include approximately $11.4 million related to the timing of deductibility of loss and loss expense reserves, the majority of which relates 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, in the aggregate, reverse to a material degree in the foreseeable future. An additional $2.7 million relates to impairment adjustments made to investments, as required by accounting regulations. The sizable unrealized gains in the Company’s investment portfolios would allow for the recovery of this deferred tax at any time. Unearned premiums discount and deferred ceding commissions represent $2.1 and $1.7 million of deferred tax assets, respectively. The balance of deferred tax assets consists of various normal operating expense accruals and is not considered to be material. As a result of its analysis, management has determined that no valuation allowance is necessary at December 31, 2012.
To the extent inflation influences yields on investments, the Company is also affected. The Company’s short-term and fixed investment portfolios are structured in direct response to available interest rates over the yield curve. As available market interest rates fluctuate in response to the presence or absence of inflation, the yields on the Company’s investments are impacted. Further, as inflation affects current market rates of return, previously committed investments might increase or decline in value depending on the type and maturity of investment (see additional comments under Market Risk, following).
Based on the structure of the Company’s investment portfolio, the most potentially significant of the three identified market risks relates to prices in the equity security market. Though not the largest category of the Company's invested assets, equity securities have a high potential for short-term price fluctuation. The market value of the Company's equity positions at December 31, 2012 was $107.6 million or approximately 16% of invested assets. This market valuation includes $49.5 million of appreciation over the adjusted 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.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc. and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income (loss), shareholders' equity and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Baldwin & Lyons, Inc. and subsidiaries at December 31, 2012 and 2011, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Fair Value Measurements: In January 2010, the FASB issued revised accounting guidance that clarifies and provides additional disclosure requirements related to recurring and non-recurring fair value measurements. The guidance requires separate disclosures for the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements, along with an explanation for the transfers. Additionally, a separate disclosure is required for purchases, sales, issuances and settlements on a gross basis for Level 3 fair value measurements. The guidance also provides additional clarification for both the level of disaggregation reported for each class of assets or liabilities and disclosures of inputs and valuation techniques used to measure fair value for both recurring and non-recurring fair value measurements for assets and liabilities categorized as Level 2 or Level 3.
In May 2011, the FASB issued updated accounting guidance that changes the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between GAAP and International Financial Reporting Standards. The guidance also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. The guidance, which was effective January 1, 2012, had no financial impact on the Company’s consolidated financial statements; however additional disclosures are noted.
In June 2011, the FASB issued revised accounting guidance that eliminates the option to present the components of other comprehensive income as part of the statement of shareholders' equity. Instead, comprehensive income must be reported in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. The guidance, which was effective January 1, 2012, had no financial impact on the Company’s consolidated financial statements; however additional disclosures are noted.
The fair value and the cost or amortized cost of fixed maturity investments at December 31, 2012, 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. Pre-refunded municipal bonds are classified based on their pre-refunded call dates.
Shareholders' equity includes approximately $20,000, net of deferred federal income taxes, of undistributed earnings from limited partnerships as of December 31, 2012.
The Company utilized the services of a broker-dealer firm of which two directors of the Company are employees or partial owners. 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 $1,869 and $19,300, respectively, at December 31, 2012. 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 net fees earned by the broker-dealer and affiliates on these transactions and for advice and consulting were approximately $186, $174 and $155 during 2012, 2011 and 2010, respectively.
The Company’s limited partnerships include one significant investment which invests in public and private equity markets in India. This limited partnership investment’s value as of December 31, 2012 and 2011 was $25,868 and $23,465, respectively. At December 31, 2012, the Company’s estimated ownership interest in this limited partnership investment was just over 4%. The Company's share of earnings from this limited partnership investment was $2,404, ($9,732) and $3,521 in 2012, 2011 and 2010, respectively. The summarized financial information of the significant limited partnership investment as of and for the years ended December 31 is as follows:
The fair value of regulatory deposits with various insurance departments in the United States and Canada totaled $47,791and $41,758 at December 31, 2012 and 2011, respectively.
Short-term investments at December 31, 2012 include $4,201 in time certificates of deposit by a Bermuda bank.
The major components of the developments shown above are as follows for the years ended December 31:
Favorable loss development is influenced by the Company’s long-standing policy of reserving for losses realistically and a willingness to settle claims based upon a seasoned evaluation of its exposures. Loss reserves pertaining to the Company’s property reinsurance business are established partially by the ceding reinsurers although the Company routinely adjusts such reserves if management determines that additional reserves could be necessary. Accordingly, there is potential for fluctuations in loss developments related to reinsurance assumed to be more pronounced than those experienced on directly produced business which is reserved entirely by Company personnel. In addition, changes in the Company’s net retention under reinsurance treaties will impact developments as more or less business is retained. These trends were considered in the establishment of the Company’s reserves at December 31, 2012 and 2011.
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, 2012 and 2011, loss reserves have been reduced by approximately $6,118 and $6,642, 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 $7,839 and $7,158 at December 31, 2012 and 2011, respectively.
Cash flows related to federal income taxes paid, net of refunds received, for 2012, 2011 and 2010 were $3,661, $2,859, and $9,000 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, 2012 or 2011. As of December 31, 2012, the Internal Revenue Service had completed examinations and settled all audits through the Company’s 2004 tax year.
The Company has no uncertain tax positions as of December 31, 2012. Previous tax positions were uncertain only as to the timing of deductibility and therefore, if recognized, would have had no impact on the Company’s effective tax rate. The Company recognizes accrued interest and penalties, if any, related to unrecognized tax benefits in income tax expense and changes in such accruals would impact the Company’s effective tax rate. Amounts accrued for the payment of interest at December 31, 2012, 2011 and 2010 were not material.
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, 2012, there were 124,099 shares (Class A) and 380,458 shares (Class B) outstanding which remain eligible for repurchase by the Company.
Under the Director Option Plan (the “Director Plan”), which is shareholder approved, the Company has reserved 300,000 shares of Class B common stock for the granting of discounted and market value options to non-employee directors. Approximately 167,000 shares of Class B common stock are available for future grants. No options were granted to directors during the three year period ended December 31, 2012. Additionally, no discounted options were outstanding or exercised at any time during this three year period. Accordingly, no compensation cost was charged against income for the Director Plan for 2012, 2011 and 2010.
Director compensation cost associated with restricted stock grants of $440 was charged against income for the restricted stock units for 2012, 2011 and 2010.
One customer of the property and casualty insurance segment, FedEx Ground Systems, Inc. (“FedEx Ground”) and certain of its subsidiaries and related entities represents approximately $19,052, $23,347 and $20,187 of the Company’s consolidated direct and assumed premium written in 2012, 2011 and 2010, respectively. An additional $146,447, $129,508 and $115,625 for 2012, 2011 and 2010, respectively, is placed with the Company by a non-affiliated broker on behalf of independent contractors of this same customer.
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 an 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 reduced based on the superior 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. In that regard, the Company is not fully collateralized for the guarantees made for, or the deductible amounts that may be due from FedEx Ground and certain of its subsidiaries and related entities, and in the event of their default, such default may have a material adverse impact on the Company. The Company estimates its uncollateralized exposure related to this customer to be as much as 31% of shareholders' equity at December 31, 2012.
Investments in limited partnerships include an aggregate of $39,745 invested in three limited partnerships, New Vernon India Fund, New Vernon Global Opportunity Fund and New Vernon Aegir Fund which are managed by organizations in which three directors of the Company are executive officers, directors and owners.
Transfers between levels, if any, are recorded as of the beginning of the reporting period. There were no significant transfers of assets between Level 1 and Level 2 during 2012, 2011 and 2010.
A summary of the carrying value and fair value by level of financial instruments not recorded at fair value on the Company’s consolidated balance sheet at December 31, 2011 is as follows:
Net income (loss) of the insurance subsidiaries, as determined in accordance with statutory accounting practices, was $29,262, ($19,120) and $12,542 for 2012, 2011 and 2010, respectively. Consolidated statutory surplus for these subsidiaries was $338,857 and $313,705 at December 31, 2012 and 2011, respectively, of which $55,192 may be transferred by dividend or loan to the parent company during calendar year 2013 with proper notification to, but without approval from, regulatory authorities. An additional $196,234 of shareholders’ equity of such insurance subsidiaries could, under existing regulations, be advanced or loaned to the parent company with prior notification to and approval from regulatory authorities, although it is unlikely that transfers of this size would be practical.