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 net 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, become negative as loss settlements on claim reserves established in prior years exceed current revenues. During 2011, cash flow from operations totaled $54.3 million compared to $49.5 million in 2010. This comparative increase in operating cash flow resulted from increases in net premiums collected and lower federal tax payments largely offset by corresponding increases in losses paid in 2011.
For several years, the Company’s investment philosophy has emphasized the purchase of short-term bonds with maximum quality and liquidity. As flat yield curves have not provided a strong incentive to lengthen maturities in recent years, the Company has continued to maintain its fixed maturity portfolio at short-term levels. The average contractual life of the Company’s bond and short-term investment portfolio decreased from 4.5 to 3.1 years during 2011. The average duration of the Company’s fixed maturity portfolio is shorter than the contractual maturity average and much shorter than the duration of the Company’s liabilities. The Company also remains an active participant in the equity securities market using capital which is in excess of amounts considered necessary to fund current operations. The long-term horizon for the Company’s equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuation, is the primary focus. Investments made by the Company’s domestic insurance subsidiaries are regulated by guidelines promulgated by the National Association of Insurance Commissioners which are designed to provide protection for both policyholders and shareholders.
Pre-tax investment income of $10.7 million during 2011 was 5% lower than the 2010 total as pre-tax yields were down nearly 8% on average, reflecting continuing depressed worldwide available rates, principally on short-term investments. After tax investment income decreased by a similar 6% during 2011, compared to the prior year.
Losses and loss expenses incurred during 2011 increased $69.6 million (48%) to $215.6 million with virtually all of the increase attributable to catastrophe losses of $66.6 million with the remainder attributable to increased premium volume. The 2011 consolidated loss and loss expense ratio was 88.1% compared to 68.0% for 2010. The Company's loss and loss expense ratios for major product lines are summarized in the following table.
After giving effect to changes in unearned premiums, net premiums earned totaled $214.7 million for 2010 compared to $181.3 million for 2009. These changes are in line with expectations and result from product expansion and continuing
consideration of these expense offsets, operating expenses remained flat decreasing $.3 million, or less than 1% from the prior year.
financial condition of each of the Company’s reinsurers is initially determined upon the execution of a given treaty and only reinsurers with the superior 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 frequently 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 loss rather than a deficiency associated with the loss reserving process.
The Company’s loss and loss expense reserves for each segment are shown in the following table on both a gross (before consideration of reinsurance) and on a net of reinsurance basis at December 31, 2011 and 2010 (dollars in thousands).
The Company’s methods for determining loss and loss expense reserves are essentially identical for interim and annual reporting periods.
Under reasonably possible scenarios, it is conceivable that the Company’s selected loss reserve estimates could be 10%, or more, redundant or deficient. The majority of the Company’s reserves for losses and loss expenses, on either a gross or a net of reinsurance basis, relates to its fleet transportation products. Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company’s fleet transportation products for policies subject to certain major reinsurance treaties (approximately $103.8 million, or approximately 32% of carried direct reserves for directly produced property and casualty business).
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, 2011 and 2010 consisted of (dollars in thousands):
Deferred tax assets at December 31, 2011, include approximately $18.4 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 $2.9 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 $2.4 and $2.0 million of deferred tax assets, respectively. The balance of deferred tax assets, approximately $2.5 million, 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, 2011.
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).
changes that the Company believes are reasonably possible over a one-year period. The Company’s selection of the range of values chosen to represent changes in interest rates should not be construed as the Company’s prediction of future market events, but rather an illustration of the impact of such events. The equity portfolio was compared to the S&P 500 index due to its correlation with the vast majority of the Company’s current equity portfolio. The limited partnership portfolio was compared to the S&P 500 and Indian BSE 500 indices due to their significant correlation with the vast majority of our limited partnership portfolio. As previously indicated, several other factors can impact the fair values of fixed maturity investments and, therefore, significant variations in market interest rates could produce quite different results from the hypothetical estimates presented below.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc. and subsidiaries (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. 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, 2011 and 2010, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, 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.
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, 2011, 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 13, 2012 expressed an unqualified opinion thereon.
Investments: Carrying amounts for fixed maturity securities 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 are carried at quoted market prices (fair value). The Company accounts for investments in limited partnerships using the equity method of accounting, which requires an investor in a limited partnership to record its proportionate share of the limited partnership’s net income. To the extent that the limited partnership investees include both realized and unrealized investment gains or losses in the determination of net income or loss, then the Company would also recognize, through its statement of operations, its proportionate share of the investee’s unrealized as well as realized investment gains or losses.
Deferred income tax assets and liabilities are recognized for temporary differences between the financial statement and tax return bases of assets and liabilities based on enacted tax rates and laws. The deferred tax benefits of the deferred tax assets are recognized to the extent realization of such benefits is more likely than not. Deferred income tax expense or benefit generally represents the net change in deferred income tax assets and liabilities during the year. Current income tax expense represents the tax liability associated with revenues and expenses currently taxable or deductible on various income tax returns for the year reported.
Restricted Stock: Restricted shares vest ratably over the vesting period from the date of grant and are accelerated for retirement eligible recipients due to the non-substantive post-grant date vesting clause per Accounting Standard Codification (“ASC”) 715, Compensation-Retirement Benefits. Restricted stock is valued based on the closing price of the stock on the day the award is granted. Non-vested restricted shares will be forfeited should an executive’s employment terminate for any reason other than death, disability, or retirement as defined by the Compensation Committee.
Pending Accounting Standards: In October 2010, the FASB issued updated guidance to address the diversity in practice for the accounting for costs associated with acquiring or renewing insurance contracts. This guidance modifies the definition of acquisition costs to specify that a cost must be directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. If application of this guidance would result in the capitalization of acquisition costs that had not previously been capitalized by a reporting entity, the entity may elect not to capitalize those costs. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2011. The Company is currently evaluating the impact that the adoption of the guidance, effective January 1, 2012, will have on the consolidated financial statements. We expect no adjustments.
The fair value and the cost or amortized cost of fixed maturity investments, at December 31, 2011, 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.
There is no primary or secondary market for the Company’s investments in limited partnerships and, in most cases, the Company is prohibited from disposing of its limited partnership interests for some period of time and generally must seek approval from the general partner for any such disposal. Distributions of earnings from these partnerships are largely at the sole discretion of the general partners and distributions are generally not received by the Company for many years after the earnings have been reported. The Company has commitments to contribute an additional $10,024 to various limited partnerships as of December 31, 2011.
The Company has invested a total of $24,000 in three limited partnerships, with an aggregate estimated value of $37,260 at December 31, 2011, that are managed by organizations in which two directors of the Company are executive officers, directors and owners. The Company’s ownership interest in these limited partnerships ranges from 3% to 16%. These limited partnerships added ($18,673), $7,464 and $18,591, net of fees, to investment gains (losses) in 2011, 2010 and 2009, respectively. During 2011, 2010 and 2009, the Company has recorded management fees of $793, $820 and $632, respectively, and performance-based fees of $0, $687 and $1,247, respectively, to these organizations for management of these limited partnerships. The Company has been informed that the fee rates applied to its investments in these limited partnerships are the same as, or lower than, the fee rates charged to unaffiliated customers for similar investments.
The Company utilized the services of a broker-dealer firm of which two directors of the Company are executive officers and 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 $1,684 and $19,026, respectively, at December 31, 2011. 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 $174, $155 and $173 during 2011, 2010 and 2009, respectively.
The fair value of regulatory deposits with various insurance departments in the United States and Canada totaled $41,758 and $34,338 at December 31, 2011 and 2010, respectively.
Loss reserves have been reduced by estimated salvage and subrogation recoverable of approximately $7,158 and $6,370 at December 31, 2011 and 2010, respectively.
Net losses and loss expenses incurred for 2011, 2010 and 2009 have been reduced by ceded reinsurance recoveries of approximately $56,600, $17,581, and $22,025, respectively. Ceded reinsurance premiums and loss recoveries for the purchase of catastrophe reinsurance coverage on the Company’s net direct business were not material.
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, 2011 or 2010. As of December 31, 2011, the Internal Revenue Service had completed examinations and settled all audits through the Company’s 2004 tax year.
As of December 31, 2011, certain tax years remain open to examination by the IRS and various state and local authorities. While it is difficult to determine when other tax settlements will actually occur, it is reasonably possible that one could occur in the next year and the Company’s unrecognized tax benefits could change within a range of approximately $0 to $6,000.
The Company maintains a defined contribution 401(k) Employee Savings and Profit Sharing Plan (the “Plan”) which covers nearly all employees who have completed one year of service. The Company's contributions to the Plan for 2011, 2010 and 2009 were $1,452, $1,497 and $1,292, respectively.
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, 2011. 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 2011, 2010 and 2009.
Under the Employee Option Plan (the “Employee Plan”), which is shareholder approved, the Company has reserved 1,125,000 shares of Class B common stock for the granting of discounted and market value options to employees. Approximately 259,000 shares of Class B common stock are available for future grants. No options were granted to employees during the three year period ended December 31, 2011. Additionally, no options were outstanding or exercised at any time during this period. Accordingly, no compensation cost was charged against income for the Employee Plan for 2011, 2010 and 2009.
Director compensation cost associated with restricted stock grants of $440, $440 and $220 was charged against income for the restricted stock units for 2011, 2010 and 2009, respectively.
Effective February 9, 2011, the Company issued 14,473 shares of class B restricted stock to certain of the Company’s executives. The restricted shares will be paid solely in the Company’s class B stock. The restricted shares represent compensation to certain executives under the Company’s 2010 Executive Incentive Bonus Plan. The restricted shares will vest ratably over a three year period from the date of grant and are accelerated for retirement eligible recipients due to the non-substantive post-grant date vesting clause per ASC 715, Compensation-Retirement Benefits. Restricted stock was valued based on the closing price of the stock on the day the award was granted. Each share was valued at $23.39 per share representing a total value of $339. Non-vested restricted shares will be forfeited should an executive’s employment terminate for any reason other than death, disability, or retirement as defined by the Compensation Committee.
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 $1,302 and $1,414 relating to such loans was outstanding at December 31, 2011 and 2010, 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 has two reportable business segments in its operations: property and casualty insurance and reinsurance. The property and casualty insurance segment provides multiple line insurance coverage primarily to fleet transportation companies and to independent contractors who contract with fleet transportation companies. Additionally, the Company offers individual personal automobile coverage, professional liability coverages and business owners’ and commercial property policies. The reinsurance segment accepts cessions from other insurance companies as well as retrocessions from selected reinsurance companies, providing property catastrophe and casualty reinsurance coverages.
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 $23,347, $20,187 and $14,822 of the Company’s consolidated direct and assumed premium written in 2011, 2010 and 2009, respectively. An additional $129,508, $115,625 and $107,724 for 2011, 2010 and 2009, 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 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 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 32% of shareholders' equity at December 31, 2011.
The Level 3 assets consist of an investment portfolio of insurance-linked securities. The insurance-linked securities are valued using the average of estimated market quotes from multiple insurance-linked securities brokers. The broker quotes include Level 3 inputs which are significant to the valuation of the insurance-linked securities. There were no Level 3 sales, no transfers in to Level 3 and no transfers out of Level 3 during 2011 or 2010. A reconciliation of the beginning and ending balances of assets measured at fair value on a recurring basis using Level 3 inputs is as follows for the years ended December 31: