For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds with maximum quality and liquidity. As interest rates and 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 very conservative levels. The average contractual life of the Company's bond and short-term investment portfolio increased from 2.2 to 3.0 years during 2006 as it was determined that after-tax investment yields could be enhanced by moving portions of the short-term portfolio into high grade municipal bonds with short to moderate maturities. 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.
Premiums assumed from other insurers and reinsurers totaled $12.9 million during 2006, an increase of $1.2 million (10%) from 2005, which included $2.0 million of reinstatement premiums related to the 2005 hurricanes. The increase disregarding reinstatement premiums was 33%, reflective of higher premium rates following the hurricane activity of 2004 and 2005. Premium volume from reinsurance assumed will 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.
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.
The Fleet trucking loss ratio for 2006 was favorably impacted by an increase in savings on prior year loss developments and a lack of extremely severe accidents. The number of severe fleet trucking losses during 2005 was also below recent historical averages. Factors such as fluctuations in premium volume, the levels of self-insured retentions and the Company's higher net retention under reinsurance treaties in recent years tend to allow for more volatility in losses. The increase in the private passenger automobile loss ratio is associated with product modifications in response to competitive conditions and the higher small fleet trucking loss ratio resulted largely from geographic expansion with higher loss ratios during the first half of the year and more favorable results in the second half.
settle larger, more complex claims and the volatility of the trucking liability insurance business, the Company has long favored a conservative posture in its reserving process. As claims are settled in years subsequent to their occurrence, the Company's claim handling process has, historically, tended to produce savings from the reserves provided. Changes in both gross premium volumes and the Company's reinsurance structure for its large trucking fleets can have a significant impact on future loss developments and, as a result, loss and loss expense ratios and prior year reserve development may not be consistent year to year.
Reinsurance ceded credits were $6.6 million (85%) lower in 2006, resulting from the Company retaining a greater percentage of the gross premium for its own account under recent reinsurance treaties. This loss of ceding commission was the primary cause for the $7.8 million increase in net operating expenses for the year.
The effective federal tax rate for consolidated operations for 2006 was 28.0%. This rate is lower than the statutory rate primarily because of tax-exempt investment income and the reversal of accruals related to tax uncertainties rendered no longer necessary by the conclusion of IRS audits during 2006.
The Company has maintained its portfolio of fixed maturity securities at an increasingly short-term level during the past several years as long-term interest rates were not considered to be sufficiently attractive to commit funds for extended periods. Since most of the Company's investments fell into the short end of the range, the increase in rates was instantly accretive, with pre-tax net investment income increasing $2.6 million (21%) during 2005. The impact on the fourth quarter was even more pronounced, with a 35% increase in pre-tax investment income compared to 2004. The average pre-tax yield on invested assets increased to 3.3% from 2.9% during 2004 (13%) and the after-tax yield of 2.4% compares to 2.2% in 2004. In addition to higher yields, average invested assets increased over 5% during the year.
Net gains on investments totaled $23.0 million in 2005 compared to only $9.8 million in 2004. The increase is attributable to equity in the earnings of limited partnership investments which have increased in significance during 2005. For several years, the Company had invested in various limited partnership ventures, consisting of real estate development, small venture capital and securities trading activities, with a cost basis of $7.8 million as of October 31, 2004. Between November 1, 2004 and December 31, 2005, the cost basis of limited partnership investments increased to $30.9 million, net of distributions received, with the majority of the increase allocated to securities trading activities, including $15 million committed to trading in the India stock market. Each of these new investments experienced very favorable earnings during 2005, with the aggregate of the Company's share of such earnings totaling approximately $14.8 million, compared to only $.6 million during 2004. The current year limited partnership total is composed of estimated realized income of $5.1 million and estimated unrealized income of $9.7 million, as reported to the Company by the general partners. The other component of this total, gains from direct trading of securities, was $8.2 million in 2005 compared to $9.2 million in 2004, including adjustments attributable to "other-than-temporary impairment", as more fully explained in Note B.
Losses and loss expenses incurred during 2005 increased $14.3 million (11%) to $140.6 million. The increase in losses incurred is due primarily to losses from hurricanes (Katrina, Rita, and Wilma) during 2005 of $17.6 million compared to $5.0 million of losses attributable to the Florida hurricanes during September, 2004. The 2005 consolidated loss and loss expense ratio was 75.5% compared to 73.4% for 2004. The Company's loss and loss expense ratios for individual product lines are summarized in the following table.
Approximately 73% of the Company's assets are composed of investments at December 31, 2006. Approximately 91% of these investments are publicly-traded, owned directly and have readily-ascertainable market values. The remaining 9% 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, 2006 are publicly-traded securities, some have been valued by the respective partnerships using their experience and judgment. In addition, approximately $15.9 million of fixed maturity investments (2.5% of total invested assets) consists of bonds rated as less than investment grade at year end. These investments are composed of shares in two diversified high yield bond funds where exposure to default by any single issuer is limited. Both of these funds carry a Morningstar rating of 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. The market value of these bond funds exceeded cost by 7% at December 31, 2006.
For the three years ended December 31, 2006, reinsurance ceded transactions were as follows:
A discussion of the Company's reinsurance strategies is presented in Item 1, Business, on page 2.
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 51 and 59, 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
A detailed analysis and discussion for each of the above basic reserve categories follows.
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, will be established. For very routine "short-tail" claims such as private passenger physical damage, the Company initially records an average 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 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 continually monitored and the recorded reserve is increased or decreased relative to information gathered during the settlement life cycle.
For the Company's large fleet trucking risks, which are covered by annually-changing reinsurance agreements and which contain wide-ranging self-insured retentions ("SIR") as low as $25,000 per loss occurrence and as high as several million dollars per occurrence, traditional actuarial methods are supplemented by other methods in consideration of the Company's exposures to loss. In situations where the Company's reinsurance structure, the insured's SIR selections, policy volume, and other factors are changing, current accident period loss exposures may not be homogenous with historical loss data to allow for reliable projection of future developed losses. Therefore, the Company supplements the above-described actuarial methods with loss ratio reserving techniques developed from our databases to arrive at the reserve for losses incurred but not reported for the calendar/accident period under review. Management relies on its extensive historical pricing and loss history databases to produce reserve factors unique to this specialty business. As losses for a given calendar/accident period develop with the passage of time, management evaluates such development on a quarterly basis and will adjust reserve factors, as necessary, to reflect current judgment with regard to the anticipated ultimate incurred losses. This process continues until all losses are settled for each period subject to this method.
The Company's methods for determining loss and loss expense reserves are essentially identical for interim and annual reporting.
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 32, 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 $58.2 million, or approximately 18% of, carried 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, 2006 would increase or decrease gross and net loss reserves by approximately $5.8 million and $2.6 million, respectively. Similarly, a 20 percentage point increase or decrease would increase or decrease gross and net loss reserves by $11.6 million and $5.3 million, respectively. The Company has initiated a study to provide a more comprehensive sensitivity analysis in its future Form 10K filings.
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 comments under Market Risk, following.)
The table below sets forth the amounts of the Company's contractual obligations at December 31, 2006.
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 $157.4 million at December 31, 2006, would approximate that of the above projected direct reserve payout.
BASIS OF PRESENTATION: The consolidated financial statements include the accounts of Baldwin & Lyons, Inc. and its wholly owned subsidiaries (the "Company"). All significant inter-company transactions and accounts have been eliminated in consolidation.
INVESTMENTS: Carrying amounts for fixed maturity securities (bonds and notes) 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 (common stocks) are carried at quoted market prices (fair value). Limited partnerships are accounted for using the equity method with the corresponding change in value recorded as a component of net gains or losses on investments. Other investments are carried at either market value or cost, 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 unless a decline in value is determined to be other-than-temporary, in which case, the loss is charged to income. In determining if and when a decline in market value below cost is other-than-temporary, an objective analysis is made of each individual security where current market value is less than cost. For any 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 subjective evaluation as to possible future recovery. Although the Company has classified fixed maturity investments as available for sale, it has the ability to, and generally does, 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.
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 dilutive effect, if any, of options outstanding. Basic earnings per share are presented exclusive of the effect of options outstanding. See NOTE K - EARNINGS PER SHARE.
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.
Gain and loss activity for fixed maturity and equity security investments, as shown in the previous table, include adjustments for other-than-temporary impairment for the years ended December 31 and is summarized as follows:
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 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 $7.9 million to various limited partnerships as of December 31, 2006.
The reserves for losses and loss expenses, net of related reinsurance recoverables, at December 31, 2005, 2004 and 2003 were decreased by $16,947, $13,692 and $14,956, 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.
The Company has not changed its original estimate for the loss sustained as a result of the terrorist attacks of September 11, 2001. Therefore, there is no impact on the loss developments shown in the above table except for payments against the original established reserves. The Company has paid $11.5 million to date and carries a remaining reserve of $8.5 million at December 31, 2006.
The Company participates in mandatory residual market pools in various states. The Company records the results from participation in these pools as the information is reported to the Company and also records an additional provision in the financial statements for operating periods unreported by the pools.
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, 2006 and 2005, loss reserves have been reduced by approximately $4,883 and $4,476, 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.
The Company also serves as an assuming reinsurer under retrocessions from certain other reinsurers. These retrocessions include individual risks but are comprised primarily of high layer catastrophe treaties. Accordingly, the occurrence of catastrophic events can have a significant impact on the Company's operations. In addition, the insurance subsidiaries participate in certain involuntary reinsurance pools which require insurance companies to provide coverages on assigned risks. The assigned risk pools allocate participation to all insurers based upon each insurer's portion of premium writings on a state or national level. Historically, the
Net losses and loss expenses incurred for 2006, 2005 and 2004 include approximately $2,623, $20,152 and $6,349 relating to reinsurance assumed from non-affiliated insurance or reinsurance companies, including involuntary residual market pools. The assumed reinsurance losses in 2006 and 2005 included $1,457 and $17,595, respectively, related to hurricanes Katrina and Wilma and 2004 assumed losses included $5,000 related to hurricanes, all before reinstatement premium.
The components of the provision for deferred federal income taxes (credits) are as follows:
Cash flows related to federal income taxes paid, net of refunds received, for 2006, 2005 and 2004 were $16,097, $12,147 and $14,865, 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, 2006. As of December 31, 2006, the Internal Revenue Service had completed examinations through the Company's 2004 tax year.
Shareholders' equity at December 31, 2006 includes $347,434 representing GAAP shareholder's equity of insurance subsidiaries, of which $54,201 may be transferred by dividend or loan to the parent company during calendar year 2007 with proper notification to, but without approval from, regulatory authorities. An additional $219,284 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.
Net income of the insurance subsidiaries, as determined in accordance with statutory accounting practices, was $26,632, $18,221 and $19,941 for 2006, 2005 and 2004, respectively. Consolidated statutory surplus for these subsidiaries was $343,974 and $331,738 at December 31, 2006 and 2005, respectively.
Minimum statutory surplus necessary for the insurance subsidiaries to satisfy statutory risk based capital requirements was $70,043 at December 31, 2006.
NOTE G - OTHER OPERATING EXPENSES Details of other operating expenses for the years ended December 31:
The fair value of the market value options granted during 2005 and 2004 was determined using a Black-Scholes-Merton option pricing model with the following assumptions: risk-free interest rate of 3.0% and 1.0%, respectively; dividend yield of 1.6%; volatility factor of the expected market price of the Company's common stock of .30; and an expected life of the option of 7 years.
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, 2006. Discounted options granted to employees were exercisable immediately. Market value options granted to employees in the past vested over three years. All options expire ten years from the date of grant. All remaining options outstanding at December 31, 2006 are exercisable at $20.60 per share and expire December 18, 2007.
A summary of option activity under the Employee Plan as of December 31, 2006, and changes during the year then ended is presented below:
Cash received from option exercise under all share-based payment arrangements for the years ended December 31, 2006, 2005, and 2004 was $6,804, $1,618, and $1,413, respectively. The federal tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $759, $157, and $689, respectively, for the years ended December 31, 2006, 2005, and 2004. Under the terms of the Employee Plan, $589, $147 and $115, respectively, was paid or payable to employees in the form of cash for the years ended December 31, 2006, 2005 and 2004.
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 $2,343 and $2,339 relating to such loans was outstanding at December 31, 2006 and 2005, respectively. Loans carry interest rates ranging from 4.75% to 6%, payable annually on the loan anniversary date. The underlying securities, with value in excess of the related debt, serve as collateral
The above amounts for voluntary reinsurance assumed include certain intersegment reinsurance agreements. Intersegment premiums earned during 2006, 2005 and 2004 were $2,283, $1,570 and $1,609, respectively. Intersegment losses and loss expenses incurred during 2006, 2005 and 2004 were $3,005, $1,595 and $1,270, respectively.
The Company, through its subsidiaries, is licensed to do business in all 50 states of the United States, all Canadian provinces and Bermuda. Canadian and Bermuda operations are currently not significant.
One customer of the fleet trucking segment represents approximately $69,636, $62,570 and $57,767 of the Company's consolidated direct and assumed premium written in 2006, 2005 and 2004, 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 35% of shareholders' equity at December 31, 2006.